Just When You Thought Due Diligence Couldn’t Be Any Crazier—Sales & Use Tax During Your M&A Transaction

To start, I want to clarify that I’m not an accountant—I’m a transaction advisor and it is my responsibility to help guide business sales to a close with as few disruptions as possible. Many potential obstacles can arise during this process, but we address and resolve most of them during the pre-marketing phase. We work closely with our clients to identify any issues that could come up during the transaction, and we either eliminate them or clearly define them to ensure a smooth process.

Lately, we have run into a number of companies that believed they were in compliance with state sale and use tax requirements but found out late in a transaction that in fact, they were not.

The Wayfair Decision of 2018

As a frequent online shopper, I noticed that my personal accountant began asking me about my shopping habits around 2018.  This was not because he was being nosy.  He was reacting to the 2018 Wayfair Rule—which allows states to collect sales tax from companies even if they are not physically located in that state. 

Previously, before a state could charge a company sales tax, it was required to have a nexus or some connection to that state and that nexus was a physical location in that state.

Wayfair effectively allowed states to redefine what their nexus with sellers could be—and unfortunately, it is not uniform.  For example, some states like Wisconsin or Washington have a dollar limit to establish that connection, while other states have a transaction trigger.  Further complicating matters are the state-by-state definition of what the sale of tangible property entails or what the measurement period is.  Michigan uses the prior calendar year, Hawaii uses the prior or current calendar year, and Tennessee uses a rolling 12 months.  Once you look at all the different tax variations, you can see where this might get tricky.

South Dakota v. Wayfair was a 2018 U.S. Supreme Court decision eliminating the requirement that a seller have physical presence in the taxing state to be able to collect and remit sales taxes to that state. It expanded states’ abilities to collect sales taxes from e-commerce and other remote transactions.

Why is This Important in Due Diligence?

Tax liability is something that a buyer will not want to acquire. Given the inconsistent economic nexus definitions of the states, it is becoming increasingly more important that a nexus analysis be performed as part of due diligence. Many jurisdictions do not have a statute of limitations when a sales tax return was required but has not been filed. Accordingly, a selling company can have unreported sales and use tax for as many years as the company has had nexus in a state, thereby resulting in tax, interest, and penalty liability that builds over an extended period.

If any sales and use tax liabilities are exposed or suspected, a buyer may ask a seller to provide an indemnification in the purchase agreement to protect them from that non-compliance.  Alternatively, a buyer could ask for an escrow account to cover those potential liabilities or even a lower purchase price.  Even transactions that are using representation and warranty insurance will see sales and use tax coverage carved out of the policy if it is suspected that there are potential tax liabilities.

I’m Not Subject to Sales Tax Because I am a Fabricator of Parts or Items That Are Resold

Not so fast. 

It is true that businesses that do not sell their products to the final consumer are exempt from sales and use tax.  However, if you are relying on this exemption, you need to make sure you have all the appropriate sales and use exemption certificates where your business has established nexus (which we know is a state-by-state, complicated definition). 

The certificate is issued by a purchaser to make tax-free purchases that would normally be subject to sales tax. Most state sales tax exemption certificates do not expire, and the seller is required to maintain exemption certificates for as long as sales continue to be made to the purchaser and sales tax is not collected.

A non-taxable sale not supported by a properly completed exemption certificate will be disallowed, and sales tax will be assessed against the seller, even though sales tax, in general, is a “consumer tax.” To make matters worse, many states will accept a retroactive certificate if you find an error, but not all of them.  A detailed analysis of where the certificates are necessary, if they are in place, and potential exposures by each state will remain.

Moral of the story, ensuring compliance with state sales and use tax regulations is a crucial, yet often overlooked, aspect of business transactions. A thorough nexus analysis and proper documentation are essential to prevent unexpected liabilities that can complicate or even derail a deal. By addressing these issues early in the process, sellers can avoid costly pitfalls and keep their transactions on track for a smooth and successful close.