Tax due diligence (TDD) is among the least considered – and yet one of the most important aspects of M&A. The IRS isn’t able to audit every single company in the United States. Therefore, mistakes and oversights made in the M&A processes can lead to massive penalties. Fortunately, a thorough preparation and thorough documentation can help avoid these penalties.

In general, tax due diligence encompasses the review of previous tax returns as well as current and historical informational filings. The scope of the review differs based on the type of transaction. Acquisitions for entities, for example are more likely to expose the company’s assets than asset acquisitions because companies that are taxable targets could be jointly and severally responsible for the taxes of the participating corporations. Other factors include whether a tax-exempt entity has been included in the unconsolidated federal tax returns as well as the amount of documentation pertaining to transfer pricing for intercompany transactions.

The review of prior tax years could also reveal if the target company is in compliance with regulatory requirements, as well as some red flags that could indicate tax evasion. These red flags could include, but aren’t the only ones:

Interviews with top management are the final step in tax due diligence. These interviews are designed to answer any questions that the buyer might have, and to identify any issues that could impact the deal. This is especially crucial when acquiring companies with complex structures or uncertain tax positions.

example of tax preparation due diligence