Legal Diligence on Company Tax Issues

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Updated August 29, 2023
Angel Investing

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Most people procrastinate on their taxes. Entrepreneurs are busier than most of us, building a company and a product and hiring and selling and raising money. With a small team, there may be no one focused on finances and accounting and taxes. Entrepreneurs tend to focus on how much cash they have and how quickly they are burning through it.

caution That said, you don’t want a big chunk of your investment going to pay taxes owed. Even if the company has no revenue, it may still need to file tax returns; and even if it is not making a profit, sales and payroll taxes still accrue.

founderWe discuss the various corporate forms (C-corp, S-corp, LLC) and the tax implications in detail (you can also visit Appendix B for further information on the differences between these entities, which will be helpful for founders). You can check in the public record whether a company has tax liens filed against it (or any other lawsuits). But here are the general tax issues to look into as part of your legal due diligence:

  • Section 83(b) elections. The founders should have given the company copies of their filed elections.

  • Federal tax returns. If a company forms a state law corporation, they have a federal tax return filing obligation that first year, regardless of whether they have any income. This is the same with a multi-member LLC. There are penalties for failure to file. Make sure you know: What is the tax status of the company? C corporation? S corporation? Limited liability company taxed as a partnership? Limited liability company taxed as an S corporation?

  • State income taxes. In what state(s) does the company pay income tax?

  • State sales taxes. With respect to which states does the company collect and remit sales tax? (Failure to collect and remit sales taxes can add up to a large liability in a short period of time, and it is not uncommon for companies to fall out of compliance with sales tax collect and remit requirements.)

  • Payroll taxes. Payroll taxes in general are worth digging into. Does the company use a payroll service so that you can feel assured that employment tax withholding has been taken care of? Payroll taxes are especially scary because directors and officers can be personally responsible for them in certain circumstances. If they are not doing so already, insist that the company use ADP or a similar service for payroll.

exampleA company did not hire a payroll service provider that would have refused to process payroll unless the company gave them sufficient cash to pay the income and employment tax withholding to the IRS. Instead, the company was trying to process its own payroll. The CEO did not remit to the IRS the amounts of the income and employment tax withholding the company was required to remit by law. The board had to fire the CEO, and the company ultimately failed from this financial setback.

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