Frequently Overlooked Tax Considerations in M&A and Corporate Deals

Business sales or similar transactions can end in disaster due to overlooked tax liabilities and poor structuring. Key areas of risk include unrecorded state and local tax (SALT) nexus, improper worker classification, and missed opportunities to optimize deal structure for tax efficiency. Early, proactive tax diligence is essential to identify these risks before they become legal and financial burdens. This article reviews hidden tax concerns, deal structure considerations, and the value of early tax review.

Hidden Tax Liabilities

Hidden liabilities can arise from a target company's past non-compliance or aggressive tax positions. These liabilities are often not apparent from the face of the financial statements and may only emerge through detailed due diligence, including review of tax returns and an analysis of historical business operations. The consequences of inheriting such liabilities can be severe.

A common overlooked liability relates to State and Local Tax (SALT) exposure. Following the Wayfair decision, businesses often have an "economic nexus" in states where they have no physical presence but have generated significant sales, creating years of unfiled tax returns. This exposure extends beyond sales and use taxes to include income, franchise, and gross receipts taxes. Many companies are unaware that their e-commerce activities, remote workforce, or affiliate relationships may have established nexus in dozens of states. The cumulative liability from multiple years of non-filing can be extreme, particularly for companies with nationwide customer bases.

Worker misclassification is another common issue. Treating employees as independent contractors can result in back taxes, penalties, and interest on employment and payroll taxes. This issue has gained heightened scrutiny from both the IRS and state agencies, with aggressive audit programs targeting industries known for misclassification, such as construction and professional services. Beyond federal employment taxes, misclassification can trigger liability for unpaid state unemployment insurance, workers' compensation premiums, and employee benefits. In severe cases, it may also expose the company to wage and hour claims, class action lawsuits, and penalties under state labor laws.

Improper Purchase Price Allocation (PPA) can also present a problem. Failing to properly allocate the purchase price to assets can lead to IRS audits, disallowed deductions, and reduced depreciation benefits. A well-structured PPA should allocate value to assets in a manner that is both defensible and tax-efficient, maximizing allocations to short-lived depreciable assets and amortizable intangibles where appropriate. Inconsistencies between the buyer's and seller's allocations, required to be reported on IRS Form 8594, can also trigger audit scrutiny. Additionally, aggressive allocations to goodwill or other non-amortizable assets may leave significant tax benefits on the table, while allocations that lack adequate support can be challenged and adjusted by the IRS, resulting in unexpected tax liabilities for both parties.

Structuring Deals to Avoid Tax Complications

The structure of the transaction (stock vs. asset) directly impacts tax liability. Depending on whether you are the buyer or the seller, you may want different outcomes.

Asset purchases, for example, are generally favored by buyers. This structure allows the buyer to "step up" the basis of the assets to the purchase price, enabling higher depreciation and amortization deductions. Sellers, however, often prefer stock purchases for lower capital gains tax rates, but this structure leaves the buyer responsible for all historic tax liabilities.

There are a variety of mechanisms to achieve the best of both worlds, including pre-transaction reorganizations or, depending on the parties' structure, a 338(h)(10) election. Such a reorganization or election presents a hybrid approach that allows a stock purchase to be treated as an asset purchase for tax purposes, giving the buyer a stepped-up basis while providing the seller with favorable tax treatment. 

If there are concerns about existing tax liabilities, Voluntary Disclosure Agreements (VDAs) are often worth considering for buyers. A VDA can be used to mitigate risks when a company discovers unfiled tax returns in various states, often limiting the look-back period to 3–5 years and reducing penalties.

The Value of Early Tax Review

As you can see, a slew of issues can arise in these transactions. Bringing in tax advisors early in the due diligence process (and before signing the Letter of Intent) helps identify, quantify, and mitigate risks, ultimately protecting the deal's value.

Early review can uncover significant liabilities, such as audits or unfiled returns, allowing for renegotiation of the purchase price, restructuring, or the establishment of escrow accounts to cover potential liabilities. This proactive approach enables buyers to quantify exposure across multiple jurisdictions, identify historical tax positions that may not survive scrutiny, and assess the risk of successor liability. In some cases, uncovered liabilities may be severe enough to warrant walking away from the deal entirely or demanding substantial indemnification protections in the purchase agreement. Those deal breakers are important to identify early to avoid wasting time and money.