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While tax concerns can often take a back seat to business considerations during these transactions, ignoring state and local tax issues during the due diligence process is a recipe for unnecessary, and oftentimes expensive, problems. A prudent buyer would do well to give state tax its proper place at the due diligence table.
Most acquisitions involve some degree of tax due diligence, but the attention given to state tax issues can vary depending on the transaction and the buyer. Often, state tax issues are something of an afterthought and play a smaller role in a process largely driven by federal income tax considerations. But with 50 separate state tax jurisdictions plus local taxes, a cursory review of the target’s state tax posture can be dangerous. Only a thorough, detailed review will reveal exposures that will affect the purchase price.
Who is Liable?
State tax is neglected during the due diligence process for a variety of reasons. Some buyers rely on indemnity clauses or escrow accounts in their haste to close a deal. But state tax issues may not bubble to the surface for several years because of long audit cycles. By then the acquisition transaction is a distant memory, making recovery under an indemnity clause difficult. If escrow accounts have been released, the buyer will be on the hook for these pre-existing state tax exposures.
Other buyers mistakenly believe that the form of the transaction shields them from the target’s state tax exposures. Take, for example, the commonly held belief that tax liabilities remain with the seller following an asset purchase. Unsuspecting buyers are frequently surprised to learn that states have successor liability provisions that allow the pursuit of the purchaser for the target’s pre-acquisition exposures unless certain conditions are met.
Some states, like New York, have very specific successor liability provisions. New York requires written notice of a bulk purchase of business assets at least 10 days prior to the acquisition. The state then has 90 days to issue a notice of tax due or a release notice. If the bulk sales notice is not filed on time, the purchaser can be held liable for the seller’s unpaid sales tax obligations. In short, a buyer setting out to purchase assets could also end up buying state tax problems.
Elements of a Due Diligence Plan
These types of problems are unnecessary and can be largely mitigated with a comprehensive state tax due diligence review. Reviewing the target’s state tax profile before making an acquisition can prevent costly headaches in the future.
A state tax due diligence plan should include a review of the target’s nexus determinations, aggressive return positions and recent audit results. Indirect taxes, such as sales and use tax, and property tax, should also be given proper attention. Indirect tax issues, such as deciding not to collect sales tax in a particular jurisdiction, can create significant exposures. Buyers should ensure that these decisions are documented and factually supported. Evolving state tax considerations, such as economic nexus, should also be given attention.
Fact gathering is a significant part of the state tax due diligence process and should involve much more than a cold review of state tax returns and work papers. Companies should spend considerable time interviewing the target’s accounting and tax personnel for specifics on key tax determinations.
Understanding what happened and why it happened is often key to supporting state tax decisions. Consider a common nexus scenario: the ‘target’ has sporadic contact with ‘state A’ through infrequent employee visits. However, the target contends that its contact with ‘state A’ is not significant enough to create nexus. Therefore, the target does not file an income tax return or collect sales tax in state A.
Factual and legal support for this decision should be carefully documented, even if the buyer agrees with the target’s conclusion. How frequently did these visits occur? What was their purpose? When was this decision made and has it since been reviewed? Are there any new facts to consider that might change this decision? The buyer may have to defend the target’s tax decisions years after the fact. By then the person who made the original decision may be long gone.
While the most immediate due diligence priority is to identify exposures that could have an impact on the purchase price, a well-designed state tax due diligence plan should also be forward thinking, with an eye towards post-acquisition integration. For example, the buyer will need to determine where the target fits within its legal structure. (This is perhaps a less pressing concern for federal income tax purposes, where consolidated returns are the norm. But the question is crucial from a state tax perspective.) Will the target operate as a separate legal entity or should it be merged into an existing entity? If merged into an existing entity, are there new nexus issues to consider?
Buyers that take the time to evaluate a target’s state tax profile can make educated decisions about the business implications of the acquired enterprise and the most tax-efficient location for the new acquisition.
Scott Novak, JD, CPA, is a senior manager in the tax practice at CliftonLarsonAllen LLP. He has 13 years of experience serving businesses on multi-state tax issues. He can be reached at firstname.lastname@example.org.