Tax Due Diligence Before You Buy or Sell a Company

In a stock acquisition, the buyer generally steps into the target entity's full tax history, including any liabilities from prior years that haven't yet been examined or assessed, since the legal entity itself doesn't change hands any differently than its liabilities do. In an asset acquisition, the buyer generally leaves most historical tax liabilities with the seller's entity, taking on a cleaner slate but often at the cost of losing favorable tax attributes like net operating loss carryforwards that stay with the seller instead. Neither structure is universally better; the right one depends on the target's specific tax history and attribute profile.

Expect a review of filed returns for open years, any prior audit history and its outcomes, unresolved tax positions or reserves for uncertain positions, sales tax nexus and collection compliance across every state the target operates in, payroll tax compliance including worker classification, and any related-party transactions and their pricing and disclosure. For a target with international operations, add a review of foreign entity structures, transfer pricing documentation, and any CFC or similar international reporting obligations.

Buyers commonly ask the seller to produce or explain the following:

• Filed returns for every open year, plus any prior audit history and how each audit was resolved.
• Unresolved tax positions and any reserves the target has set aside for uncertain positions.
• Sales tax nexus and collection compliance in every state where the target operates.
• Payroll tax compliance, including how workers were classified as employees or contractors.
• Related-party transactions, including how they were priced and disclosed.
• For targets with international operations, foreign entity structures, transfer pricing documentation and international reporting obligations.

A target with valuable net operating loss carryforwards is attractive on paper, but an ownership change of the size typical in an acquisition can trigger limitations on how much of that loss the buyer can actually use in future years, sometimes dramatically reducing its practical value. Don't value NOL carryforwards in a deal model at face value without confirming how the specific ownership change limitation rules apply to the actual transaction structure being proposed.

A seller who cleans up known tax exposures before diligence starts, resolving an old uncertain position, filing a delinquent state registration, documenting a related-party arrangement properly, generally gets a smoother process and fewer surprises that weaken their negotiating position during the deal. Waiting for a buyer's diligence team to find a problem first almost always costs more, in price adjustment or escrow, than fixing it proactively months before you're in a live deal process.

For example, a seller with a delinquent state registration and an undocumented loan to a related company can address both before going to market. File the registration, write down the loan terms, and add a short memo explaining the reasoning. When the buyer's team asks about either item, the answer is already sitting in the data room, and the issue reads as handled rather than as a surprise. The same approach works for any known exposure: decide who owns the cleanup, set a target date well ahead of the process, and keep the supporting evidence together in one folder so requests can be answered quickly.

Representations and warranties about tax matters, an indemnification structure specifically covering pre-closing tax liabilities, and sometimes a dedicated escrow or tax insurance policy are the mechanisms that actually protect a buyer from a diligence finding that couldn't be fully resolved before closing. If diligence surfaces a real but manageable risk, negotiating the right protection into the purchase agreement is often more practical than trying to walk away from an otherwise good deal over it.

Tax diligence gets treated too often as something that starts once the letter of intent is signed, on the same clock as everything else in the deal, which leaves little room for a thorough state-by-state nexus review or a careful look at an uncertain position from several years back. Starting the tax workstream in parallel with, rather than after, financial diligence gives your advisors enough runway to actually dig into a multi-state footprint or an international structure properly instead of rushing a surface-level review against a closing deadline that was set without tax diligence in mind. That extra runway is often the difference between finding a fixable issue and finding one for the first time after the deal has already closed.