When considering the purchase or sale of a business, sales taxes often require close attention due to the potential to create significant tax exposures that can influence the outcome of a deal. If sales tax issues are identified during diligence, a buyer may want to pay less for the business, may request an increase to escrows and longer indemnification periods, or the buyer may terminate the deal entirely. Sales tax stands out in importance since it’s levied on the gross proceeds from the sale of goods and taxable services rather than profits. It’s collected by the seller on behalf of the state government and generally accrued for and paid when due.
Each state has its own rules regarding sales tax nexus standards, taxable and exempt items, exemption documentation support, and filing requirements. As a result, parties to a transaction should take proactive measures to ensure that sales tax has been properly collected and remitted to the states. Sellers should consider conducting nexus and taxability studies to identify filing and sales tax collection requirements, while buyers should ensure that proper due diligence is performed on businesses they’re looking to acquire.
Seller considerations: Nexus and taxability studies
When selling a business, a seller should consider whether the business owned is filing sales tax returns in all the required states. For sales tax purposes, a physical presence such as property, employees, or agents within a state, even when only temporary, generally will establish nexus. However, even without a physical presence, a taxpayer can still have a requirement to collect and remit sales taxes to a state. This is generally established when sales in a state during the current or prior year exceed a specific threshold, such as $100,000 in sales or 200 transactions, though statutes vary by state. If management is unaware of this requirement, a business may not be filing sales tax returns in all required states, and large debts may exist upon audit.
Conducting a nexus study as early as possible prior to a sale can help a seller ensure the business it’s looking to sell has collected tax, filed sales tax returns in all applicable jurisdictions, and assess the materiality of any exposures if any noncompliance with state requirements exists. State statute of limitations don’t start tolling in situations where returns were never filed; therefore, a taxpayer could be liable for taxes owed from the date nexus was first established through the current date.
Understanding whether the risk is small or large can guide a seller in determining the appropriate course of action. If liabilities are minimal, the seller may pass on taking further action or decide to file prospectively to minimize future audit risk. However, if liabilities are significant and span many years, a seller might consider a voluntary disclosure agreement (VDA) with the state as a strategic solution. A VDA is often a contractual arrangement between a taxpayer and the state, allowing the taxpayer to disclose and settle past-due tax liabilities in exchange for benefits, like reduced or completely avoided penalties, and a limited look-back period (usually three to four years) for tax assessments.
Taxability studies are equally important, as these studies help management determine which products and services are subject to sales tax in different states. As with nexus determinations, taxability will depend on the jurisdiction. For example, Arizona typically taxes digital products like music downloads, whereas California generally doesn’t tax these items unless the digital product is delivered on a tangible medium, such as a CD. By clarifying tax collection requirements, a taxability study helps businesses avoid undercharging customers, which could create a liability, or potentially overcharging customers, which could result in losing a competitive edge on pricing.
Even though a state has defined a sale as taxable, the item may be exempt if such sales are purchased by a customer for resale, for use in manufacturing, or purchased by a nontaxable entity. For exemptions that are based on use, rules vary by state regarding what items qualify for exemption and require a seller to obtain sales tax exemption certificates or other supporting documentation from customers to substantiate their exempt use. Without proper documentation, a seller is generally responsible for the collection and remittance of any tax due on sales that may have otherwise qualified for an exemption. Having sound procedures for collecting and maintaining exemption certificates helps a seller minimize the risk of tax, interest, and penalties being assessed on exempt transactions upon audit.
Nexus and taxability studies are also crucial to prevent negative repercussions on cash flow if conducted before the sale. Since sales tax is a fiduciary tax, businesses function as intermediaries, collecting sales tax from customers on behalf of the state. If a business has established nexus in a state but fails to collect the appropriate sales tax, the state may hold the business liable, requiring the business to pay the tax from its own cash reserves, thereby adversely affecting cash flow. Although sales agreements may include provisions allowing businesses to collect sales tax retroactively from customers, the use of these provisions strain customer relationships and can impact transactions due to the time, costs, and frustrations created during the diligence process. By gaining a comprehensive understanding of sales tax through nexus and taxability studies, a seller can mitigate these risks, prepare the company for due diligence prior to selling the business, and reduce the amount of funds to be placed in escrow at the time of sale. Best practice is to have the studies refreshed on a period basis as frequently as annually.
Buyer considerations: Sales tax liabilities
When acquiring a business, a buyer often weighs the benefits of purchasing the equity of the business versus its assets. As part of tax due diligence, the buyer will generally evaluate sales tax nexus and the material nature of any noncompliance. Regardless of the chosen acquisition structure, sales tax liabilities generally transfer to the buyer or remain with the entity acquired. In an equity acquisition, the debts, known and unknown, of the target entity will remain with the business. Conversely, in an asset acquisition, a buyer is often liable for pre-transaction sales tax exposures as successors. Statutes imposing successor liability vary by state and generally require following statutory bulk sale procedures. These procedures are designed to protect a buyer from inheriting the seller’s debts, including sales tax liabilities, when purchasing a business’ assets. If there are known exposures, some sellers may not want to comply with state statutes that require notification prior to the transaction. Expected exposure will lead to withholding a portion of the purchase price until the exposures are cured, and the state confirms there are no additional outstanding tax liabilities. If the parties fail to comply with bulk sale notification procedures, the buyer remains liable as a successor for the tax debts of the seller.
A seller may not want to or may not be able to follow the bulk sale reporting requirements in all situations. For a buyer, this process is crucial to uncover potential risks before purchasing a business. By conducting sales tax diligence, a buyer can identify liabilities and ask the seller to take proactive measures, such as including indemnification clauses to protect against exposures, adjusting the purchase price, including estimated exposure in escrow amounts, or seeking VDAs to remediate the exposure.
Sales tax debts that are uncovered during tax diligence can be substantial. A thorough tax due diligence process is an effective way to address successor liability even if bulk sale notifications are filed since it provides information that the buyer and seller can use to determine the appropriate terms of the purchase agreement and can identify if any other corrective action is needed.
Conduct sales tax due diligence to protect both parties
Sales tax presents significant challenges for businesses due to its varying applicability across states. Businesses that don’t comply with the rules can incur significant liabilities that may pass to a buyer. However, there are many tools available to identify and address these risks. A seller can conduct nexus and taxability studies to understand where sales tax filings are required, whether their products and services are taxable in different states, the magnitude of liabilities, and the best course of action to take. For a buyer, the tax due diligence process offers the opportunity to address tax debts that may be inherited as part of the transaction. Due diligence and other tools can help buyers determine proper indemnification provisions and escrow accounts, mitigate historical sales tax issues, and prepare the buyer for sales tax requirements that may change depending on the post-transaction facts. If sales tax has been properly addressed before a deal, there is a higher likelihood of a smoother and more successful transaction, protecting both parties involved from potential tax surprises.
