The acquisition of a business requires thorough due diligence of a target’s tax history. There are a variety of circumstances through which a buyer can become liable for tax debts of the business that exist at the time of the close of the acquisition. It’s fairly well known that tax debts remain with the business if the business is acquired in an equity transaction. But it’s less well known that almost every state also has successor liability statutes that can hold a buyer responsible for certain pre-acquisition taxes even when assets are purchased. This article analyzes some of the state tax exposures that may be uncovered during due diligence and provides some steps buyers may take to protect against pre-transaction tax liabilities.
Critical components of tax due diligence
Much of the concern with a seller’s potential unknown tax liabilities focuses on state and local taxes, but many of those state obligations are based on information disclosed in the federal return. As a result, effective tax due diligence requires careful review of federal returns, an understanding of the relationship between federal and state treatment of similar items, and an ability to identify errors in existing state filings, as well as the absence of state returns that the business was required to file over the years. Tax due diligence procedures should include:
- Federal tax due diligence. While the accuracy of the federal return is inherently important, errors in the calculation of federal taxable income can have a ripple effect on state returns. Most states use federal taxable income as the starting point for determining state taxable income, so the due diligence process needs to consider that any modifications from the federal treatment could result in higher state income tax obligations and nonresident withholding debts.
- Federal tax election reviews. Tax due diligence procedures should also include a thorough review of federal tax elections that could give rise to tax liabilities. For instance, if a federal S corporation election is determined to be invalid, the taxpayer may no longer qualify for pass-through treatment on its income and be taxed retroactively as if it were a C corporation. Since most states impose entity-level taxes on C corporations, any change in tax treatment could result in increased federal and state income taxes to which successor liability could apply. However, states such as New York don’t automatically follow federal S status and require a separate Selection to be made in order to get pass-through treatment.
- Employee/contractor classifications. Another common issue identified during tax due diligence involves the misclassification of employees and independent contractors. Misclassification can result in the failure to withhold and otherwise pay federal and state and local payroll taxes, including nonresident withholding if applicable. This oversight can lead to successor tax liabilities which the IRS and state and local taxing authorities may recover from the buyer regardless of how the deal is structured since the liability for the amounts due often attach to the assets purchased.
- State tax nexus reviews. Nexus is a connection between a state and a taxpayer that authorizes the state to impose its taxes on the taxpayer. It can exist based on a variety of criteria, from more tangible characteristics, including a physical presence in the state to actions as innocuous as selling product to a customer if the total sales exceed statutory amounts. The threshold for establishing nexus varies depending on the state and the type of tax. To fully understand the outstanding obligations of a target, a buyer should not only review the target’s existing state and local tax filings for accuracy and compliance, but also review the target’s operations to consider if tax obligations exist in states where the business may have failed to file or misreported activities on a filed return. For example, a taxpayer’s activity in a state may create a filing requirement for sales tax but not for income taxes. Several risks arise when nexus rules have been misunderstood, otherwise applied incorrectly, or if a business decision was made to not file a return. For example, if a target company established nexus in a state and failed to file the required returns, it could be liable for a wide range of tax obligations, including income, franchise, sales and use, gross receipt, and nonresident withholdings. This component of tax due diligence often identifies substantial tax liabilities that were previously unknown. Tax liabilities may span a significant number of years since statutes of limitation don’t apply in instances where required returns weren’t filed.
- Reviewing state and local tax returns to determine if taxes were underpaid. This includes examining income, franchise, gross receipt, and sales and use tax returns.
Ongoing liability for taxes in equity purchases
When a buyer acquires a target in an equity purchase, the tax obligations of the target entity remain with the business. The due diligence steps described above should help a buyer identify potential exposures with outstanding federal income taxes and elections, employment taxes, and various state and local taxes. Any exposure determined in the due diligence process should be factored into its estimates of post-transaction revenues and potential changes to the purchase agreement, such as price adjustments or establishing an escrow to cover the exposure.
A common mistake in this area is to overlook potential tax obligations of pass-through entities (PTEs). Even though these businesses aren’t subject to income taxes at the federal level, state and local obligations can give rise to previously unknown tax obligations that could be enforced after the transaction. A PTE may have obligations in multiple states that could be imposed on the entity after the transaction, such as:
- Sales and use taxes.
- State income tax obligations where the PTE has made a pass-through entity tax election.
- States that impose entity-level income, franchise, or gross receipts taxes.
- Nonresident withholding obligations in states that require pass-through entities to withhold taxes on earnings allocated to nonresident owners.
In some cases, a buyer will pursue transactions where an equity sale is treated as a “deemed asset” purchase solely for tax purposes. This treatment allows the buyer to benefit from a step-up in the tax basis of the assets, enabling deductions for depreciation and amortization related to the deemed asset purchase. Even though the transaction is deemed a purchase of the target’s assets for tax purposes, the legal entity continues after the acquisition and all historical debts remain since legally the transaction was the purchase of equity. As such, the tax election to treat the transaction as an asset purchase doesn’t mitigate exposure for taxes.
Successor liability for taxes in asset purchases
When a buyer acquires a target in an asset purchase, outstanding federal income tax obligations of the seller generally don’t transfer unless the obligations are assumed in the asset purchase agreement, which rarely occurs. This factor may lead a buyer to believe that it’ll escape taxes arising before the transaction closes. However, many states have successor liability laws that may result in the imposition of unexpected obligations on the buyer.
Additionally, it’s possible for the IRS and state and local tax authorities to impose successor liability taxes for an asset sale based on nontax state law. For example, the “mere continuation doctrine” is a judicial rule that applies when an entity is considered a continuation or successor of a previous entity. Relevant factors to consider when determining whether the new entity qualifies as a successor include but are not limited to:
- The continuation of the same type of business.
- No change in the identity of owners and decision-makers.
- The use of the same employees and the operation of the business from the same location.
It’s important to understand that other factors and areas of law may be reviewed by state taxing authorities when it comes to determining whether successor liability exists.
Protections against successor tax liability
When acquiring a target in an equity transaction, the terms of the purchase agreement are the primary tool used to ensure that the selling parties continue to be responsible for the tax obligations of the entity that existed before the transaction. When acquiring a target in an asset transaction, buyers and sellers have several options that may limit successor liability.
Many states have procedures for obtaining tax clearance certificates that can limit a buyer’s exposure to successor liability. In most states, the buyer is required to notify the state of the transaction as part of the state’s bulk sale reporting requirements, which varies by state. Some states require nothing more than for a letter to be mailed with the request, while other states have a form or other documents that need to be submitted as part of the request. Many states require notice of the transaction within a defined period before or after the transaction. Strict attention should be paid to the deadlines imposed by the states as they often differ among states.
Further, statutes generally require the buyer to withhold a portion of the purchase price until liabilities are confirmed and paid to the state or tax clearance certificates are issued. To the extent tax clearances aren’t obtained or other reporting requirements not followed, a buyer may be unprotected from successor liability. Failure of the buyer to comply with the notification requirement is likely to result in successor liability for the target’s unpaid tax liabilities.
In some cases, it might not be feasible to obtain a tax clearance certificate. For example, if a taxpayer has never filed a return or otherwise has material unpaid tax debts in a particular state, such as sales tax collected and not remitted. Furthermore, a buyer and seller may not want to initiate the clearance process as it might trigger further review of the seller’s activity by the taxing authority that could delay the transaction until the review has been completed.
When tax clearance certificates aren’t an option, a seller may consider utilizing a state’s voluntary disclosure program to reduce the amount of tax, interest, and penalty that could be due upon audit. Voluntary disclosure agreements (VDAs) can reduce tax debts by waiving penalties and reducing the amount of tax and interest payable through a limited lookback period. When entering the program, a taxpayer comes forward voluntarily, discloses liabilities to the taxing authority, and then works with it to determine the applicable terms of the agreement. Most states require returns to be filed, including payment for any tax and interest, for the prior three or four years. Any liability outside this lookback period is generally forgiven along with any penalties owed during the lookback period. VDAs can reduce uncertainty related to state and local taxes, but they don’t eliminate the risk of successor liability completely since the related filings remain open to audit based on the state’s respective statutes of limitations.
Conclusion
Tax liabilities, whether known or unknown, are an inherent risk that all parties to a transaction must address, regardless of it being an asset or equity transaction. A thorough approach to federal, state, and local tax due diligence in both equity and asset transactions generally helps a buyer identify material tax liabilities at a point when it can modify or cancel the acquisition accordingly. State and local tax due diligence also helps a buyer identify and implement effective risk mitigation strategies throughout the process of negotiating and executing a purchase agreement and enables it to take proactive measures to uncover, limit, or even eliminate tax exposures in which successor liability could be imposed. Due to the risk of successor liability imposed on the transaction, buyers should strongly consider including tax due diligence procedures as part of the transaction process regardless of how the deal is structured.
