Tax Red Flags To Consider Before Buying a Business
While there are many reasons why deals can fall through, tax exposure is one of the most common—and one of the most complicated—areas that buyers should evaluate in a target business.
While material tax exposure can be mitigated after a deal closes through indemnification language in the legal transaction document, it can be expensive and time consuming for buyers to enforce. To save time, conserve resources and protect your deal, we believe it’s best to identify tax exposure issues ahead of time.
If you’re considering purchasing a business, it’s important to know the most common problem areas recently seen when it comes to tax exposure. These are the four tax areas we see impact deals most often: state and local tax, the Employee Retention Tax Credit, employee classification and questionable S corp elections.
State and Local Tax (SALT)
If the target company hasn’t filed state income tax returns in all of its required jurisdictions, this can potentially lead to a material tax liability. Without filed returns, the statute of limitations does not begin—which means that states can assess taxes dating back to the entity’s inception.
Additionally, incomplete sales and use tax compliance across several jurisdictions can cause significant issues. If taxes haven’t been remitted where required, and if returns are missing, it can quickly derail a transaction—even in late-stage diligence.
It’s critical to conduct an analysis of the target’s tax exposure to effectively quantify risk and to help a business assess remediation options.
Employee Retention Tax Credits (ERTC)
The ERTC was initially introduced in 2020 as part of pandemic-related aid for businesses, but many organizations that have claimed the credit haven’t followed proper compliance measures.
There is an objective test for this tax credit (a drop in revenue) and a subjective one (a government order test) that is subject to IRS interpretation. If your target has claimed payroll tax credits without good documentation or without meeting key requirements, it can create significant tax exposure.
The IRS has indicated it plans to scrutinize these credits extensively over the next several years, so it’s important to consider a target’s compliance as part of your evaluations ahead of a deal.
Employee Classification
Does the target business use independent contractors? If so, consider if those individuals are properly classified according to the Department of Labor’s guidelines. If the IRS determines that independent contractors should actually be classified as employees of the business, the buyer could be on the hook for unpaid payroll taxes, which can be a costly surprise.
Faulty/Risky S Corp Elections
Improper or risky S corporation (S corp) elections can create significant tax exposure that may impact deal value. If the target company has ineligible owners or has made disproportionate distributions/allocations of taxable income and losses, its S corp status could be invalidated.
This could result in double taxation or unexpected entity-level taxes. These issues can lead to material tax liabilities, penalties and interest—posing a real threat to the purchaser post-close structures and the willingness of a seller to move forward.
Learn More About Evaluating Tax Exposure Before Buying a Business
At a minimum, these tax exposure issues can slow down the transaction process and force additional negotiations between the principles on the seller and purchaser teams.
At worst, tax issues like these can kill your deal completely.
Identifying tax liabilities in a target early can help to identify risk, mitigate problems and protect your strategy for your portfolio.
To learn more about tax areas to consider before, during and after buying a business, connect with your Warren Averett advisor directly, or ask a member of our team to reach out to you to start the conversation.
