The energy industry saw significant consolidation transactions announced in 2023 and 2024, with notable transactions involving ExxonMobil, Chevron, Diamondback Energy, Occidental Petroleum, ConocoPhillips, and Marathon Oil to name a few. While 2025 may not see as many consolidation transactions as prior years, President Trump’s executive orders signed on January 20, 2025, Unleashing American Energy, Declaring a National Energy Emergency, and Unleashing Alaska’s Extraordinary Resource Potential, are likely to create additional tailwinds for M&A activity in the energy sector in 2025.
With every transaction, all parties need to understand which pre-close seller liabilities will be assumed by a buyer. Those known or unknown pre-close income tax and non-income tax liabilities of a target are known as successor tax liabilities. Whether it is the buyer or the seller that bears the risk of the successor tax liability depends on, among other things, the form of the transaction and the applicability of various state income and non-income tax laws.
Acquisitions can generally take two legal forms: an asset acquisition or an equity acquisition. Through tax due diligence, buyers and their tax advisors may identify certain existing tax liabilities by reading the target’s financial statements, tax returns, or other information. Other known tax liabilities may also be disclosed by the sellers or their advisors.
In this article, we will examine common successor tax liability issues that arise in both types of acquisitions and specific actions the buyer can take to mitigate its risk.
Asset Acquisitions
Generally, a purchaser of assets is not liable for the seller’s debts or obligations unless an exception applies (described below). In the case of a legal asset acquisition or a deemed asset acquisition (e.g., purchase of a single member LLC), the parties can tailor a purchase agreement such that the buyer assumes only specified liabilities. Certain legal doctrines exist, however, that result in a buyer involuntarily inheriting a liability if either the seller or target could not pay the liability and one of the below exceptions were to apply. As a result, it is common for the parties to include indemnity language in the asset purchase agreement which requires the sellers to indemnify the buyer for liabilities not expressly assumed.
Despite the inclusion of indemnity language and, depending on the jurisdiction, a buyer may still be held responsible for liabilities not expressly assumed if (1) the transaction is a de facto merger under state law, (2) the transaction results in a mere continuation of seller, or (3) the transfer was fraudulent. Note that an implied assumption in Texas will not bind a buyer of assets to a liability; instead, the Business Corporation Act requires that a Texas buyer expressly assume the liability or obligation to be held liable.
Due to the varying doctrines applicable to asset acquisitions, a buyer needs to consider successor liability in any jurisdiction applicable to the transaction and perform tax due diligence accordingly.
Equity Acquisitions
Following an equity acquisition or merger transaction, the target entity will retain its assets and liabilities, whether known or unknown. As a result, equity acquisitions generally result in the buyer inheriting more successor tax liabilities than it otherwise would in an asset acquisition.
There are four common equity acquisitions and each treat successor tax liabilities differently. This section will discuss the acquisition of (1) a C corporation, (2) a corporate subsidiary in a U.S. consolidated group, (3) an S corporation, and (4) a partnership interest.
Acquiring a C Corporation
When a buyer acquires a C corporation, whether a standalone corporation or the parent of a U.S. consolidated group, pre-closing federal and state income tax liabilities of the target corporation generally carry over and become the buyer's responsibility. In addition to income tax, the target corporation will generally retain its non-income tax liabilities (e.g., franchise tax, gross receipts tax, sales and use tax, property tax, real estate transfer tax, employment tax, etc.). As a result, a C corporation buyer will typically perform tax due diligence to understand the target’s pre-closing tax profile that may either be inherited or negotiated during closing.
Acquiring a Subsidiary of a Consolidated Group
The successor liability rules with respect to standalone C corporations described above also apply to the acquisition of a subsidiary corporation in a consolidated group. Additionally, and importantly, under Treas. Reg. Section 1.1502-6(a), all members of a consolidated group are jointly and severally liable for any federal income tax liabilities of the group for all years during which they are members. According to Treas. Reg. Section 1.1502-6(b), the IRS may
limit the potential liability of a subsidiary after its withdrawal from the consolidated group if the withdrawal was the result of a bona fide sale or exchange transaction that occurred prior to the assessment of liability. As a result, the IRS has the authority to seek payment from a subsidiary corporation for tax liabilities that were incurred by any member of the consolidated group prior to the transaction. State and local taxing jurisdictions may also impose joint and several liability on each consolidated group member for any tax year in which the entity was included in a combined state tax return. The term “joint and several liability” means all entities are potentially liable for the entire group’s tax liability while “several liability” would hold each subsidiary liable only for its applicable amount.
In practice, it may be more difficult for a buyer to fully understand the subsidiary’s tax profile in a carve-out transaction due to the seller’s unwillingness to share consolidated tax returns or other information about the consolidated group. A buyer may be limited to proforma tax returns or redacted financial information. As a result, negotiations of tax representations and indemnities, as well as increased scrutiny during diligence, are standard in this type of transaction.
Acquiring an S Corporation
Flow-through entities, including S corporations, are generally not subject to entity-level U.S. federal income tax; any adjustments to the S corporation’s income and deductions generally pass through to the member’s respective tax return. Accordingly, an S corporation typically does not retain its historical U.S. federal income tax liabilities that are reported by its members. Certain historical state and local income and non-income tax liabilities, however, may remain with the S corporation and be inherited by a buyer (e.g., gross receipts, franchise, sales and use, property, unclaimed property, and employment taxes).
Acquiring an S corporation presents unique risks and often requires additional tax due diligence procedures beyond what may be performed when acquiring a C corporation. Suppose any of the various requirements to be classified as an S corporation (see Section 1361(b)) are not satisfied at any time since the S corporation election was effective. In that case, the S corporation status may be deemed invalid or involuntarily terminated, resulting in the re-classification of the entity as a C corporation for U.S. tax purposes. A buyer that acquires an S corporation whose status was either invalid or terminated would inherit the corporate-level U.S. federal, state, and local income tax liabilities of the target and must negotiate the deal terms accordingly.
Parties may agree to certain common transaction structuring alternatives in S corporation acquisitions when the validity of the S corporation’s status is in question or if the buyer is an ineligible shareholder of an S corporation and the seller intends to roll a portion of its equity in the transaction. S corporation acquisitions may be structured as transactions with a Section 338(h)(10) election, Section 336(e) election, or an F reorganization under Section 368(a)(1)(F) to address either or both parties’ concerns. Each structuring alternative treats the acquisition as a deemed asset acquisition for U.S. federal income tax purposes and delivers to the buyer a step-up in the tax basis of the S corporation’s underlying assets. Treating the transaction as an asset acquisition often increases the seller’s overall tax burden, and, as a result, a gross-up payment is often factored into the negotiations to compensate the seller.
The potential for adverse tax implications of acquiring an invalid S corporation and the potential structuring involved requires increased due diligence in S corporation acquisitions.
Acquiring Partnership Interests
Like an S corporation, a partnership is a flow-through entity for tax purposes; therefore, the partnership itself is not subject to U.S. federal income tax. As a result, the acquisition of partnership interests historically resulted in U.S. federal liabilities of the partnership remaining the responsibility of the seller. However, the Bipartisan Budget Act of 2015 established the Centralized Partnership Audit Regime (CPAR) for tax years beginning after 2017. Under the CPAR rules, a partnership is generally liable for tax due at an entity level absent a valid election to push out any IRS audit adjustments. The election allows the partnership to issue an adjusted Schedule K-1 to its partners for the year under audit, reflecting the partners’ allocable share of any assessment. Push-out-election considerations are a common issue in deal negotiations.
Additionally, certain liabilities for state income, franchise, non-income tax, and non-resident withholding tax often remain with the acquired partnership and are inherited by the buyer. Full-scope tax due diligence is typically performed when acquiring a partnership interest, given the complex nature of the issues.
How Can a Buyer Mitigate Successor Tax Liability Risks?
When negotiating a potential acquisition, a buyer will typically seek to mitigate the inherent tax risks associated with the transaction. Such mitigation techniques will depend on whether the liability is known or unknown.
A buyer may seek to mitigate risk with a purchase price adjustment (PPA) for known historical tax exposures. Alternatively, parties may agree to a holdback of all or a portion of the purchase price for a specified period post-close. The direct reduction of the purchase price from a PPA is generally considered more seller friendly as it limits the seller’s exposure to a specified amount. Risk may also be mitigated for known exposures by negotiating specific actions to be taken by one or both parties pre-closing. One such action is for the target entity or seller to enter a voluntary disclosure agreement (VDA) with the relevant taxing authority. A VDA limits the lookback period subject to review and typically waives penalties and/or interest owed. In addition to reducing the risk of future audit assessments, a VDA may reduce the risk of exposure noted in the due diligence phase and can be an effective tool for both buyer and seller in a transaction.
For unknown tax exposures, buyers may seek to add an indemnity provision to the purchase agreement for pre-closing income and non-income tax liabilities; however, a full tax indemnity is not common as it results in the sellers remaining responsible for any liabilities that may arise post-close. A buyer may also seek to mitigate risk by purchasing a representation and warranty insurance (RWI) policy. RWI policies underwrite against costs for breaching a seller’s representations and/or warranties noted in the purchase agreement. The buyer’s remedy would be to file a claim under the RWI policy rather than seek remedies directly from the seller, thus relieving a seller from historical tax liabilities that may arise post-close. Much like any other insurance policies, RWI policies do not cover known tax exposures identified during tax due diligence or otherwise. When tax exposures are known to exist, it is common for buyers and sellers to negotiate a special indemnity provision to cover the items excluded from the RWI policy.
Whether a target’s tax liabilities are known or unknown, the parties and their tax advisors may consider structuring alternatives to reduce potential successor tax liabilities when and if it makes sense from an overall business perspective.
Strategies for Minimizing Financial Burden
Successor tax liability issues vary significantly depending on the form of the transaction. As a result, both buyers and sellers should be aware of the tax consequences and considerations to focus on in the due diligence phase. Careful tax planning is critical for both parties contemplating a transaction and consulting your tax advisors early in the bidding process is paramount to avoiding or mitigating unexpected cash taxes post-acquisition.