Should You Ask Customers to Pay the Tax Uncovered in a VDA?

When a Voluntary Disclosure Agreement uncovers historic sales tax that was never charged to customers, a natural question follows: should the company go back and collect that tax from the customers who bought the taxable goods or services, or should it absorb the liability itself?

There's no single right answer. It depends on the customer base, the dollar amounts involved, the state of the customer relationships, and, in an M&A context, what the buyer has to say about it. Here's how to think through the decision.

Why This Question Comes Up at All

Sales tax is, by design, meant to be collected from the end customer and remitted by the seller. When a VDA reveals that tax should have been charged on historic sales but wasn't, the company technically has two liabilities to consider: the tax itself, which is now owed to the state, and the question of whether that cost should be borne by the company or passed through to the customers who received the untaxed goods or services.

Legally, many states allow a seller to go back and invoice customers for uncollected tax after the fact, particularly when the underlying transaction remains within any applicable statute of limitations. But having the legal right to do so doesn't mean it's the right business decision.

The Case for Not Asking Customers to Pay

For many companies, the answer is simply to absorb the liability and move on, without ever contacting customers. Common reasons include:

• Customer relationship risk. Reopening a two- or three-year-old invoice to ask for additional payment, even if legally justified, can read as a billing error or an aggressive collections tactic. For a company trying to retain a customer relationship, this can do more reputational damage than the tax dollars are worth.

• Administrative burden relative to the dollar amount. If the historic liability is spread across hundreds of small transactions, the cost of identifying every affected customer, calculating the correct amount, issuing invoices, and following up on collection can exceed the value recovered.

• Some customers won't pay. Especially with smaller or transactional customers, there's a real chance the invoice simply gets ignored, leaving the company having spent time and goodwill without recovering the cost.

• Optics during a sale process or renewal. If a customer relationship is active and ongoing, introducing an unexpected tax bill in the middle of a renewal conversation can complicate the relationship at an inconvenient time.

For many companies, especially those with a large volume of smaller customers, simply treating the VDA liability as a cost of doing business and building better tax collection processes going forward is the more practical path.

When It Makes More Sense to Go Back to Customers

When it comes to large, sophisticated customers with mature tax functions, these companies are likely to have self-accrued the use tax or already been audited by the state. In this case, the customer can complete an exemption or direct pay certification, sometimes referred to informally as an "XYZ letter," which will alleviate the need for the tax to be paid again. In the absence of it, this group is often a good candidate for reimbursement requests, since they know they will owe the tax as part of an audit. We have found that the company suggesting that it will pay the interest while the customer pays the tax goes over well.

A Practical Approach: Segment the Customer Base

Rather than deciding on an all-or-nothing basis, many companies find it useful to segment customers before making a decision:

• Large, sophisticated, or routinely audited customers: Consider reaching out directly, ideally with their tax or accounts payable department, to determine whether the tax was already self-accrued or assessed on audit before deciding whether to invoice.

• Mid-size customers with active relationships: Weigh the dollar amount against the relationship value and the likelihood of a smooth, professional resolution.

• Small or one-time customers: In most cases, the cost of pursuing collection outweighs the benefit, and absorbing the liability is usually the more practical choice.

The M&A Context: This Decision Isn't the Seller's Alone

This issue takes on added significance when a VDA surfaces during, or shortly before, an M&A transaction. A target company that identifies historic sales tax exposure during due diligence, and resolves it through a VDA, needs to be careful about deciding unilaterally whether to bill customers for the uncovered tax.

A few reasons this decision should be run by the buyer before it's finalized:

• The buyer may be inheriting the customer relationships. If the deal closes and the buyer will continue serving these customers going forward, the buyer has a direct stake in whether those relationships are disrupted by a retroactive tax invoice.

• The purchase agreement may already address it. Many purchase agreements include specific indemnification or escrow provisions covering historic tax exposure. Depending on how those provisions are drafted, unilaterally invoicing customers, or choosing not to, could affect how the liability is allocated between buyer and seller.

• Timing matters. Sending tax invoices to customers in the weeks surrounding an acquisition announcement or transition can create confusion, especially if customers are already fielding questions about the change in ownership.

• The buyer may have a different risk tolerance. A strategic buyer with a long-term relationship strategy for these customers may prefer to absorb the cost rather than risk friction, even if the seller would have made a different call standing alone.

In practice, this means the decision of whether to invoice customers for a VDA-related tax liability should be flagged explicitly during the deal process, discussed with the buyer's deal team, and, where relevant, addressed in the purchase agreement rather than handled as an afterthought after closing.

The Bottom Line

Whether to ask customers to cover historic sales tax uncovered in a VDA is as much a relationship and business judgment call as it is a legal one. Smaller or transactional customers are usually not worth pursuing, given the relationship risk and administrative cost relative to the recovery. Larger, sophisticated customers, particularly those that are routinely audited or that self-accrue use tax, are often a different story, and a direct conversation before invoicing can avoid double-payment issues and awkward surprises. And when this issue surfaces in the middle of an M&A transaction, it should never be decided by the seller alone. It belongs on the table with the buyer, ideally addressed in the purchase agreement, before any customer receives an invoice.

This article is for general informational purposes and does not constitute legal or tax advice. Companies should consult a qualified state tax advisor or transaction counsel to evaluate the right approach for their specific facts.