As M&A advisors to countless deals, we find ourselves consistently emphasizing the important, but often passed over, state and local tax (SALT) issues that will arise during the due diligence process. Unknown tax liabilities, interest and penalties could impact the overall value of the deal and present significant delays in closing or at worst, kill the deal altogether. Forward-thinking buyers and sellers would be prudent to address these issues in the early stages of negotiation rather than bear the burden of compromise during due diligence.
So where do you begin? Compliance is the usual starting point. Income, franchise, sales and use, and property taxes are typically addressed and reviewed. However, other issues such as uncertain tax positions, nexus, allocation and apportionment, credits and incentives could have a far greater impact on deal value than you might expect. Statutory limitations, look-back periods, and improper elections are also precarious to the transactional parties.
Adding insight for our clients in these matters, we have found successful navigation of these SALT issues in advance of selling or buying a company will allow for greater efficiency to close the deal. Although each transaction is different, good judgment will recognize the material SALT issues to address.
Sales tax has become a top issue in M&A due diligence. Stock acquisitions will inherit any liability for unpaid or incorrectly calculated sales and use tax where assets acquisitions could result in unknown additional compliance filings. States are changing the definition of ‘doing business’ to capture more revenue and are increasing the number of agents and audits. The traditional thought that a company is absolved of any responsibility if it is not physically present in the state has changed. E-commerce, drop shipments, reseller certification and solicitation policies could have a negative effect and expose the company to past or future liabilities.
Income and franchise tax return compliance has seen an uptick in review by authorities. States have improved their internal communication policies of information sharing. Definitions of doing business in a state for income and franchise purposes are also changing, moving toward a more economic nexus approach to compliance. States are looking at sourced revenue, asset value employed by the business and using single sales factors to increase apportioned income to their tax base. Some cases we see have over 100% of income being exposed to state tax with the only relief available being through state credit arrangements that are not dollar-for-dollar.
Worker classification and payroll taxes are under attack by state tax authorities. During the economic downturn, many independent contractors were claiming employee status for unemployment benefits. This led to states lining up to collect back payroll taxes, penalties and interest. Most often the company lost the battle. In many cases both the employer and employee portion of the tax was assessed and required to be paid in full by the employer. Companies were left to try to collect the employee portion on their own with little success. Penalties in some cases would reach 100% of the liability.
Many states also do not conform to federal regulations and elections but rather have their own elections and procedures that must be followed. Federal and state differences in depreciation, combined reporting, income sourcing and the lack of international treaty benefits all could result in unknown state tax liabilities coming to light during the due diligence process.
When unrecorded liabilities are detected, the look-back period to quantify the liability could go back to the date of the company’s origination. Generally, unless a return was filed, the statute will not close for assessment and added interest and penalties could have a substantial effect on assumed liabilities in a transaction.
It is not all bad news, however. Deals are still closed and remedies are available, although not perfect. Many states have enacted tax amnesty programs that allow for short look-back periods of three to four years with no penalty imposed. Interest is still accrued on the unpaid tax liability. In a case where a 40-year-old company should have been filing sales tax in another jurisdiction, you can see how this remedy could be a huge benefit. Other remedies are Voluntary Disclosure Agreements (VDAs) where you disclose the liability of the company before the state contacts the company. These VDA’s also exclude the penalty and have a short look-back period. Other remedies could be first-time-offender programs, reliance on advice from a professional, and erroneous guidance from state agents.
These discovered liabilities normally result in greater scrutiny of the company in the due diligence period. This could delay the deal, cause a reduction in purchase price, more holdbacks, longer escrow periods and, in some cases, call into question the business practice of management. As a result, SALT liabilities warrant a much closer look. Indemnification can help but that has its own set of issues with enforcement.
In conclusion, spending time understanding the depth and breadth of any target business footprint and the related state tax issues will be time well spent. The result is a greater understanding of the company’s responsibility and will provide a strong level of confidence for the value negotiated. Without adequate work and due diligence, buyers and sellers could be left with surprising SALT liabilities from prior periods and jurisdictions.