We noted earlier that sales tax is often viewed as a “sideshow” to income tax considerations in structuring a deal. Regardless, it represents real economic cost to the payor. To appreciate its “true” cost, however, one must also consider its income tax consequences.
In the case of the seller or transferor who pays the tax, the sales tax is treated, for income tax purposes, as a reduction in the amount realized, thereby reducing the income tax burden from the sale.
In the case of the buyer who pays the tax, the sales tax is added to the basis of the property acquired. Thus, it may be depreciable or amortizable over a period of time dependent upon the nature of the asset acquired.
In the case of a stock purchase (without a 338(h)(10) election), the sales tax will reduce the gain on a subsequent sale of such stock.
Some Practical Considerations: Planning for the Sales Tax
We noted that sales tax applies to the sale of tangible personal property (“TPP”), but not to the sale of intangibles, including shares of stock. We also noted that the transfer of property to a corporation in exchange for equity therein is not treated as a retail sale.
What if tangible personal property were contributed to an LLC, and the LLC interests were then sold to the buyer? New York has ruled that there would be no sales tax where a seller-corporation transferred its property to a newly-formed single-member LLC and then sold the LLC interest to the buyer. The fact that the sale was pre-arranged does not appear to matter. A seller and buyer who want to effect an asset transfer for income tax purposes, but who also want to avoid sales taxes in the transaction, may be able to accomplish that goal through a sale of stock for which an IRC Sec. 338(h)(10) election is made. The stock sale is not subject to sales tax and the deemed asset sale is only hypothetical – there is no actual sale of assets.
Of course, business considerations may make this approach impractical, and step transaction principles may apply if the buyer promptly liquidates the LLC, thereby causing a taxable transaction.
The Asset Purchase Agreement
There are a number of items to consider where the tax on the sale cannot be avoided. Moreover, the issue of transferee liability or assumption of liabilities must also be addressed.
In a state like New York, which imposes a payment obligation on the buyer, practical impediments may prevent a seller from collecting the tax after a transaction is closed. Absent an express provision to the contrary in the agreement, it is good practice for the seller to collect the tax from the buyer at closing.
However, nothing prevents a buyer and seller from allocating contractual liability for any sales tax in connection with a corporation acquisition. The allocation of contractual responsibility for sales tax is an important element of any asset purchase agreement (“APA”), especially where the extent of such tax liabilities is unknown.
For example, an APA will typically provide that the seller and its shareholders shall be responsible for all sales tax liabilities arising out of the operation of the business for all tax periods or portions thereof ending on or prior to the closing date. In the case of a stock sale, the APA also typically provides that any sales tax return will be prepared by the buyer. As for the sales tax imposed upon the sale of the business itself, it is not unusual for the APA to allocate the cost either to one of the parties or to be split between both.
A contractual provision will not prevent the taxing authority from proceeding against any party it can legally pursue. As between each other, however, the buyer and seller are bound by their agreement. Thus, in an asset sale that triggers the bulk sale rules, unless the buyer complies with those rules, the buyer will be responsible for the seller’s pre-existing sales tax liabilities notwithstanding a legally effective contractual protection which allocates those liabilities to the seller.
Despite this potentially large unknown cost, the parties to an M&A deal are often eager to close the deal and are unwilling to set in motion the bulk sale notification/withholding process, which may not be resolved for many weeks. In order to help protect the buyer from this unknown liability, a due diligence investigation will be important. The target’s tax returns and payment history, including any audit reports, need to be reviewed by the buyer’s tax advisers.
The APA should include a tax representation as to sales taxes that includes representations such as the following:
– That all returns have been properly completed and timely filed;
– That all taxes have been remitted;
– That there has never been an audit;
– That the target has no liability (contractually or otherwise) for another’s taxes;
– That a deficiency has never been asserted (or, if it has, that it has been paid)
The representations should be made as of the date of execution of the agreement and then should be “brought down” to the closing date.
The APA should also include indemnification provisions for any breach thereof. Be mindful: not all indemnifications are equal. The value of a contractual protection will vary depending on the financial condition and the integrity of the seller. A holdback (escrow) or deferred payment (installment note), or other form of security arrangement, can enhance the buyer’s protection.
If significant sales taxes may be applicable to the sale transaction, it is generally advantageous, from a sales tax perspective, to allocate purchase price away from taxable assets in order to reduce the liability. Of course, the allocation must be supportable, and it must be consistent with the allocation for income tax purposes (See IRC Sec. 1060; IRS Form 8594). The preferences for one tax may be at odds with those of the other.
The foregoing highlights the importance of sales taxes in assessing the overall economic benefits and burdens of a purchase and sale transaction. In evaluating such a transaction, it behooves both the seller and the buyer to consider, as early in the process as possible, the impact of such taxes and to plan for them accordingly. For example, the seller may want to negotiate an adjustment to the purchase price so as to account for the sales tax liability and, thereby, to achieve the net economic result he expected before sales taxes came into play. The buyer may want to increase the amount and term of any promissory note given in consideration of assets being purchased so as to provide a cushion for any unexpected sales tax liabilities. Both parties may want to consider some allocation of the sales tax liability arising from the transaction itself. In any case, a party that chooses to ignore the impact of sales taxes on a transaction may come to regret its decision.