You are looking to acquire or merge with another company and have 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.
But what happens when you find that your candidate has been selling to customers throughout the United States for years but has not filed sales tax returns in those states? You may be thinking, “Why does that matter?” After all, your company had nothing to do with the operations prior to the time you purchased the other business. It’s not your issue, right?
Wrong.
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. In the most basic transaction, company one enters into an agreement to sell its business to company two.
Asset sale advantage
Company one is the target and company two is the successor, or the entity that exists after the transaction is complete. Such an agreement is typically structured as either an asset sale or a stock sale. An asset sale effectively cuts off successor liability because the buyer is acquiring only the assets of the company, and it is often the preferred structure in terms of trying to limit liability.
Stock sale exposure
Conversely, in a stock sale, the successor effectively steps into the shoes of the target and not only acquires the assets but also assumes any liabilities of the target. Liabilities can include the more obvious contractual obligations and accruals captured on the balance sheet. But liabilities can also lurk off the balance sheet in the form of unidentified tax exposure. Often, the seller isn’t aware of the filing obligation or tax exposure in a particular state or locality until due diligence is underway.
Due diligence is an investigation or exercise of care that a reasonable business or person is normally expected to take before entering into an agreement or contract with another party. The goal of the process is to analyze data and collect additional information as necessary to identify risk factors connected with a purchase so the buyer can ultimately make an informed decision about whether to proceed.
The process is completed after a letter of intent is presented to the target, but before the sale transaction is formally executed. While many types of due diligence exist, the state and local tax examination focuses on the company’s activities, level of sales to customers in different states and presence of its employees, fixed assets and inventory. The review includes an evaluation of tax filing obligations based on applicable state and local tax laws and quantification of tax exposure for a specified period of review.
State authority to impose successor liability
Almost 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.
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.
Risk mitigation
Fortunately, there are options for mitigating risk that allow the deal to proceed and afford some level of protection to the buyer. The most common remedy 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
The acquisition of a company is an exciting and challenging endeavor. The importance of including experienced advisors who understand risk and can provide creative solutions cannot be overstated. Wipfli’s state and local tax and transaction advisory services professionals can help guide you through your next purchase transaction.
Learn more about how we can help by looking at our tax and M&A services.
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