Simplified Tax Models Obscure Risks and Liquidity in M&A Deals

As mergers and acquisitions show signs of rebound in 2026, sponsors and management teams must not overlook the importance of tax as a key element of their transaction models.

Transaction models shape pricing, leverage, and return expectations. In many middle-market deals, taxes receive less scrutiny than revenue, EBITDA, or financing terms. Models often treat tax as a residual, applied through a flat effective rate and assumed to behave predictably over time.

But tax rules don’t behave predictably. Limitations, timing rules, and elections affect cash flow, especially in the first years after closing a deal. When these dynamics are ignored, models overstate liquidity and understate risk.

Treat tax as a driver rather than a plug. Many models rely on a single effective tax rate applied to pre-tax income. This approach ignores how capital structure, asset mix, and historical attributes interact with the tax code.

Tax outcomes aren’t linear. Rather, limits on deductions and attribute usage change cash taxes year by year. Treating tax as a plug produces clean models that don’t reflect reality.

Avoid overstating the value of net operating losses. Federal net operating losses generated after 2017 may only offset up to 80% of taxable income in any year, but models often assume full offset until losses are exhausted.

This assumption front-loads tax benefits that can’t be realized. The result is understated cash taxes and overstated free cash flow in early years. Losses remain valuable, but they rarely eliminate tax entirely.

Recognize interest expense limitations under Section 163(j). Interest deductions are capped based on adjusted taxable income. Highly leveraged transactions frequently exceed this threshold, particularly in the years immediately following an acquisition.

Models that deduct all interest expense understate taxable income and fail to capture the buildup of disallowed interest carryforwards. The impact is a timing difference that directly affects early year cash flow and debt service capacity.

Model Section 382 limitations on losses. When a target has pre-close net operating losses, ownership change rules may limit annual usage. Many models assume losses are freely usable without testing ownership shifts, prior transactions, equity rollovers, or valuation assumptions.

When Section 382 applies, losses may only be usable in small annual increments. In some cases, they become effectively unusable. Ignoring this risk inflates modeled tax shields and distorts purchase price economics.

Apply bonus depreciation. Tax law allows accelerated depreciation for qualifying property. Models often overlook this benefit or apply it inconsistently with purchase price allocation.

When modeled correctly, bonus depreciation can materially reduce early year cash taxes. When ignored, models understate near-term liquidity or assume benefits that don’t exist.

Properly state the deductibility of transaction costs. Deal costs are frequently expensed in full within transaction models, but tax rules require many of these costs to be capitalized or amortized.

The difference affects the timing of deductions and cash taxes, particularly in the first years after closing. Early year tax benefits assumed in models often don’t materialize.

Don’t assume asset basis step ups without structural analysis. Models sometimes assume asset basis step ups without accounting for transaction form, required elections, or seller level tax cost.

Stock acquisitions don’t automatically generate depreciable basis. Elections carry consequences that affect pricing and feasibility. When structure is assumed rather than analyzed, depreciation benefits appear in models that never materialize.

Avoid underestimating state and local tax exposure. State and local taxes often diverge from modeled assumptions after close. Common drivers include remote employees, multistate customers, prior acquisitions, and sales tax exposure on bundled offerings.

These liabilities rarely affect EBITDA—earnings before tax, interest, depreciation, and amortization—but they do affect recurring cash taxes and compliance costs. Models that ignore state taxes understate ongoing cash outflows.

Don’t rely on flat effective tax rates. Effective tax rates vary with income levels, deduction limitations, state mix, and utilization of tax attributes. Flat rate assumptions hide volatility in cash taxes that can become problematic when liquidity needs to be closely monitored.

Why early tax review changes deal outcomes: Most of these issues aren’t difficult to identify if the right questions are asked. However, they become costly when discovered after pricing, leverage, and structure are already locked.

Involving a transaction-focused tax adviser early in the modeling process helps deal teams test assumptions, align structure with economics, and avoid surprises that erode returns. Early review allows tax considerations to inform decisions rather than react to them. Taking these steps can ensure the model reflects how cash will move in reality.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Matthew Friedman is senior director of Portage Point Partners’ transaction advisory services practice.

Write for Us: Author Guidelines