Tax due diligence (TDD) is one of the least studied – but yet crucial – elements of M&A. Because the IRS is unable to conduct an audit of all tax-paying company in the United States, mistakes or oversights during the M&A process could lead to costly penalties. Fortunately, proper preparation and meticulous documentation can prevent these penalties.
Tax due diligence generally refers to the examination of tax returns, as well as documents pertaining to information from current and previous periods. The scope of the review depends on the nature of the transaction. For instance, entity acquisitions typically have greater risk than asset purchases, given that taxable target entities may be susceptible to joint and several obligation for taxes of all participating corporations. Moreover, whether a taxable target is listed in the federal income tax returns that are consolidated, and the sufficiency of documentation regarding transfer pricing related to intercompany transactions are other factors that may be reviewed.
Examining tax returns from prior years can also reveal if the company is in compliance regulatory requirements, as well as some red flags that may indicate tax evasion. These red flags include, but aren’t limited to:
Interviews with top management personnel are the final step in tax due diligence. These interviews are designed to answer any queries the buyer might have, and to resolve any issues that may affect the purchase. This is particularly crucial in acquisitions that involve complex structures or uncertain tax positions.
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