M&A transactions: The value of sell-side tax diligence

Editor: Anthony Bakale, CPA

In the world of tax due diligence for mergers and acquisitions (M&As), most experienced and well-advised buyers of businesses will conduct rigorous due diligence prior to closing on a transaction; however, the same cannot be said of the sell-side group. The value of sell-side tax diligence is the focus of this item.

At the time this is being written, middle-market companies planning on going to market are facing increasing headwinds in the marketplace. Giving buyers pause before closing on a transaction are macroeconomic worries of rising inflation; bank crashes in 2023 of Silicon Valley, Signature, and First Republic banks; and the Federal Reserve’s raising interest rates. Due to these additional risks, buyers are more willing to walk away from a messy transaction where their diligence turns up risks not contemplated in their initial investigation of the target company. Even in situations where walking away is unlikely, buyers will seek significant discounts and hold-backs when surprises arise during their diligence period.

The list of tax-risk items in the M&A context is lengthy and depends on the type of business being evaluated. For state and local taxes, risks are often identified surrounding:

• Sales tax collection and remittance;
• State income tax nexus; and
• Withholding for employees who perform services across state borders, including sales staff.

On the federal side, common risks identified include:

• Invalid S corporation elections;
• Improper employee retention credits (ERCs);
• Excess Paycheck Protection Program loans;
• Related-party transactions not performed at arm’s length; and
• Misclassification of employees as independent contractors.

This item highlights how sell-side tax diligence can mitigate some of these issues and minimize exposure. First, however, a quick discussion regarding the timing of sell-side tax diligence is appropriate.

Proper time to perform sell-side tax diligence

An owner’s and management’s decision to sell a company is not for the faint of heart. Navigating the deal process and working through multiple streams of diligence (including tax diligence) while also managing the business’s day-to-day operations can sometimes cause enough fatigue for the seller’s management to be willing to walk away from a transaction. To ease the burden and create more efficiencies in the diligence timeline, sellers can engage a sell-side tax adviser. As discussed below, this generally should be done months or longer before going to market. The sell-side tax adviser assists the seller’s management to “get the company’s house in order” to prepare for the sale of the business.

Generally, experienced buyers, usually companies with either a robust acquisition strategy or private-equity–backed investors, handle the diligence process similarly, with tax diligence being performed after entering into a letter of intent (LOI) with the seller. The hope is, assuming all goes as planned, that the transaction can march toward closing within an exclusivity window defined in the LOI. But, between LOI and closing, diligence findings communicated to buyers shape negotiations with sellers and can result in significant adjustments to the purchase price, holdbacks of the purchase price, or delays to closing. Here, the focus of the buy-side tax diligence is retrospective — what happened in the past that creates potential risk for a buyer? If tax risks are identified, tax diligence experts can recommend the best path forward to deal with the impact to valuations of target companies, whether through special indemnifications, escrow holdbacks, or a reduction in the purchase price.

Sellers should take control of the tax diligence narrative by engaging sell-side tax advisers months before going to market or longer, depending on tax planning needs. The role of a sell-side adviser is to walk the company’s management through procedures similar to buy-side diligence. On the one hand, sell-side advisers prepare sellers for the questions buyers are likely to ask during buy-side diligence. On the other hand, the sellside tax adviser will identify areas of risk and begin the remediation process with respect to material tax exposures. There are often ways to mitigate potential tax issues and/or minimize risk exposure once a problem is brought to the forefront. A seller’s goal is to identify issues and eliminate them or minimize risk before it is discovered by the buyer’s advisers. This is not the same goal as that of a buy-side adviser, who often determines the maximum potential exposure.

The critical takeaway for timing of sell-side diligence is that management can preemptively control the facts and material tax exposures before going to market. The upshot is that the company can command a higher price from buyers if any tax exposures are remediated prior to sale and the closing process is swift. Therefore, to harness the benefits of sell-side diligence procedures, sellers must engage a sell-side tax adviser well before going to market.

Most outside accountants are not engaged to focus on the unknown. They are hired to perform specific tasks, such as financial statement preparation, tax return preparation, tax planning for specific transactions, etc. For instance, if the outside accountant has not been engaged to do a sales tax study, it is unlikely they are going to focus on the sales tax compliance process. An experienced sell-side tax diligence team can efficiently and effectively review the business, identify risk areas, and develop a remediation program that the owners and management can implement to eliminate exposure and provide peace of mind.

What sell-side tax diligence involves

Sell-side diligence procedures walk management through a process that mirrors buy-side diligence. To be clear, sell-side diligence is not buy-side diligence. The critical difference between the two diligence procedures is scope — sell-side procedures emphasize mitigation, while buy-side procedures focus on risk.

A sell-side tax adviser counsels a seller’s management. In other words, the true nature of the relationship is advisory — the sell-side adviser takes steps to make management aware of potential issues that will likely be uncovered in buy-side diligence, perhaps to further refine potential exposures and to begin the mitigation process. This contrasts with buy-side diligence, where buyers retain diligence advisers to investigate, rather than mitigate, risk. Furthermore, the sell-side adviser engagement does not end after issuance of a report. Instead, a sell-side adviser remains present throughout the deal process as an advocate for the seller, likely preparing documentation to send to a buyer and participating in tax calls with buy-side tax advisers.

M&A deal investigatory procedures can be cumbersome to sellers as they continue running their operations and may have many buy-side advisers vying for their attention at the same time. Retaining an experienced sell-side adviser smooths peaks and valleys in the deal process by preparing management for what is to come. As part of sell-side diligence, management is asked questions similar to those in buy-side diligence; thus, when buy-side tax diligence is underway, their answers are polished and prepared. This preparation reduces the size and depth of follow-up requests and demonstrates a commitment to swiftness and confidence in the enterprise.

To reiterate, buy-side procedures are designed to identify risk for acquirers. When seller management takes control of the narrative beforehand by implementing processes and steps to mitigate risk, sellers can receive more cash upfront and have less money held back in an escrow account. In the end, both buyers and sellers reap the rewards of sell-side diligence — fewer follow-ups, lower fees, and fewer surprises.

Common diligence issues and mitigation

With first-time sellers especially, certain tax diligence issues frequently arise. These often can be mitigated prior to buy-side diligence with proper planning. The two examples below illustrate this.

Sales tax nexus in nonfiling jurisdictions: In 2018, the U.S. Supreme Court decided a landmark case, South Dakota v. Wayfair Inc., 138 S. Ct. 2080 (2018), which redefined state authority to require out-of-state vendors to collect sales tax. The Court held that states can require sales tax to be assessed on transactions when a certain threshold of gross receipts or number of transactions occur in the state, even if the vendor had no presence in the state. Although Wayfair is a well-known, much-discussed decision, it is still very common for small businesses to fail to file sales tax returns or collect and remit sales tax in all jurisdictions where they may have an obligation. A sell-side adviser will help sellers assess whether the company has exceeded nexus thresholds and help remediate exposures through compliance, preparation of missed returns, and implementation of procedures to minimize future exposure.

Even if a company has a tax filing obligation for sales tax, depending on the type of business it operates and in which states it has obligations, there may be no tax due. Generally, businesses that sell products to resellers or products to be used in a manufacturing process are exempt from sales tax. A classic case is a nut or bolt used in the manufacture of a car.

However, to be exempt from sales tax, sellers need to collect exemption certificates from their customers. Sell-side advisers will assist companies with getting proper documentation in place. In addition, the adviser will assist the seller’s management with entering into agreements with states where there is potential exposure to limit the length of time a state may assess tax and, potentially, penalties associated with the tax. In situations in which the seller has failed to file returns in states where sales tax should have been collected, the statute of limitation will not begin to run until the missed returns are filed. Therefore, exposure can go back to the first sale within the state. Where exposure is significant, it is important to reach an agreement with the state representatives to limit the periods in which they will seek collection of past-due taxes. These agreements can be entered into via a voluntary disclosure program. The sell-side tax adviser will help with the voluntary disclosure process and negotiation with the state representatives.

Employee retention credit: In 2020 and 2021, Congress enacted a COVID-19 relief measure designed to encourage businesses to retain employees in the face of supply chain disruptions and economic slowdowns. The outcome of the legislative process was a complex tax credit called the employee retention credit (ERC). The IRS has issued several announcements and notices to employers warning them to beware of third parties improperly advising companies about their qualification for the ERC, ultimately placing the ERC at the top of the Service’s “Dirty Dozen” list of tax scams for 2023 to make taxpayers aware of aggressive pitches from potential scammers promoting the ERC. Further, given that the IRS extended the statute of limitation to five years in certain circumstances to seek repayment of the credit, the ERC may face intense scrutiny in the diligence process in an M&A transaction. A sell-side adviser can help get in front of these qualification issues and prepare the appropriate documentation to support the legitimacy of the credit refund or help to prepare amended returns in the case of erroneous refunded amounts.

The value of sell-side tax diligence

When issues such as these are discovered through buy-side tax diligence, buyers may lose steam, increase the amount and size of holdbacks, or eventually step away from the deal. Sell-side tax diligence can help move the transaction toward a speedy closing and enable sellers to obtain the company’s true purchase price. Identified risk areas can be addressed by means such as sophisticated models, tax-efficient structuring arrangements, and voluntary disclosure procedures with states.

Editor Notes

Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Bakale at tbakale@cohencpa.com. Contributors are members of or associated with Cohen & Company Ltd.