The Org Chart Was Wrong: Entity Classification, Tax Due Diligence and Who Pays When an International Deal Springs a Leak

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By Douglas S. Stransky, J.D., LL.M.  | Partner, Sullivan & Worcester LLP

Somewhere along the way in my practice, I stopped trusting structure charts.

Here is the kind of deal that taught me that lesson, presented as a hypothetical because the real versions belong to clients. A U.S. strategic buyer signs a letter of intent to acquire Meridian Instruments, a U.S.-parented group with a profitable operating subsidiary in Ireland. The seller's chart shows the Irish entity as a disregarded entity, checked into its U.S. parent years ago. The buyer’s financial model treats Irish earnings accordingly. Price is agreed and exclusivity is running.

Three weeks into tax due diligence, an associate asks where the check-the-box election that established the entity's federal tax classification is. Nobody can find  Form 8832. It turns out the Irish entity never made an entity classification election. Under the default rules of Treas. Reg. Section 301.7701-3(b), this entity has been a foreign corporation the whole time and a controlled foreign corporation at that. Every U.S. return in the data room was prepared on a false premise and no Forms 5471 were ever filed.

The deal survives. What follows though, is three weeks of negotiation over a question the letter of intent never contemplated: who pays for this?

Why entity classification errors keep happening

Anyone who works on international acquisitions has a version of this story. Sometimes the election was filed with the wrong effective date. Sometimes an entity everyone assumed was a corporation defaulted to partnership status when a second member came in. I have seen a per se corporation modeled as though it could elect out of corporate status, which it cannot.

The reason these mistakes persist is structural. Entity classification sits upstream of nearly everything else in a cross-border deal. It determines whether a basis step-up is available, whether the CFC rules apply, how intercompany payments are treated, and whether years of filed returns were even coherent. Because so much depends on it, deal teams tend to treat classification as settled background rather than as something to verify. The chart says disregarded entity, the model assumes disregarded entity and the assumption hardens into fact.

My own rule is that classification gets proven with primary documents before anything else in tax diligence. The elections, the formation documents and the default analysis for each jurisdiction are the record. A structure chart is somebody's recollection, drawn by whoever last updated the PowerPoint.

The tax exposure with no expiration date

A classification error in a purely domestic deal is usually a bounded problem. The assessment statute runs, the exposure ages out and diligence can quantify what remains.

The international version behaves differently. When a required information return such as Form 5471 goes unfiled, Section 6501(c)(8) of the Internal Revenue Code can hold the assessment period open for the entire return until the missing form is actually filed—not just the international items—the entire return. Add penalties under Section 6038(b), which accrue per entity and per year, plus continuation penalties if the failure persists after IRS notice, and the historic exposure in the Meridian hypothetical stops being a number anyone can calculate. It becomes a range with an uncomfortable amount of daylight between the floor and the ceiling.

In my experience, that kind of open-ended uncertainty is harder on a deal than a large known liability. A known liability gets priced in an afternoon. An unquantifiable one must be negotiated and the negotiation is where the transaction either finds its footing or falls apart.

Four ways to allocate tax risk

Once diligence surfaces a Meridian-type problem, the parties are really choosing among four instruments, and the choice matters more than most deal teams appreciate.

A purchase price reduction is the bluntest. It works even when the seller will not exist in creditworthy form after closing and it ends the conversation. The trouble is that it forces the parties to value the exposure today, and with an open statute that number tends to be wrong in one direction or the other.

A special tax indemnity is usually the first instinct of the tax lawyers. Carve it out of the general indemnification package, strip the deductible, set the cap separately or leave it uncapped and key the survival period to the assessment statute instead of the standard eighteen or twenty-four months. Drafted carefully, it matches payment to actual loss. Its weakness is the counterparty. An indemnity from a seller who has already distributed the proceeds to its investors is a handsome piece of paper.

An escrow or holdback exists to cure exactly that weakness. It also ties up the seller’s money for years and guarantees a fight over sizing, since nobody can say with confidence what the escrow is supposed to cover.

Then there is tax insurance, which has done more to change how these negotiations end than anything else I have watched develop over recent years. A specific tax liability policy can convert Meridian’s open-ended historic exposure into a fixed premium, letting the seller leave clean and the buyer close covered. The catch is sequencing. Insurers underwrite what is disclosed and representations and warranties policies routinely exclude matters the deal team already found in diligence, so a known issue must be presented to the specific-risk market deliberately. Whether the exposure is insurable at all often turns on how the remediation, including the delinquent information returns and any reasonable cause position, is staged against signing and closing.

Which instrument wins depends on the seller’s post-closing substance, the buyer’s appetite, what the insurance market will take, and frankly, on who has leverage at the moment the problem surfaces. What I can say is that the deal teams who get good outcomes are the ones fluent in all four, because the right answer at Meridian is rarely the right answer on the next file.

Where the books usually stop

None of the law in the Meridian fact pattern is obscure. The classification regulations, the CFC regime, the information reporting penalties, and indemnification architecture are each well covered somewhere. What has always been harder to find is a treatment that connects them the way a live deal does, where a classification question turns into a statute of limitations question, then a pricing question, then a drafting question, all inside a sixty-day exclusivity window.

That connective tissue is what I set out to supply in International M&A and Joint Ventures: Key U.S. Taxation Issues. The treatise is organized around how these transactions actually run, with a full chapter of case studies that carry fact patterns like Meridian’s from the diligence finding through the final documents, and practice aids including a cross-border tax due diligence checklist, sample tax provisions for acquisition agreements, and a chapter on tax insurance and risk allocation mechanisms. The doctrine is all there. So is the part I had to learn on deals, which is what to do about the doctrine when the org chart turns out to be wrong.

International M&A and Joint Ventures: Key U.S. Taxation Issues

International M&A and Joint Ventures: Key U.S. Taxation Issues examines the U.S. tax implications of cross-border mergers, acquisitions and joint ventures from planning and due diligence through structuring, negotiation and post-closing considerations. The treatise includes practical analysis, case studies, tax due diligence checklists, sample acquisition agreement provisions and guidance on tax insurance and risk allocation to help practitioners navigate international transactions. The title is available in multiple formats on the LexisNexis® Bookstore.

About the Author

Douglas S. Stransky, J.D., LL.M. (Taxation), is a partner and the leader of the Tax Practice Group at Sullivan & Worcester LLP in Boston, where he has practiced for nearly two decades. He concentrates his practice on international tax planning, with a particular emphasis on cross-border mergers and acquisitions, joint ventures, and corporate restructurings. He is a Lecturer in Law in the Graduate Tax Program at Boston University School of Law, where he has taught corporate and international tax courses for over 15 years. Stransky is the author of International M&A and Joint Ventures: Key U.S. Taxation Issues, a LexisNexis® treatise that examines the U.S. tax considerations involved in cross-border mergers, acquisitions and joint ventures.