February 13, 2015

No business is perfect.

Some liabilities or poorly performing assets are obvious and stated – debts and payables, uncollectable accounts receivable, obsolete equipment and warranty agreements.

How the sale is structured will determine the new owner’s responsibilities regarding these issues.

Unfortunately, even if everything looks fine on the surface, hidden liabilities can surface to impact both the buyer and the seller. Many a lawsuit has been filed claiming negligence or even fraud on the part of the seller for failure to disclose contingencies with a material effect on the business.

Business confusionTo be fair, some of these issues blindside the seller, too. That’s why a thorough assessment of potential liabilities should be conducted before the business goes on the market. Having a hidden liability come to light during the sales process could derail the process entirely and will certainly have an impact on the selling price.

Examples of hidden liabilities include:

Litigation – Lawsuits pending, in process or possible are definitely a liability. Part of the problem is the inability to know in advance the full impact on the business. Even if the lawsuit is settled in the business’s favor, there are costs associated with it, both for attorneys and to the reputation of the company.

If a lawsuit is defined as probable – i.e., likely to occur – and an estimate of losses can be made, it must be disclosed on financial statements, according to generally accepted accounting principles (GAAP).

If the probability of loss is reasonably possible, then GAAP also requires disclosure. The gray area is when an event appears remote, yet something may already be in play that will result in a future suit.

During audits, legal opinions regarding probable outcomes and losses are sought. If your company has a history of lawsuits or your industry is subject to them, it would be wise to have a legal evaluation of your risk prepared. This area is especially important during an asset sale when it is commonly believed that such liabilities do not follow the sale. Court rulings have tested this assumption to the detriment of the buyer.

The California Supreme Court ruled that the purchaser of a manufacturing business was not covered by the previous owner’s insurance when it came to product liability claims, although the purchases were made during that coverage period (Henkel Corp. v. Hartford Acc. & Indem. Co., 62 P.3d 69 (Cal. 2003)).

In the case of Ray v. Alad Corp., the court ruled that the purchasing company is liable for defects caused by the previous owner, creating the product line exception (Ray v. Alad Corp., 19 Cal.3d 22, 560 P.2d 3, 136 Cal. Rptr. 574 (Cal. 1977)).

It’s vital that these potential situations be identified so the buyer, seller or both can purchase insurance to guard against possible lawsuits.

Environmental issues – A similar situation may arise with environmental issues. If the company at any time manufactured products, goods or buildings using injurious or defective materials, there is possible liability for buyer, seller or both.

The Michigan Supreme Court found the buyer liable despite an asset sale because the buyer presented the company as a continuation of the seller to the public (Turner v. Bituminous Casualty Co., 244 N.W.2d 873 (Mich. 1976)).

The court’s ruling asserts that, if the buyer uses the same name, premises, processes, designs and trademarks, the company appears to be under continuous ownership and therefore is liable.

Environmental issues can also arise with regulations governing waste disposal and handling of materials. The problem can be mishandling of both, or it may be that new, stricter regulations will soon be imposed.

Although the buyer should be aware of industry requirements and perform due diligence on the site, it can only help the seller to assist with this process. Banks often require environmental site assessments before approving a mortgage, so discovery of contamination will sink a deal fast.

Tax liabilities – Depending on tax structure, type of business and location, tax liabilities can come in different packages.

The prompt and thorough payment of employment taxes is an area that should be cleaned up before a sale. The federal government frowns heavily on late tax deposits and will levy huge fines and interest against an employer who fails to comply with the law.

If the company is a corporation and owes taxes at the entity level, this must be cleared up before the sale.

If your company collects sales taxes, a sales tax review will give the buyer assurance that there won’t be any surprises after the sale because they will be liable. If you’re current, why wait for the buyers to execute their own review?

Proactively cleaning up problems and preparing proof that your company is free of hidden liabilities will do a great deal to smooth out the selling process.

This article was originally posted on February 13, 2015 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at marketing@grfcpa.com.