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Once the champagne is popped and the celebrations are over, many acquirers run into a recurring and unwanted problem: the state revenue department opens an audit into a business that no longer exists.
The seller is gone, escrow has been released, and you, as the buyer, have been notified. It’s not an odd fluke of aggressive tax enforcement. It’s how successor liability is designed.
The majority of states allow the buyer of a business to inherit the seller’s unpaid sales tax unless the buyer follows a specific notification or clearance process ahead of closing. For a one-time acquisition, this is more of a checklist diligence item. For enterprise finance teams doing recurring acquisitions, it’s a structural risk if missed.
We've dug deep into state-level sales tax data to outline the best ways to identify the issue and how to solve it before it becomes a larger problem.
The hidden liability
To understand the scope of the issue, imagine a mid-market SaaS company that’s attempting to acquire a smaller competitor. The data room has clean financials, a tight deadline, and zero red flags off the bat.
Sales tax nexus doesn’t come up in the diligence calls because the target has a history of filing on time. A couple of years after closing, though, the acquiring company gets a notice about the seller’s pre-closing sales. Before the acquisition, the target had undercollected tax in three states after a product bundling change went unnoticed. Depending on the applicable state successor liability rules and any protections obtained before closing, the acquirer could be liable for that unpaid tax.
Most states with a sales tax also provide a bulk sale notification or tax-clearance procedure for this exact situation. The states understand that successor liability rules can create unintentional traps for buyers. If followed properly before a deal closes, the process helps to limit or cap the buyer’s exposure. The only catch, which most buyers miss, is that the procedure needs to be invoked by the buyer in most states.
The reason why a company doing a single acquisition is less at risk than a firm that handles many is only due to scale, it can afford to learn the lesson the hard way. It may not make the same mistake again for over a decade and can write off the tax repayment as a harsh reminder of what not to do in the future. Engaging in multiple acquisitions in a year compounds the risk.
How liability transfers
Successor liability is the legal principle that the buyer of a business or its assets can become liable for the unpaid taxes of the seller, up to the value of what was acquired. It doesn’t require the buyer to have known about the liability in advance.
It exists because states would otherwise lose the ability to collect tax from a business simply because it changed hands. A sample successorship notice form from Washington State can help clear up whether you qualify.
The mechanism of successor liability is similar across states, but procedures vary. A seller is required to pay any taxes owed, and the buyer is required to withhold sufficient funds from the purchase price until proof of payment has been shown. If the buyer opts to skip that step, they become personally liable for any unpaid amounts. That repayment is usually capped at the purchase price of the business.
The liability you inherit isn’t limited to the tax itself. The bulk of states extend the liability to include interest and penalties that the seller faced. The liability also attaches regardless of whether a purchase agreement says the seller retains responsibility for pre-closing tax items. After all, a private agreement doesn’t bind the state.
Not every transaction triggers these rules. Generally speaking, successor liability applies to sales that happen outside the ordinary course of a business. Selling substantially all the assets of a business, a stock of goods sale, or a transfer of the major part of a business’s equipment would all usually qualify. How the deal is papered and what changes hands will determine which state’s notification triggers apply.
Three different clocks
States that require an advance notice always set it before a deal closes. New York, for instance, requires a buyer to notify the tax department at least 10 days before taking possession of assets or paying for them, whichever comes first. Illinois requires the same.
Washington works differently. There, notice is filed after an acquisition, and the successor is only protected if the state doesn’t issue an assessment against the former owner within six months. This is why knowing which states are in scope is crucial.
Once a state is notified, it has its own clock for a response. California has 60 days from the later of the buyer’s written request, the sale date, or the date the seller’s records become available. Texas gives its comptroller 90 days. New York only takes five days.
There’s also a limit on the lookback period on which states can assess tax, which varies by state. The Multistate Tax Commission publishes a state-by-state reference guide. Voluntary disclosure agreement lookbacks are shorter. The average is three to four years, meaning a company that comes forward on its own generally only needs to pay back tax for that period, rather than the whole unregistered period. It’s a material difference from what a full audit could come to if the state finds the issue first.
None of the clocks apply to sales tax that a business actually collected from customers but never remitted. Voluntary disclosure agreement programs waive back taxes outside the lookback period, but this type of tax needs to be paid in full regardless of how far back it goes.
Five state requirements
Every state has different requirements, and they can quickly become muddled. To show this difference, here are the breakouts of how the liability is handled by some of the largest states: California, New York, Texas, Illinois, and Washington.
The diligence sequence
No buyer wants to be on the hook for massive sales tax paybacks. That’s why following a sequence of diligence items is so important. By adhering to the following five steps, you can identify any potential red flags in a transaction and get ahead of it:
Step 1: Map the transaction
Before you do anything else, establish what exactly is being acquired, in which states, and how the deal is structured. An asset-only deal will trigger successor liability rules that stock deals generally won’t, for instance. List every single state where the target has a nexus, regardless of whether they’re registered or not, since notification and clearance obligations are state-specific.
Step 2: Run the nexus study
Your next step should be to run a nexus study. This study will show where your target should have been collecting and remitting sales tax based on their physical presence, economic thresholds, and marketplace rules. Where it was actually registered isn’t the only obligation. This step is critical as it will show the gap between filed states and states with exposure. The exposure will still be there, but at least you, as the buyer, will know what you’re inheriting.
Step 3: Quantify exposure
Third, you should aggregate the unfiled states. This will allow you to estimate the back tax, interest, and any applicable penalties for each state. Use this figure to drive escrow sizing and remediation options later down the line. This needs to happen before your purchase agreement is finalized.
Step 4: Choose remediation
Once you have the previously unidentified exposure mapped out, you and the seller need to decide whether to resolve it before closing through a VDA, address it via escrow and indemnity, or another method. VDAs can be started anonymously, which is a benefit, and they typically limit exposure on the lookback period. The downside is that they take more time.
Step 5: Complete clearance
Regardless of what your nexus study turns up, it is still your obligation to complete each state’s actual notification and clearance procedures. Remember that much of this must be done before closing the deal in order to limit exposure.
VDA decision points
Following through with a VDA makes the most sense when a nexus study finds material unremitted exposure in a state where your target never registered.
Timing is the most important thing. A VDA can take a good amount of time to execute, meaning you need to have enough time before closing to start the process. It’s a less useful tactic for exposure that the target was already aware of and was paying off.
It’s also important to be aware of another benefit of a VDA: it generally waives penalties and can sometimes reduce interest. While this is a bonus, it doesn’t retroactively address a state’s bulk-sale notification requirement, which is why step five is arguably the most important to not forget.
If your target has exposure across many Streamlined Sales Tax Governing Board member states, registering through the Streamlined system can actually be faster than negotiating VDAs on a state-by-state basis. One registration will cover all member states at once.
Escrow and contracts
If the chosen resolution path is via escrow instead, the process might look a little different. Escrow amounts need to be sized to the nexus study’s exposure estimate rather than a percentage of the deal value. After all, an escrow that only covers known exposure isn’t helpful for protecting against unfiled-state exposure that will come up under successor liability rules. The escrow also needs to stay open long enough to cover states with longer response times, underscoring the importance of conducting the nexus study.
Reps and warranties should also specifically address sales tax nexus, registration status, and the collection accuracy of every state where your target is doing business. General tax compliance representation won’t suffice. Generic reps won’t actually establish what the target’s nexus footprint was, which is the exact information you need as a buyer to evaluate your exposure.
A smart choice is to implement pre-closing covenants into your contract that require the seller to cooperate with any state notification or clearance requests. The state isn’t bound by your private deal, but you can bind the seller. This step is important because if your seller drags their feet on producing documents, your exposure window will be extended.
Lastly, and more as a point of knowledge than anything else, indemnity provisions are beneficial but should be drafted knowing that they only bind your seller and not the state. A strong indemnity will give you a contractual remedy against them if successor liability becomes a topic, but it won’t stop the state from knocking on your door to collect.
Implementing closing controls
Forecasting out your inherited exposure is the best way to stop the issue from becoming too expensive to bear. Every deal, whether this is a first acquisition or the 50th, needs the same level of diligence.
The procedures that limit successor liability are all public and readily available, meaning you, as the buyer, have no excuse not to protect yourself. The largest exposure tends to come from situations where those procedures aren’t used.
By establishing a standing process to account for seller tax before the deal closes, you can reduce your liability. Spending the time and money to build out and prepare for the downside now is cheaper than waiting until the state is at your door.
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