Merging or acquiring? Don’t forget state and local taxes. 

By Terry Barrett, CPA 

Potential state and local tax considerations are often given only cursory attention in a merger or acquisition. If the transaction is structured as the acquisition of stock (or ownership interest in the case of a non-corporate entity), the acquiring company is obtaining the target and all of its tax liabilities and exposures, except for those which may be mitigated or limited through the purchase agreement. Therefore, it is very important that the acquiring company identify — and, if possible, quantify — potential liabilities and exposures before finalizing the transaction. 

Obtaining the information necessary to do this, though, is often hampered by the confidentiality of the proposed transaction and cooperation on the part of the target company. However, given the potential exposure, it’s imperative to analyze the target’s tax situation as thoroughly as possible. This article focuses on some of the state and local tax issues that may represent potential exposure or liability. 

In M&A, a wide range of taxes may come into play, such as income/franchise taxes, gross receipts, state/local business license fees, property taxes, sales and use tax and miscellaneous local taxes. Depending upon the nature of the business and the states or localities involved, there may also be other transactional taxes, such as utility, lodging/meals or admissions, to name a few. Other non-tax — but often considered “tax-like” — issues are state business registrations and unclaimed property. And, there may be others depending on the industry and states involved. To say that it is complicated is an understatement.  

One of the key issues to consider in any acquisition is whether the target company has been properly reporting and paying taxes where the company has nexus. Nexus is a connection with a taxing jurisdiction sufficient to create a tax registration and reporting requirement. Today, it is rare for a business to be operating only in one state. Consider Internet transactions, traveling sales people, traveling employees, the storage of inventory in another state, work performed for customers located in other states — all have the potential to create nexus. In addition, states have adopted a variety of nexus standards, with some traditional (physical presence) and others focusing on economic activity (sales). These all must be considered in light of a business’s operations/activities and compliance efforts.  

From an income tax perspective, federal law (Public Law (PL) 86-272) provides protections from income tax filing requirements when the only activity of a business in the state is the solicitation of sales of tangible personal property. However, there is generally an income tax filing requirement when the in-state activities go beyond mere solicitation. Further, PL 86-272 does not extend to sales of services or intangibles. In addition, PL 86-272 does not afford any protections against state franchise, gross receipts or other alternate base income tax. Many businesses try to claim the PL 86-272 exclusion even if their activities in a state go beyond “mere solicitation” or they are providing services in a state. Consideration must be given, however, to the actual activities and level of business in the states and the state-specific taxes (income, franchise, gross receipts).  

Sales tax is often viewed as unimportant, but the failure of a business to properly collect and remit sales tax on taxable sales or services or report use tax due on purchases can give rise to large tax liabilities. This issue frequently arises with businesses that have sales representatives traveling to multiple states, that are selling over the Internet or that are providing services by their own employees or through independent contractors in other states. A close examination of the target business’s operations from a sales tax perspective and a determination of corrective measures, if necessary, can help mitigate potential liabilities down the road. 

Keep in mind that PL 86-272 does not provide protection from the collection of sales tax. If a business is noncompliant, the sales tax liability often shifts from a customer tax to a company tax if the company chooses not to “go after” the customer to pay the sales tax. As it relates to use tax, more and more purchases are from online businesses that may not properly assess sales tax or are not required to collect in a certain state. In this case, it is up to the business to review invoices for goods purchased to be certain proper sales tax has been paid or to self-assess and remit the use tax.  

Often states or localities have business license taxes and property taxes (real and personal). These taxes may be overlooked if the target does not have a physical office in the state, but merely has property or business activity. Consider situations in which a business leases personal property to others. In most cases, the business owner is subject to the tax, but can by law pass the tax through to the customer. Local taxes due to individual states in any given year may not be significant, but often localities will not compromise on taxes due or waive interest or penalties when they identify noncompliant taxpayers or these noncompliant taxpayers voluntarily turn themselves in. Catching up on these taxes may be costly. 

Non-tax issues that should also be considered are state registrations and unclaimed property. Most states take the position that registration with the Secretary of State is required if a business is “transacting business” in the state. The term “transacting business” may or may not be defined by the state and often the Secretary of State offices provide limited guidance as to whether a particular business should be registered. However, the penalties for noncompliance can be rather substantial in some states; for example, in Connecticut, the penalties for failing to register with the Secretary of State are $300 per month for periods beginning October 2009 and after. These penalties are in addition to the annual fees that must be paid to bring a business into good standing with a state.  

Unclaimed property is property that is held by one person (the holder) that belongs to someone else (the owner). Examples of property unclaimed by the owner are payroll checks, customer credits, gift cards and deposit checks. While holders are required to report unclaimed property to the state of the last known address of the owner, often this property is not reported — whether intentional or unintentional — and is taken back into “income.” Depending upon the nature of the business, unclaimed property may present a significant liability. The increased use of gift cards across many businesses makes this an issue of increasing importance. 

There may be state and local tax implications if the transaction is structured as the sale of assets. Transactional or transfer taxes may apply, depending upon the states and localities involved. The sale of business assets may be subject to the sales tax in some states unless certain exemptions apply. Many states have occasional or casual sale exemptions that typically apply to the sale of assets not normally sold in the ordinary course of business, such as capital assets, or the sale of all or substantially all the assets of a business. These exemptions generally do not apply, however, to vehicles where taxes typically are due upon the transfer of owner. Inventory typically is not covered by these exemptions but may be exempt under a resale exemption. The states’ rules where assets are located should be carefully considered as a seller generally is required to collect the tax unless an exemption applies, however, the state may pursue the payment of the tax from the buyer.  The sale of real property may be subject realty transfer taxes. These taxes generally must be paid at the time a deed is recorded.  

In recent years, some states have enacted controlling interest transfer taxes. These are imposed on transfers of an ownership interest in an entity that directly or indirectly owns real estate, unlike the realty transfer taxes that are imposed only when the real estate itself is transferred. The intent of these controlling interest laws is to capture tax that may be avoided by a taxpayer who contributes property to an entity and then sells an equity interest in the entity. These laws are all different and complicated but should be considered, if applicable. 

State and local tax considerations should not be overlooked in any business acquisition.  

Terry Barrett is a tax senior manager at Keiter. Terry focuses on state and local tax consulting, and primarily non-income tax issues, such as sales and use tax, and business license and personal property tax, in Virginia and other states.