Sales tax and M&A: Don't wait until it's too late

Mergers and acquisitions (M&A) capture a lot of headlines. The right merger or acquisition can spell fortunes for execs and shareholders and offer great chances to cut costs or snap up a valuable but distressed prize company. But sometimes, the deal is held up for various reasons – including sales tax exposure within the company being acquired. Not looking for the unexpected 

At first glance, sales tax risk might be considered immaterial, but when you think of how up to 10% of a business’s overall revenue could be exposed, compounded over a period of multiple years, including penalties and interest for non-compliance, sales tax risk can become a deal killer. 

It’s much easier in general to spot a financial blemish on a public company because of the added scrutiny of public reporting and independent auditing. Smaller, private companies are less scrutinized. 

When most execs involved in an M&A examine underlying tax issues of either a potential partner or a target company, they often only think to search for liabilities stemming from COVID-related financing and tax relief, or perhaps troubled income, payroll or property tax issues, or problems with operating loss carrybacks on tax returns, to name a few. 

But many business owners have been gut-punched during due diligence when an unanticipated sales and use tax deficiency pops up. What happens next can turn ugly: An escrow is set up and the new owners put little effort into minimizing the expense and liabilities which the escrow was set up to protect against. The founder who created the business and created the real market value ends up getting the short end of the stick, forfeiting the money in escrow. 

This could all be avoided if founders know their potential risk with sales and use tax beforehand and protect their company by being in compliance. 

Determining sales tax risk 

Here are the five steps to determining sales tax risk as early as possible in a potential merger or acquisition: 

1. Determine Sales Tax Nexus. Nexus is the connection between a person or entity and a taxing jurisdiction. A thorough review of all sales activities including transaction volumes should be looked at for each business. (Not every business will be willing to pay the fees associated with a formal economic nexus review.) If nothing else, all businesses should review the last 12 months’ sales activities and see if any states have more than $100,000 in sales. While this is not a 100% accurate method, it’s a first guide that would suggest the need for a deeper dive into that specific state to determine if the economic nexus thresholds have been crossed. 

2. 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. 

3. Estimate Exposure. There are two primary reasons to estimate the prior-period exposure: The data can help determine a strategy to mitigate the liability; and if a company is publicly traded, it’s required to disclose the exposure on the financial statements if it meets the reportable criteria/thresholds.

4. Evaluate Mitigation Options. If prior-period liabilities are identified prior to acquisition, a business should evaluate mitigation options. If the liabilities are identified during diligence, the options are often limited – consisting of either escrowing funds or entering voluntary disclosure agreements.  

5. Establish a Tax Compliance Filing Process. Once a business has determined a requirement to collect and remit sales tax, they must establish a way to charge sales tax, register with each required state and set up a process for filing the sales tax returns. This can be a daunting process with many steps. Many businesses look to outsource the compliance process to remove the stress – and the legal liability.

Ignoring your sales tax obligations could have a massive impact and cause a deal to not go through. If you are looking to purchase a business, make sure you are aware of where sales tax exposure exists and have steps in place to remediate the prior period risk. Treat sales tax with the same reverence and fear that you treat any other tax. 

(Click here to download our ebook, “How Sales Tax Impacts M&A.”) 

If you’re looking to reduce costs, increase efficiencies and minimize the substantial risk of noncompliance, 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.