There are number of aspects that always get immediate attention when a business is analyzed for an acquisition. These are standard elements that are practically on a default checklist of any decent due diligence team.
A number of tax traps become apparent during the process for those professionals who knows how to look for these issues. This article seeks to identify a few that commonly show up during the due diligence process of acquiring the equity of a company.
Any business that has employees has a payroll has a tax withholding liability, and many business farm this accounting work out to third parties. It’s mundane work that has little to do with core functions of most businesses, so third party accounting firms and offices get a lot of the workload. Unfortunately, they also get lump sums of money to pay for the withholding requirements as well on a monthly basis. And those pots of cash can often be very attractive to a character who wants to shave off a few percentages of the total or “lose” a monthly payment altogether. Because the IRS and tax agencies get so much withholding on a regular basis, a shorted payment or a missing amount can be overlooked for a while. However, eventually the IRS and tax agencies reconcile amounts owed and eventually target a business for an audit. Should a business be acquired before that audit happens, the review can be a painful hit of withholding due, compounded tax interest, and tax penalties.
Small businesses are notorious for having very inflated tax-deductible expenses that tend to disappear when the real accounting books are reviewed. No surprise, the IRS often casts a very pessimistic eye on small businesses as a result. If a company has a history of inflated tax returns it’s not going to become apparent unless so those same returns are examined in direct comparison to the real accounting records. Any appraiser who is aware of this relationship knows to ask for both and looks to tie out specific expense numbers accordingly. A failure to look for this kind of baggage means the new owner could be stuck with tax penalties or worse, a tax investigation for tax evasion.
Businesses are allowed to depreciate large equipment and asset purchases, but they need to be depreciated over time. Incorrect calculations on tax filings can trigger audits and corrections. However, like other tax issues, the tax agency correction can be years after the fact. These landmines often get missed unless someone actually looks at the depreciation figures filed and checks on their validity.
Tax traps don’t have to be discovered the hard way. A targeted due diligence assignment will catch these issues, specifically looking for tax problems when examining liabilities. Don’t consider an acquisition of the equity of a business without knowing the tax records have been specifically reviewed.
This article was originally published in Valuation Viewpoint, April 2015.