February 2020
By Ned A. Lenhart, MBA CPA
Interstate Tax Strategies, P.C
Is your business sitting on a state tax time-bomb that could explode at any minute? Do you even know? Business owners and investors dream of the day when they sell their business for a high cash-flow or earnings multiple. Successful business exits are life-changing for the owners and are the tangible reward for their dedication in building an enterprise appetizing to someone else. Exit strategies are generally structured as “asset” or “equity” sales. There are tax, legal, and business benefits and pitfalls to both types of exit strategies which require sellers and buyers to carefully evaluate the type of ‘deal’ best suited for the future operations of the organization and for the parties involved. Regardless which structure is chosen, no seller wants to be surprised about unknown and undisclosed state and local tax (SALT) liabilities that may reduce the business sales price and cost precious time and money to fix. The time has come for business sellers to take control of this SALT due diligence process. Identifying and correcting SALT liabilities early can increase the target company’s value and streamline the business exit transaction.
Stock or equity sales involve the sale of the owner’s interest in the underlying assets and liabilities of the target enterprise. This normally requires the new business owner to assume most the business liabilities of the target. To avoid assuming these liabilities, transactions can be structured as an asset sale where all or part of the assets (tangible and intangible) of the entity are acquired and certain specific liabilities are assumed. General liabilities of the business remain with the surviving business entity and its owners.
Successor Liability
By structuring the transaction as an asset sale, most advisors believe that all of the known and unknown liabilities of the seller remain with the seller and are not transferred to the asset purchaser. While this strategy is generally true for most general business liabilities, it is NOT TRUE concerning known and unknown state and local tax (SALT) liabilities. The legal theory governing the transfer of SALT liabilities from the asset seller to the asset purchaser is known as ‘successor liability’. Nearly every state considers the business asset purchaser to inherit any known or unknown SALT liabilities of seller unless specific statutory procedures are followed to eliminate the successor liability. State law does not generally allow the buyer and the seller to contractually limit successor liability or to put dollar limits on how much liability is assumed by the purchaser.
Buy-Side SALT Due Diligence
To identify and quantify SALT liabilities (primarily sales tax), asset purchasers generally include a specific SALT data request and work plan as part of their tax due diligence process. Having conducted buy-side sales tax due diligence for 25 years, the process generally includes a detailed review of the target’s multistate business activities, a full understanding of the goods and services sold by the target, scrutiny of current tax returns filed, analysis of exemption certificates, a review of open or planned state tax audits, and a detailed review of current sales tax collection rules and procedures. Depending on the business being evaluated, SALT due diligence procedures can be completed quickly or may be quite protracted and detailed. Quite often, buy-side sales SALT due diligence reveals problems, risks, and undisclosed liabilities. SALT liabilities identified by the purchaser usually means less money going into the pockets of the seller and a slower close. In some cases, the SALT liability can be so large that the deal is cancelled. More often, the SALT liabilities identified are not so material that they kill the deal, but they are large enough to require an escrow of funds until the problem is resolved.
It is surprising how many sellers are unaware that there is any SALT problem at all. Once the liability is identified and quantified, the purchaser will generally control how and who will resolve the SALT problem. In many cases, the SALT liability is added to the general escrow amount and held back by the purchaser until the seller resolves the problem. In more dramatic cases, the purchaser may actually reduce the price they are willing to pay for the assets being acquired. Either situation can lead to less money going to the seller and a delay in closing the deal and getting paid for the assets they are selling. The normal SALT due-diligence procedures put the seller on the defense and allows the purchaser to dictate the terms of resolving the problem.
Sell-Side SALT Diligence
The time has comefor sellers to become proactive and take control their SALT exposure in advance of selling their business. There is no excuse for a potential buyer of your business to be the first to tell you that your SALT procedures are inadequate and that your business has a material contingent liability. Sell-side SALT diligence must be part of a seller’s exit planning process so there are no surprises when the buyer conducts their SALT diligence. Identifying and resolving SALT issues before buyers starts their review will maximum the price you get for your business and streamline the closing process.
Business sellers normally work with brokers and business valuation specialist in advance of actually putting their business on the market. These professionals examine each element of the business and coach the seller on strategies to maximize the value of their business and make it attractive and appetizing to potential investors and purchasers. Using these valuation, HR, IT, and financial professionals can add significant cash to the pocket of the seller and provide a significant ROI on the cost of these efforts. At some point in this business assessment process, the sellers must devote intentional effort to proactively determining their SALT liability. This may include sales tax, payroll tax, property tax, and other SALT liabilities that normally survive an asset sale and absolutely survive an equity sale.
Sell-side SALT diligence should be started 12 months before any proposed transaction. I suggest this for several reasons. First, depending on the sophistication of the seller, it may take some period of time to gather the required information specific to the SALT diligence. The data needed for this review may not be easy to gather, especially if the review is for multiple years and requires the use of IT resources to obtain. In most cases, there is no statute of limitation for unpaid taxes, so a review of four or more years is quite common.
Second, if the review identifies significant SALT liabilities and compliance errors, it may take several months to quantify and resolve the specific issues. One of the primary methods used to resolve historical liabilities is by engaging in a process called “voluntary disclosure”. This will be discussed in more detail below, but the voluntary disclosure procedure may take three to six months to complete.
Finally, if new SALT compliance procedures are required, it may take several months to get billing systems integrated into new tax software and for other compliance procedures to be implemented and for A/R and sales personnel to be trained concerning new SALT compliance rule. A proper documentation of these processes must be developed and provided to the purchaser. Finding and fixing SALT errors before a potential buyer may improve the overall profitability of your business and increase the sales price.
Even if no material deficiencies are identified during the sell-side due SALT diligence, a report showing the processes conducted, the documents reviewed, and the basis for the conclusions reached may provide the buyer with sufficient comfort that the buy-side SALT diligence can be streamlined. This analysis also shows the potential buyers that the seller was insightful in evaluating these SALT issues which may allow for a better bargaining position by the seller.
Sell-Side Diligence Procedures
Sell-side due diligence looks a lot like buy-side due diligence. To coin the old sports adage, ‘the best defense is a good offense’ and that is exactly the case when it comes to seller’s being proactive to identify and resolve SALT issues before buyers start their review. The goal of buy-side due SALT diligence is to find SALT procedural and compliance mistakes and to portray these errors in the worst possible light. Most diligence work is done for the buyer with the goal of communicating the worst-case scenario to the buyer. The diligence report prepared by the buyer’s team may make assumptions and projections that are not reasonable in an effort to drive the value of the business down or to adjust the sales price lower than it needs to be. If the seller is not prepared to counter these assertions, they may unknowingly allow the buyer to
When seller’s initiate their own SALT review as part of the exit planning strategy it allows them to have an advisor who is working just for their interest. This does not mean that SALT liabilities will be ignored if identified. Rather, a SALT advisor working for seller can develop strategies for the seller to minimize or even eliminate identified liabilities before the buyer’s team starts their work. If one of the issues identified by the seller’s SALT advisor involves missing documentation to support untaxed sales, the seller can implement procedures to secure the proper documentation from customers before the buyer’s diligence process starts. A potential major problem has been averted.
Because sales tax is industry and transaction specific, it is vital for the seller’s SALT advisor to develop documentation about the sales tax procedures used by the seller, so they are easily communicated to the buyer’s SALT advisor. SALT due diligence reviews are stressful and time consuming if accurate facts are not properly conveyed to the buyer’s team. This is especially common with service providers and technology companies where language in the contracts and invoices may be in conflict with what the seller has described their business to be. For example, if the seller portrays their business as a software-as-a-service (SaaS) enterprise, the buyer may conduct diligence using that SALT rules for SaaS. If, however, the seller’s SALT advisor believes the seller is providing a web-based service that may not necessarily be treated as SaaS for sales tax purposes, then this must be adequately communicated to the buyer to avoid confusion and the possible calculation of a liability that is not valid.
Because of some very significant recent changes in the requirements for businesses to be filing sales tax and income tax returns in other states, seller’s may not be fully aware that their compliance obligations have changed. Having the seller’s SALT advisor evaluate and document the company’s multistate filing obligation in light of these new and evolving standards may assist the buyer in performing their due diligence.
Finally, because the seller’s SALT advisor will be reviewing most of the same documents as the buyer’s SALT advisor, it can be a time saving effort for these documents to be submitted to the data room when requested by the buyer. Seller’s that have access to a skilled SALT advisor will be able to defuse or minimize any issues identified by the buyer’s SALT diligence team.
Voluntary Disclosure Agreements
As mentioned above, one method to resolve a sellers’ SALT liability is through a program called voluntary disclosure. Most states have procedures whereby unregistered businesses come forward voluntarily to resolve past due taxes. Some states also allow voluntary disclosure agreements for companies that are registered for sales tax. Most states limit the look back period for which tax is due to three or four years. In addition to limiting the look back period for which back taxes are owed, the state will abate the penalties due on the tax paid under the voluntary disclosure agreement. As such, sellers with multiple years of SALT exposure can eliminate their exposure for years prior to the earliest look back period. Depending on how long the business has operated in that state, the historical savings can be significant.
Voluntary disclosure is available only when the company seeking an agreement in a specific state has not been contacted by that state concerning the tax liability. If the seller was contacted previously by the state or is under audit, there is no possibility of completing the voluntary disclosure agreement.
Conclusion
For decades, SALT due diligence was solely the territory of the business acquirer. The power held by the buyer in this due diligence process put the sellers on the defense and positioned the buyer to control the quantification of the SALT liability and the tax resolution. With the advent of seller focused business exit planning consulting services, the time has come for sellers to include SALT diligence as part of their exit planning process. Unknown liabilities can make your business “SALty” and maybe unappetizing to some buyers. Knowing how “SALTy” your business is before the buyer starts reviewing your SALT documents and tax filings can position the you (the seller) to take control of the liability and to resolve any material issues before the buyer completes their business proposal. Identifying and tackling SALT liabilities before your business is sold allows you to be in control of the process and may put more money in your pocket at the closing.
For more information concerning this topic, please contact me at nlenhart@salestaxstrategies.com for a free 30 minute discussion.
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