The private equity community is busy finding and completing strategic investments for their portfolios. As part of their analysis process, a wide variety of reviews and due diligence is completed. During 2016, I’ve been asked to participate in the tax due diligence on several transactions and I have seen a lot of careless sales tax practices that are leading to hold-backs and escrows. Here are just some of the issues that I’ve encountered and some commentary on the situation.
Nexus in more states than thought: Nexus is the term used to describe the situation when a company has a physical connection with a state that would require it to take some action with respect to sales and use tax. These actions may include collecting tax on taxable sales or collecting exemption certificates to support nontaxable transactions. In the due diligence I completed, the target company had sales tax nexus in far more states then they believed. The failure of the target company to understand where it had nexus lead to the under collection of tax and the failure to obtain valid exemption certificates. In one situation, the exposure was over $500,000. Not only did the company have sales tax nexus, but it had income tax nexus and had also underpaid corporate income tax. Reviewing where your company has nexus is an ongoing process and one that must be carefully completed. Failure to know where your company has a sales tax collection or reporting obligation can create audit exposure and significant expense if detected.
Tax Collected but not remitted: On more than one occasion the due diligence revealed situations where sales tax had been collected from customers but had not been remitted. When talking with the companies, we learned that they had implemented a sales tax automation system which was set to collect tax in more states then the company actually was required to. Once the tax was collected, the company had no idea what to do since they were not registered in that state. In one case, tax had been collected for more than 3 years! If your company has collected but not remitted sales tax, you have few options. Your company either needs to return the collected tax to the customer or register and remit the tax to the state. I’ve completed several voluntary disclosure agreements with states to remit tax collected. This is a very good option to resolve this issue.
Incorrect tax rules leading to under collected tax:: The leading issue identified during my due diligence reviews was the application of incorrect tax rules to the sales transactions conducted by the business. In these situations, the company had made a reasonable effort to determine in which states it had nexus and had made some effort to collect and remit tax. However, the rules used to collect tax were incorrect. Tax was being collected on non-taxable sales and tax was not being collected on taxable transactions. The misapplication of sales tax to services was rampant. Failing to tax “bundled” transactions and failure to tax delivery charges (when taxable) were common. When reviewing materials from technology companies, I noted significant liabilities related to the taxation of SaaS and data processing services.
Missing exemption certificates: In general, all sales of personal property are taxable unless the seller has a valid exemption certificate to support not charging tax in states where the seller has nexus. In many due diligence reviews, missing exemption certificates created the most liability. The most complicated issue involved drop-shipments of property into states that do not accept the ‘home state’ resale certificate. The absence of an exemption certificate or the acceptance of the wrong resale certificate both create the same problem; the sale is taxable. As a drop-shipper of property into states where your company has nexus, your company has a very challenging responsibility to avoid liability.
Reliance on outdated advice:One due diligence project involved the review of a report prepared for the target 10 years prior to the sale transaction. The report was correct at the time it was written, but due to changes in the law and changes to the business, the report became outdated within just a few years. However, the target continued to rely on this report and failed to understand the obligations it had for collecting tax and exemption certificates in the states covered by the report and a host of states not included in the report. The target relied for years, to its detriment, on a report that was obsolete 24 months after it was issued. If your company is relying on reports and opinions issued in the past, get these reports updated. Changes in business activities and in the law can dramatically affect the validity of these reports.
Failure to understand successor liability: One concept that can create significant confusion is called ‘successor liability’. In each state but 4, the purchaser of the assets of a business inherits the sales and use tax liability of the seller unless the purchaser follows state specific procedures to shield itself from this liability. The most common response I get when I bring up successor liability, is that the sales contract requires the seller to remain liable for these liabilities. In short, these contractual obligations of the seller are meaningless when evaluated against the successor liability law. State law, and not the sales contract, will determine who is liable for tax after the deal closes. From a purchaser’s stand point, the entire reason for completing due diligence is to identify issues that can be addressed before the deal closes. When it comes to sales tax, the purchaser of the assets inherits all the sales tax problems that the seller and the only time to address these issues with the seller is before closing. Don’t rely on the sales contract to protect you from your successor liability. Under audit, the state will come against the purchaser for these taxes.
Conclusion
For many businesses, the only exit strategy they have is to be purchased by a private equity firm. Companies spend years positioning themselves for this transaction. Then, someone like me shows up and starts asking questions about something as mundane and unexciting as sales tax and the report I present sends a chill down the seller’s back. They immediately start blaming their CPA and attorney for not brining these matters to their attention. They frantically start trying to find flaws with my work or find ways to get the rules to not apply to their business; few succeed. The time to identify these sales tax issues is before the buyer comes to your business. Paying a small price annually to have these issues reviewed can save significant fees in the future. Identifying and fixing these issues before the buyer comes forward can ensure you get top dollar for your business.
Ned Lenhart, CPA
President
Interstate Tax Strategies
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