When we get involved in sell transactions with our clients, we instruct them that tax due diligence will be a key item for a buyer to review prior to purchasing their assets and/or ownership interest. This is usually more important in an ownership transition versus an asset transaction, since the buyer assumes all liabilities – known and unknown – in a stock transaction. Taking time to ensure that everything in your tax house is in order in advance of the sale of a business can help you avoid unwelcome surprises during the sales process as well as potentially lower proceeds from the transaction.
Tax due diligence generally aims to answer the following questions:
- Have the proper tax methods been used? For example, if it is a cash basis tax payer, does the entity properly qualify as a cash basis taxpayer?
- Have there been any transactions that could potentially disqualify an S election?
- Has the tax return reporting been reconciled to the financial statements?
- Are the owner’s personal expenses properly treated as distributions or loans?
- Is the entity filing in all the proper states and jurisdictions?
- Are the state and local tax allocations accurate and prepared in accordance with that tax authority’s regulations?
On those last two points, given the recent Wayfair decision companies will now be subject to sales tax in many more jurisdictions. Plus, state sales tax rules are typically much more complicated than income taxes. There are over 10,000 tax jurisdictions in the U.S. that impose sales taxes. Each has its own rules and regulations on the percentage for sales tax, the goods or services subject to sales tax, how the allocation between jurisdictions should be prepared, who should file to pay taxes, and the timing of such registrations. For smaller companies that ship to multiple states/localities, it is a monumental task to properly track shipments, determine how much should be added to the invoice, and then file all the relating sales tax returns.
We also expect that many of these jurisdictions will begin to audit companies to verify that they are paying the proper amounts timely. Most states are looking for additional revenue, especially from companies that don’t operate in their state. For instance, Pennsylvania reported surplus revenues of over $300 million and much of this was the result of increased collections of sales taxes from out-of-state companies.
If you think you might have a sales tax issue, below are some steps you should take:
- Speak with your advisors to come up with a plan to address the issue.
- Source your revenue by state.
- Most states have established dollar and transaction limits for when a company needs to file. For those states in which you conduct business, determine whether you meet the criteria for filing.
- If you do meet the dollar or transaction criteria, verify that the sales in those states are taxable.
- If you conclude you do need to file, develop systems and processes to bill customers in those states, collect the taxes, and file the necessary tax returns.
- For states where you file, determine whether there are localities that may also impose sales taxes (such as Philadelphia and Pittsburgh in Pennsylvania) and repeat the above three steps.
We understand that this is a large task for most businesses and you may not have sufficient resources to address this issue. However, your advisors can be a tremendous help in sorting through the issue and ensuring you are in compliance.
Given all of the items discussed above, you can see why buyers conduct tax due diligence prior to the transaction. When potential problems are identified there are a number of possible ramifications:
- Buyers may request that additional amounts be escrowed until returns are corrected.
- Buyers may request the seller to file for a change in accounting method and/or file amended tax returns.
- Buyers are NOT testing all transactions, so they will typically overstate the potential issue and request a larger reduction in purchase price than what was identified.
Take time to conduct your own tax review prior to a sale in order to minimize surprises during the transaction. The effort will be well worth it.