Business sale transactions require buyers and sellers to consider a wide variety of criteria, from economic factors and business operation planning to federal, state, and local tax issues. Among the tax concerns that must be evaluated during the due diligence phase, few are as complex and potentially significant as state tax “nexus,” which governs when a state is able to impose a tax on a business.
Nexus standards are often complicated, applied differently by tax authorities, and can vary depending on the type of tax. For example, a business could meet nexus criteria that require it to file and pay sales tax in a state while having no obligation to pay income tax in the jurisdiction. In order to identify potential outstanding state and local tax obligations during the due diligence process, buyers and sellers should conduct a thorough and careful analysis of nexus during the transaction planning phase and work to limit any state and local tax burden and eliminate surprises.
What is nexus?
Nexus is the minimum connection that must exist between a jurisdiction and a taxpayer for state and local taxes to apply. Physical presence has historically been an accepted standard for determining whether nexus has been established for all forms of state tax. Physical presence can occur when a taxpayer owns or leases property in a state, including storing inventory at a third-party warehouse. Additionally, nexus can be created when a company’s employees or agents are present within a state, such as meeting in-person to conduct business activities.
For those selling tangible property, Public Law 86-272 is a federal law that all states must follow when it comes to the imposition of income taxes. This law provides that nexus doesn’t exist for income tax purposes if a taxpayer’s activities within a state are limited to soliciting sales of tangible personal property, the orders are approved outside the state and, if approved, the orders are fulfilled from inventory located outside the state. State tax authorities narrowly interpret solicitation activities, so not all activities performed by a salesperson will qualify for the protections of Public Law 86-272. This protection doesn’t extend to a taxpayer that solicits services. It also doesn’t apply to taxes other than income taxes, such as franchise, sales and use tax, and gross receipt taxes.
In addition to the physical standard, many states have imposed statutes that establish nexus based on a taxpayer’s economic activity in the state. Generally, economic — or factor-based nexus — occurs once a taxpayer exceeds a defined threshold amount of property, payroll, or sales in the state. Other factors may also create economic nexus, such as the number of transactions to customers in the state and obtaining authority from the Secretary of State in the jurisdiction to conduct business. Economic nexus statutes vary from state to state and may be limited to certain taxes.
Nexus implications for buyers and sellers
During the tax due diligence process, it’s important to determine the target’s pre-acquisition nexus status in all states where it conducts business. If the seller hasn’t been filing and paying taxes in required states, state and local tax liabilities can be particularly significant because liabilities compound over multiple years and the statute of limitations never tolls when a taxpayer fails to file required returns. In addition, most states have some form of successor liability standard that can require a purchaser to pay the pre-transaction taxes owed by the company even in asset transactions.
The purchase agreement may provide protections for the buyer related to pre-acquisition taxes, but these protections generally still require the buyer to collect the taxes from the seller directly or from the escrow established for such taxes. As a result, it’s critical that exposures for pre-acquisition obligations be known before the transaction so that they can be mitigated, managed, or negotiated.
Planning to mitigate the impact: The importance of nexus studies
To mitigate the significant risks associated with pre-transaction state and local tax liabilities, sellers can conduct a pre-sale nexus study. These studies can inform the seller about the filing requirements, quantify any exposures if the business is not filing in all required jurisdictions, and resolve any exposures through payments, voluntary disclosure agreements, or other means allowed by the state. In addition to identifying states where obligations exist, a nexus study also arms the seller with information that supports why nexus does not exist in various states and why returns aren’t filed in all states with sales.
Even if a seller presents a pre-sale nexus study, a buyer may want to conduct its own independent review. A pre-closing review might identify issues that the seller missed, as well as changes in facts and circumstances that could arise after the transaction. A study performed after the transaction can help determine whether nexus has been established in new states, identify where nexus no longer exists, and confirm conclusions derived from the previous study.
Avoid unwanted surprises
Determining the jurisdictions where a business has established nexus can be a daunting task for both prospective buyers and sellers. A nexus study can avoid unwanted surprises and equips companies with accurate and up-to-date information about filing requirements for various taxes. It provides a seller with information that allows it to identify risks and mitigate existing exposures, and it gives buyers some assurance that state and local tax debts have been paid, steps are being taken to mitigate unpaid taxes, and awareness of the balances the seller may owe on any taxes due.
