Preparing for Due Diligence

By Kenneth H. Bridges, CPA, PFS     November 2015

Most growth-oriented companies will eventually go through due diligence, either in connection with a capital raise or a sale transaction.  Proper preparation can improve the likelihood of a favorable outcome; and preparation for such should begin the day you start the business.

Hire a good attorney – While our forte is accounting and tax, the first advice we give someone starting a new business is to hire a good attorney.  Don’t go cheap here or try the do-it-yourself route.  A skilled attorney can help ensure that your articles of incorporation or organization, shareholders agreement or operating agreement, employment agreements, stock options, intellectual property agreements, etc. are handled correctly.  If you get ready to sell and can’t prove you own your company or can’t prove that your company owns its intellectual property, you are going to have a problem.

Financial controls and GAAP financials – A critical part of any due diligence will be the adequacy of your financial controls and the accuracy of your financial statements (including whether such are GAAP compliant).  In many cases, we have clients who are not required by a lender or investor to have CPA audited or reviewed financials who choose to do so in order to lessen the risk of inadequate financial statements and financial controls someday becoming an issue in due diligence.

Federal income tax returns – Expect the potential buyer or investor to request copies of your Federal income tax returns for at least the past three years (and sometimes further back) and to give such close scrutiny; especially if your business is a C-corp (since the liability for any underpaid income tax in past years remains with the company).  If your business is conducted through an S-corp or an LLC, the due diligence here may be a bit lighter, since exposure to underpaid income tax for earlier years would rest with the selling shareholders.

Validity of S election – If your company is an S-corp, expect to have to document that you timely made a Subchapter S election (which may have been many years ago) and that you have done nothing since that would jeopardize the S election (e.g. 2nd class of stock or impermissible shareholder).

State income tax – If the company has customers in multiple states, then expect scrutiny as to whether you have properly complied with the income tax rules of each state with which you might have “nexus” and from which you have derived meaningful revenue; including the requirement to withhold and remit the state’s tax on behalf of nonresident LLC members or S-corp shareholders.

Sales and use tax – Of potentially much greater magnitude than income tax, is sales and use tax.  If you derive revenue from multiple states and what you are selling is potentially subject to sales tax (generally most sales of tangible personal property, some sales of software, and some sales of services), then you need to get out in front of this issue to avoid the buyer wanting a potentially substantial escrow to deal with it.

International tax – If you derive revenue from outside the U.S., expect some questions about whether your activity outside the U.S. arises to the level of a “permanent establishment” (in which case you generally need to file income tax returns with the foreign jurisdiction), and if you have a foreign subsidiary (or your company is a U.S. subsidiary of a foreign company) expect some scrutiny as to whether transactions between the related companies have been at “arms-length” pricing.

IRS and DOR examinations – Expect to provide documentation about any completed or in-process IRS or DOR examinations.  Successfully completed examinations with no changes are a big plus.

Independent contractors – Expect questions about your usage of “independent contractors”.  Widespread use of contractors, especially in roles more typically filled by W-2 employees, may be a cause for concern for the potential buyer.

Employment tax compliance – Unpaid payroll taxes and penalties associated with such can represent a significant liability, so be prepared to document your compliance with employment tax rules.

Benefit plans – Be able to document that all employee benefit plans are in compliance and that all required Forms 5500 have been properly filed.

Property tax – If the business has a meaningful amount of tangible property, expect to be able to document that all property taxes have been paid.

Related party transactions – Be prepared to explain any related party transactions and show that such are on arms-length terms.

Structured tax shelters – If you have participated in structured tax shelters or “listed transactions” expect scrutiny of these.

ACA compliance – This is a relatively new area, but now you can expect questions about whether your business is in compliance with provisions of the Affordable Care Act.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.