2015-Issue 37—“Wow, this seems like a great company. I’m going to spend millions of dollars to acquire it without performing any basic due diligence to determine whether I’m inheriting any unrecorded liabilities that will diminish its future value. Shut up and take my money!”
Said no one ever.
Much like kicking the tires on a car you’re considering buying, and then thanking your lucky stars that you did when it subsequently explodes (without you in it, obviously), conducting due diligence on a target you’re considering acquiring is a must in today’s complicated world. Acquiring a company and then finding out after the fact that there are substantial historical exposures and contingencies that you’re now on the hook for may lead you to wonder if you might have been better served by taking the money you spent acquiring the company out back and setting it on fire.
This edition of Tax Advisor Weekly surveys some of the more common issues that are reviewed during tax due diligence.
1. Tax Return Filings and Payments
The starting point in any tax due diligence exercise includes the review of a target’s federal and state income tax returns for the open audit period, and confirming that all tax payments are current. This includes reviewing estimated tax payments for the current year to verify that the target has remitted all applicable estimated tax payments. It bears noting that in the context of smaller “mom and pop” companies, there’s frequently been no analysis of transaction-related expenses that will be incurred in connection with the contemplated transaction, and as a result, the target may have remitted more to the IRS than it will ultimately owe, of which the resulting refund will need to be dealt with in the purchase agreement.
This review also includes the assessment of the viability of the target’s historical tax attributes (e.g., net operating losses, tax credits, tax depreciation and amortization, etc.) and their availability to be used by a buyer post-acquisition.
2. Tax Audits
Whether a company has historically been audited can be quite revealing in the course of performing tax due diligence. The revelation of what prompted the audit, and whether any additional taxes were assessed, may highlight deficiencies in the company’s tax function that might be of concern to a potential buyer. In addition, in the context of an acquisition of a public company where no indemnities are available, any ongoing audits that will not be completed prior to the acquisition will inevitably become the responsibility of the acquirer, and the magnitude of any assessment from such audit should be considered in arriving at the purchase price to be included in the tender offer. Finally, even in the context of an acquisition of a private company, identifying the potential assessment of an ongoing audit is important such that an escrow can be established, if needed, to protect a purchaser from inheriting the sellers’ liabilities.
3. Uncertain Tax Positions
In certain instances, Generally Accepted Accounting Principles require that financial statement reserves be established for tax contingencies. Generally speaking, with respect to contingencies related to income taxes, Accounting Standards Codification (ASC) 740-10, formerly known as FIN 48, requires that a financial statement reserve be established with respect to an income tax position that is taken (and that such reserve be equal to the tax benefit received, plus interest and penalties) if it’s “more likely than not,” meaning there is a greater than 50 percent likelihood that the position in question would not be sustained upon examination by the tax authorities. With respect to non-income tax contingencies (e.g., sales tax), ASC 450 requires that a financial statement reserve be established if it’s “probable” that the contingency will materialize (a higher threshold than “more likely than not,” we might add) and the amount of the contingency is “reasonably estimable.”
When conducting tax diligence on a target that undergoes financial statement audits, we always inquire as to whether management has recorded any financial statement reserves for uncertain tax positions or tax contingencies, since these would represent management’s best estimate of where the bodies are buried, to put it mildly.
4. Changes in Methods of Accounting
When a taxpayer adopts a new accounting method, it’s required to compute its taxable income under the new and old methods and determine what the cumulative effect on taxable income would have been if the taxpayer had always used the new method. If adopting the new accounting method results in a positive, or unfavorable, adjustment to taxable income, the adjustment generally must be recognized ratably over four tax years (however, see below). If adopting the new accounting method results in a negative, or favorable, adjustment to taxable income, then the entire adjustment may be recognized in the tax year that the change is adopted.
A typical concern when performing tax due diligence is determining whether there have been, or will be, any accounting method changes that will impact a buyer post-acquisition. As one example, consider a target corporation that uses the cash method of accounting to compute its taxable income and is on a calendar tax year. On December 31, 2015, target corporation is acquired by a private equity fund that uses a corporation as the acquiring entity, thereby forming a new consolidated group for U.S. federal income. Target corporation adopts the accrual method of accounting in the 2015 tax year, and the corresponding adjustment to taxable income is $1 million (i.e., a positive adjustment to taxable income). Target corporation would recognize the positive adjustment to taxable income over four tax years, from 2015 through 2018, 75 percent of which would be recognized during the private equity fund’s holding period. This is obviously an unfair result: since the sellers received the benefit of using the cash method of accounting (primarily the deferral of recognizing the $1 million of taxable income), it stands to reason that they should suffer the burden of recognizing such previously deferred taxable income when the accrual method is adopted.
Prior to 2015, situations such as the one described above would be handled either through a complicated working capital adjustment in the purchase agreement or characterizing the corresponding tax liability as a debt-like item, both of which required extensive negotiations with the sellers. But in Revenue Procedure 2015-13, the IRS allowed sellers to make an election to recognize the entire positive/unfavorable adjustment in the year of change, rather than over four tax years, so now the sellers can deliver the target to the buyer without any hangovers from prior accounting methods.
And there was much rejoicing.
5. Deferred Revenue
The financial reporting treatment of deferred revenue is relatively straightforward: Deferred revenue is recognized into income when such deferred revenue is earned (for example, either though the delivery of goods or the performance of services). For U.S. federal income tax purposes, deferred revenue is generally recognized when cash is received unless it qualifies for certain limited deferral. This disconformity in the financial reporting and tax rules can result in large differences between financial statement income and income recognized for tax purposes, particularly in industries where advanced payments are common, such as software. And even in instances where deferred revenue is properly deferred for U.S. federal income tax purposes, certain events may result in the immediate recognition of all previously deferred revenue, such as when a transaction results in the target ceasing to exist.
It’s worth inquiring during due diligence as to whether the target is properly recognizing deferred revenue in accordance with U.S. federal income tax rules, since the improper accounting of such deferred revenue can impact a buyer post-acquisition.
6. International Issues
On the international front, the primary concern when performing tax due diligence is whether a company has sufficient activity abroad to constitute a taxable presence. If there is a treaty between the United States and the foreign country, such a taxable presence usually will not arise until there is a “permanent establishment.” If a company is found to have a permanent establishment in any foreign country, it may be required to file local country income or excise tax returns. While having an office, factory or branch in a foreign jurisdiction is generally sufficient to create a permanent establishment, in certain jurisdictions merely having a dependent sales agent that solicits business and executes contracts may be enough to result in a finding of a permanent establishment.
Other concerns on the international front include payments made to foreign recipients (e.g., shareholders, employees, licensors, etc.) that live abroad and whether or not such payments require withholding. On the flip side, if a target has substantial cash that has built up offshore, we’ll investigate what the potential cost (i.e., withholding taxes) might be in order to repatriate such cash to the United States and, and ultimately the owners of the business.
In addition, the sufficiency of a company’s transfer pricing documentation related to any intercompany transaction (e.g., loans, sales, management fees, etc.) should be evaluated. Finally, the appropriateness of an entity’s classification (e.g., controlled foreign corporation, disregarded entity or branch) and the associated informational filings require careful scrutiny given the severity of the penalties for failure to file and the potential to extend the statute of limitation for U.S federal income tax purposes.
7. Foreign Bank Account Reporting
Foreign bank account reporting is not, strictly speaking, a tax concept. The Treasury Department, pursuant to the powers conferred on it by the Bank Secrecy Act, may require anyone with a financial interest in, or signature authority over, a foreign financial account, including a bank account, brokerage account, mutual fund, trust or other type of foreign financial account (exceeding certain thresholds) to report the account yearly by electronically filing with it a Financial Crimes Enforcement Network (FinCEN) Form 114, Report of Foreign Bank and Financial Accounts.
Overseas financial accounts are maintained by United States persons for a variety of legitimate reasons, including convenience and access to foreign currencies. However, foreign bank account reporting is used by the Treasury Department and the IRS to identify persons who may be using foreign financial accounts to circumvent United States law. Information garnered by the foreign bank account reporting rules may be used to expose terrorist and criminal activity, or to identify unreported taxable income maintained or generated offshore.
The penalties for failure to comply with the foreign bank account reporting rules are harsh, possibly even draconian, and may result in fines and incarceration, depending on the nature of the noncompliance.
8. Sales and Use Taxes
Depending on the industry of the business to be acquired when doing tax diligence, sales and use taxes can range from being a minor annoyance to potentially causing a multi-million-dollar exposure. Consider your typical distributor that purchases widgets from a manufacturer and then sells them to retailers. So long as the distributor is collecting sales tax exemption certificates from its customers documenting that all of its sales are for resale, there’s a low risk that any historical sales tax exposures exist.
On the other hand, consider the software-as-a-service provider (or “SaaS” as it’s called in industry parlance). Questions such as where the company is operating, whether it has employees who travel, what’s the true object of the company’s offering, and do its invoices separately state each service rendered are just a smattering of what needs to be addressed when performing diligence. And frequently, given the ever-changing sales tax rules of the states that impose such taxes, it’s often unclear whether a jurisdiction imposes a sales tax on the company’s specific offering.
9. Worker Misclassification
Misclassification of employees as independent contractors is a widespread phenomenon in the United States. While some employers misclassify their employees as independent contractors in error due to ignorance of the law, other employers intentionally misclassify their employees in order to avoid paying state and federal payroll taxes by passing that responsibility onto the employee. Employers that are found to have misclassified their employees are subject to onerous penalties.
Certain employees, such as corporate officers, are required by statute to be classified as employees for payroll tax purposes (referred to as “statutory employees” in industry parlance). With respect to employees who are not classified as statutory employees, the IRS provides a 20-factor test to help determine whether an individual should be classified as an employee or independent contractor for payroll tax purposes. Some of the primary factors that are considered are the following:
- The degree of instruction provided by the employer to the individual;
- The flexibility of the individual’s schedule;
- Whether the individual provides his own tools, or whether such tools are provided by the employer;
- The method in which the individual is compensated; and
- Whether the individual works for other employers.
During tax due diligence, we typically review the Forms 1099 that the target has issued to its individual independent contractors to determine whether there is a risk that such contractors were inappropriately classified for federal and state payroll tax purposes.
10. Unclaimed Property
Similar to foreign bank account reporting, unclaimed property is not, strictly speaking, a tax concept, but since unclaimed property statutes are generally administered by state tax agencies, it’s a topic that we generally inquire about during the course of tax due diligence (sometimes law firms cover this topic when conducting legal due diligence, in any event make sure someone is reviewing it when contemplating an acquisition).
The concept of unclaimed property is an ancient one, dating back to feudal England. Back then, if a landowner died and had no heirs, the ownership of his estate would revert (or “escheat” as it’s known in industry parlance) to the King, since at that time the King was vested with all of the powers of the government.
It goes without saying that it’s good to be the King.
In today’s world, each state has an unclaimed property statute governing when and what types of property must be escheated to it. A typical example of unclaimed property is a bank account in which the owner dies and no heirs, if there are any, claim the balance. After a certain period of time has lapsed (referred to as the “dormancy period” in industry parlance), the bank would generally be required to escheat the balance of the bank account to the state of the owner’s last known address (or if unknown, then generally the state where the bank is incorporated; the rules vary by state).
Unclaimed property can take many shapes and forms. Consider the example of a business that terminates an employee and then shortly thereafter sends the employee a final paycheck, but the paycheck is never cashed. Does the business get to keep the money since the employee never cashed the check? No, of course not, that’s not its money! After the applicable dormancy period has lapsed, the business would generally be required to escheat the amount of the paycheck to the state, again depending on the particular state’s statutes governing unclaimed property.
And don’t get us started on gift cards. Unclaimed property laws with respect to those are all over the board. Any business that issues a substantial number of gift cards during the ordinary course of business (e.g., retailers, restaurant chains) is a prime candidate for having unrecorded unclaimed property liabilities.
Alvarez & Marsal Taxand Says:
President John Adams famously observed that “facts are stubborn things.” Indeed they are, and any tax due diligence practitioners worth their salt will use what limited facts are available to them to ascertain whether a target has unrecorded historical tax liabilities. The tax rules are only becoming more complicated, so it’s critical that when you are acquiring a company you have a solid understanding of its tax posture and history.
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Simon Bernstein, Senior Associate, contributed to this article.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in nearly 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.