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Jun 20, 2011
Article #72
Author: Joe Sandbank

A major concern of anyone buying a business should be whether or not they will be exposed to any of the seller’s liabilities.  Successor liability (i.e., a buyer being held liable for a seller’s obligations) exists in the following situations:

1. Stock Purchase instead of an Asset Purchase.  If a buyer purchases a business by acquiring the common stock of a corporation, the partnership interests in a partnership, or the membership interests in a limited liability company, the buyer steps into the shoes of the seller as the owner of the entity.  The entity continues to own its business assets, and the entity continues to be responsible for its obligations and liabilities.

A seller of such an ownership interest is obligated to disclose the entity’s known liabilities to a buyer, but another major concern to a buyer should be the “contingent” liabilities of that entity.  Contingent liabilities are those liabilities that have been incurred by the entity prior to the ownership interest being acquired by the buyer, but the seller is unaware of them.  Contingent liabilities may or may not turn into actual obligations.  For example, a customer that slips and falls in a store before an acquisition might or might not file a lawsuit against the entity for their injuries.

In general (see exceptions below), a buyer can avoid these contingent liabilities by structuring the purchase transaction as an asset purchase.  In an asset purchase, the buyer acquires the business assets, but not the business liabilities.

2. Public Policy Exception for Manufacturing Businesses (the “Product Line Successor” rule)

Although structuring the purchase transaction as an asset acquisition will normally protect a buyer from a seller’s contingent liabilities, California’s Supreme Court has created an exception that applies under certain limited circumstances for manufacturing businesses.

Thus, even when a buyer acquires just the assets of a manufacturing business, courts have imposed liability where all of the following apply: (1) the plaintiff's remedies against the original manufacturer have been destroyed as the result of the successor's acquisition of the business; (2) the successor has the ability to assume the original manufacturer's risk-spreading role; and (3) it is deemed to be fair to require the successor to assume a responsibility for defective products because it was a burden necessarily attached to the original manufacturer's goodwill that is being enjoyed by the successor in the continued operation of the business.

The best protection for a buyer against this type of liability would be to obtain insurance that provides coverage against this sort of claim.  Such insurance could be either obtained by the buyer to cover liabilities arising prior to the acquisition or by requiring the seller to carry insurance against this sort of claim for a reasonable period after the acquisition.

3. Failure to Comply with Bulk Sale Laws

In an asset sale, successor liability for the seller’s trade credit may also exist where a buyer acquires more than one-half of the seller’s inventory and equipment.  The buyer can obtain protection from such liability by complying with California’s bulk sale laws.  These laws protect trade creditors by imposing liability on the buyer, unless the buyer provides appropriate notice of the bulk sale.  The notice must contain specific information, and it must be recorded, published and provided to the county tax collector.

Bulk sales law also provides a mechanism for creditors making claims on the purchase money consideration.  These laws do not apply to all businesses, but they do apply to businesses that purchase and sell inventory.  Because of the complexity of complying with the bulk sales laws, buyers should open a bulk sale escrow with a reputable escrow company to ensure that bulk sale procedures are followed.

4. Taxes

While a buyer is not obligated to pay the seller’s income taxes when the transaction is structured as an asset sale, successor liability may exist for California Sales and Use Tax, taxes payable to the California Employment Development Department, and taxes required to be withheld by the California Franchise Tax Board.

A buyer is required to withhold a sufficient portion of the purchase price to cover the seller’s liability for California Sales and Use Tax until the seller produces a receipt from the Board of Equalization showing full payment or a certificate indicting that no amount is due.  This liability includes both taxes due from the sale of the assets to the buyer and taxes from prior sales made by the seller.

A buyer is also required to withhold a sufficient amount to cover the seller’s due or unpaid contributions to the California unemployment fund, employment training fund, and unemployment compensation disability fund until the seller produces evidence from the Employment Development Department that no such payments are due.

A similar withholding requirement exists for the seller’s taxes required to be withheld under California’s franchise and income tax laws, and buyers should obtain a release from the Franchise Tax Board to avoid liability for these taxes.

To avoid being saddled with the seller’s tax liability and related penalties, a buyer would be wise to acquire the business through a business escrow service.  The escrow officer will either obtain the necessary releases from the taxing authorities prior to closing escrow or withhold enough of the purchase price from the seller to pay these taxes if any are due.

About The Author:  Joe Sandbank is an attorney specializing in assisting business buyers, business owner/sellers, business brokers, and agents with legal matters pertaining to buying and selling businesses throughout California. Joe can be reached direct at 800-875-1480.

Joe Additional Comments:

To address some of the comments: 1. When a deal is structured as a stock purchase, publishing a bulk sale notice may result in creditors making a claim for payment in escrow and keeping them from being concealed, but doing so won't terminate a buyer's exposure to the seller's vendors claims like it will with an asset purchase. 2. If a customer returns a defective product or requires warranty work, the buyer (in an asset purchase) is not legally obligated to satisfy those claims, although it would be good business to do so. For businesses where this is a concern, the buyer should required that the asset purchase agreement address warranties and returns (and having seller carried financing is a good way to leverage enforcement of the seller's promises re: same). 3. Stock sales are admittedly riskier with respect to successor liability. Bulk sale laws are really not applicable and indemnity and due diligence prior to closing become your only practical protection.

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