Sales Tax and the M&A Process

Mergers and acquisitions (M&As) play an active role in the corporate landscape, facilitating growth, consolidation, and strategic realignment among businesses. Companies often include M&A activity in their short-term and long-term strategies. To successfully navigate M&As, tax directors and chief financial officers identify areas that tend to present pitfalls that can harm a transaction. Tax due diligence aims to spot weaknesses in a target company, with sales tax a common and complex problem area for buyers and sellers. Buyers and sellers alike should expect sales tax to affect the M&A process, and both parties should minimize risks to the transaction through tax diligence, purchase agreement indemnifications, and structuring opportunities.

Diligence—Buyer’s Side and Seller’s Side

Tax due diligence is critical to the M&A process and involves a comprehensive review of a target company’s tax position, liabilities, risks, and compliance. Due diligence can identify tax structuring opportunities and facilitate tax-efficient transactions. A key component of M&A tax due diligence is a review of state sales taxes, since they can represent a significant tax exposure to the buyer. According to the Tax Foundation, in 2023 average state sales tax rates ranged from 5.50 percent to 9.55 percent. When applied to a company’s revenue regardless of tax income or loss position, these percentages may result in significant sales tax liability in an environment of expanding sales tax bases. Furthermore, sales taxes typically succeed to a buyer whether the acquisition is structured as an asset purchase, an equity purchase, or a corporate restructuring. Given the complexity and variation of statutes governing sales taxes from state to state, buyers should comprehensively review a target company’s sales tax procedures and processes.

Diligence includes reviewing sales tax filings, audits, exemption certificates, and other relevant documentation to:

Identify tax risks and liabilities. Assessing the target company’s compliance with tax laws and regulations, identifying any outstanding liabilities or audits, and evaluating the potential impact of tax contingencies on the transaction will help identify potential tax risks and liabilities;
Assess tax compliance. Tax due diligence provides an opportunity to assess the target company’s compliance with tax laws and regulations at the federal, state, and local levels. This diligence includes reviewing tax filings, returns, and documentation to ensure that taxes have been accurately calculated, reported, and remitted;
Evaluate tax planning opportunities. Buyers can evaluate potential tax planning opportunities that may arise from the acquisition by identifying avenues to optimize the target company’s tax structure, minimize tax liabilities, and maximize tax efficiencies post-acquisition;
Determine transaction costs and structure. The results of tax due diligence can impact the overall transaction costs and structure. By identifying potential tax risks and liabilities up front, buyers can negotiate appropriate adjustments to the purchase price, allocate tax-related liabilities between the parties, and structure the transaction in a tax-efficient manner;
Assess tax contingencies and reserves. Assessing potential tax contingencies and reserves can reveal issues that may affect the transaction. This includes evaluating the likelihood and magnitude of potential tax liabilities, such as unresolved tax audits, pending litigation, or uncertain tax positions, and determining appropriate reserves to address these contingencies;
Mitigate risks and uncertainties. By identifying tax risks and liabilities early in due diligence, buyers can take steps to mitigate them, such as negotiating indemnification provisions in the purchase agreement, obtaining representations and warranties from the seller regarding tax matters, or seeking insurance coverage for specific tax-related risks;
Facilitate post-acquisition integration. By understanding the target company’s tax position and compliance status, buyers can gain insights that can facilitate post-acquisition integration efforts, including the development of integration plans that address tax-related issues, streamlining processes, and optimizing tax efficiency within the combined organization; and
Meet regulatory and compliance requirements. By thoroughly assessing the target company’s tax position and liabilities, buyers can ensure they comply with regulatory requirements and fiduciary responsibilities and make informed decisions that protect their interests and minimize potential liabilities post-acquisition.

A misconception exists that only equity transactions require sales tax diligence. However, unlike income taxes, regardless of the structure of the transaction, sales tax generally succeeds to the buyer. For that reason, buyers should conduct tax due diligence to understand what sales tax exposures, if any, they will likely inherit in the transaction.

Benefits of Sell-Side Diligence

When considering a transaction, sellers, like buyers, should proactively conduct sell-side diligence to identify and address potential sales tax issues. Sellers will want to identify and consider disclosing to prospective buyers any sales tax exposures, liabilities, and compliance risks identified during sell-side diligence. Sell-side state tax diligence further enables sellers to address and mitigate potential tax risks and exposures. Sell-side diligence improves transaction efficiency and maximizes deal value given that the seller is aware of sales tax exposures and can statutorily support exposures including penalties and interest. Not only can disclosing such exposures increase deal transparency and assist with transaction structure decisions, engaging in sell-side diligence often streamlines the buyer’s own due diligence by providing much needed and complete information regarding taxability analysis, nexus, sales data, and audit history, among other factors. This process reduces transaction costs and delays associated with the buyer’s diligence. Likely the greatest benefit to the seller is the potential to protect the purchase price, given the seller’s understanding of and ability to support the magnitude of its sales tax exposure.

To summarize the benefits of sell-side sales tax diligence:

Identify and mitigate risks. By thoroughly reviewing the company’s state tax positions, compliance history, and audit exposure, sellers can address issues that may arise during the transaction early in the M&A process. Identifying and mitigating risks up front can help prevent deal delays, negotiation breakdowns, and post-closing disputes, ultimately preserving deal value;
Enhance deal certainty and transparency. By disclosing relevant state tax information up front, sellers demonstrate transparency and build trust with potential buyers. A comprehensive understanding of the company’s tax profile can facilitate smoother negotiations, expedite the due diligence process, and increase buyer confidence in the transaction;
Optimize transaction structure and pricing. By identifying potential tax inefficiencies, opportunities to optimize tax, and strategies to mitigate tax liabilities, sellers can negotiate more favorable terms and pricing with potential buyers to maximize the value of the deal; additionally, sellers can proactively address any tax-related issues that may impact the transaction value, ensuring that the deal is structured in a tax-efficient manner;
Streamline the due diligence process. Sell-side state tax diligence streamlines the buyer’s due diligence by providing a comprehensive overview of the company’s state tax positions and exposures. By addressing potential tax issues and providing detailed documentation and analysis, sellers can reduce the time and resources required for buyers to conduct their own due diligence. Streamlining due diligence can expedite deal negotiations and increase deal certainty;
Reduce transaction costs and delays. Identifying and addressing potential tax risks up front helps sellers to avoid costly disputes, renegotiations, and post-closing adjustments. Additionally, sellers can provide buyers with confidence in the transaction by demonstrating that tax-related issues have been thoroughly vetted and addressed, reducing the likelihood of deal breakdowns or delays;
Preserve seller reputation and relationships. By disclosing relevant tax information and addressing potential tax issues, sellers demonstrate integrity, professionalism, and transparency. This approach can build trust with potential buyers and maintain good relationships with them throughout the transaction process, increasing the likelihood of a successful deal; and
Preserve purchase price. When sellers understand sales tax exposures, penalties, and interest before the transaction occurs, they can better support purchase prices. In turn, having statutory support available helps the seller understand reasonable escrow or purchase price reduction prior to negotiations.

Sales Tax Diligence—What to Expect

To complete sales tax diligence effectively, buyers and sellers should understand what facts they need to review the target company’s sales tax processes. During buy-side and sell-side diligence, tax directors and chief financial officers for buyers and sellers alike should consider the following information:

where the target company has filed sales tax returns in the past three to four years and who files the company’s returns;

the company’s engagement of external advisors to assist with sales tax compliance;
the company’s nexus profile and lines of revenue;
the profile of the company’s customers and documentation;
the company’s audit history, voluntary disclosures, and related documentation;
the company’s accounting procedures;
the company’s sales by state by line of revenue as well as invoices and exemption documentation, since it will likely be asked to produce them; and
the company’s procedures and documentation for its self-assessment of use taxes.

Efficient diligence will take approximately three weeks depending on the complexity of the anticipated transaction, availability of needed information, and access to the seller’s knowledgeable employees and advisors.

Purchase Agreement Indemnifications

When a buyer identifies a procedural weakness during sales tax diligence, the buyer will generally require the seller to indemnify the buyer through purchase agreement indemnifications. The specific due diligence findings should dictate the scope and terms of the indemnification provisions. Such provisions are essential to allocating risk between buyers and sellers and are particularly important due to the complexity and potential liabilities involved. These provisions typically outline the extent to which the seller will indemnify the buyer for any undisclosed or contingent sales tax liabilities discovered after closing. State sales tax indemnification may cover a range of issues, including unpaid sales tax liabilities, audit assessments, and compliance failures.

The following indemnification provisions are common:

Definition of covered liabilities. The types of state sales tax liabilities covered by the indemnification provisions are clearly defined, including unpaid taxes, penalties, interest, audit assessments, and compliance failures. Providing a precise definition of covered liabilities helps avoid ambiguity and disputes regarding the scope of indemnification;
Disclosure requirements. Sellers may be required to disclose any known or potential state sales tax liabilities, such as outstanding tax assessments, pending audits, or compliance issues related to state sales tax. Failure to disclose material information may trigger indemnification obligations;
Limitations on seller liability. Limitations of the seller’s indemnification liability for state sales tax matters help to avoid excessive risk exposure. Consider imposing caps on indemnification amounts, time limits on indemnification claims, and thresholds for triggering indemnification obligations. Additionally, carve-outs may be included for certain types of liabilities, such as liabilities disclosed in due diligence or arising from buyer actions post-closing;
Survival periods. Specifying the survival period for state sales tax indemnification obligations can dictate how long the seller remains liable for covered liabilities. Survival periods typically range from twelve to twenty-four months post-closing but may vary depending on the nature of the transaction and the specific risks. The longer statute of limitations for tax assessments may warrant extending the survival period for state sales tax indemnification;
Escrow arrangement and terms. The buyer may withhold a portion of the purchase price to fund an escrow account to cover any potential indemnification claims related to state sales tax. Escrow arrangements provide assurance to the buyer that funds are available for a certain period (often eighteen to twenty-four months) to address potential liabilities and mitigate seller risk. Conversely, rather than creating an escrow account, the buyer and seller may agree to reduce the transaction purchase price by a stated amount;
Dispute resolution mechanisms. Dispute resolution mechanisms in the indemnification provisions can address disagreements between the buyer and seller regarding indemnification claims. Mediation, arbitration, or litigation procedures may be specified to resolve disputes efficiently and cost-effectively. Clear procedures for resolving disputes can facilitate prompt resolution and preserve the relationship between the parties; and
Post-transaction obligations for both parties. Compliance obligations post-transaction are clearly defined as well as post-close transfer tax obligations.

Experienced legal counsel with expertise in M&A transactions and state tax matters should be engaged to assist in drafting and negotiating indemnification provisions. Legal counsel can provide valuable guidance on industry best practices, regulatory requirements, and emerging trends in indemnification negotiations.

Structure and Related Transfer Taxes

The distinction between asset and stock transactions is crucial in determining the sales tax implications of an M&A deal. Specific sales tax implications depend on the nature of the transaction, the assets involved, and the relevant jurisdictions.

In asset purchase transactions, the buyer acquires specific assets of the target company, including tangible and intangible assets. Depending on jurisdiction, the transfer of tangible assets subject to sales tax may trigger additional tax obligations for the buyer. Buyers must carefully assess the sales tax implications of asset purchases and factor them into the price and structure of the transaction.

Stock acquisitions involve the purchase of the target company’s stock or ownership interests, resulting in a change of ownership but not a transfer of assets. Unlike asset purchases, stock acquisitions generally do not trigger sales tax liabilities directly. However, buyers may inherit contingent liabilities, such as pending sales tax audits or assessments, which can impact the overall transaction value. Due diligence is critical to identifying potential sales tax exposures in stock acquisition transactions.

Corporate restructurings such as mergers, consolidations, and spin-offs may trigger sales tax implications depending on the transaction and the assets. For example, the transfer of assets between affiliated entities within the same corporate group may be subject to sales tax if improperly structured. Companies undergoing corporate restructurings must carefully consider the sales tax implications and use tax-efficient strategies to minimize liability.

Transfer taxes and sales taxes on the transfer of property ownership can affect the structure of the transaction. States impose transfer taxes and sales taxes on the transfer of real property and personal property from one party to another. These taxes are typically assessed according to the sale price or the fair market value of the property and are payable at the time of transfer.

State transfer taxes pose significant implications for buyers and sellers. For buyers, transfer taxes represent an added cost that must be factored into the overall transaction expenses. Depending on the jurisdiction and the value of the property, these taxes can range from a nominal amount to a substantial percentage of the purchase price, affecting affordability and influencing purchasing decisions.

For sellers, transfer taxes can reduce the net proceeds from the property sale, potentially diminishing the return on investment. Additionally, transfer taxes may influence pricing strategies and negotiations, as buyers and sellers seek to allocate the burden of these taxes effectively. In some cases, sellers may agree to pay a portion or all of the taxes as part of the negotiation.

Several considerations should be taken into account when planning for state transfer taxes, including:

Structuring transactions for efficiency. Buyers and sellers should consider how tax efficient the transaction structure is. Structuring tax-efficient transactions can minimize sales tax liabilities. Considerations include asset versus stock acquisitions, tax-deferred exchanges, and allocation of purchase price for tax purposes;
Jurisdictional variations. State transfer tax rates and exemptions vary significantly from state to state, making it essential to understand the rules and regulations specific to the jurisdiction where the property is located. Some states impose a flat rate transfer tax, whereas others calculate the tax based on the sale price or value of the property. Additionally, some states offer exemptions or reductions for certain types of transactions. Buyers and sellers may need to seek tax rulings or opinions from state taxing authorities or legal advisors to help provide certainty on the sales tax treatment of the pending transaction. Clear guidance can mitigate tax risks and assure buyers and sellers;
Exemptions and credits. Understanding available exemptions and credits can reduce transfer tax liabilities and maximize tax savings. Many states offer exemptions or credits for certain types of transfers, such as transfers between spouses, transfers of primary residences, or transfers for charitable purposes. By leveraging these exemptions and credits, buyers and sellers can reduce their tax burden and preserve more of the transaction proceeds. Additionally, occasional sale and bulk sale exemptions may apply to assets transferred; and
Negotiated allocation of transfer taxes. Determining how to allocate the transfer of taxes between sellers and buyers should be part of transaction negotiations and should consider factors such as overall transaction structure.

Post-Acquisition Integration and Compliance

Once an M&A transaction is complete, integrating the acquired business into the buyer’s operations likely requires integrating sales tax procedures. This may involve consolidating sales tax registrations, filing requirements, and compliance processes, as well as implementing systems and controls to ensure ongoing compliance with state sales tax regulations. Failure to address sales tax compliance issues post-acquisition can result in sales tax collection gaps, missed filings, audits, penalties, and interest.

In addition to integrating compliance, the acquisition of a business may create or change nexus for sales tax purposes, potentially subjecting the buyer to tax liabilities in additional jurisdictions. This is particularly relevant for businesses engaged in e-commerce or with multistate operations, where the threshold for establishing nexus can be relatively low.

Companies should develop a 100-day post-transaction plan to integrate sales tax compliance and software, review nexus, address concerns, and remediate any sales tax deficiencies that diligence identifies. Given that escrows may be limited to a period of twelve to twenty-four months, any sales tax remediation processes should begin as soon as possible to avoid running up against expiration.

Mary Montague is a director at Riveron Consulting LLC, a national business advisory firm, where she leads the firm’s state and local tax practice.

Sales Tax and the M&A Process
Understanding the entire journey—from diligence through post-transaction