M&A considerations in light of Wayfair

By Sara Britt, J.D., Pittsburgh, and Hannah M. Prengler, CPA, Cleveland

Editor: Anthony S. Bakale, CPA

June 21, 2018, marked the end of an era. The Supreme Court's 5-4 decision in South Dakota v. Wayfair Inc.,138 S. Ct. 2080 (2018), abandoned the "physical presence" standard it had established in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Since Quill was decided, there had been substantial changes in how business is conducted. The growth of purchases of goods through online markets and through third-party facilitators made the standards in Quill outdated. In Wayfair, Justice Anthony Kennedy noted that Quill'sphysical presence standard is "unsound and incorrect" and served as a "judicially created tax shelter." As merger and acquisition (M&A) activity continues to be strong, buyers and sellers must now consider how Wayfair affects M&A tax due-diligence efforts, purchase agreement indemnities, and navigating remediation plans between the parties around prior-period exposures.

Key items to consider

States have been looking for ways to generate more tax dollars, and it is no surprise that nearly every state has passed laws or adopted guidance to move away from a physical presence nexus standard to an economic nexus standard. Most states have adopted laws similar to the South Dakota law that was at the center of Wayfair. South Dakota's standard for economic nexus for a seller is a dollar volume of $100,000 in annual sales into the state or 200 or more separate sales transactions per year. Standards for economic nexus like those for South Dakota are especially problematic for taxpayers that sell low-cost, high-volume goods. The dollar amount of their sales into any one state may not meet the threshold, but the volume of transactions is almost certain to exceed that threshold.

In addition, a handful of states adopted notice-and-reporting requirements prior to the Wayfair decision that require remote sellers to either elect to collect and remit applicable sales tax or comply with the notice-and-reporting requirements. Failure to comply with a state's notice-and-reporting requirements can lead to multiple penalty assessments. States, including Colorado, Pennsylvania, and Washington, assess separate penalties for each failure to: (1) file an annual report to the state; (2) notify each customer; and (3) disclose on each invoice, or at the time of sale, a customer's potential use tax obligations. Many of these provisions remain in effect for dollar thresholds that fall below a state's economic threshold.

Whether an M&A deal is structured as a stock or an asset purchase, sales tax exposure has always been a significant due-diligence consideration. Before Wayfair, states were aggressively pursuing nexus, but they were largely considered rogue policies and did not typically necessitate large sales tax escrows before closing an M&A transaction, unless nexus had been verified during tax due diligence. However, Wayfair creates a heightened risk to buyers due to the lowering of the sales tax nexus thresholds and the broadening of potential exposures across multiple industries and states. Buyers now need not only to spend time analyzing employee activities throughout the states to evaluate nexus, but they also must now analyze state-by-state sales reports to understand where a target's sales or transaction volume has exceeded state collection thresholds. When thresholds are exceeded, a post-Wayfair liability consequentially may arise.

A target may have exposure for a much longer lookback period than just the previous year if the company historically had employees or inventory in a state or performed other nexus-creating activities within that state. As such, buyers are cautioned to not merely evaluate any post-Wayfair sales tax liabilities. They must also understand when a target's nexus existed before the Wayfair decision in June 2018 and negotiate an appropriate reserve for any potential historic tax liabilities.

Many taxpayers sell goods on which sales tax is not required to be collected. This includes when a manufacturer sells goods to a distributor that provides a resale exemption certificate. Companies making such sales must also make changes to their internal policies post-Wayfair. Buyers should evaluate if such a target has procedures in place to collect sales tax exemption certificates and refresh current forms. Many companies have historically collected exemption certificates only in those states where they had a physical location. However, post-Wayfairsuch a policy would not protect the company or a buyer. A best practice would be to require the collection of state exemption certificates from all applicable customers. Although this is a relatively simple policy update, this can be especially difficult for companies when customers can purchase products online where there is not an advance acceptance of the customer before the sale is made or the sale is made through a third-party fulfillment company.

While many buyers have considered pursuing an asset purchase in the misguided belief that this will allow them to avoid succeeding to a target's sales tax liabilities, historic sales tax exposures very often follow the property or business acquired, even in asset sales. Accordingly, a buyer must thoroughly vet and address sales tax exposures with a seller prior to closing an M&A transaction. Most often the purchase agreement is used to reserve funds to cover any potential tax, interest, and penalty liability, as well as compliance costs. As the seller is able to show the company has become compliant or that a liability has been resolved, a portion of the escrow funds are released.

Some states offer bulk sale notifications, where a buyer may provide notice to a state that it is about to purchase a local business. These types of notifications, when timely filed, may shield a buyer from successor liability. States that offer these notifications will confirm the target company is currently in compliance with tax filings and will issue a release letter to the buyer if the target's filings are up-to-date.

While this option seems like a great solution to limit successor liability, most buyers prefer to rely on their purchase agreement indemnities. The reason for this is that many times when a bulk sale notification is filed, states shortly thereafter issue an audit notification to the sellers. Buyers do not want their employees dealing with new state sales tax audits for pre-acquisition periods while they are also very busy dealing with immediate post-acquisition issues. Buyers and sellers should maintain adequate books and records for pre-acquisition periods in the event of an audit. Many companies have been assessed tax liabilities for pre-acquisition periods because adequate books and records were not maintained. Buyers should remember that if the seller did not file a return, the statute of limitation did not begin to toll for the nonfiled year(s).

Often a buyer and seller agree to pursue state voluntary disclosure programs. State voluntary disclosure agreements (VDA) are a popular way to limit historic tax exposures. State VDA programs offer short lookback periods, penalty waivers, and, in some states, interest abatements or reductions. Most states have VDA programs for an entity that has not previously filed for a certain type of tax. Sellers may want to consider remediating prior-period liability in anticipation of a sale to better control the costs associated with remediation. Buyers and sellers should note that state VDA programs apply to tax exposures and therefore may not apply to the potentially significant penalties imposed for failure to abide by a state's notice-and-reporting requirements.

Income tax considerations in light of Wayfair

Similar to what they have done in the area of sales taxes, states have increasingly looked for opportunities to extend the income and/or franchise tax nexus threshold in recent years. Many states had before Wayfair begun shifting toward economic nexus or factor-based nexus standards and away from the physical presence standard, and several states had successfully argued in the courts that Quill only applied to sales tax.

Examples of states moving to an economic nexus standard include Ohio and Washington, which both impose gross receipts taxes, and numerous other states that impose a franchise tax calculated on net worth or other nonincome factors. States also began imposing gross receipts thresholds on income taxes, including Michigan with a threshold of $350,000; California at $583,867 for 2018; and New York at $1 million. While gross receipts thresholds have been successfully applied, federal law limits their application in the case of sellers of tangible personal property that merely solicit sales within a state and all orders are approved and shipped from outside the state. When a company can meet this criterion, federal P.L. 86-272 (also known as the Interstate Income Act of 1959) applies. In the post-Wayfair tax world, it will be critical for sellers of tangible personal property to understand and monitor their activities to determine when P.L. 86-272 applies and identify when activities may exceed the protections of P.L. 86-272.

Many states, emboldened by the Supreme Court's decision in Wayfair, are challenging any rule or law impeding their ability to subject nonresident taxpayers to taxation. As state laws change or states begin to more aggressively impose their nexus policies, M&A buyers must also consider Wayfair'sincome tax impact. Well-advised buyers must consider the aggressive nature of states when evaluating both sales/use tax and income/franchise tax during due diligence.

As buyers evaluate tax remediation plans, they must consider how sales tax nexus in a state may also trigger questions by the state around their activities, as those states seek opportunities to impose income tax nexus as well.

Heightened due diligence

M&A buyers are moving forward extremely cautiously post-Wayfair. They are wary of a misstep that could cause them to unknowingly assume a target's sales tax liability. While most deals are still moving forward even when a significant risk is identified, informed buyers are using the tools available to them to mitigate successor liability. Often buyers reserve a portion of the sale proceeds in escrow. Some buyers have negotiated reduced purchase prices to account for the estimated exposure they are assuming.

However, it is very important for buyers to understand the risks they may be undertaking. Furthermore, as buyers push new acquisition targets to become compliant, there are a host of administrative issues the operating companies are up against. A newly acquired business may not have the staffing in place to handle transition matters, potential new owner reporting requirements, or the addition of 30 new state sales tax returns to their plate. Multistate sales tax compliance requires a plan not just for the historic exposure, but also for future tax-compliance complexities.


Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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