IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family businesses. The following blog article has been provided by Pete Miller of Clark Nuber PS (https://clarknuber.com/):

Federal Tax Due Diligence in the Merger and Acquisition Process

Introduction

Mergers and acquisitions (M&A) are among the most significant endeavors a business can undertake.  While M&As can help businesses achieve rapid growth, expand into new markets, or gain a competitive edge, M&A transactions are complex endeavors that involve navigating a maze of legal, financial, and operational challenges.

An essential aspect of these deals is tax due diligence. Assessing tax considerations may seem routine, but their implications are far-reaching. The manner in which a targeted company has handled its federal tax obligations can directly impact a deal’s value, alter its structure, and even derail it entirely. Understanding the tax position of the targeted business is not just a formality, it is a cornerstone of sound deal-making.

The Purpose of Federal Tax Due Diligence

Federal tax due diligence identifies and assesses any actual or potential tax liabilities of the target company including underreported income, disallowed deductions, aggressive tax positions, uncollected payroll taxes, and misapplied tax credits. Due diligence ensures that buyers include unrecognized tax when assessing the target company’s financial health. A company’s reported net income may look robust, but if substantial tax liabilities are hidden, the true value of the business could be much lower. Identifying these risks early allows buyers to seek protections such as indemnities, escrow accounts, or purchase price adjustments.

For sellers, tax due diligence is equally important. By proactively examining and addressing tax issues before going to market, sellers can minimize the risk of surprises during negotiations. This can lead to closing deals faster and preserving value by instilling confidence in the buyer.

Common Federal Tax Issues

Federal tax due diligence often reveals issues that can impact the deal’s final value or terms. These issues include:

1. Income Tax Compliance: Review federal income tax returns for the last three to five years to assess filing positions, reporting accuracy, and consistency. Audits, appeals, or unsettled tax disputes with the Internal Revenue Service (IRS) are red flags.
2. Net Operating Losses: Examine net operating loss carryforwards and any limitations under Internal Revenue Code §382 or §383. Change of ownership can severely limit the ability to use these tax attributes post-transaction.
3. Employment Taxes: Verify that payroll taxes (FICA, FUTA) have been properly withheld and remitted. Misclassification of workers (independent contractors vs. employees) often surfaces here.
4. Withholding and Reporting Obligations: Scrutinize compliance with backup withholding rules and Forms 1099 reporting.
5. Tax Credits and Incentives: Assess credits (e.g., research and design credits under §41, energy tax credits) and whether proper substantiation exists. Buyers will want to confirm that such credits won’t be disallowed later.
6. Transfer Pricing: In deals involving multinational operations, ensure related-party transactions comply with §482 transfer pricing rules to avoid IRS adjustments.
7. Tax Accounting Methods: Review whether the target has consistently applied permissible methods of accounting (cash, accrual, etc.) and if any method changes are pending.
8. Deferred Tax Liabilities: Understand how deferred tax assets and liabilities are reported, especially in asset deals where stepped-up basis impacts future tax expense.
9. Tax Elections: Identify any key tax elections (e.g., S corporation elections, §338(h)(10) or §336(e) elections) that could influence transaction structuring.

The Impact of Deal Structure on Tax Risks

Whether it is an asset acquisition, a stock purchase, or a merger, the structure of an M&A transaction has significant implications for tax exposure. In an asset deal, the buyer generally acquires a stepped-up basis in the purchased assets and can avoid assuming the target’s historical liabilities. This provides a layer of protection, but it can be less attractive to sellers, especially if the transaction involves a C corporation due to potential double taxation.

Sellers often favor stock purchases for their simplicity and the favorable tax treatment of capital gains. However, stock deals expose the buyer to the target’s historical liabilities such as unresolved federal tax issues. This reality makes robust tax due diligence even more vital in stock transactions.

To balance these considerations, buyers and sellers sometimes utilize tax structures, such as the Section 338(h)(10) election or an F reorganization. This allows a stock deal to be treated as an asset sale for tax purposes. These elections provide buyers with the benefits of a stepped-up basis while allowing the legal form of the transaction to remain a stock sale. Tax due diligence plays a vital role in determining whether such elections are available and advisable. To learn more about stock and asset sales, click here.

Due Diligence Best Practices

Effective tax due diligence involves document review, interviews with the target company’s finance team, and detailed analysis by tax advisors. Buyers begin by collecting and reviewing all relevant tax returns, audit reports, IRS correspondence, and documentation supporting tax positions taken. They pay particular attention to areas of known risk such as net operating losses, credits, and payroll taxes.

Discussions with the target’s management are also important to clarify reporting practices, internal controls, and any areas of concern that may not be obvious from the documents. Management may bring in outside advisors to conduct specialized reviews of complex issues, such as transfer pricing or deferred tax assets and liabilities.

A tax diligence report highlights key risks, quantifies potential exposures, provides recommendations for mitigating actions, and summarizes the findings. This report will become a critical resource in negotiations, informing decisions on representations, warranties, indemnities, and adjustments to the deal’s terms.

Avoiding Common Pitfalls

One of the most common mistakes in M&A transactions is underestimating the importance of tax due diligence. Even in deals involving small or mid-sized companies, the risk of significant tax liabilities is real. Another frequent issue is relying solely on the seller’s representations without independent verification. While sellers typically provide assurances about their tax compliance, these representations are no substitute for thorough diligence.

Buyers must also ensure that diligence covers the full scope of potential exposures, not just income taxes. Overlooking areas such as employment taxes, backup withholding obligations, and tax accounting methods can leave buyers vulnerable to unexpected liabilities.

Conclusion

Federal tax due diligence is not merely a step in the M&A process—it is a fundamental safeguard that protects the interests of both buyers and sellers. By identifying tax risks early, businesses can avoid costly surprises, structure deals more effectively, and lay the groundwork for post-closing success.

In today’s ever-changing regulatory environment, there is no room for shortcuts. Comprehensive federal tax due diligence is essential to unlocking the full value of a transaction and ensuring that the deal achieves its intended strategic and financial objectives.

If you have questions relating to the content of this article, Pete Miller, CPA, CFE, CM&AA and Shareholder, at Clark Nuber, PS., would welcome the opportunity to connect. Mr. Miller can be reached at (425) 709-6696 or [email protected].

This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.

This article was originally published by Clark Nuber PS and is republished with permission. Copyright © 2026 Clark Number PS. All rights reserved.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.