Not so long ago, if a business owner decided to put his company up for sale, all the tax liabilities associated with said business had to be paid first. Now, it’s buyer beware. In order to further the chance of securing tax liabilities, the government has widened its focus in order to get its tax debts paid and money in the treasury.
This widening now encompasses the purchasers of the business. If the buyers are not careful, they can find themselves having to shell out more money to cover the previous owner’s unpaid tax debts during the escrow process.
A buyer should always require the seller to provide certified letters from tax agencies showing all tax debts have been settled. Individuals who wish to buy or sell a business need to pay extra attention to the circumstances surrounding the transaction. Buyers and sellers can be responsible for any tax liabilities that were incurred prior to the sale.
This can cause additional burden to the purchaser if the seller had defaulted on their tax responsibilities, which transfers the debt to the new owner. Trying to collect back taxes from the seller is often fruitless, which socks the purchaser with dual taxation.
The purchaser of a business of stock of goods is a successor and should request from the seller (predecessor), a Certificate of Payment (CDTFA-471). In most cases, this protects the purchaser from liabilities incurred by the selling company.
However, in some instances, the successor will be responsible for existing and future liabilities associated with the previous owner. Some examples are if the purchaser agreed to assume the predecessor’s liabilities or if the liabilities were fraudulently transferred to the successor in order for the seller to avoid payment.
The CDTFA will first attempt to collect from the predecessor. If that is unsuccessful, the successor will receive a notice of successor liability and collection proceedings will begin. A notice of successor liability is issued for any amount owed by the predecessor over $500, up to the purchase price of the business or stock of goods.
A successor's liability only extends to the amount the successor was required to withhold from the purchase price at the time the successor purchased the predecessor's business or stock of goods.
The liability incurred by a successor with regard to the purchase of a business or stock of goods includes all amounts incurred by the predecessor (or any former owner), from the operation of the business, including amounts incurred from the sale of the business, even though such amounts may not be determined as of the date of purchase.
All tax, interest, and penalties incurred by the predecessor, up to the amount of the purchase price, shall be billed to the successor. Although the successor liability billings are not directly subject to accrual of interest, successors are liable for all the predecessor's tax, penalty, and interest, including interest accrued after the issuance of the notice of successor liability.
Duel Determinations Against Predecessor
When a predecessor (seller) fails to notify the CDTFA that they discontinued, sold, or transferred their business, the predecessor may be held liable for tax, interest, and penalty (except for fraud or intent to evade) incurred by the successor/transferee.
However, the limitation on liability does not apply in cases where, after the transfer, 80 percent or more of the real or ultimate ownership of the business is still owned or held by the predecessor (see RTC section 6071.l (a) and (b), and Regulation 1699.)
Collection problems can arise due to the lapse of time between the determination of liability against the successor and issuing a dual determination against the predecessor. Some examples of these problems are:
- The predecessor's account is closed out with no record of a liability and the predecessor's security deposit is refunded prior to issuing a dual determination.
- The predecessor is not immediately informed of a tax liability that he/she shares equally with the successor.
- The predecessor's file, along with possible collection leads, may have been destroyed prior to issuing the dual determination.
When a predecessor's liability is involved, three determinations may result.
- A determination issued against the predecessor for any period that he/she actually operated the business.
- A second determination issued against the successor for the period during which he/ she operated the business.
- A dual determination issued against the predecessor concurrent with the issuance of a determination against the successor.
In the case of a billing for predecessor's liability, current practices applying to dual determinations will be followed. The only exception would arise if a 25 percent fraud penalty is applied to the successor's tax liability. Sales and Use Tax Regulation 1699(e) specifically states that the predecessor is not liable for any fraud penalties. In this instance, the fraud penalty will be replaced by a 10 percent negligence penalty on the dual determination issued against the predecessor.
Determinations and Alter Ego
When the shareholders are merely the "alter ego" (other self) of the corporation, the courts can treat the body of shareholders and the corporation as synonymous rather than as separate entities and hold the individual shareholders personally liable for the corporate obligations as a matter of equity.
Collection via the alter ego approach is pursued by court action against the "alter ego" of the corporation. In those cases, involving "closely-held" corporations and statutory "close" corporations having no shareholder's agreement or acting contrary to such agreement. Since the burden of proof rests with the CDTFA to prove the alter ego theory, thorough investigations are necessary to uncover the required evidence.
If collection from a closely held corporation appears unlikely and the liability is $5,000 or more, the alter ego approach may be used to pursue collection from individuals through court action. Due to the expense of the court system and the difficulty in proving that alter ego exists, this action is employed as a last resort.
The control of the corporation by an individual, group or other person for the purpose of working a fraud on the creditors is an important element necessary to establish the alter ego theory. When attempting to establish alter ego, the following factors are essential before the corporation can be disregarded and others held liable:
- Inadequate financing of the corporation.
- Lack of corporate records.
- Commingling of funds and collection of corporate funds to be used for the purposes of those controlling the corporation.
Examples of information to be secured are:
- Has the corporation been suspended for nonpayment of franchise taxes?
- Has a full set of records been set up and followed for the corporation, including records showing the issuance of stock? The corporate records to be considered are its records on issuance of capital stock, correspondence, bank accounts, payrolls, licenses, sales and purchase orders.
- Has there been a commingling of corporate and personal funds? If the principals have commingled the corporate funds with their own funds, this is an indication the corporate officers are disregarding the corporate entity.
- What is the capitalization of the corporation? Inadequate capitalization may be considered as a factor determining whether the corporate entity should be disregarded.
- Have the minute books been maintained and are the corporate meetings being held with reasonable regularity?
In all cases where the possibility of asserting the alter ego theory exists, the burden of proof rests with the CDTFA.
Speaking to a lawyer about any pending litigation, tax audits or insurance disputes before the final purchase of a business will help to disclose any potential issues before escrow closes. There are also different types of taxes associated with the land, and if the transaction is a bulk sale, (also known as the Uniform Commerical Code), the predecessor’s creditors must be given notice of the sale.
A buyer has a set amount of time to conduct an investigation of any company. Using this time as discovery will allow for a thorough inspection of its financial records. Having a lawyer that understands what the CDTFA is capable of can help the sale and transfer of the business be trouble free with no unhappy surprises down the road.