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Understanding Sales Tax Exposures in Business Acquisitions

Understanding Sales Tax Exposures in Business Acquisitions

Investors often take painstaking measures to structure deals and perform financial due diligence. Income tax consideration and structural planning are important, but failure to include sales and use tax¹ assessments in diligence can create financial land mines. Due to the transactional nature of sales taxes, exposure can build quickly. Unprepared investors can soon find themselves assuming sales tax liabilities they hadn’t expected.

A common misunderstanding is that sellers of taxable products or services can limit their liabilities by adding contractual clauses that clarify the customer’s responsibility to pay the tax. While this can indeed obligate the buyer for the tax, if the seller has nexus in the customer’s location state, then it does not transfer the seller’s statutory requirement to collect the taxes at the time of sale. Authorities will assess uncollected taxes, together with penalties and interest, to the seller under audit. When this happens, a seller’s ability to recoup the assessed tax from its customers will determine its financial impact. Thorough diligence can identify, scale and allow for appropriate resolution within transaction documents for this type of historical tax liability.

Know Your Industry

Business owners need to consider how sales taxes work in their industry to really understand the impact. Historically, most states have taxed property but not services. Over-generalizing is dangerous, however, as many services are also taxable in some states. It is also critically important to understand that sales tax is a consumer-based tax, which is fundamentally different than income tax.

This consumer tax concept is best understood when looking at the retail industry. For example, consider a common retail transaction where an individual buys a product from their favorite convenience store. In this situation, the customer is the taxpayer. The convenience store acts as a middleman to collect tax from its customers (i.e., taxpayers) and remit those dollars to the state. Simply put, identifying your company’s role as taxpayer or tax collector is critical for proper treatment. To continue this retail example, we can look at the supply chain and see that manufacturers and/or distributors obtain retail exemption certificates from their customers in order to sell merchandise exempt from sales tax. This method of issuing resale certificates effectively pushes the tax to end users.

Industries can make a difference:

      • Did you know that most states treat construction contractors as consumers (i.e., taxpayers)? This means contractors generally pay sales tax when purchasing building materials but do not charge tax to their customers. Here are a few important questions relevant to businesses in this industry:
        • What happens if your construction business also has a store that sells materials at retail?
        • Can your construction business buy materials exempt for resale like other retailers?
        • What state should get your tax dollars if your job is outside of your home state?
        • Does it matter if those materials are shipped to the out-of-state job site by the supplier, or whether you buy them locally and deliver them with your own vehicles?

      Construction company owners need to understand all these questions for proper handling of sales and use tax obligations.

      • Software is an industry where product classification is important – and, to make matters more complex, the answers to the following questions can lead to different results in different states:
        • Are sellers offering traditional software delivered on tangible media, such as disks or CDs?
        • Is the software limited to digital downloads?
        • Are software licenses even being issued?
        • What’s the difference between a software license and a monthly subscription to cloud-based software?

      Many states tax software as tangible property when it’s sold on tangible media but exempt that same software when it’s downloaded. Meanwhile, taxability of cloud-based software, often referred to as software as a service (SaaS), varies by state.

State Tax Nexus

If your business has enough connections to a given state, the state may impose income tax and/or sales tax requirements on your business. When this occurs, your business has nexus with that state. Many entrepreneurial business owners are very family with income tax nexus, which commonly focuses on sales, property and payroll factors. However, sales tax responsibilities are frequently not discussed with knowledgeable advisors, leading to unknown risks.

Prior to 2018, companies were not required to register for sales tax unless they had physical connections to the state in question, such as resident employees or in-state property. Then in June 2018, the U.S. Supreme Court case Wayfair v. South Dakota changed everything. Since then, businesses can create sales tax nexus by simply having enough sales to customers in other states.

Wayfair era rules are important, but there are many nexus requirements that have long caused problems. Traveling employees, independent sales representatives and third-party warehouses are all commonly misunderstood when evaluating state tax nexus.

Evaluating Sales Tax Exposure

Properly evaluating sales tax exposure involves analyzing both nexus and taxability. If a business does not have income tax nexus within a state, its decision makers are not likely to be concerned about whether their products are taxable in that state. Additionally, if management is not monitoring annual sales thresholds, nexus may be created and not discovered until much later. This oversight could lead to unidentified sales tax exposure if the company’s products are taxable in that state where nexus was unknowingly created.

For example, consider a software company with headquarters in Minnesota. This company has sold its products to customers all around the United States for many years, including hundreds of annual sales totaling $1.5 million each year to customers in New York. This company does not have employees or property outside Minnesota, so management has never been concerned with sales tax outside the state. Management was also not aware that new laws in 2018 required sellers of taxable property and services to register in New York when annual sales exceed $500,000. This means the company began incurring sales tax liabilities at that point in time. With annual New York sales of $1.5 million and an estimated state/local sales tax rate of 7%, the company will build sales tax exposure of approximately $56,000 each year, plus penalties and interest.

Liability Transfers

Sales tax liabilities generally follow businesses when stock sales occur, but is it the same for asset sales? It depends on several variables, but sales tax can certainly transfer to new ownership under asset sales as well. In assessing the magnitude of such liabilities, understand that statutes of limitations only start when tax returns are actually filed. When none have been filed historically, exposure time periods can be unlimited. Because liabilities can transfer, it’s important for investors to properly evaluate sales tax exposure during the due diligence process, allow for escrows or similar processes to ensure seller responsibility for pre-transaction liabilities, and plan for post-transaction actions such as filing voluntary disclosure agreements with affected states to minimize exposures.

Equally important to assessing past liabilities is creating processes to collect and remit sales taxes on future transactions so that similar liabilities do not stack up within the new organization. Software is available to help minimize your burdens. Boulay’s qualified advisors can help you assess risks in different tax jurisdictions and taxable products and services so that you understand your responsibilities and direct your resources to the appropriate risks. Contact an advisor today at 952.893.9320 or learnmore@boulaygroup.com.

¹ Sales and consumer’s use taxes refer to the same tax on products, with the former being collected by the seller at the time of sale, and the latter being remitted by a buyer when a tax was not collected by the seller. For purposes of this article, both will be referenced as “sales tax.”

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