Tax liabilities a buyer can’t escape in an asset purchase

The pace of merger and acquisition activity in the healthcare industry remains brisk. A key step in evaluating the suitability of a target business is the performance of tax due diligence, which involves a thorough analysis of the different types of tax liabilities, both disclosed and undisclosed, that may exist. Material tax liabilities and exposures can serve to reduce the sales price and, sometimes, cause a prospective buyer to abandon a deal altogether.

Where the shares of a company are acquired, the liabilities of the business are likewise acquired. For this reason, buyers often seek to structure business acquisitions as asset purchases. (There are often tense negotiations around this deal point as seller’s usually prefer share sales for both business and tax reasons.) Buyers recognize that the purchase of assets can reduce the possibility of unintentionally assuming latent tax liabilities. As explained below, however, comfort in this regard can be misplaced. It is counter-intuitive that the purchase of assets can involve the carryover of tax liabilities.

What tax liabilities must a buyer consider in an asset purchase?

While we are referring to an “asset purchase,” it should be recognized that a business generating income, and expenses is the target. The business is simply not contained within a corporate legal entity for U.S. tax purposes. In this construct, buyers may be able to avoid some types of tax exposure, but there are two liabilities they generally cannot escape: sales tax and payroll tax.

In many jurisdictions, liabilities associated with sales or payroll tax attach to the assets of the entity, and, in most situations, the buyer can become responsible for paying the liability. These areas of exposure are commonly under-emphasized during the due diligence process, yet either can negatively affect the outcome of the transaction and the buyer’s forecasted operating results post-acquisition.

Substantial penalties can be assessed in connection with these unpaid tax liabilities, making a bad situation even worse and further diminishing the deal economics. The following is an overview of several potential areas of sales and payroll tax exposure that can exist in the context of a purchase/sale.

Sales Tax

The U.S. Supreme Court’s decision in the Wayfair case from 2018 has given states more power to impose sales tax on out-of-state businesses and has heightened awareness around sales tax compliance and exposures. The Wayfair case essentially eliminated the need for a seller’s physical presence in a state to create sales tax nexus (i.e., the trigger for a filing requirement and/or collection obligation).

Prior to Wayfair, a business needed to have a physical presence in a state in order for that state to require the collection and remittance of sales tax. Today, states have changed their laws governing sales tax nexus to focus on economic measures of presence—often the volume of sales and/or the number of transactions. For example, for some states, nexus can be triggered when a business has at least $100,000 in sales and more than 200 transactions. This results despite the seller having no physical contact with the subject state.

LBMC performs many tax due diligence engagements each year through our dedicated Transaction Advisory Team. The two most common and material issues with sales tax we observe are (a) businesses not fully understanding the potential taxability of the product or service and the triggers for collection obligations (see above), and (b) businesses failing to obtain exemption or resale certificates to document nontaxability, even if selling to an obviously tax-exempt entity.

A key point to note, especially in the context of due diligence, is that the statute of limitations for sales tax does not begin to toll until a tax return is filed or the tax has been paid. If a sales tax return has never been filed, a state can assess taxes, penalties, and interest starting with the first year the business established nexus in the state. The acquirer of a business can unknowingly step into this trap and be liable for years of target filing failures.

Payroll Tax

Payroll taxes remain an area of focus with the IRS, especially the misclassification between employees and independent contractors. Using independent contractors relieves the principle of employer tax and administrative obligations and can be key to achieving the profitability metrics posted by the subject business. In a similar vein, LBMC has also observed states becoming more aggressive in the collection of payroll taxes on nonresident individuals spending workdays in their state.

For example, if a Tennessee employer has an employee working outside of his/her “home” state (e.g., in California) for a month, the employer may be legally required to withhold California’s payroll tax, file a California tax return and remit any required withholding. The widespread popularity of hybrid work arrangements has brought this issue to the forefront. Each state has different laws that determine when a nonresident individual is subject to state tax and when his/her employer is obligated to collect and remit nonresident payroll tax withholding. Most impose the tax obligations once an employee has worked in the state for a specified amount of time (e.g., two weeks, one month, etc.).

As with sales tax obligations, if the target business did not file payroll tax returns, the state’s payroll statute of limitations never tolls. In such cases, the liabilities could go all the way back to the company’s first presence in the state.

Payroll tax exposures can grow exponentially and adversely affect a deal. A recent example in a due diligence with which LBMC assisted involved a company seeking to make a business acquisition for $6 million. A payroll tax liability exposure due to employee misclassification of $600,000 was discovered. That $600,000 tax exposure negatively affected EBITDA, the overall valuation of the company and the purchase price offered.

Key Takeaways

If a business sale is on the horizon, the deal structure will materially affect the tax liabilities for which the seller may be liable. Make sure you identify and quantify all areas of exposure so plans for remediation can be developed and the resulting costs can be considered in the business valuation.

If you are planning to sell your business or are seeking new investors, it is wise to engage someone knowledgeable in tax diligence matters to perform sale-side tax diligence so that you know your exposures and have an opportunity to take remedial actions in advance. Such preventative measures taken while the seller remains in control are usually far less expensive than reacting to issues raised by a prospective buyer in due diligence. Such front-end planning can also increase your credibility with prospective buyers demonstrating your foresight and transparency.

On the flip side, if you are acquiring a business do not underestimate sales and payroll tax obligations—they should be a part of your due-diligence checklist. Even if a scaled back tax diligence process is justified, make sure these two areas are examined.

Whether buying or selling, the key to successful tax due diligence in any acquisition is to make sure you are working with a qualified transaction specialist who knows what to look for and how to work through previously undiscovered tax problems. Such specialists not only can save time, money and headaches, but also bring credibility and objectivity to the process.

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.

What tax liabilities must a buyer consider in an asset purchase?

Sales Tax

Payroll Tax

Key Takeaways

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