Content by Dave Bartoletti, Jim Duffy and Nathan Hagerman

As you may be aware, the Supreme Court decision in South Dakota v. Wayfair in 2018 substantially expanded the ability of states to require out-of-state sellers to collect and remit sales tax on sales into that state. Many companies that make sales into multiple states have found it challenging to maintain compliance with the sales tax requirements for all of the states into which they make sales. These liabilities have taken on substantially increased significance in the negotiation of M&A transactions.

Potential noncompliance with obligations to collect sales tax are commonly discovered in the due diligence process in an acquisition transaction. A seller, believing that it has complied with its sales tax obligations, may be prepared to represent to the buyer that it had collected and paid all required sales tax. When potential noncompliance is uncovered in due diligence, the failure to collect and remit sales tax and file sales tax returns becomes a “known issue” and generally will not be covered by representations and warranties (“R&W”) insurance.

Often times a buyer will wish to pursue a voluntary disclosure action with a state where exposure is identified in order to settle any potential legacy sales tax liabilities and avoid worsening exposure. Predictably, buyers will expect the seller to indemnify it for any such pre-transaction tax liabilities. In addition, buyers may demand that an amount equal to the projected tax liabilities be withheld from the purchase price and placed in escrow pending resolution. Such buyer proposed escrow amounts will invariably represent a worst-case scenario and be extremely unpalatable to the seller.

While a known tax issue will likely not be covered by R&W insurance, a seller may be able to acquire tax insurance against that known tax issue when the tax liability is uncertain (and thereby avoid having to escrow or holdback sales proceeds to cover potential tax exposure). For example, tax insurance may bridge the negotiation gap between the parties in a situation where the buyer views a transaction as taxable for sales tax purposes while the seller maintains the transaction is exempt from sales tax. If the seller can reasonably support its argument with support from its third-party tax advisors, the tax position may be ripe for tax insurance coverage. The cost of this insurance varies based on perceived risk of liability, but typically equals a single-digit fraction of the potential liability.

Bottom Line: Be aware that R&W insurance is unlikely to cover a known issue for unpaid sales taxes uncovered during M&A due diligence; however, where the parties have identified an issue but disagree as to the proper tax treatment of that issue, tax insurance may provide an avenue for sellers seeking to limit escrows or holdbacks.

“The early bird might get the worm, but the second mouse gets the cheese.” – Steven Wright