Don’t assume that an asset purchase will protect you from successor liability

Businesses that acquire another business risk assuming responsibility for their new acquisition’s liabilities. That’s why some acquirers look to avoid successor liability by structuring an M&A as an asset purchase.

But while this does often provide some protection, an asset sale is not a guarantee that you’ll avoid all liability issues completely. Keep reading to learn more about successor liability, why an asset sale can help limit your liability and what you should do to further mitigate your risks.

What is successor liability?

Successor liability, broadly speaking, refers to any debt or other obligation inherited by the buyer and for which the buyer remains liable after the purchase of another business.

Successor liability can leave a buyer exposed to creditors, lawsuits and other consequences based on the actions of its acquisition target before the sale closed.

Here’s an example. Let’s say your company is preparing to buy another company:

• You’ve found what you believe to be a promising candidate. You are excited at the prospect of increasing your company’s market share, expanding into new product or service lines or leveraging different strengths to make the resulting company even stronger.
• Then you discover that your candidate has been selling to customers throughout the United States for years but has not filed sales tax returns in those states. But surely this isn’t your problem, right? After all, your company had nothing to do with the operations prior to the time you purchased the other business.
• Wrong. Depending on the structure of the sale and certain legal considerations, you may be responsible for the liabilities incurred by a business prior to your purchase of that business or its assets.

How does successor liability change for stock sales versus asset purchases?

Depending on whether you buy a company in a stock sale or an asset sale, you risk different degrees of exposure to successor liability. A stock sale leaves you more open to successor liability than an asset sale does, because a stock sale involves buying the company itself while an asset sale means only acquiring its assets.

What happens to liabilities in a stock purchase?

In a stock sale, the successor buys a business outright, effectively stepping into the shoes of the acquisition target by not only acquiring its assets but also assuming any liabilities. These liabilities can include the more obvious contractual obligations and accruals captured on the balance sheet, but can also lurk off the balance sheet in the form of unidentified tax exposure or other risks.

Often, the buyer isn’t aware of the filing obligation or tax exposure in a particular state or locality until due diligence is underway. As the legal successor to the acquired business, buyers may also find themselves exposed to litigation or government enforcement action.

What happens to liabilities in an asset purchase?

In an asset purchase, one company acquires the assets of another company without buying the underlying business itself. An asset sale aims to eliminate the risk of successor liability by structuring the deal so that while the acquirer ends up with the valuable assets of its acquisition target, it is not legally a successor to the latter.

Acquirers concerned about successor liability often prefer to pursue an asset purchase rather than a stock sale. And that strategy usually works. However, in certain circumstances, companies may still be exposed to successor liability even after an asset purchase — which makes assessing exposure risks during due diligence all that much more important.

State law often imposes successor liability

If you think you don’t have to worry much about successor liability when evaluating a potential acquisition, you may be overlooking an important source: tax obligations under state law.

All states have statutory and regulatory authority to impose successor liability with respect to sales tax, gross receipts tax and other transaction-level taxes. Pennsylvania specifically requires that a seller transferring more than 51% of its assets to a buyer must secure and provide a bulk sales clearance certificate.

If the clearance certificate is not obtained from the seller, the buyer becomes liable for all unpaid taxes owed by the seller up to and including the date of transfer, regardless of whether they have been determined or assessed as of the date of transfer.

Factor in the cost of potential tax liability when weighing a deal

Exposure can consist of tax, interest and penalties. If the acquired company was not filing required returns, the statute of limitations does not run, and all years in which the nexus-creating activities occurred are open for assessment.

How does a business address any potential state and local tax liability that surfaces during due diligence? A buyer has the option to back away from the deal and not expose the acquiring company to that liability. For many buyers, however, the benefits of continuing with the transaction outweigh the state and local tax exposure.

What are the exceptions to the rule of non-liability for asset purchases?

Even with an asset purchase, you can still be vulnerable to successor liability under certain circumstances. There are four major exceptions to the broad rule of non-liability that you should consider:

• The buyer assumes the seller’s liability, either explicitly or implicitly.
• The deal constitutes a de facto merger by representing a merger or consolidation between buyer and seller in substance.
• The buyer is a mere continuation of the seller.
• The transaction is a fraudulent effort to avoid liability or creditors.

Depending on the circumstances of your specific transaction, you may be exposed to additional risk factors as well.

Risk mitigation strategies for buyers

Buyers worried about exposure to successor liability should take steps to thoughtfully mitigate risk. Here are three to consider:

1. Work with a transaction advisor: Before seriously considering an acquisition, consult a transaction advisor. An advisor can guide you through the process, help you vet potential targets, assess potential liabilities, including exposure to nuances of state tax law and otherwise help guide your deal to a successful conclusion.
2. Conduct careful due diligence: Before completing a transaction, you’ll need to conduct careful due diligence on a target to better understand what you may be buying. Work with your transaction advisor here to assess all aspects of the potential deal, including successor liability issues that could arise due to state tax law, potential litigation, debt or other risk factors.
3. Create a liability fund: Another common step is to set aside a portion of the purchase price for a specified period post-closing. This helps ensure that in the event of a liability, damage or loss incurred by the buyer resulting from the seller’s pre-closing actions, the seller has adequate funds to cover that loss and make the buyer whole.

Depending on the specifics of the transaction, additional avenues for mitigating exposure may also be available.

How Wipfli can help

We help guide buyers through the process of acquiring a company. Let’s talk about how you can complete a successful acquisition that grows your business and mitigates risk. Start a conversation.

Read more

• Economic nexus reporting requirements reference table
• 10 areas to consider when implementing your succession management plan
• Managing the people and culture side of M&A