The fast-paced world of private equity investment, mergers and acquisitions (M&A) and the art of aligning business interests in the perfect deal certainly sounds glamorous. It’s often where Wall Street meets Hollywood and depicts people reaping lots of money in the process! There are so many components in the making of a successful merger, including synergies between the companies’ cultures and employees, financial aspects, logistics, and other important areas. Tax matters (and in our world, state tax matters) are often the last pieces of the puzzle to be brought to the deal process. And while taxes are rarely the things making the headlines in a transaction, they really are an important piece of the overall transaction – both on the state income tax side (which we’ll discuss briefly below) and the sales tax side. And all the things that we discuss regularly here in our blog – nexus, taxability, look-back, exposure and remediation – they all come up in an M&A transaction. And if the exposure is big enough, it can derail a deal. Unfortunately, we’ve seen it happen!
Some Basics
In an acquisition of a company the deal is structured as either the purchase of the stock of a company (an equity deal) or its assets (an asset deal). From an income tax perspective (federal or state), the structure of the deal makes a difference as well.
Regarding sales tax, on the actual purchase itself, there is generally no sales tax due on the consideration paid for a company in equity-based deals. However, there may be sales tax ramifications on the purchase of assets in an asset-based deal. Most states have exemptions for assets transferred as part of an acquisition (for instance an “occasional sale” exemption), but it is always important to understand the transaction itself, including the actual assets transferred, timing of such transfers, etc.
Certainly, the sales tax ramifications on the actual transfer of assets or stock in the purchase transaction are often brought up during the pre-deal due diligence process. However, another key area is the successor liability matter for any prior exposure and areas that the seller may have treated incorrectly in the past. Successor liability is important because the purchaser can be held responsible to state taxing authorities for any sales tax debts of the selling entity – particularly in stock transactions. Officers of the acquiring company must be mindful of the potential successor liability as they are now the “responsible party” for any retroactive exposure.
In order to mitigate those risks, purchasers engage in a due diligence process to determine if there are any sales tax related skeletons in the seller’s closet. In a perfect world, the seller (whom we often represent) would have completed its own internal “sell side” due diligence within a year or so of the proposed sale. However, we often find that not to be the case.
In a recent conversation with a colleague, Mike Mogin of M&A Business Advisors, Mike mentioned that “15-20 years ago, companies on the selling side didn’t do as much due diligence in advance of the sale. My struggle in today’s market is to convince business owners to spend a little time and money now to put yourself in a good position to sell when the right buyer comes along.”
Sales Tax – Buyer Side
As a buyer contemplates an M&A deal with a seller, they engage in a due diligence process prior to the sale. It is at this time that queries are made about all the various things that could be indicative of sales tax exposure on the seller’s part.
A buyer’s accountants and attorneys will want to focus on several areas to determine what level of retroactive exposure might exist.
- Nexus – Has the seller recently engaged in a nexus review?
- Taxability of revenue streams – Has the seller determined the proper sales tax treatment, by state, of its various products and services?
- Registrations and filings – Is the seller filing in all the jurisdictions required?
- Has any sales tax been collected and not remitted?
- Has the seller undergone any quantification of the exposure, including penalties and interest?
- Has the seller considered any plans for remediation, to likely include Voluntary Disclosure Agreements, or registrations and retroactive filings?
Oftentimes there is not much time allotted in the deal flow process for this exercise, and the buyer’s diligence team often makes “worst case” decisions in determining the possible exposure of the seller. That amount may well be in excess of what is actually due, but it is then tied up in escrow until the seller remediates the liabilities or can prove the liability to be less than estimated and recoup the excess escrow amount. It results in less money paid to the seller at the time of the deal. That’s just one reason why we recommend sellers to engage in their homework well in advance of a deal.
Sales Tax – Seller Side
In our experience, sellers are often not as well represented by state tax consultants, accountants and attorneys (at least at the beginning of the process) as the buyer side. Consequently, they often are caught unaware of potential exposure that might be discovered in the due diligence process. We recommend that companies who wish to be acquired within the next 12-18 months actually perform their own internal due diligence to address the issues mentioned above internally so that they are ready for the actual due diligence when the buyer comes to the table.
The focus items are, of course, similar to the above, but viewed from a slightly different lens – when more time is available than the “end-of-deal” scramble that often happens. We often assist companies on the “sell-side” of a transaction, and address these items preferably early in the process. But we are also often brought in right before the deal closes. Either way, we recommend to consider these areas.
- Nexus – perform an analysis of when nexus has been created in various states, taking into account both physical presence and economic nexus. Make inquiries not only about current employees, but also employees no longer with the company, those hired under a PEO relationship, employees who travel regularly for sales or other activities, independent contractors acting on behalf of the company, inventory stored outside the home state, etc.
- Taxability of revenue streams. Perform a detailed review of the nature of the revenue generating activities. Does the company provide services which are related to any tangible property sold (i.e.; delivery, assembly, customization)? If a software or SaaS company, how is the product delivered? Are any services bundled into a subscription model? We recommend to clients to analyze line items which appear on invoices to determine whether they are being properly treated. “Bundled items” which include some tangible personal property and some services included as one price can often be problematic.
- Determine estimated retroactive exposure. As part of the nexus and taxability reviews above, sellers should determine the amount of sales tax potentially owing to various states. Within that process, a company might possibly explore exemptions (for instance – sales for resale and proper documentation to support those sales) and also whether their customers may have self-assessed tax over the years.
- Develop a plan for remediation of past taxes. Even if a company wants to begin registering and filing on a go forward basis, they must fix the past before moving forward. (That’s because in the state’s required registration documentation, a taxpayer must detail activities in the state and sign under penalty of perjury.) We generally recommend to clients that they enter into voluntary disclosure agreements if the sales tax exposure is significant as the VDA process includes waiver of penalties and limited lookbacks, among other benefits.
- Develop a go-forward plan for compliance. Once the retroactive liabilities have been addressed, a company needs to put in place a system for properly collecting and remitting sales tax in states going forward. Often this includes a combination of software and ongoing human oversight. (See our recent blog for more details.)
