Sales tax and due diligence in an M&A

Those involved in mergers and acquisitions often get understandably excited about the deal, especially execs who stand to see their business power (and paychecks) expanded. These execs might also go into the deals knowing all about the familiar M&A landmines such as employees’ reactions or overpaying the target company.

Other potential deal-killers, though, might get less scrutiny in due diligence – including problems with a target company’s past sales tax compliance.

Ignoring tax

Tens of thousands of M&As happen in the U.S. every year, and the incoming federal administration is expected to create an environment to encourage even more. But “happen” doesn’t mean “succeed”: Some four out of every five M&As swiftly tank.

One frequent culprit is poor due diligence – and due diligence that doesn’t properly account for past tax liability. “Tax is arguably the least discussed of all motives for conducting mergers and acquisitions,” according to the M&A consultancy Dealroom. “Managers undertaking M&A tend to be less keen to espouse the tax benefits of a deal – probably wishing to avoid accusations of tax avoidance – than they are to talk up how it gives them a platform for future growth.”

Common tax-related red flags can be COVID-related financing and tax relief such as the federal Employee Retention Credit or troubles with income, payroll or property taxes. Against such a backdrop, sales tax risk might seem trivial.

But considering how up to 10% of a business’s overall revenue could be exposed via sales tax infractions, compounded over years and with penalties and interest for non-compliance, sales tax risk can lead to expensive detective work and escrow accounts – and, in some cases, jeopardized or dead deals.

Look carefully

Tax due diligence should scrutinize the target company’s tax background, including all returns, audit history and accounting methods. Sales tax histories should get even sharper attention if the two companies in the M&A are in different industries.

Steps to determining sales tax risk and prior exposure include:

Determine nexus, the connection between an entity and a taxing jurisdiction. All businesses should be reviewed for the last 12 months’ sales activities to see if any states have more than $100,000 in sales – a first indication that a deeper dive into a specific state can determine if the economic nexus thresholds have been crossed. 

Review taxability of products and services. Once nexus is established, determine whether a business’s products or services are subject to sales and use tax; not all are in every jurisdiction, and the requirements can vary widely.

Estimating exposure can help determine a strategy to mitigate the liability, though if liabilities are identified during due diligence options can be limited but worth pursuing, such as escrow funds or voluntary disclosure agreements. A VDA can allow for self-reporting back taxes and perhaps get penalties waived and the look-back period shortened. If the sales tax liability is immaterial, registration and retroactive remittance of sales taxes may get a company into compliance. Other mitigation options include “XYZ letters” from a company to ask past customers if they’ve already paid the tax or they’re exempt on some transactions.

Ignoring sales tax obligations could have a massive impact on a deal. Treat sales tax with the same reverence and attention paid to any other kind of tax – and risk.

(Click here to download our ebook “How Sales Tax Impacts M&A” and listen to our webinar “Mergers and Acquisitions Case Studies & Actual Negotiations” here.)

If you want to the risk of sales tax non-compliance, reach out to an expert. Consider working with TaxConnex. Contact us to learn how we partner our clients with an experienced and dedicated practitioner to ensure sales tax is taken off their plate.