Tax Due Diligence: Uncovering Hidden Liabilities Before Closing

Before you acquire a business, a tax due diligence review identifies hidden liabilities—unpaid taxes, aggressive positions, and audit exposure—that could transfer to you at closing. What the seller doesn't know about their tax history can cost you six figures after signing.

Review prior tax returns. A CPA examines at least three years of federal, state, and local returns for aggressive positions, missed elections, and unresolved audit adjustments. Amended returns or late filings are red flags that demand deeper investigation.

Sales tax and nexus exposure. Many businesses have unreported sales tax obligations in states where they have economic nexus. Post-Wayfair, any business selling across state lines may owe sales tax in dozens of states. This liability transfers to you in a stock purchase.

Worker classification risk. If the business classified workers as independent contractors when they should have been employees, the back taxes, penalties, and interest can be substantial. The IRS uses a 20-factor test; states often apply stricter standards.

Outstanding audits and notices. Open audits or unresolved IRS/state notices represent unknown financial exposure. A stock purchase means you inherit them.

The pitfall: Skipping tax due diligence to save a few thousand dollars in CPA fees can expose you to six figures in inherited tax debt. The seller's representations in the purchase agreement are only as good as the diligence behind them.