When you evaluate a business to buy, the tax returns look like the most objective documents in the data room. They were filed with the IRS, signed by a professional, and they match the bank deposits closely enough.
That is exactly why buyers trust them too much.
In the deals we work on, the seller’s tax history is only as good as the person who prepared it. A lot of small business owners picked their CPA on price years ago and never revisited the choice. That preparer did what they were paid to do, which was file on time.
Nobody asked them to build a record that would hold up when a buyer and a lender started asking questions.
This post covers where those cheap CPA problem gaps show up, how long they can follow a business, and what we check during financial due diligence to find them before you sign.
A Compliance-Only CPA Sees Taxable Income, Not The Business
Most low-cost preparers work once a year. They get a trial balance or a box of statements in March, turn it into a return, and move on. That is a legitimate service, but it means the person who knows the seller’s numbers best may never have looked at how the business actually runs.
We have been on deals where the seller’s CPA was asked a simple question: is this business profitable?
The honest answer was that they didn’t know. They only saw taxable income, and taxable income is not cash flow. When you hear an answer like that, it tells you who can and can’t answer your diligence questions.
Map this out early. Ask who prepares the returns, who keeps the books during the year, and who reconciles the accounts. If those are three different people who never talk, expect gaps between them.
That brings up the next question, which is why any of this is your problem once you own the business.
Why Does The CPA’s History Matter To A Buyer?
Because the tax positions the seller took don’t expire when the keys change hands. In a stock purchase, you buy the legal entity, and its open tax years come with it. The IRS generally has 3 years after a return is filed to assess additional tax.
That window stretches to 6 years if the return left out more than 25% of the gross income it reported.
So a shortcut the seller’s preparer took on a return filed before you ever saw the listing can still be examined after you own the company. The seller may owe you under the purchase agreement. You are still the one opening the IRS letter, pulling records, and paying for the response.
We also ask when the current CPA took over and why. When a seller switched preparers, or their longtime CPA retired or passed away, the documentation trail often goes cold at that date.
S-corp election confirmation letters, prior amended returns, and the history of the entity structure may simply be missing. The first thing we check in that gap is payroll.
S-Corp Owners Who Skipped Payroll Leave A Quiet Liability
This is one of the most common findings in small S-corp targets. The owner took distributions for years and ran little or no salary through payroll, and the preparer filed the return anyway.
The IRS is clear that S corporations must pay reasonable compensation to a shareholder-employee before taking non-wage distributions.
When that rule was ignored, there is payroll tax exposure sitting inside the entity. In a stock deal, that exposure is now yours to manage. It also distorts your earnings analysis, because the seller’s profit looks higher than it will once a market-rate operator is on payroll.
Fixing the seller’s past filings is rarely your job, but pricing the risk is. We look at payroll filings against the return and the P&L, and we normalize owner compensation to what the role would actually cost. That adjustment is one of the biggest in most small deals.
Wrong-Period Income Creates Audit Risk For Both Sides
Timing mistakes are easy for a rushed preparer to make and hard for a buyer to spot. We have seen deals where the seller’s CPA reported income on the seller’s final return that technically belonged to the buyer’s period.
The buyer’s first reaction is usually relief, since the tax was already paid. That instinct is wrong. The IRS can still come to the buyer for tax on income that belonged to the buyer’s period, regardless of what the seller filed. The seller would then have to go back and claim a refund, and sorting out a double payment takes time and fees nobody budgeted for.
This matters most around close, when deferred revenue, deposits, and receivables are split between two owners. If the preparer didn’t track which period a dollar belongs to, somebody has to rebuild it.
The next question buyers ask is whether structuring the deal as an asset purchase makes all of this go away.
Does An Asset Deal Protect You From The Seller’s Tax Problems?
Partly. In an asset purchase, the seller keeps the legal entity, and income tax exposure from the seller’s history generally stays with the seller. That is one reason experienced buyers push for asset structure.
Sales tax is different. In the deals we work, sales tax problems outnumber payroll tax problems by a wide margin, and sales tax is the first thing we look at in any asset acquisition. Many states can pursue a buyer of a business’s assets for the seller’s unpaid sales tax. The rules vary by state, so the question needs a state-by-state answer, not a general one.
We covered the mechanics in our post on successor liability when buying a business. The short version is that legal responsibility and practical pain are two different things. Even with good indemnification language, a messy compliance history can create real headaches after close.
Route the legal question to your attorney, and bring the numbers to them early.
Sloppy Fixed Asset Records Skew Your Purchase Price Allocation
In an asset deal, the buyer and the seller both report how the price was split across asset classes. The IRS requires both parties to use Form 8594 when the sale includes goodwill or going concern value. That allocation sets your tax basis in everything you bought.
A low-cost preparer often keeps a depreciation schedule that nobody has cleaned up in years. Equipment that was sold or scrapped is still on the list, and assets that are fully depreciated for tax purposes are still running the business every day. A fully depreciated asset is not worthless. Its tax basis is zero, but what it would sell for is a separate question.
When the schedule is unreliable, more of the price tends to land in goodwill by default. Goodwill is amortized over 15 years for tax purposes, no matter how fast you plan to pay off the deal. That makes the allocation worth negotiating with real numbers.
Getting those numbers starts with the documents you request.
How Do You Find These Problems Before You Sign?
Start before the LOI with the basics. Ask for three years of federal and state returns, the depreciation schedule, payroll filings, and sales tax filings for every state the business sells into. Put the returns next to the P&L and the bank statements and look for gaps.
The red flags are usually visible once you look. Watch for owner pay that jumps around year to year, revenue on the P&L that doesn’t match gross receipts on the return, no sales tax filings in states where the business clearly has customers, and a recent change of preparer with no explanation.
After the LOI, go deeper. That is when you get full bank and credit card statements and do a real reconciliation. The LOI is your permission slip to look under the hood.
If the deal is under a couple of million dollars, a scoped review such as our Quality of Earnings Lite can cover the tax risk without the cost of a full engagement.
Tax Diligence Is A Separate Job From Quality Of Earnings
A quality of earnings report tests whether the seller’s earnings are real and repeatable. Tax diligence asks a different question: what the business owes, or might owe, that isn’t on the balance sheet yet. They use different skills and a different risk lens.
On many deals, a QoE provider is already engaged, and tax gets carved out entirely. Make sure someone owns it. If your provider isn’t looking at sales tax, payroll filings, and the seller’s open tax years, nobody is.
This is where the cheap CPA problem gets solved. It isn’t about criticizing the seller’s accountant. It is about knowing exactly what their choices left behind, so you can price it, negotiate it, or walk away.
If you’re working through a deal right now, our buy-side due diligence checklist walks through every document to request.
When you want a second set of eyes on a seller’s tax history, reach out to Ashford Sky.
We work with acquisition entrepreneurs on buy-side diligence and tax services before and after close, and we would much rather help you find these issues before the LOI than after.
Until next time.
