By Brian Davis, Managing Director, M&A Tax
Key Takeaways
- An asset deal is often preferable from a tax risk perspective, but it is not a complete shield against all historical tax liabilities.
- State sales and use tax statutes often include successor liability provisions that can result in a purchaser of business assets becoming liable for the seller’s unpaid sales and use tax. While tax clearance certificates, bulk sale clearances, or similar state confirmations can significantly reduce or eliminate this exposure, pursuing these procedures is generally impractical for a buyer in a pending acquisition, given applicable notice and timing requirements. Buyers are more commonly protected through voluntary disclosure agreements, escrow arrangements, and specific indemnities.
- Federal payroll tax liabilities generally remain liabilities of the employing entity; however, trust fund taxes, information reporting failures, worker classification issues, and responsible person exposure can create substantial risk for owners, officers, and other responsible individuals.
- In some states, successor liability concepts are drafted broadly enough to reach taxes beyond sales and use tax, including income, franchise, gross receipts, or employer-related taxes, particularly where substantially all business assets are acquired, or the purchaser continues the business.
- If the target never filed a return for a particular tax, exposure may reach back to the first period of noncompliance, with tax, penalties, and interest accumulating over multiple years. In an asset deal, that history can become the buyer’s problem if the state’s successor liability rules apply.
Tax due diligence is a critical part of evaluating any business acquisition. Its purpose is to identify disclosed and undisclosed tax liabilities that may affect valuation, deal structure, indemnity negotiations, escrow amounts, or, in some cases, whether a buyer proceeds at all. Within the context of an asset deal, historical federal income and payroll tax liabilities generally stay with the selling entity. However, an asset deal does not eliminate all tax risk. Certain tax exposures can follow the transferred business or its assets by statute (e.g., sales and use taxes, property taxes, and abandoned and unclaimed property), and others can indirectly affect deal economics even when they do not technically transfer (e.g., payroll taxes).
This article provides a general overview of tax due diligence considerations in asset acquisitions, with particular focus on sales and use tax, payroll tax, and broader state successor liability concepts.
Sales and Use Tax
Sales and use tax remains one of the most commonly identified and significant areas of exposure within the context of a tax diligence exercise. Buyers of business assets may assume that, because they are purchasing assets rather than equity, historical sales tax liabilities remain with the seller. In practice, that assumption can be misleading. Many states have statutes that impose successor liability on the purchaser of a business, or of substantially all of its assets, for the seller’s unpaid sales and use tax unless the purchaser complies with prescribed notice, withholding, or clearance procedures.
These rules matter because sales tax liabilities can be both large and difficult to quantify with any reasonable certainty. Since the U.S. Supreme Court’s 2018 South Dakota v. Wayfair decision, state taxing authorities have expanded economic nexus standards, and many businesses now have filing obligations in states where they have no physical presence. As a result, multistate sales tax exposure is now common across industries, including service businesses, digital businesses, manufacturers, distributors, and consumer-facing companies. A target may have historical exposure because it misunderstood whether its products or services were taxable, failed to register in states where economic thresholds were exceeded, or did not maintain valid exemption or resale certificates to support nontaxable transactions.
In many jurisdictions, a buyer can request that the target obtain a tax clearance certificate, bulk sale clearance, tax status letter, or similar confirmation from the taxing authority. Such clearance certificates or letters may provide confirmation from the state, subject to the scope of the applicable procedure, that the target has satisfied its known or identified tax obligations for the covered tax types and periods (e.g., appropriate returns have been filed, and the requisite taxes have been paid). When followed properly, these procedures can significantly reduce or eliminate the buyer’s successor liability for unpaid sales and use tax. However, obtaining these certificates / letters is generally impractical for a buyer to pursue or request in the context of a pending acquisition, as these procedures are typically subject to strict notice and timing requirements. In addition, failure to comply with applicable state-specific requirements may prevent the buyer from qualifying for statutory protection, leaving the buyer exposed to the same successor liability the procedure was designed to prevent.
NOTE: While obtaining a tax clearance certificate / letter is generally impractical from a buy-side perspective, it can be a practical route to rectify potential issues from a sell-side perspective. It gives a prospective buyer assurance that pre-closing sales and use tax exposure has been cleansed and confirmed by the state.
Even where a formal clearance process is unavailable, the buyer may obtain similar protections through escrow arrangements, specific indemnities, and targeted post-closing remediation. Specifically, entering into a voluntary disclosure agreement (“VDA”) with a state related to a sales and use tax issue can significantly reduce historical exposure by limiting lookback periods and penalties. A VDA can also be paired with escrow and indemnity protections to address any residual buyer exposure related to identified sales and use tax issues.
Payroll Tax
Payroll tax is also a major item that is commonly analyzed during diligence, but it should be analyzed differently. As a general matter, payroll tax liabilities do not automatically carry over to the buyer in an asset acquisition in the same way sales tax liabilities often can. The employing entity remains responsible for its historical federal and state payroll tax obligations, including income tax withholding, Federal Insurance Contributions Act (FICA) taxes, Federal Unemployment Tax Act (FUTA) taxes, and comparable state payroll-related obligations.
That said, payroll tax diligence remains essential because the underlying issues can materially affect purchase agreement protections and post-closing operations. Worker classification is a common example. If the seller treated employees as independent contractors, failed to withhold employment taxes, or mishandled multi-state payroll withholding for remote or traveling employees, the seller may face substantial assessments, penalties, and interest. Those liabilities may affect deal economics and require specific indemnities even if they do not technically transfer with the assets.
In addition, payroll tax exposure does not end with the entity. Trust fund taxes, meaning amounts withheld from employees for income tax and the employee portion of certain employment taxes, can create personal exposure for officers and other responsible persons. Under federal and many state regimes, individuals who were responsible for collecting, accounting for, and paying over those taxes, and who willfully failed to do so, may be assessed personally. Accordingly, while an asset buyer may not automatically inherit the seller’s payroll tax debt, owners, executives, and other control persons connected with the seller can remain subject to potential exposure.
Finally, a buyer may inherit operational consequences even where the payroll tax liability itself stays with the seller. Misclassified workers may need to be converted to employee status immediately after closing. Remote employee footprints may reveal state registration and withholding obligations that the buyer will need to address going forward. Unpaid wage, benefit, or information reporting issues may also intersect with labor and employment diligence. In short, payroll tax liabilities generally do not “follow the assets” by default, but payroll tax problems can still meaningfully affect deal value and execution.
Broader State Successor Liability for Other Taxes
A further point often overlooked within the context of an asset acquisition is that successor liability is not limited to sales and use tax. Some states have broader statutory regimes or tax collection rules that can cause other liabilities, including income tax, franchise tax, gross receipts tax, or employer-related taxes, to follow the business assets or otherwise attach to the purchaser when substantially all of a business is acquired.
These rules vary significantly by jurisdiction. In some states, the purchaser of business assets may be liable if it fails to withhold a portion of the purchase price after notice of the sale, fails to obtain a clearance certificate, or continues the seller’s business without satisfying statutory requirements. In others, the taxing authority may assert successor liability principles more aggressively where the acquisition resembles a continuation of the prior enterprise. Because these rules are highly state-specific, diligence should include an analysis of the target’s filing footprint and the successor liability statutes in the states where the business operated, held assets, had employees, or generated revenue.
The practical takeaway is that buyers should not assume an asset acquisition limits tax successor exposure to sales tax alone. Depending on the state, income and franchise tax liabilities may also require active mitigation.
The Statute of Limitations Conundrum
In general, the statute of limitations for most tax types in most states is 3 to 4 years (assuming no extension applies for substantial understatements, fraud, or failure to file). If the target never filed a return for a particular tax, the exposure may reach back to the first period of noncompliance, with tax, penalty, and interest accumulating over multiple years.
In an asset deal, that history can become the buyer’s problem if the state’s successor liability rules apply. Notably, some states impose successor liability regardless of whether the buyer had actual or constructive knowledge of the exposure, which underscores why pre-closing tax diligence matters even when a seller represents that all returns have been filed. For that reason, tax diligence should focus not only on identifying historical exposure, but also on determining whether state law provides a path to cut off successor liability.
Conclusion
Asset acquisitions reduce, but do not eliminate, historical tax risk.
Sales and use tax represents the most commonly identified and significant areas of exposure where unpaid liabilities may follow transferred business assets by statute. While tax clearance certificates or comparable state relief can materially reduce or eliminate exposure, obtaining such protections is generally impractical for a buyer in a pending acquisition, making VDAs, escrow arrangements, and specific indemnities the more common and practical tools for managing historical sales and use tax risk.
Payroll tax requires a different analysis. Historical payroll tax liabilities generally do not automatically carry over in an asset deal, but worker classification errors, multistate withholding failures, and trust fund tax exposure for responsible persons can still materially affect deal economics, indemnity negotiations, and post-closing compliance.
Buyers and sellers should also account for broader successor liability rules in some states that can extend beyond sales tax to income, franchise, or similar state taxes. Early confirmation of the application of these broad successor liabilities rules in the states in which the target operates or which may have nexus from a state income tax perspective is a crucial step in the tax diligence process.
Because the statute of limitations generally does not begin to run until a return is filed, unfiled returns can leave tax exposure open back to the first period of noncompliance. In an asset deal, that exposure (including accumulated tax, penalties, and interest) can transfer to the buyer under state successor liability rules.
Disclaimer
This discussion is provided for general informational purposes only and is intended as a high-level summary of selected tax due diligence considerations in asset acquisitions. It is not legal or tax advice and should not be relied upon for any specific transaction or fact pattern. Successor liability rules, clearance procedures, and the treatment of payroll, sales and use, income, and franchise taxes vary significantly by jurisdiction and by the structure of the transaction. Buyers and sellers should consult qualified tax and legal advisors regarding their specific circumstances, the states involved, and any available pre-closing or post-closing mitigation steps. Information is subject to change as laws, administrative practices, and interpretations evolve.
Content provided by Brian Davis, Managing Director, M&A Tax. Contact him at brian.davis@lbmc.com.
Additional contributions from Bob Miller, Ellen Cates, Griffin Aerts. Contact them at bob.miller@lbmc.com, ellen.cates@lbmc.com, or griffin.aerts@lbmc.com.
