Buyers of businesses generally prefer to arrange for an asset purchase transaction instead of purchasing an ownership interest in the target business entity. Why? The primary reason is to avoid exposure to liabilities — both known and unknown — related to the business that’s being acquired. However, liability avoidance can’t be assured unless the seller complies with the applicable bulk sales law.

The level of diligence differs depending on whether you’ll purchase the entity’s assets in bulk or whether you’ll buy an ownership interest in the target business. On the other hand, if you buy an ownership interest in the target business, the bulk sale law doesn’t apply, but other due diligence procedures may be appropriate. Here’s a primer on fundamental due diligence issues if you’re considering buying a business.

Asset Purchases

There are two main due diligence concerns when purchasing an entity’s assets. The first is compliance with so-called “bulk sale” laws. Various federal and state laws have been enacted to protect the interests of creditors and ensure the collection of sales taxes when most or all of the assets of a business are transferred in a bulk sale to a new owner (the buyer).  

If the seller is a state-law legal entity — a corporation, partnership, or limited liability company (LLC), including one that’s treated as a partnership for tax purposes — it might liquidate shortly after the asset sale. Upon liquidation, the entity would distribute the sales proceeds, and anything else left on the books to the owner or owners. At that point, there’s nothing left for the entity’s creditors to pursue if they haven’t been paid. Credit protection laws require sellers to give creditors notice of asset sales to prevent this outcome.

The seller and the buyer of business assets in a bulk sale may have to notify state taxing authorities to ensure that applicable sales taxes are paid. The buyer may be required to withhold some of the purchase prices until the sales tax due has been determined. If the applicable bulk sale laws aren’t complied with, creditors and sales tax collectors can “follow the assets” to the buyer (the new owner) and make claims against the buyer.

The second due diligence issue for asset sales is conducting a Uniform Commercial Code (UCC) filing search. This search should be done under:

• The official name of the target business,
• All other names used by the target business, such as “doing business as” (DBA) names, and
• The names of the principal owner(s) and officer(s) of the target business.

A UCC search aims to uncover security interests granted with respect to any assets you’re buying. Examples include leases or loans secured by equipment that you’re buying.

Ownership Interest Purchases

Due diligence procedures are particularly important when purchasing an ownership interest in an entity. The term “ownership interest” refers to stock for a corporation, a partnership interest for a partnership, or a membership interest for an LLC, including an LLC that’s treated as a partnership for tax purposes.

If you arrange to buy an ownership interest (or interests) in the legal entity used to conduct the target business, focus on protecting yourself from liability exposure. That’s because when you purchase an ownership interest, the liabilities generally remain “inside” the entity and become the new owner’s problem.

Similar to the due diligence required for an asset sale, buyers of ownership interests must conduct a detailed UCC filing search to uncover security interests that have been granted with respect to any assets of the target business entity.

In addition, buyers should consider the following supplemental due diligence procedures to uncover liabilities that may be undisclosed or understated on the balance sheet of the target business entity:

Public Records Search

Inspect local court records to identify undisclosed liens or judgments against the target business or the existence of current or past litigation against the business, its owner(s), or its officer(s).

Examination of tax Returns

Review the target business entity’s income, payroll, property, sales, use and excise tax returns for several years to identify any exposure to underpaid taxes due to aggressive tax positions. Examples of tax issues that may be uncovered include:

• Whether workers that have been treated as independent contractors should have been classified as employees, with related unpaid federal employment taxes that will become an issue if the business is audited,
• In the case of a target S corporation, whether all applicable federal income tax rules that allow S corporation status has been complied with,
• In the case of a target C corporation, whether past tax returns understated tax liabilities, and
• In the case of a target C or S corporation, whether reasonable compensation has been paid in the past to shareholder-employees.    

Review of Insurance Policy Loss Payable Endorsements

When insured assets are used as security for borrowings, this will usually appear as a loss payable endorsement on insurance policy declarations pages. Examine these documents to uncover loss payable endorsements that direct the insurance company to pay all or part of the insurance proceeds to a lender if the insured asset is damaged or destroyed.

It’s also essential to check for the existence of miscellaneous liabilities, such as

• Liabilities under contractual arrangements (for example, employment contracts, leases, maintenance agreements, and warranties),
• Long-term contracts with significant customers or suppliers with terms that are unprofitable or unfavorable to you as the buyer,
• Obligations under royalty or licensing agreements,
• Environmental liabilities, and
• Contingent liabilities due to patent or trademark infringement litigation, employee or product liability lawsuits.

For added protection against liability claims, buyers should obtain a general representation by the seller that there are no undisclosed liabilities associated with the target business entity or its assets. This statement can help protect against fraud and misrepresentation by the seller.

Buyer Beware

Business buyers need to protect themselves against business-related liabilities — including those that are understated or undisclosed. The specific due diligence procedures depending on how the deal is structured and the nature of the target entity’s operations. Consult a business attorney to guide you through the legal aspects of the due diligence process. Then hire a tax pro to review tax returns filed by the target business and suggest tax-smart ways to structure the purchase transaction.