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How Wayfair v. South Dakota Changed M&A Due Diligence

April 26, 2019

The U.S. Supreme Court recently shifted one of the foundational principles that determine how a state can tax business transactions within its boundaries. This change will have a cascading effect in the deal space.

In South Dakota v. Wayfair (Wayfair), the court held that an out-of-state company could establish nexus by exceeding certain thresholds of dollar volume or number of sales into the state, a standard known as “economic nexus.” Moving forward, potential buyers and sellers need to understand the new complexities the Wayfair decision has added to the due diligence process. It is more important than ever to have deep knowledge of what the target business sells, where it has established nexus, and whether or not it has complied with obligations in those states.

At the same time, many states are scrambling to adjust their laws to align with the Wayfair provisions. For the next several years, many state standards for physical and economic nexus will be moving targets that interstate sellers will need to monitor. Such sellers must update sales, shipping, and delivery tracking as needed to maintain compliance with the latest laws.

Wayfair’s effect on sell-side due diligence

When owners plan an exit strategy that involves the sale of the business, they can conduct their own version of due diligence in order to prep for buyers’ examinations. Here are some steps to make sure that neither you nor your potential buyers are surprised by sales tax obligations during negotiations:

  • Identify what you sell and where you sell it. You need to know the overall number of transactions and sales numbers on a state-by-state basis. You also need to track individual products and services. Depending on the jurisdiction, some products or services may be exempt from tax.
  • Identify exemptions that may apply and make sure they are documented. If a customer qualifies for a resale or use-based exemption (e.g., manufacturing), obtain the proper state documentation from the customer. Before the economic nexus rules affirmed by the Supreme Court, sellers might have paid limited attention to documenting exemptions because they had no physical nexus in a state and had no sales or use tax collection responsibilities. These exemption records take on more significance with the expansion of what creates nexus in a state.
  • Determine where you are in compliance, where you are out of compliance, and why. When a seller can demonstrate thoughtful analysis of an issue like this, it adds credibility to your position and helps you manage the impact of potential sales tax liabilities on the deal. Buyers may not be happy to hear that there are risks in this area, but they will be much more receptive when you raise the issue, as opposed to a buyer discovering a potential liability of which the seller was unaware.
  • Understand that having gotten away with noncompliance in the past won’t help. Even before the Wayfair decision, there were intense efforts underway to crack down on noncompliance. If you’ve done it this way for years and not been caught, that will not persuade a potential buyer to overlook the risks and potential costs of previous and ongoing noncompliance.
  • Invest in the longevity of your business, and accept that many buyers may already be thinking about selling it again. Many entrepreneurs and investment groups are looking for businesses that they can buy and expand for a relatively short period, then resell. They are not likely willing to invest significant time and money in resolving sales tax compliance issues. If they are, it may cost you in the form of purchase price reductions or as a condition of closing as a cost to you as the seller.

Wayfair’s effect on buy-side due diligence

In addition to the items above, for many buyers, post-Wayfair due diligence should also include the following:

  • Understand your risk as a successor regardless of the type of transaction utilized. In most states, buyers can still have successor liability for sales and use taxes even if they acquired a company in an asset transaction.
  •  If the target is noncompliant, options include:
    • Walk away and find another business to acquire if the risk is too great.
    • Require the seller to remedy noncompliance before the sale, or, while the seller or buyer completes this process post-sale, place funds in escrow that are an estimated amount of the costs of remedying past noncompliance plus prior tax liabilities. Using escrow when there is no plan to correct past noncompliance creates challenges. If sales tax returns were never filed by the seller, states’ statute of limitations conceivably never expires, and the potential liability may exist even after the escrow amount is returned.
    • Assess the monetary risk of noncompliance and, where sales tax exposure is large, insist on a separate line item indemnification clause for potential sales tax issues that arise post-close. Most indemnification clauses generally cover sales tax exposure that existed pre-close, but a separate line item indemnification for known issues avoids future confusion or doubt.
    • Review insurance coverage, which may offer protection for noncompliance that is discovered after the purchase. However, note that insurance might not cover issues that you knew about (or reasonably should have known) at the time of the deal.
  • If you proceed with the sale, understand the potential costs.
    • If the buyer is going to rectify the seller’s prior issues, tracking down good data, its analysis, voluntary disclosure processes, and all things involved in resolving prior year issues take significant hours and financial resources. This includes the dedication of employees and staff and the employment of external tax professionals. It could also result in a significant tax, penalty, and interest bills depending on how the prior liabilities are rectified.
    • Once the past compliance is completed, future compliance costs will likely increase. Companies will likely need to acquire a software system to assist in tracking data needed for multistate sales and use compliance. Additionally, the time commitment each month, quarter, etc. to comply with the required filings will increase.
    • Becoming a multistate filer will require an emphasis on detailed record keeping, updated software systems for rate and taxability changes as laws change, and potential for more reviews and audits by states. It may also involve the expansion of an internal finance team, the development of a training or learning strategy, or the investment in additional software or software-related resources.

Sales taxes present bigger transactional risk

The Supreme Court’s expanded interpretation of nexus has further complicated an already problematic area of transactional due diligence. At a time when states were already beefing up their enforcement of existing sales tax collection rules, the Supreme Court has permitted them to cast a much wider net over out-of-state sellers.

All businesses need to understand their nexus footprint and related state tax obligations under the new rules. Parties involved in transactions need to make sure that the team of advisors performing due diligence and valuing the deal appreciate the complexities of this issue and the wide variety of costs associated with addressing it.

For questions on how these rules apply to you, please contact your KSM advisor.

Mike North Partner-in-Charge, Advisory

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