There are a number of things to look at before acquiring a business. But there’s one exposure many businesses overlook until it’s too late: sales tax liability. In this blog, we look at four sales tax due diligence items to review before acquiring a business.
Businesses that have a significant physical or economic presence in a state are liable to collect and remit sales tax there. But knowing where you have sales tax liability can be complex. This makes it easy to put off getting compliant or make a single, costly mistake.
When one business acquires another business with high sales tax liability, it inherits that liability. Six figure exposures are common. Seven and eight figures can happen. Because of these stakes, unexpected sales tax liability can turn a profitable acquisition into a disastrous one.
If you’re conducting acquisitions, you’ll need to be careful you’re not buying millions in liability. If you want to sell your businesses, it’s in your best interest to address potential liabilities before they cause the deal to fall through.
Fortunately, it’s possible to conduct due diligence before sales tax liability ruins your acquisition. Just follow these four steps.
Conducting Sales Tax Due Diligence: 4 Steps
Review the Nexus Footprint
To determine the sales tax liability of a company up for acquisition, first review its nexus footprint.
If the business has a physical presence in a state, that triggers physical nexus. If the business has sales that exceed an economic threshold in a state, that triggers economic nexus. When either of these conditions are met in the state, the company you’re trying to acquire is liable for sales tax on transactions in that state.
This is easier said than done. Conditions for nexus vary wildly, and you’ll have to review the process in every state the company does business. Many businesses turn to sales tax consultants for help.
If the company is compliant in all of the states it has nexus, that’s good news. There’s no exposure yet that could derail the acquisition.
However, if you find that the company has a significant nexus footprint and is not compliant, that’s a problem. If you continue with the acquisition, you’ll inherit all of this exposure.
If this happens, you have four options:
- Buy the company if the exposure is manageable.
- Check with state governments to see if you can avoid inheriting the exposure. (This rarely happens.)
- Renegotiate the terms of the acquisition to account for the liability you’ll inherit.
- Walk away from the transaction if the liability is a deal breaker.
Once you’ve evaluated the nexus footprint and compliance of the company you’ll acquire, you should also consider how it will impact your nexus footprint.
When you merge two companies together, your physical and economic footprints also merge. This can create new and unexpected nexus and liability in multiple states.
Say, for example, your business makes $75k/year in sales in Ohio, and you acquire a company with $50k in sales there. This combined revenue would exceed Ohio’s $100k economic threshold, creating economic nexus. Depending on the legal relationship between the two companies, the acquisition could create new sales tax liability in Ohio.
Verify the Certificates
The next area of due diligence after nexus footprint is exemption certificates. To verify the certificates, you have to make sure your target company has the right certificates on file. If you don’t, you’re setting yourself up for potential exposure.
Reviewing exemption certificates is critical because they’relow-hanging fruit for auditors. If a state audits your business, it’s incredibly easy for auditors to find missing certificates. This is a huge penalty and exposure you could prevent by checking beforehand.
Certificate verification is important for wholesalers and resellers who claim or provide exemptions on inventory the consumer will pay sales tax on.
In recent years, certificates have also become important for businesses that sell through marketplace facilitators. Some states require you to request and maintain exemption certificates if a marketplace facilitator manages your sales tax on their platform. Failure to do so can lead to significant penalties.
Check the Sales Tax Returns
The next step in your due diligence is to look at the company’s sales tax returns.
Sales tax returns have the potential to create a lot of liability. If the company hasn’t been filing, there’s not much to look at. The process is simple, but the exposure is high.
If they have been filing, make sure that they’ve been filed on time and accurately. The states will eventually catch late or inaccurate returns and assess penalty and interest. If you find that there is exposure in the tax returns, make sure there’s a reserve in place to cover it.
After a simple verification of the returns, it’s a good idea to investigate the transactions and history behind them. Here’s how to do it:
- Follow the payments on the return and make sure they’re remitted properly.
- Review the tax payable account and the reconciliation of it in detail.
- Make sure the returns are filed to the proper entity. (This is important for companies that restructure.)
Check for Ongoing Audits
The last step in your sales tax due diligence is to check if the company you’re acquiring is the subject of an ongoing state audit.
A state sales tax audit is the real deal. Fighting an audit is a long and challenging process. And the assessments, penalties and interest can be devastating. If you buy a company in the middle of an audit, you’ll inherit a lot of problems.
So how do you avoid inheriting an audit?
Check if there are any states auditing the company you’re acquiring. But don’t just ask around. The only way to really protect yourself is to conduct thorough due diligence and verify audit statuses.
Ask to see audit notices. Check with the state Departments of Revenue. In states like Texas, the list of companies under audit by the state is often public information.
Should you find the company is under audit, assess the situation. If the exposure is only a few thousand dollars, you might be able to accept it. If the exposure is in the six or seven figures, it might be time to consider other options.
The stakes of a state sales tax audit are high. Conducting due diligence can ensure you don’t inherit one by surprise.
Conclusion – What’s Next?
During an acquisition, sales tax due diligence can be the difference between a profitable acquisition and a disastrous one.
If you need more resources or information to conduct your due diligence, here are a few steps to take.