Sales and use tax and exposure mitigation recommendations – Part - 2
Baker Tilly Virchow Krause
Description
BY JON P. SKAVLEM, CPA AND
PHILLIP A.H. ROEMAAT, J.D., CPA
P
art one of our article, which appeared in November/
December 2013 On Balance, highlighted the
importance of state and local taxes when purchasing
or selling a company. That part of the article focuses on
due diligence generally and income/franchise taxes.
This part focuses on sales and use tax and concludes with recommendations on how to mitigate the exposures prior to a sale. SALES AND USE TAXES Increasingly, sales and use taxes are a major exposure item for businesses. As the number of businesses operating as pass-through entities has grown, the yield to states from corporate income tax audits has diminished. Attention and audit resources have shifted to sales and use taxes. In addition, new sales tax jurisdictional standards such as “affiliate” and “click through” nexus have dialed up exposure for businesses.
Under Generally Accepted Accounting Principles, material sales and/or tax exposure should be recorded on a target’s books as a contingent liability pursuant to ASC 450, formerly FAS 5. Nexus is an especially key issue for retailers since they are primarily liable for remitting sales tax on sales of taxable goods or services, regardless of whether the tax is or is not collected. Due diligence requires that a retailer’s nexus footprint be mapped and material liability for unfiled returns be computed, including tax, interest and potential penalties. This can be a challenge for certain businesses such as equipment leasing where the location of the lessor’s property might change during the course of the lease. Another key exposure factor for retail businesses is the maintenance of exemption certificates.
State and local tax authorities will assess sales that qualify as non-taxable, e.g. resale or manufacturing exemption, in the absence of valid, properly executed exemption certificates. Additionally, some states provide exemptions to manufacturers that acquire tangible personal machinery, equipment and supplies used in the production process.1 It can be a nasty surprise for the seller to find out that its sales to manufacturers were not exempt during the years under scrutiny. It is a due diligence red flag if a target company’s exemption certificate files are in poor condition and procedures for obtaining certificates are faulty. For all types of businesses, use tax must be selfassessed and paid on purchases of taxable goods and services where the retailer does not collect sales tax. Surprisingly, this is a major area of audit exposure, and states continuously issue large assessments for failure to report use tax.
Even if the target business self-assesses use tax, certain industries face major challenges in determining the proper amount to accrue. Additional 1 16 On Balance See, e.g. Tex.
Tax Code Ann. § 151.318(a)(2); Wis. Stat.
§ 77.54(6)(a) January|February 2014 Reposted with permission from On Balance, the magazine of the Wisconsin Certified Public Accountants www.wicpa.org . vigilance is required when analyzing the use tax accruals of construction contractors and manufacturers due to complexity of state and local tax codes. The complexity extends to select purchases such as software or advertising services where the line between taxable and exempt is often blurred. Similar to sales tax, the lack of clear documentation and procedures for accruing use tax signals a due diligence problem. The sales and use tax compliance function should be documented in the company’s policies, tax files and related work papers. This includes maintaining a tax calendar of the applicable due dates and having an organized collection of past filed returns (both in paper and electronic copies).
A company’s audited financial statements, including management comments, might make note of any concerns that exist about the target’s sales and use tax compliance efforts because of their tie-in to the company’s system of internal controls. OTHER TAXES Companies may be subject to other taxes based on the states where it does business. Examples of these types of taxes include property taxes (both personal property and real property), unclaimed property and specific excise taxes if the company is in a specialized industry. Unclaimed property audits are growing in frequency, even in states that traditionally have not been active in the area such as Wisconsin and Michigan.
As a result of recent legislation, the enforcement and compliance responsibilities in Wisconsin have been transferred to the Department of Revenue, likely signaling more audit activity on holders’ unclaimed property in the state. Like income tax and sales and use tax, documenting the process and procedures surrounding the filing of the required returns is imperative. This includes keeping a compliance calendar, copies of the particular returns that have been filed, related work papers and notices from state and local tax officials. www.wicpa.org Reposted with permission from On Balance, the magazine of the Wisconsin Certified Public Accountants On Balance January|February 2014 17 . Prior to selling, companies should identify the risks they face related to state and local taxes. The first phase in this process is defining the scope of material risk. For some companies, having $10,000 of past exposure is material, but for others this amount might be $100,000. Understanding the company’s materiality level ultimately helps guide the decision process once risk is identified. Given the impact it could have on the earnings multiple of a deal, it is important to define and understand materiality. The second phase in this process is analyzing specific areas of exposure. The risk assessment starts with cataloging the company’s activities and their locations. Questions should include (and often mirror state nexus questionnaires): • What is the nature of the target’s product or service? • Is the company an industry with special state and local tax concerns such as financial services, franchising and regulated transportation? • Where does the company have employees? • What are the employees doing outside the company’s home state? • Where does the company own or lease property outside its home state? • Where does the company maintain inventory? • Does the company render repair, maintenance or installation services through employees or subcontractors? • Does the business sell or license intangible assets such as software or patents? The company’s tax adviser can provide advice as to whether the company has risk in certain states and localities and special industries.
Additionally, the company’s tax adviser might perform a nexus study, tax procedures review or reverse audit to get an understanding of the business’s overall state and local tax exposure. The last phase in the process is developing ways to mitigate the company’s risk. After the initial exposures are found and they are determined to be material, it might warrant entering into a voluntary disclosure agreement or amnesty program with select states and localities. 18 On Balance Voluntary disclosure and amnesty programs are offered by states to encourage taxpayers, often anonymously, to file prior year returns and pay the related taxes. Most states will limit the prior filings to a look-back period, ranging from three to six years (or higher depending on the state).
The state will also waive any penalties associated with the taxes due. Voluntary disclosure agreements are often executed by potential sellers of a business in order to “clean up” its balance sheet. The removal of ASC 740 or ASC 450 tax liabilities prior to or as part of due diligence can lead to smoother negotiations with interested buyers. Pre-sale state and local tax due diligence by a seller might only lead to the recognition of unrecorded tax exposures if the proposed sale falls through. However, the process helps in setting a realistic selling price and the drafting of appropriate buy-sell warranty provisions. Again, the final result will likely be better for the seller and the buyer. The state and local tax due diligence investigation should not be the end of the process for the target. Leveraging off the findings, the new owners and management of the company should develop appropriate state and local tax compliance procedures, including an annual nexus review for the various types of tax.
They can be carried out as a part of year-end planning for the company. It should document its state and local tax compliance systems in the same way that other internal controls are documents as part of a financial audit. CONCLUSION If you are contemplating buying or selling a company, it is important to understand the company’s state and local tax exposure. Given the impact on deal multiples, coupled with an ever-increasing difficult compliance environment, buyers and sellers need to be aware of the possible existence of unrecorded liabilities.
Advance planning can go a long way toward a successful outcome for both sides of the deal. Jon P. Skavlem, CPA is a director in the State and Local Tax Group at Baker Tilly Virchow Krause, LLP in Milwaukee. Contact him at 414-777-5333 or jon.skavlem@bakertilly.com. Phillip A.H.
Roemaat, J.D., CPA is a manager in the State and Local Tax Group at Baker Tilly Virchow Krause, LLP in Milwaukee. Contact him at 414-777-5445 or phillip.roemaat@bakertilly.com. January|February 2014 Reposted with permission from On Balance, the magazine of the Wisconsin Certified Public Accountants www.wicpa.org shutterstock.com RISK MITIGATION PRIOR TO SALE .
This part focuses on sales and use tax and concludes with recommendations on how to mitigate the exposures prior to a sale. SALES AND USE TAXES Increasingly, sales and use taxes are a major exposure item for businesses. As the number of businesses operating as pass-through entities has grown, the yield to states from corporate income tax audits has diminished. Attention and audit resources have shifted to sales and use taxes. In addition, new sales tax jurisdictional standards such as “affiliate” and “click through” nexus have dialed up exposure for businesses.
Under Generally Accepted Accounting Principles, material sales and/or tax exposure should be recorded on a target’s books as a contingent liability pursuant to ASC 450, formerly FAS 5. Nexus is an especially key issue for retailers since they are primarily liable for remitting sales tax on sales of taxable goods or services, regardless of whether the tax is or is not collected. Due diligence requires that a retailer’s nexus footprint be mapped and material liability for unfiled returns be computed, including tax, interest and potential penalties. This can be a challenge for certain businesses such as equipment leasing where the location of the lessor’s property might change during the course of the lease. Another key exposure factor for retail businesses is the maintenance of exemption certificates.
State and local tax authorities will assess sales that qualify as non-taxable, e.g. resale or manufacturing exemption, in the absence of valid, properly executed exemption certificates. Additionally, some states provide exemptions to manufacturers that acquire tangible personal machinery, equipment and supplies used in the production process.1 It can be a nasty surprise for the seller to find out that its sales to manufacturers were not exempt during the years under scrutiny. It is a due diligence red flag if a target company’s exemption certificate files are in poor condition and procedures for obtaining certificates are faulty. For all types of businesses, use tax must be selfassessed and paid on purchases of taxable goods and services where the retailer does not collect sales tax. Surprisingly, this is a major area of audit exposure, and states continuously issue large assessments for failure to report use tax.
Even if the target business self-assesses use tax, certain industries face major challenges in determining the proper amount to accrue. Additional 1 16 On Balance See, e.g. Tex.
Tax Code Ann. § 151.318(a)(2); Wis. Stat.
§ 77.54(6)(a) January|February 2014 Reposted with permission from On Balance, the magazine of the Wisconsin Certified Public Accountants www.wicpa.org . vigilance is required when analyzing the use tax accruals of construction contractors and manufacturers due to complexity of state and local tax codes. The complexity extends to select purchases such as software or advertising services where the line between taxable and exempt is often blurred. Similar to sales tax, the lack of clear documentation and procedures for accruing use tax signals a due diligence problem. The sales and use tax compliance function should be documented in the company’s policies, tax files and related work papers. This includes maintaining a tax calendar of the applicable due dates and having an organized collection of past filed returns (both in paper and electronic copies).
A company’s audited financial statements, including management comments, might make note of any concerns that exist about the target’s sales and use tax compliance efforts because of their tie-in to the company’s system of internal controls. OTHER TAXES Companies may be subject to other taxes based on the states where it does business. Examples of these types of taxes include property taxes (both personal property and real property), unclaimed property and specific excise taxes if the company is in a specialized industry. Unclaimed property audits are growing in frequency, even in states that traditionally have not been active in the area such as Wisconsin and Michigan.
As a result of recent legislation, the enforcement and compliance responsibilities in Wisconsin have been transferred to the Department of Revenue, likely signaling more audit activity on holders’ unclaimed property in the state. Like income tax and sales and use tax, documenting the process and procedures surrounding the filing of the required returns is imperative. This includes keeping a compliance calendar, copies of the particular returns that have been filed, related work papers and notices from state and local tax officials. www.wicpa.org Reposted with permission from On Balance, the magazine of the Wisconsin Certified Public Accountants On Balance January|February 2014 17 . Prior to selling, companies should identify the risks they face related to state and local taxes. The first phase in this process is defining the scope of material risk. For some companies, having $10,000 of past exposure is material, but for others this amount might be $100,000. Understanding the company’s materiality level ultimately helps guide the decision process once risk is identified. Given the impact it could have on the earnings multiple of a deal, it is important to define and understand materiality. The second phase in this process is analyzing specific areas of exposure. The risk assessment starts with cataloging the company’s activities and their locations. Questions should include (and often mirror state nexus questionnaires): • What is the nature of the target’s product or service? • Is the company an industry with special state and local tax concerns such as financial services, franchising and regulated transportation? • Where does the company have employees? • What are the employees doing outside the company’s home state? • Where does the company own or lease property outside its home state? • Where does the company maintain inventory? • Does the company render repair, maintenance or installation services through employees or subcontractors? • Does the business sell or license intangible assets such as software or patents? The company’s tax adviser can provide advice as to whether the company has risk in certain states and localities and special industries.
Additionally, the company’s tax adviser might perform a nexus study, tax procedures review or reverse audit to get an understanding of the business’s overall state and local tax exposure. The last phase in the process is developing ways to mitigate the company’s risk. After the initial exposures are found and they are determined to be material, it might warrant entering into a voluntary disclosure agreement or amnesty program with select states and localities. 18 On Balance Voluntary disclosure and amnesty programs are offered by states to encourage taxpayers, often anonymously, to file prior year returns and pay the related taxes. Most states will limit the prior filings to a look-back period, ranging from three to six years (or higher depending on the state).
The state will also waive any penalties associated with the taxes due. Voluntary disclosure agreements are often executed by potential sellers of a business in order to “clean up” its balance sheet. The removal of ASC 740 or ASC 450 tax liabilities prior to or as part of due diligence can lead to smoother negotiations with interested buyers. Pre-sale state and local tax due diligence by a seller might only lead to the recognition of unrecorded tax exposures if the proposed sale falls through. However, the process helps in setting a realistic selling price and the drafting of appropriate buy-sell warranty provisions. Again, the final result will likely be better for the seller and the buyer. The state and local tax due diligence investigation should not be the end of the process for the target. Leveraging off the findings, the new owners and management of the company should develop appropriate state and local tax compliance procedures, including an annual nexus review for the various types of tax.
They can be carried out as a part of year-end planning for the company. It should document its state and local tax compliance systems in the same way that other internal controls are documents as part of a financial audit. CONCLUSION If you are contemplating buying or selling a company, it is important to understand the company’s state and local tax exposure. Given the impact on deal multiples, coupled with an ever-increasing difficult compliance environment, buyers and sellers need to be aware of the possible existence of unrecorded liabilities.
Advance planning can go a long way toward a successful outcome for both sides of the deal. Jon P. Skavlem, CPA is a director in the State and Local Tax Group at Baker Tilly Virchow Krause, LLP in Milwaukee. Contact him at 414-777-5333 or jon.skavlem@bakertilly.com. Phillip A.H.
Roemaat, J.D., CPA is a manager in the State and Local Tax Group at Baker Tilly Virchow Krause, LLP in Milwaukee. Contact him at 414-777-5445 or phillip.roemaat@bakertilly.com. January|February 2014 Reposted with permission from On Balance, the magazine of the Wisconsin Certified Public Accountants www.wicpa.org shutterstock.com RISK MITIGATION PRIOR TO SALE .
