Protecting your company from state tax exposure in your next acquisition

When you acquire another company, there is a hidden exposure that is catching many new owners by surprise — state sales taxes.

Often, the entity’s prior owners did not file sales taxes in a number of states they were doing business in. Then, one of those states conducts an audit and notifies the company of the tax liability, interest and penalties.

As the new owner, this is something to pay attention to because states have the ability to come after the company and current CEO, CFO and/or board of directors, regardless of when the tax was incurred.

“Most, if not all, states have these types of laws on the books. In addition, it doesn’t matter if the deal is a stock or asset acquisition, or what your corporate structure is,” says Mike Goral, partner-in-charge of State and Local Tax Services at Weaver.

“As the buyer of a company, you may not know that this risk exists. The issue can even make the transaction completely different,” Goral says. “States can put levies on bank accounts and can even go so far as to use criminal sanctions in order to get the company’s attention.”

Smart Business spoke with Goral about this contingent liability and how you can mitigate the state tax exposure.

Why is this state tax liability even more of  a risk right now?

States have become much more aggressive with this issue. Their budgets are down, and they’re looking to generate revenue. When states become aware that a business should have been filing sales tax, they will pursue it to get those back taxes.

Part of the problem is that there is no statute of limitations. So, if you haven’t filed a tax return, the state can go back to whenever the company first started doing business in the state, whether that’s five, 10 or 20 years ago. This can lead to a small initial tax liability growing exponentially over the years as interest and penalties are imposed on top of that. For example, in one case, Hawaii went after a company for a $5,000 tax from 1978. In the end, the company had to pay significantly more after interest and penalties incurred over the years were applied.

Private equity and venture capital firms that are holding on to their investments may be completely unaware of this exposure, which could mean a good deal turns bad or becomes less attractive.

Wouldn’t it make sense to get these back taxes from the seller?

The state has the ability to go after either the seller or the buyer, and it may decide to pursue the entity within the easiest reach and/or with the deepest pockets. As the buyer, you can pay the tax and then sue the previous owner to recoup the cost using the indemnification in your sale documents. However, this can be complicated if the seller has moved to another country, for example.

How do you recommend companies proactively deal with this risk?

Before the transaction takes place, consider a nexus review for sales tax purposes to see whether the prior owner has sales tax exposures in any states. If there’s exposure in just one state, it could be immaterial; but if the company owes a small amount in 10 different states, the tax liability can add up quickly.

If the nexus review spots a problem, a potential buyer can:

  • Set aside extra funds in escrow.
  • Work out a voluntary disclosure agreement, where a neutral third-party contacts that state on an anonymous basis to settle the tax.
  • Reduce the purchase price.

The right strategy depends on the situation and the deal’s structure. However, at any time, a buyer or seller can start the procedure for a voluntary disclosure agreement, which may take two or three months to negotiate. States usually ask for three year’s worth of taxes and interest before waiving all penalties and prior back taxes and interest.

Taking the extra steps to better understand your state tax exposures will take more time and money up front, but it can save both the buyer and seller a significant amount of money in the end.

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