Taxand USA explores some of the common federal income tax diligence areas for S corporations.
At first glance, acquiring an S corporation is a seemingly innocuous event; after all, S corporations are flow-through entities that generally are not subject to income taxes. Instead, income, losses, deductions and credits all flow through to the shareholders and are reported on the shareholders’ respective federal income tax returns. While in theory, any audit adjustments made to pre-close periods should affect only the S corporation’s shareholders, in reality, the failure to qualify as an S corporation may have nightmarish implications for the buyer.
If a corporation inadvertently terminates its S election, it will be treated as a C corporation beginning on the date of termination. This means the target will now have a corporate tax liability, including interest and penalties, for all years in which it failed to qualify as an S corporation. Needless to say, the amount of back taxes owed can be astronomical for targets where the S election was never valid to begin with. Given the magnitude of the potential tax liability a buyer may inherit, buyers must perform federal diligence on S corporations to avoid unwanted tax implications.
As is the case with all tax diligence, the goal is to examine where the potential for assessment by the IRS exists. In the case of an S corporation target, this means focusing on whether the target made a valid S election and whether the target satisfied the S corporation requirements at all times.
Discover more: Say yes to S corporation federal tax diligence…your IRS tax bill may depend on it
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Given the myriad of ways in which an S corporation can lose its favorable tax status, resulting in not only the loss of future amortisation deductions but also a potential tax liability at the S corporation level that the buyer may inherit, buyers must say yes to federal income tax diligence for S corporation targets.
