Should I run tax diligence on a SMB acquisition?

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A couple of weeks ago, I wrote a post about the importance of getting a quality of earnings (“QoE”) study on your SMB acquisition. At AppHub, we went a step further and also did tax diligence on our deals. Our goal (and by extension, our private equity investor’s goal) was always to eliminate as many unknown risks as possible on transactions, especially if they could be uncovered and possibly quantified with diligence. And taxes generally fall in this category of unknowns, mainly because most of us are not tax experts, and let’s face it, tax codes are constantly changing.

You might be saying to yourself, “but I’m already paying $20k for financial DD, now you want me to spend extra on tax diligence?”. Yes, but I’ve found (and as you’ll see below) that the incremental cost of tax diligence is typically modest.

To dive deeper into tax diligence for SMB acquisitions and understand its importance, I caught up with Josh Thomas (Co-Founder and Managing Director) and Chase Duvall (Managing Director, Tax) from Cayne Crossing.

The team at Cayne is super knowledgable about financial and tax diligence, so if you’d like an intro to discuss further, please let me know.

Who is Cayne Crossing?

Cayne Crossing is a boutique consulting firm solely focused on due diligence (financial and tax) and QoE for SMB transactions (generally $1 to $30 million in revenue). In 2023, we worked on over 100 diligence projects. We’re entrepreneurs at heart who left promising big accounting firm roles to fulfill our own dreams. We love to fuel our own entrepreneurial spirits through building Cayne Crossing, investing in our own portfolio of SMBs, and investing in searchers and other entrepreneurs. We like to think we can relate to our clients, and we love to bring a unique viewpoint from our own consulting and investing experience.

What is tax diligence?

Once under LOI, a searcher generally knows the importance of financial diligence / QoE but often times does not consider tax diligence. In the realm of acquisitions, the significance of tax diligence cannot be overstated. This meticulous process serves as a crucial safeguard, ensuring that potential tax liabilities are thoroughly examined and addressed prior to finalizing any deal. 

Do I need tax diligence for an asset deal?

While asset purchases may offer certain protections against historical income tax liabilities compared to stock purchases, taxing authorities may hold the buyer responsible for outstanding tax obligations linked to the purchased assets. In an asset deal, the following taxes could still present potential liabilities for the buyer: sales and use taxes, payroll taxes, property taxes, unclaimed property, and employee vs. independent contractor classification. Thus, tax due diligence is strongly recommended regardless of whether the deal is a stock or asset acquisition.

How long does tax diligence generally take?

Tax diligence generally starts after a QoE is completed. The timing generally depends on the target’s management team and CPA firm replying to questions and fulfilling request lists. In our experience, this takes around two weeks. 

How much does it cost?

A QoE’s cost has many variables but in our experience, SMB transactions generally fall into the range of $20,000 - $25,000. On the other hand, tax diligence for SMB transactions generally ranges between $6,000 - $9,000 assuming one entity. The lower end of the range is for asset deals and the upper end is for stock deals. 

Why should a searcher consider tax diligence?

There are several reasons why tax diligence is paramount in any asset or stock acquisition:

1. Identifying Tax Risks: One of the primary purposes of tax diligence is to identify any potential tax risks or exposures that could impact the transaction. This includes uncovering any outstanding tax liabilities, potential audits, or disputes with tax authorities. By conducting a comprehensive review of the target company's tax records, the buyer can assess the level of risk involved in the acquisition and factor it into their decision-making process.

2. Understanding Tax Compliance: Tax laws and regulations can be complex and subject to change. Conducting tax diligence allows the buyer to gain a clear understanding of the target company's historical tax compliance. This includes reviewing tax returns, filings, and nexus laws to ensure that the target company is properly filing and remitting taxes in the proper jurisdiction(s). For instance, a common scenario observed during tax diligence is when a target entity has sales tax nexus but fails to file or remit any sales tax in such state, and if such exposure nexus exists, it’s important for the buyer to obtain tax indemnification in the purchase agreement along with potentially performing a nexus study. In our experience, sales tax nexus exposures can vary significantly, sometimes exceeding $500,000. It's also crucial to note that merely lacking operations in a state does not necessarily exempt one from the obligation to collect and remit sales tax depending on a state's economic nexus laws.  On one transaction, our client delayed a deal for over a year due to sales tax exposures, and it took ~12 months for the target company to rectify these issues with the various jurisdictions. Had tax diligence not brought these exposures to light, this would have been our client’s problem (and related costs) post transaction. Thus, understanding the target company's compliance history helps the buyer assess the level of ongoing compliance risk post-acquisition.

3. Quantifying Tax Exposures: A crucial aspect of tax diligence is quantifying the potential tax exposures associated with the transaction. For example, another common exposure can involve employee vs. independent contractor misclassification. Such misclassification could result in a payroll tax exposure should an employee be incorrectly classified as an independent contractor by the target entity. Based on our experience, independent contractor misclassification exposure can vary significantly, sometimes exceeding over $500,000. Another instance of a payroll tax exposure involves the potential ineligibility for claiming employee retention credits, and based on experience, this exposure can also vary significantly and can exceed $1 million. By assessing the magnitude of potential tax exposures, the buyer can accurately evaluate the financial impact of the acquisition and plan accordingly to mitigate such risks.

4. Mitigating Tax Risks: Once potential tax risks and exposures have been identified, tax diligence enables the buyer to develop strategies for mitigating these risks. This may involve negotiating indemnification clauses in the purchase agreement to protect against unforeseen tax liabilities or implementing tax structuring strategies to optimize the tax efficiency of the transaction. By addressing tax risks upfront, the buyer can minimize the potential impact on the overall success of the acquisition, and we have also worked with buyers and their legal counsel to ensure that the tax indemnification clause properly covers the tax exposures observed in tax diligence. 

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