As the mergers and acquisitions market continues to heat up, so should the scrutiny of sales tax in the due diligence review. Unlike income tax, sales tax is transaction-based and applies to sales, regardless of whether the company is in a profit or a loss position. A company can be financially sunk by a significant and unforeseen sales tax assessment.
A buyer of a company should be aware that sales tax successor liability generally applies to the purchase of a business, even an asset purchase. A due diligence review can reduce the surprises and, in some circumstances, enhance negotiations for a reduced sale price.
Nexus and Tax Exemptions
The biggest sales tax exposures generally result from a failure to (1) register and collect tax in a state and (2) collect tax based on an erroneous decision that the receipts are not subject to tax. Many companies are caught off guard by inquiries from distant states and are surprised at the low nexus standards for sales tax. “Nexus” is defined simply as the minimum connection or physical presence that must exist before a state can impose tax liability and reporting requirements on a company. The Supreme Court ruled in Quill v. North Dakota, 504 US 29 (1992), that a “physical presence” exists by the temporary presence of property, inventory, employees or independent representatives in a state.
However, states vary in interpreting the degree of physical presence required. For example, 11 visits to Kansas during three months of a four-year audit period were insufficient to establish nexus; see In the Matter of Appeal of Intercard, 270 Kan. 346 (Kan. 2000). Arizona concluded that the presence of employees in the state for more than two days a year establishes nexus; see Arizona Dep’t of Rev., Pub. 623, Nexus in Arizona, May 2006. “Nexus with Texas” can be established by a single day’s visit to the state by either an employee or an agent.
Generally, a target company with sales representatives promoting its products across the country has established nexus in most states. If that company has not registered with the states and reported sales tax, it potentially owes sales tax, interest and penalties for past years on taxable sales in those states.
Another common error is mistakenly concluding that the sale of a product or service is exempt from sales tax. Sales tax determinations can be challenging for the advanced business models of many target companies; mixed transactions involving the sale of services and tangible personal property are particularly prone to error. As with nexus, failure to collect tax can result in significant exposure for tax, interest and penalties.
A due diligence review can expose other common errors, such as failure to properly document exempt transactions, accrue use tax on purchases and collect tax at the correct rate. By developing and following a thorough due diligence plan, the buyer can uncover these and other significant sales tax issues.
Possibility of Mitigation
After receiving the “parade of horribles” from the buyer, a target may have the opportunity to mitigate the liability. First, the seller should closely review the basis for the buyer’s nexus, taxability and other determinations. In many cases, the conclusions are not certain; arguments can be made to support a position that favors the seller.
When taxability or nexus is conceded, the potential liability can be mitigated by a customer’s exempt status. For example, some states provide an exemption for sales to a reseller. Sales to the U.S. government are always exempt, and most states provide an exemption for sales to the state and its subdivisions. In addition, a use by the customer can also be exempt; for example, many states provide an exemption for equipment used in the manufacturing process.
Potential exposure can be mitigated by use taxes that the customer self-reported to the state or by collecting use tax from the customer. If the target sells to only a few large companies regularly audited by the state, it is quite likely that the customer either accrued the tax or paid it on audit. On the other hand, if the sales were to individuals, there is little chance of recouping the tax.
Liability may also be mitigated by the opportunity to enter into a voluntary disclosure agreement with a state. If a taxpayer approaches a state with its tax liabilities, the latter is likely to waive penalties and reduce the number of years under review. For example, Utah has formalized voluntary disclosure programs that significantly reduce liability. This option should be taken in consideration of other potential liabilities (such as state income and payroll taxes).
Structuring a Deal
Sales tax should also be considered when structuring the deal itself. Sales tax does not generally apply to a transfer of assets pursuant to a stock purchase or statutory merger; however, asset sales are subject to tax in some states. For example, California sales tax applies to the sale of capital assets if the seller is engaged in a business that requires holding a seller’s permit if more than two sales are made in a 12-month period. In Hotel Del Coronado v. State Board of Equalization, 15 Cal. App.3d 612 (1971), the court held that a hotel was required to hold a seller’s permit because it made 12 (seemingly insignificant) salvage sales of old furniture during the audit period. California’s “occasional sale” exemption is narrow in application, causing many asset sales in that state to be subject to sales tax.
Unlike California, many states provide an occasional sale (or “isolated sale”) exemption that includes the sale of assets not customarily sold by the taxpayer. Some states, such as Texas, provide an exemption for the sale in a single transaction of the entire operating assets of a business or of a separate division, branch or identifiable segment of a business; see TX Tax Code Section 151.304(b)(2). Unlike the conclusion in Hotel Del Coronado, many states would not impose tax on the transaction, because the sale would qualify for a (much broader) occasional-sale exemption.
In states that impose tax on asset sales, the potential sales tax liability should be considered in light of other factors driving the form of the sale. The transaction would not be subject to California sales tax if it took the form of a stock purchase or merger.
A buyer should carefully review the potential for sales tax successor liability. Many states impose successor liability for sales tax even if the buyer purchases the business’s assets. Some states also have “bulk sale notifications” that need to be considered.
Sales tax liability can be a significant factor in the sale or purchase of a business enterprise. Generally, the key concern is the failure to collect sales tax from customers. The potential exposure can be mitigated by carefully reviewing customers’ exemption status, the likelihood that customers self-reported (or would pay) the tax and voluntary disclosure opportunities with the state.