Main Street Buyers: Don't Sleep On This
Most buyers go into a deal thinking that they understand what they need to do to close the deal. Chances are high they have attended a course, read way too much X or LinkedIn threads or attended an ETA conference.
At this point the LOI is signed, the SBA loan is in process, the close date is circled on the calendar and their team is in place to nail the landing on their deal.
Flash forward six months after closing, the new owner is working on their business transition and you receive an IRS letter in the mail. Your heart sinks as you immediately know what comes next.
Before you know it, you are dealing with a statutory notice of deficiency and fighting with the IRS about a historical tax liability from a time before you ever owned the business.
Talk with any tax litigation attorney and they will tell you war stories for days. For me, it was a bridal store in Tennessee where the new owners discovered that the prior owners never collected sales tax and they were now stuck with a $200,000 tax bill owed to the state.
Legal Due Diligence Only Gets You Halfway
Your M&A lawyer is doing their job. They're reviewing the statement of facts, turning over contracts, identifying gaps with employee contracts and licenses. They are also drafting non-compete, transition agreements and forming your entity while negotiating key terms of the agreement. This is all meaty parts of the transaction and critical to protecting you as a buyer.
Where most buyers get tripped up is thinking legal diligence also covers tax due diligence, when in reality they are not the same thing. Legal diligence tells you what the seller is promising, i.e., the contracts are what they say they are, the company has all its licenses, and is not dealing with any hidden litigation. Tax diligence, however, tells you whether the business's actual tax history supports those promises, and what liabilities are sitting beneath the surface and need addressing immediately after closing.
It's this gap between legal and tax due diligence where most buyers get caught. The M&A lawyers think that the accountants are handling tax due diligence, the accountants think the M&A lawyers are handling it, and in reality no one looks deeper into the tax issues.
What Tax Diligence Actually Covers
In a typical Main Street deal, I find that it is rare that anyone is running a structured tax review. The buyer gets three years of returns, an accountant gives them a quick look, or the bank makes sure the financials pencil for underwriting. From there everyone moves on. In reality though? That's not tax diligence.
A real tax review cover a number of different areas depending on the type of business (think parntership, S Corp, or C Corp), how the deal is structured, and the industry for the transaction. A few issues that consistently surface in smaller deals:
- Worker classification. Many small businesses have been treating employees as 1099 contractors for years. They do it because it lowers their payroll tax liability or the workers asks for it. The seller may not even know it's a problem. But the IRS does, and in an equity deal, that exposure transfers to you. Underlying this is not only additional payroll tax liability, but possible trust fund recovery penalties too, which can equal (i) The unpaid income taxes withheld plus (ii) The employee's portion of the withheld FICA taxes.
- Nexus and filing footprint. If the business has customers, employees, or inventory in multiple states, it may have filing obligations it hasn't been meeting. Unfiled returns don't disappear at closing. Similarly, stripping profits from a state to "avoid" a tax filing obligation in that jurisdiction could pose a huge tax exposure.
- Successor liability. In some states, buying substantially all of a seller's assets doesn't protect you from their unpaid tax obligations without a clearance certificate of some kind. Bulk sale notification requirements exist for a reason, and skipping them can make you personally liable for a debt that was never yours.
- Entity structure. S corporations have eligibility rules that are surprisingly easy to violate. There is a joke within the tax industry that all S Corps are just C Corporations that don't know it yet. An inadvertent termination of an S election can mean the business has been taxed as a C corporation for years without knowing it. That's a mess to clean up after the fact.
The Real Takeaway
Legal diligence protects you from what the seller does wrong on paper. Tax diligence protects you from what the business has been doing wrong for years.
They are not redundant. They are not interchangeable. And in Main Street M&A, only one of them is consistently being skipped.
Next week, I'm doing a webinar on Tax Due Diligence and the things I look for. If you're someone searching to buy a business, this webinar might be for you. I'm capping registration at 20 people.
Until next time,
Josh
