As states look for new ways to raise revenue through tax law changes and increased enforcement, private equity groups buying and selling companies can gain an edge by being aware of new trends in sales and use tax.
PEGs buying companies should incorporate existing liabilities into pricing or set up escrow accounts to protect against exposure, while sellers can take steps to increase the marketability and price of their companies by proactively addressing existing exposure.
NEXUS STANDARDS, COMMON MISTAKES
States are limited in their authority to require out-of-state companies to register and collect tax, following a US Supreme Court decision – Quill Corp vs North Dakota – requiring a company to have more than the slightest physical presence in a state for a state to assert nexus. Transitory presence in the state for the purposes of selling, delivering, installing, and performing maintenance and warranty work generally has been interpreted to create nexus – as have activities conducted on behalf of a company by affiliates, agents and independent contractors. The nexus-creating activity in the state doesn’t need to be directly related to the sales to create nexus.
Often, companies can risk exposure as their business grows faster than the internal tax department’s ability to keep up with new products, services, and markets. Some areas commonly missed by companies include:
Treating single-member LLCs disregarded for federal income tax as disregarded for sales tax: Currently, only Wisconsin extends disregarded status for these entities to sales tax;
Ignoring transitory activities: Many companies file only in the state where their employees reside, but don’t consider sales territories or other regular visits to customers. States increasingly look at customer invoices for items such as installation, training and repair charges for signs of vendor nexus;
Assuming safe harbors for sales tax: The statute that allows a company to solicit business in another state without being subject to net income tax does not apply to sales and use tax nexus;
Disregarding wholesale or other exempt sales: States require sellers to collect exemption documentation or charge tax. While most allow sellers to collect documentation after the fact, exposure can arise when this is not possible due to customers being acquired or going out of business.
Buyers and sellers often disagree about what constitutes sufficient contact for nexus in negotiations. States generally impose their jurisdiction over out-of-state companies to the broadest extent allowed, and if significant dollars are involved it is difficult to win a nexus argument at agency level unless the contact with the state is truly irregular and isolated and the cost of litigating can equal or exceed the tax liability. Buyers should consider escrow or indemnification for these exposures in their negotiations.
EMERGING SALES AND TAX ISSUES
As more and more transactions are done via e-commerce sites and over the cloud, state sales and use tax regulations are evolving accordingly. These are some of the significant changes:
Click-through nexus (used in more than a dozen states): Out-of-state sellers that have a commission-based relationship with in-state companies based on a click-through link to the out-of-state sellers’ website that generates more than $10,000 in sales over four calendar quarters have nexus;
Fulfillment and warehousing services: Many companies act as online marketplaces using a fulfillment service to reach customers and deliver products. As the fulfillment service company is performing services for the seller and often storing the seller’s product in its warehouses, the seller will have nexus based on inventory in the states. When evaluating its nexus footprint, a seller may need to consider whether the fulfillment company may be delivering inventory in its own trucks or moving inventory to different warehouses;
Software as a service: As software increasingly moves to the cloud, states are catching up by taxing software accessed remotely by customers. Currently, 19 states tax companies that remotely host software or provide software as a service to in-state users. Users need to carefully review the language of the agreements to see if a license is being granted to the user;
In-state affiliates: States including California and Michigan are seeking to gain nexus over out-of-state companies through the presence of in-state affiliates. Existing law requires physical presence by a company by either employees or agents or affiliates acting on the company’s behalf, so these laws may be subject to challenge if the in-state affiliate performs no activities on the out-of-state company’s behalf;
Intellectual property: States including Illinois have extended nexus to out-of-state companies that sell products using the same trademarks or trade names as in-state companies;
Economic nexus for sales tax: A number of states have adopted regulations designed to provide for nexus with no direct or indirect physical presence in the states, challenging the Supreme Court ruling;
Reporting requirements for out-of-state sellers: To skirt physical presence requirements, some states have imposed reporting requirements for out-of-state sellers exceeding a sales threshold. Under these statutes, sellers must inform the state’s customers of their use tax payment obligation and report to the state any sales to its residents by customer name and amount.
TACKLING EXPOSURES, MITIGATING RISK
For PEGs contemplating the sale of a portfolio company, sell-side due diligence can identify issues that may arise in a potential transaction and enable the PEG to address these issues proactively, effectively taking them off the table in a future sale. A clean company will result in less leverage for the buyer to reduce the purchase price or tie up sales proceeds in escrow and will provide some certainty related to any future indemnification claims. Several avenues are available for addressing exposures pre- or post-close:
Voluntary disclosure agreements with states: These can limit the lookback period for taxes (generally three to four years), waiving penalties and sometimes interest, and are particularly useful for companies that have been operating for many years;
States amnesty programs: These waive both penalties and interest but don’t limit the lookback for taxes; usually the VDA is a better option;
Contacting customers for exemption certificates: This can reduce potential exposure, and can also be achieved by contacting customers to determine whether they have self-assessed and remitted use tax for past transactions or if the customer has been audited for the past periods. Both can potentially eliminate the need to report tax on past transactions to the customer.
Buyers and sellers should engage experienced advisors to help identify potential sales and use tax exposures and support the transaction team in purchase negotiations. Proactively addressing potential tax issues will put sellers in a position to set the best possible price. For buyers, being aware of the issues will encourage them to seek funds for remediation of issues that will affect not only current exposures but future marketability of the company. Buyers should attempt to negotiate an escrow for potential exposure or – at a minimum – make sure that sales and use tax liabilities are clearly covered by any indemnification provisions.
Mike Gamboa and Paul Yoder are with Crowe Horwath; Steve Lalor is a managing director with Crowe Horwath