Business Acquisitions: Don’t Forget Your State Tax Due Diligence
Universal Advisor, 2004 Issue No. 3


Business acquisitions, start-up companies, and reorganizations continue to be hot topics in the financial news. The state and local tax issues associated with business transactions are important to consider but are often overlooked until it’s too late. Generally these issues will not kill the deal, but state and local tax issues can result in significant tax costs that could have been avoided if addressed during the negotiation process. This section provides a brief overview of the due diligence process related to a business acquisition and will provide a discussion of common state and local tax issues to consider.

Step 1: The Due Diligence Review

The due diligence review is conducted to determine whether the company being acquired (“target”) has any exposure for unpaid state and local taxes. To be effective, one must first develop a thorough understanding of the target’s business operations. The due diligence review in a stock purchase is more complex than in an asset purchase, because in a stock purchase, all known and unknown liabilities follow the target corporation. State tax due diligence is also essential in an asset purchase, since many states have imposed successor liability statutes under which the purchaser is liable for the seller’s unpaid taxes.

Purchasers are often surprised to learn that successor liability can apply not only to sales and use taxes but also to income taxes, property taxes, and employment taxes. States imposing successor liability generally issue a document indicating that the seller is in compliance with tax laws and that tax payments are current. Clearly, obtaining such documentation from the state taxing authorities is preferable from the buyer’s standpoint. However, in the rush to consummate a transaction, this tax clearance document is often overlooked.

Step 2: Determine Tax Exposure

Once the target’s business operations are fully understood, the next step is to determine whether any state and local tax exposure exists. To make this determination, it’s critical to address two questions: In which states is the target conducting business, and in which states is the target registered to do business?

In determining this exposure, state tax due diligence should focus on the following key areas:

• Income and franchise taxes: Assess whether the target is filing in all states and municipalities in which it has nexus as well as its regulatory audit history.

• Sales and use taxes: Determine whether the target is collecting sales and use taxes in all jurisdictions in which it has nexus and is selling taxable products or services; in addition, assess whether properly completed exemption certificates are maintained to support any exempt sales of goods or services.

• Other Issues To Consider: Determine whether the target is properly filing property tax returns and is in compliance with abandoned and unclaimed property laws, and review the employment tax reporting procedures.

Step 3: Transactional Issues and Taxes

During this phase of the review, it’s important to determine whether any state or local taxes are triggered by the transaction itself and whether the form of the transaction will be respected by the relevant states. The following issues should be reviewed:

• IRC Sec. 338(h)(10): This Internal Revenue Code section allows certain stock purchases to be treated as an asset acquisition. While virtually all states recognize this election, certain states’ treatment of the election may vary from the federal treatment.

• Responsibility for Filing Returns and Payment of Taxes: It may seem obvious to the purchaser that any taxes resulting from a 338(h)(10) election should be paid by the seller. However, which party is responsible for remitting the tax is less obvious in states that don’t recognize the election. Also, in states such as Ohio, which may require a different tax year than the federal short period, the resulting state tax liability may appear on the buyer’s return.

• Carryover of Value and Tax Attributes: The issues to consider include whether the states permit the purchaser to use the target’s net operating losses (NOLs) if the target is merged into the purchaser and, even if the target has not generated significant losses, the purchaser should ensure that all NOLs to which the target is entitled are identified during the due diligence process.

• Casual or Occasional Sale Exemption: In an asset purchase, it’s critical to determine whether the sale of assets will be subject to sales and use taxes. Although many states have an occasional sale exemption, the applicable purchase price may be capped at a certain dollar amount, or certain conditions may apply to specific assets.

• Real Estate Transfer Tax and Revaluations of Real Estate: Even in a stock purchase, it’s important to determine whether a realty transfer tax will be imposed on the transaction. Certain states look through a stock transfer and subject the real property to a transfer tax.

Step 4: Discuss Planning Opportunities

Certain business transactions could present an ideal opportunity to implement state and local tax planning strategies, such as:

• Use of special purpose entities. Using special purpose entities, such as holding companies, LLCs, and LLPs, to acquire a portion of the target’s business can reduce the state tax burden.

• Proper placement of acquisition debt. If the target is expected to generate taxable income, the buyer can derive significant benefits in separate filing states by placing the acquisition debt at the target level.

• Payroll tax planning. An opportunity may exist for a successor employer to carry forward the state unemployment taxable wage base, state unemployment tax experience rate, and the associated state unemployment tax account of a predecessor to reduce the overall payroll tax liability.

• Property tax planning. A buyer’s overall property tax liability may be reduced by properly allocating the purchase price among the intangible or nontaxable property.

• Tax return filling positions. Identifying and electing the optimal filing position (such as combined/consolidated vs. separate filings) can achieve significant tax savings by offsetting income and losses of entities and diluting the apportionment factors.

In summary, this section addresses the variety of state tax issues that must be considered in any business transaction. Each transaction is unique and requires assessment of all surrounding factors when conducting a due diligence review, identifying transactional issues, and/or considering state tax-planning strategies.