As the Representations and Warranties Insurance (RWI) market continues to mature, RWI carriers are experiencing pressure on policy margins1. In large part this is due to an increase in claim sizes in 20242. What many deal teams aren't aware of is that tax claims were the largest contributor thereof (36% by value)3 with sales taxes being the largest component. RWI carriers are increasingly taking greater and greater tax risk as they underwrite policies for transactions.4 Sales tax risk is therefore an increasing area of due diligence focus.
In this article, members of Riveron's M&A Transaction Tax team discuss some of the unique risks presented by sales taxes in the RWI market and outline why identifying and managing sales tax risk at an early state in the deal process is a best practice for both buy- and sell-side deal professionals.
The Size and Complexity of Sales Tax Risk
Insured risks are taking longer to resolve with the RWI carrier. According to certain market reports, in over 50% of cases, it takes more than six months from when a claim was submitted for RWI insurers to provide an initial coverage position and between 1 and 3 years from the time the claim was submitted to be paid.5
Recently due diligence has been perceived as useful but with increasing exclusions and longer RWI claim times the due diligence process is increasingly expected to provide negotiation support to move deal risks back to the Seller upfront.
Sales taxes are a critical component of state level funding, comprising $663bn (43%) of the $1.4tn state taxes raised in 2023.6 As such, states collection agencies are understandably diligent in pursuing sales tax compliance matters through audits and, ultimately assessments. Further, sales tax compliance is complex, driven in large part by the number of states a particular business operates in and the specific legislative requirements relevant to each. Adding risk is the fact that, unlike income taxes in which successor liability for historical tax exposure can be mitigated by changing the structure of a transaction (i.e., implementing an asset sale where the legal entity is left with the sellers), sales tax risks are relatively hard to mitigate through buy-side structuring. Further, the 2018 South Dakota v. Wayfair decision eliminated the physical presence rule (requiring sellers to have physical presence in a state to become subject to sales taxes therein). Wayfair prompted all 45 U.S. states that impose a statewide sales tax to enact economic nexus legislation which materially increased the potential for sellers to attract sales tax obligations7.
Given the above it is perhaps surprising that sales taxes are rarely viewed as a top priority at the start of M&A negotiations as buyers and sellers alike often focus on the myriad of legal, commercial and other matters first. Additionally, federal and state income tax matters are usually a leading priority. This situation clearly overlooks the underlying size and complexity of sales tax matters and potentially creates risk in the transaction by not prioritizing work on sales taxes.
Unique Challenges of High-growth, Privately Held Targets
At Riveron, our focus is on serving private equity clients, many of which are targeting the buy-out of owner managed (privately held), high-growth businesses across a wide variety of sectors. We have learned that a given target's level of tax compliance sophistication often varies. Even in situations where the targets have a well-structured internal finance and tax compliance team and appear to be supported by skilled external advisors, the rate of growth of new sales channels and products often outstrips the back-office ability to correctly address these changes.
While instances of a complete lack of sales tax reporting are rare, the drive to increase sales, onboard new customers, deliver new products and service lines are regularly activities which introduce 'gaps' in sales tax compliance. Identifying these gaps can be difficult and usually requires a thorough understanding of the targets business and changes thereto.
An example illustrates the point: On a recent buy-side tax due diligence project, the target's management team discussed the Company's existing and longstanding B2B e-commerce platform. For over a decade, the Company had been (correctly) relying on reseller exemptions and (correctly) not charging sales taxes on those sales. However, as the due diligence discussion widened to understanding recent marketing initiatives, it became apparent that the Company's marketing team had evolved their offering to include B2C customers. By repositioning the sales channel, the marketing team had inadvertently created a sales tax obligation on these new sales directly to customers. The resultant exposure was a material enough percentage of the deal to cause it to be a point of negotiation. Had the diligence team not identified this matter at closing, two scenarios might have played out for the RWI provider and Buyer. Firstly, the RWI provider would likely have suffered a claim based on the liability up and until closing. Secondly, as this new sales channel was growing rapidly the Buyer would have experienced an unmodelled cash tax not initially considered in its first-year post-closing. Examples such as these are numerous in high-growth business with active marketing teams and regular product evolutions in which compliance often lags corporate development activities.
Where time allows and buyers and sellers alike can agree on the process, certain pre-closing steps can be taken to fully examine these risks. Strategies such as Voluntary Disclosure Agreements and similar solutions can be undertaken as outlined in the following article by Riveron's Mary Montague in addressing embedded sales tax risk. Closing can happen after such risk remediation. However, in most instances, time does not permit such solutions and a 'deal solution' needs to be found.
Increased pressure on buy and sell-side deal teams
Difficult situations arise for sellers and buyers alike when due diligence teams identify a potential sales tax issue; however, due to time restrictions (i.e., deal closing imminent) or simply a lack of available data (i.e. sales history, accurate shipping information) teams are unable to fully quantify the exposure. In our experience, these are common fact patterns that can be avoided with the proverbial "ounce of prevention" early in the buy or sell side process.
From a sell-side standpoint, the sellers may not have been made aware of the risks at the outset and, in our experience, are often placed on the back foot during negotiations due to aggressive exposure estimates raised during buy-side due diligence.
From a buy-side standpoint, buyers will naturally seek protection from these risks but without a defensible dollar amount, they will find hard protections (i.e. debt like items, purchase price reduction etc.) difficult to negotiate with sellers. At the same time, RWI carriers will similarly want to limit their risk to these now identified but yet unquantified exposures and will typically do so through policy exclusions which carve out the risk from the insurance carrier.
Early identification of risk is in all parties' best interest
Ultimately, addressing these matters is in the best interests of buyers, sellers and RWI carriers alike.
As a buyer, it is crucial to identify key issues upfront to understand any RWI policy carve-outs and negotiate protections with the sellers for uncovered risks. Riveron is seeing a growing buy-side trend of much more in-depth, "RWI ready" diligence processes/procedures and related, more robust reporting showing RWI teams the rigor of their analysis in order to minimize carve-outs –- these are usually being negotiated as one of the last items before closing. The only other option is a scramble before closing to try to do "just enough" to remove exclusions.
Sellers' early awareness of these issues are equally important, as it can significantly impact purchase price negotiations. Riveron is seeing a growing trend in the use of sell-side diligence as part of exit planning performed in conjunction with pro forma quality of earnings and other analyses. The rationale is to help sellers understand their embedded risks and formulate the "story to tell" to buyers or develop a strategy to handle these items early in the deal process, prior to having these items exposed by buy-side teams and used as leverage in negotiations.
Sell-side due diligence can range from an initial assessment of potential material risk to more fulsome buy-side diligence-friendly tax fact books and reports shareable with potential buyers. Riveron was recently appointed to undertake sell-side due diligence involving the sale of a company to a large private equity buyer represented by a major accounting firm. Our sell-side diligence anticipated that the buyer might seek an $8M reduction in the purchase price given certain historical sales tax compliance matters (which was material in the context of this particular transaction). However, through proactive analysis and selected, cost-effective remediation in preparation for their sale process (which included voluntary disclosure agreements and discussion with state revenue agencies), we assisted the client in constructing a tax fact book outlying, among other things, a compelling case that justified a reduction of only $1.5M. Being prepared with a robust case for a much lower reduction significantly improved the outcome for the seller and allowed a much smoother closing, demonstrating the value of a well-executed sell-side tax process.
The Importance of a Pro-active, Risk Focused Approach
As noted above, the latest RWI market studies communicate to deal professionals the importance of tax (specifically transaction related taxes such as sales tax) to deal completion and, ultimately, deal value. Making sure your deal teams are ready to proactively identify, remedy, and deal with these issues is increasingly a market-defined best practice.
Footnotes
1. Rising Claims Severity Challenges Sustainability of Low RWI Insurance Rates. Assured Partners. See Article
2. 2024 M&A Claims Insights Report '2024 M&A Claims' SRSAquiom, see Report
3. 2024 M&A Claims (supra)
4. Rising Claims Severity Challenges Sustainability of Low RWI Insurance Rates. Assured Partners. See Article Navigating Uncertainty: Legal Trends in Share Purchase Agreements for Private Equity in the Face of Market Volatility, Cassels. See Article
5. Why Are M&A Deal Parties Thinking Twice About RWI?, SRSAquiom. See Article
6. U.S. Census Bureau, 2023 Annual Survey of State Government Tax Collections. See Data
7. Tax Foundation, May 2025.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
