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Sales and use tax can look like a back-office detail during a merger or acquisition, right up until it becomes a purchase price adjustment, escrow issue, indemnity fight or post-closing surprise.
That is why Sales Tax Due Diligence deserves careful attention early in the deal process, especially for companies with multistate sales, digital products, software, remote employees, exempt customers or historical gaps in registration.
Below are the main sales tax issues buyers, sellers and advisors should evaluate during M&A due diligence.
Issue: The target may have sales tax obligations in states where it is not registered, filing or collecting tax. This can arise from physical presence, such as employees, inventory, offices or contractors, as well asEconomic Nexus created by sales volume or transaction thresholds.
Diligence action: Conduct a sales tax nexus study across all states where the target has customers, personnel, inventory, services, marketplace activity or other business contacts. The review should compare state thresholds against historical sales data and filing positions.
Risk: If the target had nexus but never registered, the statute of limitations may not have started. That can leave years of exposure open, including tax, penalties and interest.
Issue: In many states, a buyer can inherit unpaid sales and use tax liabilities, even in an asset purchase. Sales tax is often treated as a trust fund tax because the seller collected money from customers that should have been remitted to the state.
Diligence action: Request tax clearance certificates, bulk sale releases or similar documentation from relevant state tax authorities before closing. Review whether the purchase agreement properly addresses known and unknown sales tax liability.
Risk: A buyer may acquire more than assets. It may also acquire the seller’s historical noncompliance, including unpaid tax, interest and penalties.
Issue: The target may have applied the wrong taxability rules to its products or services. This is especially common with SaaS, digital goods, data processing, information services, bundled transactions and mixed sales involving both tangible goods and services.
Diligence action: Review the target’s taxability matrix, invoice coding, product mappings and automated tax system settings. Compare those determinations against current state rules in the jurisdictions where the company sells.
Risk: Undercollected tax can accumulate quickly. If the target charged customers incorrectly for several years, the buyer may face a large historical exposure that is difficult to recover from customers after the fact.
Issue: Companies often treat sales as exempt without maintaining valid exemption certificates. Common issues include missing certificates, expired forms, wrong state forms, incomplete customer information or certificates that do not match the transaction type.
Diligence action: Sample the exemption certificate database and compare exempt sales to supporting documentation. Confirm whether certificates are properly completed, current and accessible in the event of an audit.
Risk: During an audit, unsupported exempt sales are often reclassified as taxable. That can convert a large portion of exempt revenue into tax due, plus interest and penalties.
Issue: Targets may fail to self-assess Use Tax on purchases where vendors did not collect sales tax. Common categories include software, equipment, supplies, promotional materials, furniture, technology purchases and items shipped across state lines.
Diligence action: Review accounts payable data, expense accounts, fixed asset purchases and vendor invoices. Identify purchases where no sales tax was charged and determine whether the target accrued and remitted use tax.
Risk: Use tax exposure is easy to miss because it does not always appear in sales reports. Over time, small purchasing errors can become a material hidden liability.
Issue: The M&A transaction may trigger sales or transfer tax, particularly in asset deals. Some states provide occasional sale or bulk sale exemptions, but those exemptions may not apply to every asset transferred.
Diligence action: Review the purchase agreement and asset schedules. Determine whether transferred equipment, vehicles, software, inventory or other assets are taxable in the applicable jurisdictions.
Risk: The buyer or seller may face unexpected transaction level tax costs after closing.
Issue: If the target has unfiled sales tax exposure in certain states, there may be an opportunity to reduce the damage before the transaction closes.
Diligence action: Evaluate whether a Voluntary Disclosure Agreement should be pursued. A properly managed disclosure can often limit the lookback period and reduce or waive penalties.
Risk: Waiting until after closing may reduce leverage, increase exposure and complicate responsibility between buyer and seller.
Issue: Identifying a compliance issue is only the beginning. The deal team also needs to estimate the dollar exposure.
Diligence action: UseTransaction Lookback Reviews to test historical invoices, returns, exemption records, tax codes and customer locations. Quantify exposure by state, period and issue type.
Risk: Without quantification, parties may understate the risk or negotiate protections that do not match the actual exposure.
Issue: Even when historical issues are addressed, the combined company may create new filing obligations or operational weaknesses.
Diligence action: Plan for registrations, account updates, tax engine configuration, exemption certificate migration, invoice coding and internal ownership of compliance after closing.
Risk: A clean closing can still lead to future exposure if the buyer does not integrate systems and processes quickly.
Sales tax diligence is not just a compliance exercise. It is a deal protection exercise. Strong tax due diligence helps buyers understand exposure, negotiate escrows or indemnities, address Tax Controversies before they escalate and avoid inheriting problems that could have been identified before closing. Done early, it can turn a potential deal obstacle into a manageable business issue.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact DiAndria Green, Partner in Bennett Thrasher’s State and Local Tax (SALT) practice, or call us at 770.396.2200.
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