Private equity (PE) groups should be concerned about state tax liabilities before finalizing a potential deal and should strongly consider performing state and local tax due diligence prior to close. The June 21, 2018 Supreme Court’s decision in South Dakota v. Wayfair, Inc. enhanced the ability of states to require out-of-state businesses to collect and remit sales tax, and that change has in turn made the landscape of tax due diligence significantly more complex.
The ruling upheld a state law that required out-of-state businesses to collect and remit sales taxes based on “economic nexus,” a concept focused on the level of sales activity the taxpayer conducts in the state. South Dakota’s law imposed a collection requirement on out-of-state businesses, with no physical presence in the state, that had either $100,000 in sales or 200 separate transactions in the state during the year.
In the wake of the Wayfair ruling, almost every state that imposes a sales tax adopted some type of economic nexus requirement on out-of-state businesses, with no physical presence, that sell into its jurisdiction. However, not all of the states use South Dakota’s thresholds. States are aggressively expanding the economic nexus statutes to include income, franchise, and gross receipt taxes. The varying rules and regulations make state tax compliance considerably more challenging and significantly increased the risk a buyer may inherit related to historical state tax liabilities of a target.
Unknown state tax obligations are particularly troublesome in the deal space for several reasons, including:
- Extended statutes of limitation: Liability for failure to collect and remit sales taxes or file and pay other applicable state taxes, often extends beyond a normal three- or four-year statute of limitations. States will generally calculate the tax, penalty, and interest based on the date that nexus was first established, meaning the business could be on the hook for multiple years of unpaid state taxes since statute of limitations doesn’t begin to run until returns are filed.
- Successor liability: States can hold the purchaser liable for tax obligations incurred by previous owners of the business, even if the deal is structured as an asset purchase.
Whether you’re a business owner looking to sell or a PE group considering an acquisition, it’s critical to assess a seller’s state tax obligations — both known and unknown — before you close a deal.
Avoiding PE buy-side deal-killers
On the buy side, PE groups should strongly consider state and local tax due diligence with a focus on economic nexus statutes, and they need to make sure the contracts include proper indemnification clauses for any unknown obligations that are found after the sale. Post-Wayfair buy-side due diligence should include:
- Nexus: State and local tax due diligence should be performed to make sure the target company has properly addressed its state and local tax liabilities in the states business is conducted. Buyers have more risk for state tax purposes since a seller may now have more state tax filing obligations than it would’ve had in earlier years.
- Tax clearance certificates: Request tax clearance certificates or other documentation from state tax departments attesting that the target company has no outstanding state tax liabilities. If these procedures aren’t followed, a buyer may be deemed a successor and could be required to pay the taxes owed, along with penalty and interest, for pre-transaction activities of the seller.
- Resolve outstanding liabilities: Work with the seller to address any known state liabilities and file returns in all applicable jurisdictions as soon as possible after closing if not before. Take advantage of voluntary disclosure or amnesty programs where available.
- Adjust escrow: Given the current uncertainties and frequent changes in state tax rules, consider increasing amounts held in escrow to protect against the increased risk a buyer may inherit due to a seller’s state tax liabilities and to address any professional fees that may be incurred in addition to the state tax liabilities of the seller.
Avoiding PE sell-side deal-killers
Sales tax — along with other state tax obligations that are uncovered during the tax due diligence process — can easily kill deals. On the sell side, business owners considering a sale as part of their exit strategy need to prepare themselves ahead of time in order to resolve issues before starting discussions with potential buyers. These preparations include:
- Nexus studies: You can be sure that any potential buyer will perform state and local tax due diligence on a pending purchase. Therefore, it’s important to identify any state tax liabilities before going to market. A nexus study should be considered for all applicable subsidiaries and updated annually to keep your business in compliance as it grows into new states or as states impose new requirements.
- Self-disclose and resolve errors: Many states offer reduced liabilities or even amnesty for businesses that come forward voluntarily and agree to stay in compliance once the past liability is resolved.
- Review internal procedures: Make sure internal processes are in place to document and minimize sales tax exposures. Maintain and update exemption certificates where applicable and periodically perform state sales taxability studies to determine if the products or services sold are subject to sales tax in the states nexus exists.
- Stay current on state rules/regulations: Whether you do the research in-house or rely on an outside advisor, make sure that your business has a process for staying current on changes to all relevant state tax rules, including economic nexus.
- Consider outsourcing: Similar to payroll taxes, sales tax compliance is getting complicated and expensive to manage internally. Third parties like Plante Moran offer outsourced sales tax management functions to minimize the complexity and costs of compliance.
Moving forward with Wayfair
The changes brought about by the Wayfair decision may make sales tax compliance and due diligence more complicated, but PE investors that work in this environment day-in and day-out know what it means to manage risk.
If you want more information on how you can more effectively manage the new risks introduced by state economic nexus rules, please contact your Plante Moran advisor.
