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December 6, 2022

Financial Due Diligence During the M&A Process Can Reveal Hidden Tax Liabilities

During a merger or acquisition, determining the cost of acquiring assets or equity requires a thorough understanding of the financial due diligence process. As a part of this process, taking a close look at all tax liabilities and implications is an important step. When considering a business purchase or sale opportunity, many will consider the federal income tax implications but overlook the state and local sales taxes.  

Being caught off guard by these hidden tax liabilities can negatively impact the viability of a transaction. Reviewing the sales and use tax implications should be a contributing factor to the overall cost of capital and consideration of purchase. 

How Do I Determine If I Will Have Sales Tax Liabilities? 

Determining the sales tax liabilities in a transfer of assets will depend on the structure of the deal between the purchaser and seller. In an asset deal, the taxability of each asset being transferred should be considered. Ask yourself, do I have an exemption that is applicable to such an asset?  

For instance, inventory can be exempt as a purchase for resale. Manufacturing equipment may be exempt under the manufacturing exemption. If no exemption applies, the asset may be taxable, despite the fact the original purchaser already paid tax years ago.   

Tangible Personal Property vs Intangible Tax Liabilities 

Generally, any sale that involves the purchase of tangible personal property will impose sales tax. The details of these taxes depend on the tax law in each individual state where the property will be transferred. In the case of a merger or acquisition, the sales tax liabilities can be hidden within the entity.  

In a stock deal, the purchase of an intangible, such as stock, is typically an exempt purchase. However, this does not consider the tax liability and possible sales tax consequences that a corporation or partnership is “assuming” when transferring the ownership of the asset or acquiring the stock. An in-depth search into the company’s sales history, as well as its tax history, is an important part of the due diligence review.  

Financial Due Diligence to Meet Economic Nexus 

To identify potential sales and use tax liability, reviewing the previous year’s sales and use tax returns, examining the nexus relationships with states that the company may sell goods to consumers, and reviewing state tax exemption certificates can form a strong opinion on the sales and use tax payment history.  

Economic nexus can be met faster than one might think, easily missed by the business you are looking to acquire and can quickly be found by a state auditor – leaving you liable for mistakes you did not make, instead mistakes you assumed during the purchase. 

What Can I do to Manage Sales Tax Liability? 

Each state has its own rules/regulations on whether a sale is taxable or exempt, so you should determine the taxability of the product being sold by or purchased from the target entity. Be diligent in the purchase agreement in order to build in helpful protections such as indemnification clauses and/or escrows.  

Assessing your purchase to identify if it falls under a tax exemption may make the deal seem more profitable from a baseline perspective, but a thorough investigation into the past of a company could save you from assuming thousands of dollars in back taxes.  

Planning on a Large Asset Purchase or Involved in a Merger or Acquisition? 

Anders has State and Local Tax advisors that can help identify these sales tax liabilities to give you confidence in your business purchase or sale and limit future tax risk. For more information regarding the due diligence process, review our Quality of Earnings sell sheet. Contact an Anders advisor below for more information.  

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