Identifying state and local tax exposures during acquisition
Tax due diligence often focuses on the identification of tax exposures at the federal level. This is often appropriate due to the high federal tax rate imposed on underreported income and the fact that major transactions are reported on the federal return. However, the identification of tax exposures at the state and local levels can often be even more important since successor liability rules are often broader at the state and local levels. In addition, potential tax exposures for items such as sales and use tax can also be very high since they are also often calculated based on a percentage of the proceeds as opposed to the income earned on the transaction.
Tax due diligence should be conducted for state and local taxes such as income, franchise, gross receipts, sales, use, property, payroll, and others.
Tax due diligence should be conducted to determine whether the entity is filing pursuant to its correct tax classification. For example, some entities are required to separately elect to be taxed as S corporations in a state. Some states impose entity level taxes on a pass-through entity even though the taxation of the entity passes through to its owners for federal tax purposes. The exposure for these entity level state taxes should be clearly identified since there is often successor liability for these taxes even in an asset transaction.
One primary issue relates to whether the business or business owners have filed tax returns in every jurisdiction where they are required. The nexus issue is critical for tax due diligence since statutes of limitations often do not begin to expire until tax returns are filed. As a result, the tax exposure is often not limited to the target company’s most recent tax years. This question of nexus can be determined differently depending on the underlying tax involved. For example, the threshold to create nexus for sales and use tax purposes is often less than the threshold for creating a filing requirement for income taxes.
Another issue often relates to whether a target company is apportioning its income appropriately between the states. Different states impose different apportionment rules depending on the nature of the underlying business. This can result in a company being taxed on more than or less than 100 percent of its total income.
Another common area of concern that has the tendency to become a large exposure item is the non-collection of sales tax or the lack of proper documentation for exempt sales. Taxpayers should generally obtain exemption certificates from their customers to be relieved of the obligation to collect sales tax. When sales tax nexus exists, states require companies to collect and remit sales tax from their customers on the products (and sometimes services) they sell, unless an exemption exists. If a company fails to collect the sales tax from its customers, most states consider the tax to then be a liability of the seller.
Tax liabilities caused by the transaction
When the assets of a business are sold, certain taxes may apply to the transaction itself and may become due within a short period of time following the transaction or even at the time of the transaction. A major component to transaction based taxes is the sales tax on the transfer of assets. Generally, all sales of tangible personal property are subject to sales tax unless an exemption applies, such as the casual sale or resale exemptions. These exemptions should be investigated as they vary widely by state and usually have limitations for items such as titled assets. If a transfer tax applies, it is imperative to understand the different components within an asset transaction. Obtaining a valuation that itemizes the different assets included in the deal is often necessary in order to bifurcate the assets that may be subject to sales tax versus the assets that can clearly be excluded from a sales tax calculation. The buyer may be responsible for these transfer tax liabilities depending on the form of the transaction, contractual provisions, and the state involved.
Performing tax due diligence for state and local taxes can assist the buyer in identifying the various exposures that may exist. Once an item of exposure is identified, it can be very challenging to quantify it, depending on the capability of the seller’s systems and processes. For example, the seller might not be able to extract the appropriate apportionment data if its systems have not been designed to capture this information at the point of sale. However, the buyer may be able to protect itself in negotiating the deal if the nature of the exposure is identified.