The Need for Buy-Side Tax Due Diligence
Within our financial institution practice, we assist many banks across the country with due diligence as they are either looking to acquire or be acquired by another institution. There are lots of areas where CLA can help from evaluating accounting issues to assessing credit quality to assisting with IT system selections, but one area that isn’t always top of mind is tax due diligence.
But as the tax world continues to become increasing complicated, buyers may want to consider whether there are any potential red flags lurking in the tax files.
What is tax due diligence?
Unlike annual income tax preparation, tax due diligence is less concerned about minor missed items and miscalculations and is instead focused on material issues that could impact the buyer. Reviewing prior tax filings, employment agreements, and other documents, can help to uncover potential tax risk areas prior to closing.
State Tax Filings
Today many community banks are only filing state tax returns in their home state where they have physical locations and employees. But in recent years, state tax laws have evolved and many states now have economic tax nexus standards. So if the target institution has customers that live out of state or has loans secured by property out of state, there could be additional filing requirements. States are becoming more aggressive at enforcing these rules across borders and have more electronic data today to track out of state lenders and identify potential tax revenue sources.
Buyers should consider whether their targets could have unknown state filing obligations as part of their due diligence process.
S Corporation Targets
Because S corporations are taxed at the shareholder level rather than the corporate level, many acquirers believe there is limited tax risk when you acquire an S corp. Though most adjustments on examination would impact the shareholders and not the corporation, there are still potential risks to consider.
S corporations have strict limitations in place on ownership and permissible shareholders. As shareholders change over time, old owners die, or shares are placed into trusts, violations of the eligibility rules can occur that could lead to an inadvertent termination of the S election.
Inadvertent terminations are not uncommon for S corporations and though they can often be corrected, they are costly and time consuming to resolve. And, there is the potential of owing substantial C corporation taxes for the impacted years if the issue cannot be corrected.
Buyers should consider reviewing S corporation eligibility as part of due diligence particularly in cases where the institution is widely-held.
Compensation – Related Plans
Mergers and acquisitions often trigger termination of compensation or benefit plans and can accelerate payouts to participants. Understanding the tax consequences of these transactions, which party will be entitled to the tax deductions for the payouts, and how participants will be taxed on the benefits can be significant considerations as part of transaction. Buyers should ensure that all existing deferred compensation plans, benefit plans, vacation and sick pay policies, and similar arrangements are carefully considered as part of due diligence.
Next Steps
The benefits of due diligence can far exceed the costs and can give your shareholders additional peace of mind. CLA is here to help. Please contact us.
Amanda Garnett is a principal in the financial institutions practice of CliftonLarsonAllen (CLA) from Peoria, Illinois. She currently leads the firm’s Midwest financial institution tax team and serves institutions ranging in size from $15 million to $3.5 billion in total assets. In addition to tax compliance, Amanda assists clients in the areas of tax consulting, mergers and acquisitions, and regulatory reporting. She also routinely teaches courses for banking associations across the country.
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