Before the U.S. Supreme Court’s 2018 decision in South Dakota v. Wayfair, Inc., a business generally had to collect sales tax only in states where it had a physical presence (i.e., an office, employees, or property, which included downloaded legacy software). However, the ruling in 2018 allowed states to impose sales tax based on economic activity alone (i.e., revenue, transaction volume, or both), even without a physical presence.
For software businesses, which often sell to customers across various states and have remote workforces, the result is that many have sales tax obligations that have not yet been identified.
Why Sales Tax Matters in a Transaction
Unpaid sales tax exposure does not go away when a company is sold. In an equity transaction, the liability stays with the target company, which the buyer now owns. Even in an asset transaction, many states’ successor liability or bulk-sale rules can still leave the buyer on the hook.
Prior to a transaction close, buyers must understand the nature and magnitude of any potential sales tax liability, how likely it is to be assessed, how it impacts the purchase price and purchase agreement, and what it will cost to become compliant after closing.
For sellers, assessing exposure before going to market allows management to identify and quantify any potential liability, pursue remediation options such as voluntary disclosure agreements (VDAs), and address the exposure while negotiating with multiple interested parties before executing an exclusive letter of intent.
How the exposure is treated in a potential transaction depends on its size, its certainty, and the negotiations between buyer and seller. In our experience, historical sales tax exposure is most often addressed through a specific tax indemnity, escrow, or holdback, or treated as a debt-like item that reduces the purchase price.
Evaluating Historical Sales Tax Exposure in Software Companies
Confirming whether a company is registered and collecting tax today is only a starting point. A thorough analysis typically considers:
- Nexus: where the company established physical or economic nexus and when
- Taxability: whether each product and service was taxable in each relevant state and period
- Sourcing: whether customer-location data is reliable enough to support the analysis
- Exemptions: whether valid exemption or resale certificates are on file
- Interest, penalties, and remediation: the likely cost of interest and penalties, and whether VDAs could reduce them
Because taxability varies by revenue stream and by state, evaluating historical sales tax exposure is complex. SaaS subscriptions, downloadable software, usage-based fees, implementation services, and support can each be taxed differently, and the rules continue to evolve over time. For example, California, which has long excluded SaaS from sales tax, will begin taxing SaaS and certain digital products effective January 1, 2027.
Bundled offerings can also complicate the analysis. A single contract may combine a subscription with implementation, training, and support. However, if the invoice does not separate the nontaxable charges, some states will tax the entire invoice.
Separately, customer location data is often incomplete. Without reliable billing or service-location data, it is hard to determine where a company crossed nexus thresholds, how sales should be sourced, or how large the historical exposure is.
How ML&R Can Help
ML&R’s Transaction Advisory team works with buyers and sellers of software and recurring revenue businesses to identify sales tax exposure, estimate its financial impact, and advise how any potential liabilities should be addressed in the purchase agreement.
Because we rebuild revenue from invoice-level detail in our Quality of Earnings work, we are well positioned to connect a company’s revenue data, contracts, and operating footprint to its sales tax obligations. Specifically, we build a state-by-state nexus analysis from invoice-level detail, apply taxability considerations by revenue stream, and layer in interest and penalties to estimate historical exposure.
ML&R helps both buyers and sellers address those issues earlier in the diligence process and avoid surprises prior to (or after) transaction close.
