When buying a business, one of the principal considerations is ensuring that one obtains a "clean" title unencumbered by liens and obligations to others. I've previously posted about why sophisticated buyers often prefer structuring the acquisition of a business as an asset sale rather than a stock deal to address this concern. However, even if the transaction is done as an asset sale to minimize the likelihood of unwanted liabilities following the new owner, purchasers must still be concerned about the prospect of "successor liability" if proper precautions are not taken. If "successor liability" is found to be applicable, the new owner will discover that the overall cost of the transaction is substantially greater than expected.
General "Successor Liability" Conditions. The seminal case in Ohio regarding "successor liability" is Flaugher v. Cone Automatic Machine Co., 30 Ohio St.3d 60, 507 N.E.2d 331 (1987).  Although the purchaser of a business generally cannot be held liable for the obligations of the seller, Ohio law as interpreted by the Ohio Supreme Court in Flaugher recognizes four specific exceptions to this rule, namely:
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If the new entity has expressly or impliedly agreed to assume the liability
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The transaction amounts to a de facto consolidation or merger
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The new entity is "merely a continuation" of the already existing entity
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The transaction is entered into fraudulently for the purpose of escaping liability
Mere Continuation. A company will be held to be a "continuation" of an existing entity, and therefore subject to successor liability when the two entities have "significant shared features" such as the same equity ownership, same employees, the same service or product being produced, same supervision, etc.; in addition the dissolution or liquidation of the existing company soon thereafter is seen as a marker that successor liability should be applied. Inadequacy of consideration for any assets conveyed from the existing entity to the new entity is also a red flag. Thus, the more the new company looks like the old one, the more likely it is to be vulnerable to successor liability.
De Facto Merger. The "hallmarks of a de facto merger" were explained by the Ohio Supreme Court in Welco Industries, Inc. v. Applied Companies, 67 Ohio St.3d 344, 617 N.E.2d 1129 (1993) to include:
(1) the continuation of the previous business activity and corporate personnel, (2) a continuity of shareholders resulting from a sale of assets in exchange for stock, (3) the immediate or rapid dissolution of the predecessor corporation, and (4) the assumption by the purchasing corporation of all liabilities and obligations ordinarily necessary to continue the predecessor's business operations. Â
Applicable to Contract as Well as Tort Liability. Initially the "successor liability" doctrine applied primarily to tort liability for claims of negligence and similar actions.  In Welco, however, while the Ohio Supreme Court deslined to find successor liability under the facts of that case, it did indicate that under appropriate facts, a successor corporation might also be held liable for contractual obligations of its preedecessor. For those wanting an in-depth discussion of Flaughler and Welco and the evolution of the successor liability doctrine in Ohio, the Franklin Couty Court of Appeals' decision in Mandalywala v. Omnitech Electronics, Inc., 2006 Ohio 2872, 2006 Ohio App. LEXIS 2717 contains an excellent discussion.  Â
Example. The recent case of Pottschmidt v. Klosterman, 169 Ohio App.3d 824, 865 N.E.2d 111 (2006) provides useful perspective in the practical application of this test for "successor liability" in the extreme case. In that case, a doctor joined the existing practice of another doctor which was organized as a corporation and became a shareholder in that organization. Eventually, one of the doctors chose to resign as a shareholder and instituted suit against the corporation for various employment related claims.Â
Thereafter, the remaining doctor formed a new corporation with a new bank account, but continued in the same office location with the same furnishings, employees, phone number, and patients. The departing doctor sought to impose liability upon the new corporation for his employment related claims. In finding that a de facto merger had occurred and that the new corporation was a "continuation" of the original company (and therefore liable to the departing doctor), the Court of Appeals found:
At trial, however, evidence was presented that the new corporation took possession of the original corporation's office equipment, medical supplies and accounts receivable. The new corporation served substantially the same patients and was operated in the same building as the original corporation. There is a single 100% shareholder of both corporations, Dr. Klosterman. The new corporation pays the monthly office lease and equipment payments that the original corporation previously paid. The original corporation's employees were employed by the new corporation and were compensated by the new corporation for services rendered to the original corporation.... the original corporation retained no assets. Moreover, the original corporation closed its corporate bank account, changed the name on the profit sharing accounts and filed a final tax return with the IRS, which effectively constituted an end of the original corporation.  Â
Although not directly applicable to the sale of a business, it does show the types of things purchasers should try to avoid. Thus, even in structuring asset transactions, care should be taken in specifically disclaiming unwanted liabilities and in how the post-transaction company should operate. Â
Sales Tax Liability. By statute, if provision is not made for payment of outstanding sales tax, the new owner can remain liable for its predecessor's obligation to the State of Ohio. And that liability can also extend personally to the equity holders of the new owner. This is one I did not fully appreciate until recently when I started acting as Outside Counsel for the State of Ohio with respect to the collection of state tax obligations.
Pursuant to Ohio Rev. Code 5739.14, an escrow account containing a sufficient amount to cover any outstanding sales tax obligation must be established:
His successor shall withhold a sufficient amount of the purchase money to cover the amount of such taxes, interest, and penalties due and unpaid until the former owner produces a receipt from the tax commissioner showing that the taxes, interest, and penalties have been paid, or a certificate indicating that no taxes are due.
Thus the prudent business buyer will insist on receiving a Sales Tax Release Certificate which can be obtained by completing a Request for Sales Tax Release and submitting it to the Ohio Department of Taxation. For further information, click here for instructions provided by the Ohio Department of Taxation. According to the Department of Taxation, it will take approximately 30-90 days to process the request. A tax release will be issued by the Department of Taxation after:
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The Department has reviewed the seller's account and found that:
 a) All sales tax returns have been filed,
 b) all reported tax, interest and penalties have been paid,
 c) all filing and reporting requirements have been met.
Penalties for failing to pay state sales tax can be substantial. In addition, other consequences such as suspension or revocation of any liquor license held by the new owner can occur if payment of sales tax is not made in a timely manner. Thus, it is important not to overlook this aspect in the midst of everything else involved in the acquisition of a business.
