Voluntary Disclosure Agreements Are Not a Guaranteed Penalty Waiver: Understanding When Penalties Still Apply

Voluntary disclosure agreements are widely, and generally correctly, understood as one of the most favorable ways for a company to resolve historic sales tax exposure. In exchange for coming forward before a state identifies the company through an audit or other enforcement action, most states offer a limited look-back period and a waiver of penalties that would otherwise apply. That combination is precisely why VDAs are so often the recommended path for companies, and for buyers addressing a target company's historic exposure in an acquisition.

But the assumption that a VDA automatically eliminates all penalty exposure is not accurate, and treating it as a given can lead to unwelcome surprises once a state actually reviews the company's submission. Penalty relief under a VDA is typically conditioned on the nature of the underlying liability, and there are specific circumstances, most notably tax that was collected from customers but never remitted to the state, where penalties can still apply even within an otherwise successful VDA.

Why States Distinguish Between Types of Liability

Sales tax is fundamentally different from most other tax types because the company itself is not the party bearing the economic burden of the tax. The seller collects the tax from the customer at the point of sale and holds it, at least in principle, as an agent of the state, with an obligation to remit it on a periodic basis. This distinction matters enormously to how states evaluate voluntary disclosure requests.

Most state VDA programs are designed to address a specific, sympathetic scenario: a company that did not realize it had nexus in a state, did not register, and therefore never collected tax from its customers in the first place. In that scenario, the company's failure is a failure to collect and remit, stemming from a good faith misunderstanding of its own nexus footprint. States are generally willing to waive penalties in this situation because the underlying conduct looks like an honest compliance gap rather than a deliberate withholding of funds.

A materially different scenario arises when a company was registered, or otherwise collected sales tax from customers, but failed to remit some or all of that tax to the state. In this case, the company actually received the funds from its customers on the state's behalf and simply did not turn them over. States view this conduct far more seriously, because it is no longer a story about an unknown compliance obligation. It is a story about funds that were collected in trust for the state and were, for whatever reason, retained or diverted instead.

The Practical Effect on VDA Penalty Relief

Because of this distinction, companies pursuing a VDA should not assume that penalty abatement will extend to any tax collected and not remitted, even if that same VDA successfully waives penalties on other, uncollected liability. In practice, this can create a bifurcated result within a single VDA:

• Tax that was never collected because the company was unregistered typically qualifies for the favorable treatment most people associate with VDAs: a limited look-back period and full penalty abatement.

• Tax that was collected from customers but not remitted is frequently carved out of that penalty relief, even when it is being disclosed as part of the same voluntary process, and even when it relates to the same state and the same general time period.

• Some states go further and exclude collected-but-unremitted tax from the look-back limitation as well, meaning the state may reserve the right to assess that liability outside the negotiated look-back window, not merely with penalties intact but without any of the usual limitations at all.

This means a company or a buyer evaluating the expected outcome of a VDA needs to look carefully not just at whether nexus existed, but at what actually happened operationally during the exposure period. A period where the company was unregistered and never collected tax is a very different risk profile from a period where the company was registered, charged sales tax on invoices or at checkout, and then failed to remit it.

Why This Matters in an M&A Context

This distinction is particularly important in the acquisition context, where a buyer may be relying on the assumption that a VDA will resolve a target's historic exposure cleanly and predictably. If part of the target's exposure involves periods where the company was registered in a state and charged customers sales tax that was not fully remitted, the buyer should not assume that the VDA process will eliminate penalties on that portion of the liability, regardless of how the escrow or indemnification provisions are structured.

This has several practical implications for diligence and deal structuring:

1. Diligence should specifically identify whether any historic exposure involves collected-but-unremitted tax, rather than treating all exposure as a single, undifferentiated nexus problem. A target that was unregistered throughout the exposure period presents a meaningfully lower penalty risk than one that collected tax under a registration and simply failed to remit some portion of it.

2. Escrow sizing should account for the likelihood that penalties will not be waived on collected-but-unremitted amounts. An escrow calculated assuming full penalty abatement across the board may understate the buyer's actual exposure if any portion of the liability falls into this category.

3. The purchase agreement's indemnification and escrow provisions should be drafted with enough flexibility to capture penalties that survive the VDA process, rather than assuming the VDA will resolve all liability, penalties included, in every instance.

4. Tax advisors conducting the nexus study should be asked directly whether any collected-but-unremitted tax exists, since this is not always volunteered as part of a general nexus review focused primarily on identifying where the company should have been registered.

Other Circumstances Where Penalty Relief May Be Limited

Collected-but-unremitted tax is the most common and most significant carve-out, but it is not the only circumstance in which penalties can survive a VDA. Depending on the state, penalty relief may also be limited or unavailable where:

• The company was already under audit, or had already been contacted by the state, before submitting the VDA request, since most programs require that disclosure be truly voluntary and made before any state contact.

• The company had previously registered and then deregistered in the state without properly closing out its filing obligations, which some states treat differently from a company that was simply never registered.

• The disclosure involves certain excluded tax types that a particular state's VDA program does not cover, even if sales tax generally is covered.

• There is evidence of intentional or fraudulent conduct, as opposed to an inadvertent compliance gap, which most VDA programs are explicitly not designed to protect.

Because these carve-outs vary meaningfully by state, and because state VDA programs are not uniform in how they define or handle collected-but-unremitted tax, this is an area where state-specific guidance from a qualified tax advisor is particularly important before assuming a given outcome.

The Bottom Line

Voluntary disclosure agreements remain one of the most effective tools available for resolving historic sales tax exposure, and in most cases they do deliver the limited look-back period and penalty abatement that make them attractive. But that outcome is not universal, and companies, along with buyers relying on the VDA process to resolve a target's historic exposure, should not assume that all liability will be treated the same way. Tax that was collected from customers and not remitted sits in a fundamentally different category than tax that was never collected because the company was unregistered, and states frequently reserve the right to assess penalties, and in some cases pursue liability outside the standard look-back period, on that collected-but-unremitted portion. Identifying whether this circumstance exists before finalizing escrow amounts, indemnification terms, or expectations about the VDA outcome is an important step that should not be skipped.

This article is intended for general informational purposes and does not constitute legal or tax advice. Companies and buyers evaluating historic sales tax exposure should consult with qualified state and local tax counsel or a qualified tax service provider regarding the specific treatment of collected-but-unremitted tax and other circumstances that may affect penalty relief under a given state's voluntary disclosure program.