Tax Due Diligence Before Selling a Startup: What Buyers Find

A buyer's tax due diligence checks every year the IRS or a state can still assess. In a stock sale or merger, the company keeps its own tax history, so the buyer inherits every open year and prices it. A year with no return filed never closes. File what you can before signing, and disclose the rest so it can be priced into escrow or an indemnity.

The case is not simple when the deal is an asset sale, staff work in states where the company never registered, a founder is neither a US citizen nor a US resident, the company has a foreign subsidiary, or change-in-control bonuses are large. Gather:

• Every federal and state return, and IRS account transcripts for each year
• State registrations, with a map of where employees work and where sales go
• Payroll filings: Forms 941, 940, W-2 and state withholding and unemployment returns
• Contractor list and Forms 1099
• The option ledger, each 409A report, and Forms 3921
• Every bonus, severance and acceleration term tied to a sale

What does a buyer's tax due diligence look for in a startup?

A buyer looks for tax the company owes but has not paid or reported, and for tax benefits that are worth less than the seller says.

For research costs, new rules let a company recover the 2022 to 2024 domestic amounts it was still amortizing, in one year or over two (Revenue Procedure 2025-28); see deducting US software development costs.

How many years back can the IRS and states assess, and why does that set the buyer's look-back?

The IRS can usually assess income tax within 3 years after a return is filed, and a buyer looks back at least that far. A return filed early counts as filed on its due date (26 U.S.C. 6501(a), (b)). The exceptions below are what keep older years open.

States set their own periods. California's is usually 4 years from the due date or the date the return is filed (FTB); each state has its own rule for years with no return. So the buyer's look-back is not a fixed number of years: it reaches every federal year with no return, and every state year that state's rules leave open.

Unfiled returns and missed state registrations: fix them before signing or disclose them?

File what can be filed before signing, and disclose what cannot. A filed return starts the assessment clock; an unfiled one never does. Every C corporation files Form 1120 each year whether or not it has taxable income (Instructions for Form 1120). The late-filing penalty is 5% a month of unpaid tax, so a loss year usually costs little to file late. The order of work is in catching up on unfiled business returns.

State registrations take longer. Registering, filing back returns or applying for a state's voluntary disclosure program can take months, so start before signing and list what is still in progress in the purchase agreement. Registration steps are in registering in another state, and California's minimum tax in California minimum tax.

A founder who is neither a US citizen nor a US resident and owns 25% or more may mean missed Forms 5472: see missed foreign-owner filings and penalties.

What if we never collected sales tax on our software?

A seller that should have charged sales tax usually owes it itself, plus penalty and interest, and a buyer will estimate that amount state by state. Which states tax software and SaaS differs: see sales tax on SaaS and software.

In a stock sale or merger the liability stays with the company the buyer acquires. In an asset sale it generally stays with the seller, but some states make the buyer liable too. California, for example, says buyers can be held responsible for a seller's unpaid taxes unless a tax clearance certificate is obtained (CDTFA Publication 74). Voluntary disclosure, billing customers later and the lookback period are in catching up on uncollected sales tax.

What payroll and contractor problems worry a buyer?

Unpaid withheld payroll tax worries a buyer most: the company still owes it after the sale, and the people responsible can owe it personally. The IRS can charge a penalty of 100% of unpaid withheld tax to each responsible person who willfully failed to pay it (26 U.S.C. 6672). Late deposits cost 2% to 15% of the deposit. A buyer also checks for state withholding and unemployment accounts in every state where an employee works, and for workers paid as contractors who may be employees.

Catching up is in behind on payroll taxes and contractors who may be employees. State accounts are in employees in another state.

Will the buyer check our option grants, 409A dates and Forms 3921?

Yes. A buyer compares each option's grant date and exercise price with the 409A report in force that day. A nonqualified option is outside section 409A only if its exercise price can never be less than the stock's fair market value on the grant date (26 CFR 1.409A-1(b)(5)). An independent appraisal is presumed reasonable only for grants within 12 months of its valuation date, and not when later information could materially change the value.

An option granted below fair market value is deferred pay. If it fails section 409A, the holder includes the deferred amount in income once it vests, plus an additional 20% tax and interest (26 U.S.C. 409A(a)(1)), and the company has wage reporting and withholding to correct. An incentive stock option priced below fair market value is not an incentive stock option, unless the price was a good-faith attempt at fair market value (26 U.S.C. 422(b)(4), (c)(1)).

Form 3921 is due for each incentive stock option exercise (Instructions for Form 3921). A missed form generally costs $60 to $340 for the IRS copy and again for the employee copy. The buyer also asks for each founder's 83(b) election; the company should hold a copy.

Do change-in-control bonuses trigger the golden parachute rules?

They can. Payments contingent on a sale to someone who works for the company and is an officer, a shareholder owning more than 1% of the stock's value, or a highly paid person are parachute payments if they total 3 times that person's base amount or more (26 U.S.C. 280G(b)(2)). The base amount is the person's average yearly taxable pay from the company over the most recent 5 years before the sale, or the years they worked there if fewer. Bonuses, severance and faster vesting all count. An agreement signed or changed within 1 year before the sale is presumed contingent on it.

Once over the line, everything above 1 times the base amount is an excess parachute payment. The company cannot deduct it (280G(a)), and the person owes a 20% excise tax on it, withheld when it is wages (26 U.S.C. 4999).

A private company has two ways out (26 CFR 1.280G-1, Q&A-6 and Q&A-7):

• Small business corporation: a company that could be an S corporation, ignoring the rule against nonresident shareholders, is exempt. That needs no more than 100 shareholders, all of them individuals, estates, certain trusts or certain exempt organizations, and one class of stock (26 U.S.C. 1361(b)). Preferred stock or a fund as a shareholder rules it out.
• Shareholder vote: if no stock is readily tradeable, shareholders holding more than 75% of the voting power immediately before the sale approve the payments, after full disclosure to every shareholder entitled to vote. Stock held by the people being paid does not count. The vote must decide whether the payment is made, so each person first waives what the vote does not approve, and the deal itself cannot depend on the vote.

The vote has to happen before closing. The company's lawyer runs it; the tax work is the base-amount and payment calculation behind the disclosure.

Will the buyer get our losses, and what is a section 382 study?

In a stock sale or merger the losses stay with the company, but the sale itself is usually an ownership change that caps them. An ownership change happens when shareholders owning 5% or more increase their stake by more than 50 percentage points within 3 years (26 U.S.C. 382). After it, the losses usable each year are capped at the company's value just before the change times the long-term tax-exempt rate. If the buyer does not continue the business for 2 years, the cap is zero (382(c)).

A section 382 study traces ownership through every financing round to find whether an earlier change already capped the losses. A buyer values the losses at what any earlier cap still allows. In an asset sale the losses stay with the selling company, which can use them against the gain on the sale. The study, the yearly cap and the state rules are in net operating losses for startups.

Stock sale, merger or asset sale: what changes for the company's own tax?

In a stock sale, or a merger in which the company survives, the company pays no tax on the sale; its shareholders do. In an asset sale the company pays tax on its gain, and shareholders pay again when the company distributes the cash.

A buyer can change the stock-sale result. A corporate buyer that buys at least 80% of the stock within 12 months can elect under section 338(g) to treat the company as selling all its assets at fair market value at the close of the closing day, so the company is taxed on that gain. The buyer files Form 8023 by the 15th day of the 9th month beginning after the month of the acquisition date (26 U.S.C. 338; Instructions for Form 8023).

Property the company distributes instead of selling is taxed to it as if sold at fair market value (26 U.S.C. 336). If the company pays its cash out to shareholders and still owes income tax, the IRS can collect it from them as transferees, until one year after the company's own assessment period ends (26 U.S.C. 6901).

When a selling shareholder is a foreign person, the buyer must withhold 15% of what it pays for that shareholder's stock, unless the company certifies, under penalties of perjury, that its stock is not a US real property interest. A company that held little US real estate over the past 5 years can generally give that certification (IRS: exceptions from FIRPTA withholding). For an owner-run business choosing between the two, see selling your business. Each holder's tax on cash and buyer stock is in taxes when your startup is acquired, and QSBS on the sale in QSBS for founders and early employees.

How do tax findings turn into escrow, holdbacks and indemnities?

A finding that is not fixed before signing becomes a deal term. The purchase agreement can lower the price, hold part of it in escrow or back until the issue is settled, or have sellers repay the buyer for tax from before closing. The amounts and time limits are negotiated; the numbers usually rest on the estimated tax, penalty and interest, and on how long the year stays open.

That is why filing matters before signing: a filed return starts a 3-year clock, so an escrow tied to it has an end date; an unfiled year never closes. How sellers are taxed on escrow released later is in escrow and holdback payments; earnouts are in earnout payments.

Which company returns are due after closing, and who files them?

The company still files for the part of the year before closing; the purchase agreement says who prepares those returns and who pays the tax on them. After a stock sale the buyer controls the company, so it files.

• Buyer files a consolidated return: the company's tax year ends at the end of the closing day (26 CFR 1.1502-76(b)). The company files a short-year Form 1120 for the part before closing, generally due no later than the buyer group's consolidated return, including extensions (1.1502-76(c)). The rest of the year goes on the buyer's consolidated return.
• Buyer does not file a consolidated return, for example a foreign buyer: the company's tax year does not end at closing, and one Form 1120 covers the whole year.
• Asset sale: the selling company reports the gain and attaches Form 8594 to its Form 1120 for the year of sale. If it then dissolves, the final return and closing filings are in closing a company.

State returns, Forms 941 and W-2s, and Forms 3921 for options exercised at closing are still due for the year. Excise tax on parachute payments is withheld through payroll.

Example

Illustrative figures in US dollars.

$40 million stock sale with staff in California and no California filings

A Delaware startup run from New York has had four engineers in California for three years and never registered or filed there. The buyer treats those years as open and holds $300,000 of the price in escrow until the company registers in California, files the back returns and pays what they show.

$5 million asset sale with $8 million of losses

A company sells its assets for $5,000,000; their tax basis is $500,000, so the gain is $4,500,000. The company has no other income or deductions that year, and state tax is ignored. Its $8,000,000 of losses arose after 2017, so they can offset only 80% of taxable income: $3,600,000. Taxable income is $900,000, and tax at 21% is about $189,000. The remaining $4,400,000 of losses stays with the company and is lost when it liquidates; shareholders are then taxed on what it pays out.

A $1.5 million change-in-control bonus

An officer's base amount is $300,000, and the company has preferred stock, so the small business exemption does not apply. Three times the base amount is $900,000, so a $1,500,000 sale bonus is a parachute payment. The excess parachute payment is $1,500,000 − $300,000 = $1,200,000.

• Without a vote: the company cannot deduct $1,200,000, and the officer owes a 20% excise tax of $240,000, withheld from the bonus, on top of income tax.
• With a vote: the officer first waives the bonus unless shareholders approve it. Shareholders holding more than 75% of the voting stock, not counting the officer's shares, approve it before closing after full disclosure. The bonus is then not a parachute payment.

Different for you?

• You want to know your own tax on the cash and buyer stock: taxes when your startup is acquired.
• Part of the price sits in escrow or a holdback: escrow and holdback payments.
• Part of the price is an earnout: earnout payments after a startup sale.
• Sales tax was never charged in states that tax software: catching up on uncollected sales tax.
• Payroll deposits or Forms 941 were missed: behind on payroll taxes.
• Some contractors may be employees: contractors who may be employees.
• A foreign founder and no Form 5472: missed foreign-owner filings and penalties.
• The buyer asks what the losses are worth: net operating losses for startups.
• Shareholders want QSBS on the sale: QSBS for founders and early employees.
• You are raising a round, not selling: tax clean-up before investor due diligence.
• The company sells its assets and returns the cash to investors: returning cash to investors when a startup closes.
• Several findings, missed years or an asset sale with a short closing date: corporate tax services.