Best Practices: What is a Tax Clearance Letter and Why do we need one?

During the current economic climate, many SBA borrowers have chosen to structure their business acquisition deals as an asset purchase rather than a stock purchase. The primary motive cited by the borrowers for choosing an asset purchase versus a stock purchase structure is to avoid the liabilities of the seller. Although this reasoning is sound, unsuspecting borrowers are unaware that many states have adopted successor liability tax statutes that could make the purchaser of the business assets liable for seller’s liabilities pertaining to unpaid taxes (e.g, sellers’ past sales tax liabilities, state unemployment and withholding taxes, etc.). As such, in order to fully protect the interests of the borrower, all participating SBA lenders should require the seller of the business to provide the borrower with a tax clearance letter, where applicable, even when the terms of the purchase agreement waive this requirement.

A tax clearance letter is a document issued by a state government branch, which certifies that certain tax obligations of the seller have been met or are current, and that no amount of tax is outstanding to the state. Requesting the tax clearance letter should be on a lender’s due diligence checklist for acquisition transactions, since failure to obtain it in some states could expose the borrower to successor liability of seller’s debt that may impact cash flow.  In cases where the tax clearance letter may not be issued before closing, successor liability may also be avoided if the purchaser withholds part of the purchase price from the seller sufficient enough to cover any outstanding tax liabilities.  Lenders should take note that a tax clearance letter or its equivalent is not available in all jurisdictions.

Generally, the process for obtaining a tax clearance letter involves submission of a notice, or an application, to the applicable state governmental branch(es) (e.g., Department of Revenue, Division of Taxation, Department of Labor, etc.), whereby the relevant tax authority will either: (1) provide a tax clearance letter stating that no amount is due to the state; (2) provide the parties with the amount that must be escrowed until final tax determination is made; or (3) provide the parties with the amount that must be paid to the state to satisfy the seller’s outstanding tax liabilities. In the event this money is not escrowed or otherwise remitted to the state, the purchaser of the business may become liable for unpaid successor tax liabilities, and potentially, interest, late fees and penalties.

Although the parties may wish to proceed to closing by relying on seller’s representations and warranties, or indemnity provisions contained within the agreement of sale, this decision may potentially expose the borrower to litigation or dispute with the tax authorities due to unpaid taxes of the seller, which, in extreme cases, could lead to liens on the purchased assets that were pledged to the bank as collateral for the loan.

For further information, please contact the attorneys at Starfield & Smith, P.C. at 215-542-7070