Selling your business can be a lucrative and life-changing decision, so it’s essential to navigate the entire process carefully to avoid any tax pitfalls. One of the most overlooked areas in the due diligence process of a transaction often falls within the tax realm, especially on the state and local tax side. 

Just as you are looking to maximize your purchase price, state and local jurisdictions are also looking to collect revenue from your transaction activity. Proper planning and understanding of these tax implications can help your transaction value of the sale while minimizing your tax liability. 

State and Local Tax Pitfalls to Avoid

Some of the most common state and local tax pitfalls often seen in the due diligence process include: 

Income Taxes

Not all states follow federal flow-through, which creates a misconception that there are no income tax due diligence concerns.  

It can be increasingly complicated as your business activities expand across more states. A buyer/investor will want to know where business activities are occurring, where employees and customers are located, what types of business activities are happening and whether returns are being filed where required. 

Once business activity occurs outside your home state, a S corporation or partnership could be liable for taxes, either through a composite filing (like in Indiana), or through withholding payments, if you have a certain level of activity within that state (California, for example). Also, some states tax S corporations and partnerships at the entity level – just like a C corporation. 

By evaluating your state and local tax positions prior to a business sale, income tax obligations can usually be settled at the entity level within a state, limiting or eliminating exposure which may carry to the buyer.

Sales/Use Tax 

A common misconception with sales tax is that businesses do not have to worry about it because their customers are exempt, i.e., manufacturers/wholesalers, and therefore, a buyer will not be concerned. However, this is a top issue that often arises in due diligence. Buyers will ask about your sales tax liability, regardless of it being an asset or stock sale.

For example, if you sell a piece of equipment to a business and they use it in their sales office, it may create a tax liability and require you to collect and remit tax. To help keep you protected from a tax standpoint, always obtain a signed exemption certificate from the business that claims it is exempt and make sure it meets all the documentation requirements for the state your customer is purchasing for. This will help validate your customer is properly claiming exemptions in various states and scenarios. 

Buyers will also want to make sure you are paying sales tax on your purchases, where appropriate. It’s important to ensure you have a process in place to pay vendors when tax is due on your purchases, or that you self-assess use tax when they haven’t. 

Payroll Tax  

If you have employees, a buyer will typically request copies of payroll filings. Key reasons why include:  

• Ensures taxes collected from employees are being collected and remitted to the right state.  
• Provides an understanding of where employees are located.  
• Avoids State Unemployment Tax Act (SUTA) dumping. [1] 

Property Tax  

This is often a pitfall for businesses that house inventory across multiple states, i.e., through Amazon facilities. [2] Depending on the state, your inventory may be taxed, even if it’s sitting in a warehouse or site you don’t own. This is a critical area in due diligence, so it’s important to remain proactive in tax filings to avoid a larger liability later. A buyer will want to know where your inventory is being held, whether compliance was maintained through filing returns that reflect all personal property at a location and if the related taxes were remitted.     

Planning Considerations 

It’s never too early to start evaluating your tax position to prepare for your future transaction. Some ways to prepare your business for sale from a state and local tax perspective includes: 

1. Conduct a nexus study. A "nexus" refers to the connection a business has with a state or jurisdiction that triggers tax responsibilities. A nexus study can be highly beneficial for your business, as it will help determine where you have a tax obligation and for which tax types.
2. Evaluate your prior-year returns and entity elections. Be sure to collect a list of any refunds due to you before entering a business sale transaction, especially if it is a stock sale. It’s also an opportune time to have your elections reviewed to see if anything should be done differently to minimize expenses or make it less costly when you do sell.
3. Obtain a tax clearance certificate. States will issue a tax clearance certificate, which confirms all registered taxes within that state have been paid. To ensure a smooth diligence process, we encourage you to obtain this certificate as part of your business sale preparation to provide to the buyer. Keep in mind, a tax clearance certificate does not identify unknown liabilities or guarantee returns were filed correctly, so they are not a substitute for a good tax advisor.

Here to Help 

Our dedicated state and local tax advisors stay abreast the always-evolving state and local tax obligations to help keep tax liabilities small for business owners across the nation. If a business sale is in your near horizon, contact us to evaluate your current position, determine liabilities and prepare you to maximize your purchase price when the right opportunity presents itself. 

[1] SUTA dumping is a tax evasion plan used by some employers to lower their Unemployment Insurance (UI) tax rate to avoid paying higher UI taxes. It can have severe penalties and is something several states strictly enforce. A buyer will want to see unemployment returns, because when they inherit the workforce, they will report information to states and their UI rate may be adjusted based upon your history.

[2] With Amazon, another consideration is the physical presence inventory you hold in their warehouses, as it can trigger additional filing responsibilities, including income taxes and sales taxes.