M&A Tax Due Diligence: State & Local Tax Risks

For finance leaders at PE-backed companies approaching a sale, M&A tax due diligence has become a longer, harder process than it was five years ago. Buyers are digging deeper, investors are taking more time, and the gaps they find — particularly in state and local tax compliance — are no longer minor line items. They show up in escrow accounts, quality-of-earnings adjustments, and purchase price negotiations that can shave real value off a deal.

Jennifer Daniel of Consero and Chris Vignone of Source Advisors walked through exactly how this plays out, and the lessons are worth understanding well before a buyer’s team arrives.

Most growing companies treat M&A tax due diligence as something they’ll deal with when it comes up. The companies that protect their valuations treat it as an ongoing operational posture. The difference between those two approaches often determines whether a deal closes cleanly or gets complicated.

Being diligence-ready protects your valuation — and the gap between prepared and unprepared sellers is measurable in escrow dollars, deal speed, and purchase price adjustments. What follows is a practical breakdown of where state and local tax exposure originates, what buyers find when they look, and what you can do about it now.

Gaps in Finance Readiness Show Up Fast and Invite Deeper Scrutiny

When a buyer’s diligence team arrives, they’re looking for patterns. One gap signals that there are likely more. As Jennifer Daniel put it, when a buyer finds something missing, they go deeper. A single compliance gap invites a more exhaustive review, which is exactly the opposite of what a seller wants.

“Time kills deals. If you’re not ready because you don’t have things in place, they’re going to go deeper in your review and they’re going to want to analyze more of the problems that they might find because they found one thing missing.”

The four gaps that appear most consistently at diligence-stage reviews fall into predictable categories.

1. Revenue recognition is either not GAAP-compliant or not following ASC 606.
2. Sales tax is either not collected, not remitted, or not tracked at all.
3. Systems — often still on QuickBooks at companies that have outgrown it — can’t produce the clean, scalable reporting that buyers expect.
4. The finance team lacks segregation of duties, internal controls, or the technical knowledge to handle issues like sales tax or deferred revenue correctly.

Each of these is fixable. The problem is that companies find out about them during diligence, when they’re under time pressure and the buyer holds negotiating leverage. Addressing these ahead of time is a good valuation strategy.

M&A Tax Due Diligence in a Stock Deal vs. an Asset Deal

The deal structure is one of the most consequential decisions in any transaction, and its implications for state and local tax exposure are significant. In an asset deal, the buyer acquires specific assets and generally avoids inheriting the seller’s liabilities. In a stock deal, the buyer acquires the entire company — including every known and unknown tax liability on the books.

Under a stock deal, the buyer accepts full successor liability for all taxes, which means the diligence level is higher and the scrutiny more thorough. Sales tax, income tax, and any other outstanding state obligations are all in scope. The buyer will review them closely, and anything unresolved becomes a negotiating point.

Asset deals have their own complexity. Most states require a bulk sale notification when 51% or more of a company’s assets change hands. This notification triggers a state review process — essentially asking the seller to confirm all taxes are paid before the transaction closes. If the notification isn’t filed on time, the buyer can inherit successor liability even in an asset deal.

There’s also a meaningful distinction between a bulk sale notification (required in most states) and a bulk sale exemption (which, in most states, exempts the asset transfer itself from sales tax). Three large states — New York, Maryland, and Washington — don’t offer that exemption, which means sales tax on tangible property transfers may apply regardless.

Dimension	Stock Deal	Asset Deal
Liability inherited by buyer	All known and unknown liabilities	Generally none (select liabilities by agreement)
Diligence depth	Higher — income tax and sales tax both in scope	Lower — sales tax primary focus
Bulk sale notification	Not typically required	Required in most states for 51%+ asset sales
Sales tax on transfer	Generally not applicable	May apply in NY, MD, WA for tangible property
Income tax exposure	Significant — unfiled returns, sourcing errors	Lower — buyer generally not exposed

Sales Tax Is the Biggest State and Local Tax Risk in M&A Due Diligence — and Most Sellers Don’t Know Their Exposure

The 2018 South Dakota v. Wayfair Supreme Court decision changed the rules for sales tax collection fundamentally. Before Wayfair, physical presence in a state was required before a company had to collect sales tax there. After Wayfair, economic presence alone — generally $100,000 in sales or 200 transactions in a state — creates a collection obligation. Many companies still haven’t updated their compliance posture to reflect the change.

The Wayfair decision created years of retroactive exposure that buyers now find routinely during diligence — and sellers who haven’t done an economic Nexus study often don’t know the size of their liability until a buyer’s team calculates it for them.

The compliance failures Chris Vignone described fall into a few distinct patterns. Complete non-compliance — a company that simply never assessed its Wayfair obligations — is the most obvious. Partial compliance failures are just as common and often just as costly:

• A company might be registered in some states but haven’t updated its Nexus map in years.
• A software platform might have implemented a tax automation tool like Avalara three years ago but never updated the tax mapping — leaving dozens of product codes either over-taxed or under-taxed.
• Wholesalers and distributors often assume they don’t need to collect sales tax because they sell to businesses, but if they haven’t maintained exemption certificates for every state where they have Nexus, a buyer will require them to go back and collect certificates from every customer in every state.

“We had one company recently — a software company owned by a PE firm. We realized that about 72 of their codes were never mapped. They implemented technology years ago, we did an update on the tax mapping, and 72 codes weren’t charging sales tax in states where they should be.”

Sales and payroll taxes are what the law calls “trustee taxes” — the business collects them on behalf of the state, which means the corporate veil doesn’t protect individual owners from personal liability for uncollected amounts. That’s a different risk profile than property tax or income tax. It’s also why buyers escrow aggressively for sales tax exposure: the liability can follow people, not just entities.

If You Find Exposure Before the Sale, You Have Options — During Diligence, You Don’t

Sales tax liability that surfaces during a buyer’s diligence review arrives with maximum leverage on the wrong side. Buyers will calculate the liability conservatively, layer in penalties and interest, and propose escrow accounts that often exceed the actual exposure. The escrow period can stretch for years while tax issues resolve. And the dollar amounts get used directly to knock down the purchase price.

The path to a better outcome is identifying and quantifying exposure before negotiations start. An economic Nexus study — a targeted analysis of where the company has collection obligations — can be done in a few weeks and for a fraction of what a disputed escrow account costs. Once the liability is calculated, there are mitigation strategies that aren’t available once a buyer is across the table.

A Voluntary Disclosure Agreement (VDA) is the most significant. In a VDA, the company goes to the state proactively, discloses the liability, and pays what’s owed. In exchange, the state typically reduces the lookback period to three years and eliminates penalties — sometimes interest as well. That’s a materially different outcome than having a buyer’s team quantify the full historical exposure and negotiate from there.

For wholesalers and B2B companies that sold to large corporate customers without collecting sales tax, there’s another option: many large buyers self-assess and remit use tax when vendors don’t charge it. Calling those customers to confirm they self-remitted can reduce the historical liability significantly before any VDA calculation is made.

The checklist for a seller approaching diligence looks like this:

• Perform an economic Nexus study to map where collection obligations exist
• Audit current tax mapping in any automated tax platform (Avalara, Vertex, etc.) — don’t assume it’s current
• Collect and organize exemption certificates for all exempt customers in Nexus states
• Contact large B2B customers to confirm whether they self-assessed use tax on purchases where you didn’t charge sales tax
• Evaluate whether a VDA makes sense to reduce historical liability before the sale
• Review state income tax filings — confirm you’re registered in all required states and sourcing revenue correctly
• Check for unfiled personal property tax returns in states where you have physical locations
• Review contractor vs. employee classifications — buyers review this as part of payroll tax diligence
• If you have a gift card program, confirm expired card balances are being handled correctly under unclaimed property rules

State and Local Tax Risk Extends Beyond Sales Tax

Sales tax gets the most attention because the post-Wayfair exposure is large and poorly understood. But buyers performing thorough state and local tax diligence look across a broader set of obligations, and sellers sometimes get caught off guard by categories they assumed were low risk.

State income, gross receipts, and franchise taxes are one area. Companies that sell tangible personal property often benefit from a federal statute (PL 86-272) that limits states’ ability to impose net income tax on out-of-state sellers without physical presence. But that protection doesn’t extend to service companies, software companies, or businesses with economic presence in states like Ohio (CAT tax), Texas (franchise tax), or California (franchise tax). Companies that haven’t filed returns in all required states face open statutes of limitations — the clock never runs on unfiled returns.

A buyer reviewing a stock deal will identify every state where the seller had economic activity and compare it to where returns were filed — any gap is an open liability with no expiration.

Payroll tax compliance is another area buyers consistently review. The primary question is worker classification: are contractors being classified correctly, or are people who function as employees being treated as independent contractors to avoid payroll taxes? This is both a federal and state exposure, and buyers will look at it closely, especially in a stock deal. Some companies also miss state-specific obligations — unemployment insurance accounts, workers’ compensation programs administered by the state rather than private insurers — because they run payroll but haven’t kept up with where new obligations apply as they’ve hired across state lines.

Local taxes — city and county business taxes, local gross receipts taxes, business license fees — are less consistently reviewed because they depend on the sophistication of the buyer’s team. But for companies with multiple physical locations, the Philadelphia BIRT, Los Angeles city business tax, and thousands of similar local levies can add up and represent either a quality-of-earnings adjustment or an escrow item if the buyer finds them and the seller hasn’t been paying.

Get Your Finance Function Diligence-Ready Before a Buyer Asks

The companies that move through M&A processes fastest, and with the least value erosion, are the ones that treated diligence readiness as an ongoing standard rather than a pre-sale project. That means clean financials, compliant systems, and no surprises in state and local tax.

If you’re working through any of the gaps covered here, or if you’re not certain where your exposure stands, that’s the right conversation to have now instead of during a quality-of-earnings review. Consero works with PE-backed companies to build and maintain finance operations that hold up under scrutiny. Talk to our team to see what readiness looks like for your situation.