Due Diligence Checklist for Buying a Small Business: Financial, Tax, Legal, and Operational

Due diligence is the buyer's investigation of a business before closing. Good diligence protects against overpaying, inheriting hidden liabilities, and discovering that a key customer is about to leave. It is also useful to sellers, who can see their business as a buyer would and fix problems in advance.

Set the scope and the team

Decide what matters most given the business and the deal structure. An asset purchase focuses on the assets and assumed liabilities, while an equity purchase requires deeper review of the entity's history. Assemble a team: an attorney for contracts and corporate matters, a tax adviser for tax and structure, an accountant for financial analysis, and industry experts if the business is specialized. Use a confidentiality agreement before receiving sensitive information, and create a data room or shared folder with a request list.

Financial review

Financial statements: three to five years of profit and loss statements, balance sheets, and cash flow, with monthly detail for the latest period.
Quality of earnings: verify that reported profit is real and sustainable. Adjust for owner-specific expenses, one-time items, and unusual income or costs.
Owner compensation: normalize for what a replacement manager would cost. See S-corp reasonable compensation for how compensation is evaluated.
Revenue analysis: by customer, product, and month. Look for concentration, seasonality, and trends.
Bank statements: compare deposits to reported revenue. Discrepancies need explanations.
Accounts receivable aging: collectability and disputed balances.
Accounts payable and debt: liabilities, loan agreements, liens, and covenants.
Inventory: counts, valuation, and obsolescence.
Working capital: normal levels needed to run the business, which matter for price adjustments.
Capital expenditure needs: deferred maintenance and required upgrades.
Accounting method: cash or accrual, and consistency. See cash vs accrual accounting.

Tax review

Income tax returns for the past three to five years, federal and state, for the entity and, where relevant, owners.
Entity classification and elections: verify the S-corp election was valid, if applicable, and accepted by the IRS. A defective election can be a major hidden liability in an equity purchase. See S-corp election guide.
Payroll tax filings: Forms 941, 940, W-2s, and state returns. Look for late deposits and unresolved notices.
Sales and use tax: registrations, filings, and nexus exposure in other states. See sales tax nexus basics.
1099 compliance and worker classification. See contractor vs employee.
Tax audits, notices, and payment plans.
Property and franchise taxes, and annual reports.
Tax basis and depreciation schedules for assets.
Reasonableness of deductions, including owner-related and personal expenses.

Entity and corporate records

Formation documents, operating agreement or bylaws and amendments.
Ownership records: who owns what, with transfer history, options, and any promises of equity.
Good standing certificates in all states of operation.
Foreign qualifications where needed. See foreign qualification basics.
Minutes and consents. See corporate formalities and minutes.
Prior mergers, conversions, or restructurings.
Subsidiaries and affiliated entities, and related-party arrangements. See intercompany charges and agreements.

Contracts and commercial relationships

Customer contracts: terms, renewal, termination rights, change-of-control clauses, pricing, and exclusivity.
Top customers: talk to them if the seller allows and timing is appropriate.
Vendor and supplier contracts: dependencies, minimum commitments, and pricing.
Leases: assignment provisions, term, rent escalations, and personal guarantees.
Licenses and franchise agreements: transferability and fees.
Loan and lease agreements: prepayment terms and default provisions.
Insurance policies and claims history.
Warranties and guarantees given to customers.

Intellectual property and technology

Ownership of trademarks, domain names, and social accounts. Confirm they belong to the entity being sold, not to the owner personally.
Software and content ownership: especially where contractors created materials. Confirm written assignments. See agency client contracts and IP.
Third-party licenses and open source obligations.
Data privacy and security practices.
Website analytics and marketing data.

Employees and labor

Organization chart, roles, and compensation.
Employment agreements, non-competes, and confidentiality agreements.
Key employee retention and change-of-control payments.
Benefit plans: retirement, health, and accruals for vacation and bonuses.
Classification of workers and compliance with wage and hour laws.
Pending claims or complaints.
Immigration and I-9 compliance.
Workers' compensation history.

Legal and regulatory

Litigation: pending, threatened, or settled.
Licenses and permits required for operations.
Regulatory compliance specific to the industry.
Environmental issues for property-related businesses.
Zoning and property records for owned real estate. See real estate in an LLC or personal name.
Liens and UCC filings against the business or assets.

Operational review

Business processes and reliance on the owner.
Customer acquisition sources and costs.
Systems and software used, and the quality of records.
Inventory and supply chain.
Facilities and equipment condition.
Competition and market position.
Owner dependence: how much revenue depends on the owner's relationships. Transition plans and consulting agreements may help.

Red flags

Books that do not reconcile to bank statements or tax returns.
Owner-related and personal expenses running through the business.
Customer concentration where one client is a large share of revenue.
Undocumented verbal agreements.
Unfiled or late returns and unresolved tax notices.
Missing entity records or a questionable S election.
Heavy reliance on cash transactions with weak documentation.
Key employees who might leave after the sale.
Unclear ownership of intellectual property.
Sudden changes in revenue or margins before the sale.
Reluctance to provide records.

From findings to deal terms

Diligence results feed price adjustments, representations and warranties, indemnification provisions, escrows and holdbacks, closing conditions, and post-closing covenants. If issues are serious, you may restructure the deal, ask for a price reduction, or walk away. Document conclusions.

Preparing as a seller

Sellers who anticipate a buyer's requests can gather documents, resolve tax and compliance issues, and clean up books before marketing the business. See entity cleanup guide and catching up on books and returns.

For help evaluating the tax and financial side of a transaction, AE Tax Advisors can assist, and a discovery call is a good first step. Legal review belongs with an attorney.