M&A negotiations and sales tax liability

It’s a common scenario: A company has decided to sell, then due diligence turns up a $2 million risk in past sales tax obligations and compliance. The buyer looks to secure against the risk via escrow – on the conservative, high side – and requires the seller to mitigate the risk.

Let’s say you’re the seller. Do you have solid positions and reasons for your sales tax decisions? Can you defend your sale tax position to minimize the escrow’s impact?

At first glance, sales tax risk might be considered immaterial to a merger or acquisition, but when you consider that up to 10% of a business’s overall revenue could be exposed, compounded over multiple years, including penalties and interest for non-compliance, and you can see that sales tax risk can become a deal killer.

What steps can you take to ensure it doesn’t happen to your business?

Nexus and taxability

First, you need to determine where you have sales tax nexus; the connection between a tax jurisdiction and a company that creates a sales tax obligation on behalf of the company. Nexus can be physical, created by an office or personnel in a state. Or it can be economic, created by a number of invoices or volume of sales (200 transactions or $100,000 respectively, for example) over the course of a year. While the $100,000 or 200 transactions is a good general rule for establishing economic nexus, there are nuances from state-to-state including different revenue and transactions thresholds, whether gross sales or taxable sales is used as the measure, and the time period as well.

When it comes to due diligence, prospective buyers often perform a high level sales tax review with limited consideration to the refined details of activities.

In addition to understanding where you have nexus, you also need to determine the taxability of your services and products in various states. Not all products are taxable in all states (tech and food/groceries are two big examples) and not all services are non-taxable in all states. Your nexus plus your taxability equals your sales tax obligation.

If you have an obligation but are not collecting and reporting sales tax, you are accruing risk/exposure.

Estimating exposure

Getting an idea of your existing sales and use tax exposure is an important early step in the M&A negotiations process. This requires looking at a variety of factors in addition to the above taxability of products/services, including:

• The taxability of your customer base. Are they nonprofits, resellers, government entities, or in some other industry that has an exemption to sales and use tax?
• The statute of limitations. It’s typically just 36 to 48 months for a registered taxpayer who’s filing sales and use tax returns on time. If you’re not registered in a state where you should have been collecting and remitting sales tax, there is no statute running and a state can assess you as far back as when you established nexus and had taxable sales.

Precise quantification of your prior sales and use tax liabilities may require contacting past customers (more on this in a minute).

Evaluate mitigation options

If your sales tax liability is immaterial, you may be looking at just a registration effort to get into compliance and start managing sales and use tax liability prospectively. You may also find it easiest to register retroactively with states and file and remit from that period through current.

One common mitigation practice is the voluntary disclosure agreement (VDA), a legal means for taxpayers to self-report back taxes owed, including sales tax. For voluntarily reporting the tax due, states generally waive penalties if you haven’t charged and collected the tax. There’s also a limited look-back period: generally three or four years, potentially reducing your tax due significantly. (If your back taxes are not disclosed but are instead discovered through an audit, you could end up assessed various penalties plus interest plus all historical tax due.)

Other mitigation options:

XYZ letters. These documents from you simply ask past customers if they’ve already paid the tax or they’re exempt on some transactions (and asking for exemption documentation).

Escrow settlements. These split the risk, with a cash benefit to both the buyer and the seller. In this situation, sellers may not be require to mitigate their risk with the states. Instead, after a predetermined amount of time, the buyer and seller agree to split the escrow in an equitable fashion – the timeframe and percentages agreed to up front.

When you’re selling your business, remember that your buyer will be protecting their business with an escrow that’s as big as possible to cover your potential sales and use tax liability. It’s up to you to identify what the true number should be – and be able to argue that escrow down.

(You can hear our webinar “Mergers and Acquisitions Case Studies & Actual Negotiations” here.)

(Click here to download our ebook, “How Sales Tax Impacts M&A.”)

If you’re looking to reduce costs, increase efficiencies and minimize the substantial risk of noncompliance, reach out to an expert. Contact us to learn how we partner our clients with an experienced and dedicated practitioner to ensure sales tax is taken off their plate.