A target company’s financial statements can appear clean on their face while the company carries an unresolved state tax audit position, a defective S election, or a net operating loss worth a fraction of its stated value once the deal closes. Tax due diligence exists to surface exactly these problems before the purchase price is finalized, since a liability discovered after closing is far more expensive to fix than one identified while the parties still have leverage to negotiate.
Lincoln PLLC conducts tax due diligence for buyers and sellers as part of the firm’s M&A tax structuring work, and the process is built around the specific categories of exposure a standard financial audit is not designed to catch. Erik Lincoln, founding member of Lincoln PLLC, brings his experience as a former senior tax manager at Ernst & Young to this work, and the firm’s approach to due diligence treats every finding as something that can still move the price or the indemnity structure before signing, not just a note for the file.
What a Financial Statement Audit Does Not Cover
A financial statement audit provides an opinion on whether a company’s financial statements are presented fairly, in all material respects, under generally accepted accounting principles, but it is not designed to identify the full extent of the company’s tax exposure, particularly for taxes other than income taxes. An unresolved state audit position, a sales tax nexus problem in states where the target never registered, and worker misclassification issues can all remain undetected beneath financial statements that otherwise appear correct.
These gaps matter because, in a stock acquisition or merger, they remain with the acquired entity rather than disappearing with the transaction, and even in an asset acquisition, certain state taxes can follow the business under successor liability rules. A buyer who omits this layer of review can inherit years of accumulated exposure the moment the deal closes, often without any mechanism to recover the cost from the seller afterward.
Net Operating Losses Are Rarely Worth Their Face Value
A target with a large net operating loss carryforward can look attractive on a balance sheet, but the value of that loss depends heavily on whether the transaction triggers an ownership change under Section 382. An ownership change generally occurs when there is a shift of more than fifty percentage points in ownership among five percent shareholders over a rolling three-year testing period, and once that threshold is crossed, the amount of pre-change losses that can offset taxable income each year is limited.
The annual limitation is generally calculated by multiplying the value of the target’s stock immediately before the ownership change by the long-term tax-exempt rate published monthly under Section 382. If the target does not continue its business enterprise for two years after the ownership change, the limitation is generally reduced to zero. A target with fifty million dollars in losses can see annual usable losses limited to a fraction of that figure once the calculation is applied, changing the real economics of the deal well before any tax return is filed on the losses. Lincoln PLLC runs this analysis as a standard part of diligence on any stock acquisition involving a loss corporation, since assuming the losses transfer at face value is one of the most consistently costly mistakes in deal pricing.
Reviewing the Categories That Diligence Most Often Misses
Certain categories of tax exposure surface repeatedly in diligence, and each deserves specific attention rather than a general review of the target’s tax filings. A few categories in particular tend to carry outsized risk relative to how often they are actually checked.
- Prior ownership changes: A target that has already undergone one ownership change may have a reduced Section 382 limitation carried forward from that earlier event, compounding the effect of the current transaction.
- Built-in gain or loss position: A target with a net unrealized built-in gain at the time of the ownership change can increase its Section 382 limitation by built-in gains recognized during the following five years, while a target with a net unrealized built-in loss will find that built-in losses recognized during that period are themselves subject to the limitation.
- S election validity: A defective S election discovered during diligence can mean the target has been taxed as a C corporation for years, exposing it to corporate-level tax for open years and invalidating any planned Section 338(h)(10) or 336(e) election on which the buyer’s basis step-up depends; relief may be available under Section 1362(f), an issue closely tied to the firm’s S corporation tax counsel.
- Deal structure itself: The reorganization structure chosen for the transaction, mapped out in the firm’s reorganization chart, directly affects whether tax attributes like net operating losses survive the transaction at all.
Reviewing these categories together, rather than checking each in isolation, turns a diligence finding into something the deal team can actually act on before the letter of intent establishes the transaction’s structure.
Turning Findings Into Leverage Before Closing
The value of tax due diligence comes from timing. A finding identified before the purchase agreement is signed can still move the price, be addressed through an escrow, or become the basis for a specific indemnity, while the same finding discovered after closing usually leaves the buyer with far less recourse.
Lincoln PLLC’s role is to take a red flag identified in a target’s filings, run the technical analysis needed to size the actual risk, and translate it into specific purchase price adjustments, escrows, indemnities, and representations that can be used at the negotiating table.
Working With Lincoln PLLC on Tax Due Diligence
Erik Lincoln, an attorney and CPA, brings both legal and accounting training to due diligence work, which matters because sizing a tax exposure correctly requires rigorous technical analysis, not a surface-level review of prior filings. His background as a former senior tax manager at Ernst & Young and former equity partner at Moore & Van Allen shapes how the firm approaches diligence, treating every finding as a number belonging in the deal terms rather than a footnote in a report.
For buyers and sellers in a business transaction, Lincoln PLLC is available to conduct tax due diligence and quantify findings on either the buy side or the sell side before the deal’s structure is finalized. If you are considering an acquisition or sale, please contact Lincoln PLLC to discuss the specific facts of the transaction and confirm that nothing material has been missed.