DUE DILIGENCE GUIDE (SAMPLE) COMPANY XYZ, INC. FOR THE YEARS ENDED DECEMBER 31, -

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1 DUE DILIGENCE GUIDE (SAMPLE) COMPANY XYZ, INC. FOR THE YEARS ENDED DECEMBER 31, - I. BUSINESS OVERVIEW II. III. A. Obtain business background (possible sources) 1. SEC Filings a) 10K Filings b) 10Q Filings c) Other SEC Filings 2. Prior audited financials 3. Internal financials 4. Annual reports 5. Company brochures 6. Dunn & Bradstreet reports 7. Seller s Internet website 8. Purchase agreement 9. External merger & acquisition memorandum 10. Current organization chart 11. List of facility locations (owned, leased and rented) 12. Job descriptions for multistate employees 13. Travel logs/summaries for transportation equipment 14. List of states where company is qualified to do business 15. Identify intangible holding companies, financing companies, procurement companies, or other special purpose affiliates FASB 5/ACS 450, ACCOUNTING FOR CONTINGENCIES A. Rules for recording loss contingencies 1. It is more likely that not that a liability has been incurred at the date of the financial statements 2. And the amount of the loss can be reasonably estimated B. Disclosure may be required even where a loss contingency is not recorded C. Review work papers supporting FASB 5/ASC 450 analysis ACQUISITION STRUCTURE & TRANSACTION ISSUES A. Is the acquisition a taxable or nontaxable transaction for federal and state income tax purposes? Sales and use tax purposes? B. Is the acquisition a purchase of equity interests or assets? C. Should a Newco or existing company acquire the equity interests or assets? 1. Tax base implications 2. Apportionment factor implications Page 1 of 12

2 IV. 3. Nexus implications 4. Use of C corporation, general or limited partnership, limited liability company D. Can Alternative structure be used? 1. Limited liability company 2. Limited liability partnership 3. Partnership (general or limited) 4. S corporation E. Structuring of acquisition debt and related interest expense F. Implications of Internal Revenue Code ( IRC ) 338 or 338(h)(10) election G. Transaction Taxes on acquisition 1. Real estate transfer taxes 2. Sales and use taxes 3. Document recording fees or taxes H. Carry overs of tax attributes NEXUS EVALUATION A. Returns filed in all state and local taxing jurisdictions B. Sales (taxable and exempt) by taxing jurisdiction C. Personal property owned, rented or leased 1. List of locations and activities at each location 2. Personal property tax filings 3. For vehicles, travel logs/summaries D. Real property owned, rented or leased 1. Real property tax filings E. Business or occupational license filings F. Regulatory licenses or fees G. Employees 1. Job descriptions of interstate employees 2. Travel logs/summaries H. Agents and Independent representatives 1. Scope of engagement 2. Travel logs/summaries I. State employment tax filings J. Personnel activities and duties of employees, independent representatives and agents K. Sales tax registration accurate L. State tax filings consistent (payroll, property, income and franchise) Page 2 of 12

3 M. Negotiated filing agreements N. Managed audit agreements O. Letter rulings P. Voluntary disclosure agreements Q. Interests in general or limited partnership R. Interests in single-member or multi-member limited liability companies 1. Manager-managed limited liability companies 2. Member-managed limited liability companies S. Licensing of intangibles and filings in Geoffrey states T. Recently-completed state or local nexus questionnaires U. Cloud computing and similar agreements for access to software, data and data processing V. Location of computer servers and software W. Locations of computer software users V. SALES AND USE TAXES A. Obtain sales tax return filings and sales tax audit history for both state and local level sales/use taxes 1. Sales tax filing calendar 2. Open sales and use tax permits/registrations 3. Sales tax returns (open periods) 4. Audit history 5. Audit files 6. Open audits (audit periods) 7. Open refund claims 8. Open contingency agreements 9. Open waivers 10. Audit appointments scheduled 11. Direct payment permits held 12. Special filing agreements 13. Managed audit agreements 14. Voluntary negotiation agreements (open or closed) 15. State correspondence (rulings, filing invitations and inquiries, nexus questionnaires) 16. Sales tax credits 17. Reserve documentation 18. Sales tax collection and remittance policies and procedures 19. Use tax accrual policies and procedures 20. Exemption certificate policies and procedures B. Inquire about 1. Products and services sold, rented, leased or provided 2. Invoicing methods 3. Copies of sample customer invoices 4. Return and refund policies Page 3 of 12

4 5. Bad debt policies 6. Bad debt carry forwards 7. Discount policies 8. Resale certification policies (issuance and receipt) 9. Record retention policies 10. Reserve policies 11. Accrual policies 12. Workflow for sales/use tax system 13. Sales/use tax manuals, taxability matrix or similar resources 14. Sales/use tax personnel 15. Sales/use tax controls for compliance 16. Warranties offered 17. Sample and promotion policies 18. Repair policies 19. Maintenance agreements 20. Policies and procedures for adding customer information 21. Vendor selection policies C. Testing 1. Sales a) Exemptions b) Exemption documentation c) Sample selection d) Error calculation e) Extrapolation techniques f) Assumptions 2. Purchases a) Asset acquisition b) Supply purchases (purchase cards) c) Resale materials d) Direct pay permits e) Compliance with negotiated agreements f) Accruals g) Sample selection h) Error calculation i) Extrapolation techniques j) Assumptions 3. Capital Assets a) Sales b) Transfers (intercompany and otherwise) c) Gifts d) Donations e) Business restructuring Page 4 of 12

5 VI. 4. Leasing Activities D. Closing Items a) Intercompany transactions b) Leasing Subsidiaries c) Procurement subsidiaries d) Transportation subsidiaries 1. Transaction-Specific exclusion/exemption certificates and documentation (e.g. resale certificate, casual sale certificate, manufacturing machinery and equipment exemption certificate, research and development exemption certificate) 2. Bulk Sale Requirements a) Notification b) Tax clearance certificates c) Old permits d) New permits e) Permit consolidation f) Resale/exemption certificates g) Final returns 3. Record retention a) Location of and access to documents b) Master lists and indexes c) Destruction dates under document retention policies d) Computer programs INCOME/FRANCHISE TAXES A. Issues to evaluate (1) Computer program licenses and user agreements (2) Computer program documentation 1. Cumulative apportionment percentage 2. Determination of business and non-business income items 3. Expenses related to non-business income items 4. Computation of apportionment factor numerators and denominators and supporting documentation 5. Use of correct apportionment formulas 6. Sourcing of property, payroll and sales 7. Alternative apportionment formulas a) Requested by seller b) Required by taxing authority 8. Filing methodologies 9. Unitary business group composition 10. Computation of franchise tax base Page 5 of 12

6 11. Computation of franchise tax apportionment formula 12. Identify intercompany transactions 13. Computation of state net operating losses (and loss carry over schedules) 14. Disposition of material assets (or divisions) 15. Federal deferred intercompany transactions 16. Federal consolidated return issues/adjustments 17. Reserve analysis (FIN 48/ASC 450) 18. State tax planning strategies implemented and related documentation B. Document Request 1. Federal income tax returns for all open years 2. State and local income/franchise tax returns for all open years 3. Supporting schedules and work papers for computation of property, payroll, sales/receipts and any other factors for apportionment formulas 4. Sales throwback information 5. Sales throw out information 6. List of income/franchise tax liabilities by state and local jurisdiction 7. Net operating loss carry over schedules by state 8. List of open audits identifying jurisdiction, audit periods, issues, status and amounts 9. List of open refund claims 10. List of closed audits identifying jurisdiction, audit periods, issues, status and tax amounts 11. Copies of federal, state and local waivers of statute of limitations/prescriptive periods 12. Copy of accrual review workpapers (including reserve analysis) 13. Copies of income/franchise state tax calendars C. Discussion Issues 1. Business/Non-business Income a) Identify material non-business income items b) Is contemporaneous documentation of factual support and analysis of law available? 2. Apportionment a) Composition of sales/receipts factors (e.g., interest, dividends, net gain from sales of assets, proceeds from sales of assets, commissions, service income, etc.) b) Sourcing of sales/receipts (1) Sales of inventory by destination, by origination, or other Page 6 of 12

7 (2) Service income by location of services, location of benefit, billing address, or other (3) Income from intangibles - commercial domicile, legal domicile, location of intangibles, or other (4) Net gain from the sale of a division or company by location of tangible assets, commercial domicile, legal domicile or other (5) Throw back sales - What is the treatment of U.S. government sales, foreign country sales, out of state sales c) Property valuation (original cost or net book value) d) Capitalization of rented property e) Sourcing of movable property f) Sourcing of payroll g) Payroll sourcing where a common paymaster is utilized h) Special or alternative apportionment formulas i) Apportionment/Allocation of income and losses from general and limited partnership interests j) Apportionment/Allocation of income and losses from limited liability companies 3. Addition and Subtraction Adjustments to Federal Taxable Income a) What addition modifications were taken on the returns? b) What subtraction modifications were taken on the returns? c) Are intercompany transactions on an arms-length basis? d) Dividend received deduction results e) Is the company claiming exemption from any state interest or intangible expense add-back provisions? (1) Obtain documentation 4. Unitary Business Issues a) Where is the company filing unitary returns? b) Which companies are included in the unitary group? c) Is contemporaneous documentation of factual support and analysis of law available? d) Do any states require worldwide combined reporting? e) List of states where the company has made water s edge elections f) Have the water s edge elections been properly made? g) Have any other return-filing methodology elections been made? 5. State Net Operating Losses a) Are detailed net operating loss carry over schedules available showing years losses were incurred and years losses were carried forward or carried back? Page 7 of 12

8 b) Are the state carry forward and carry back periods the same as federal? (1) If not, has the company conformed to the state carry forward and carry back periods and made any necessary state elections (if required)? 6. Deferred Intercompany Transactions a) Identify existing deferred intercompany transactions under the federal consolidated return rules b) How and when have the deferred intercompany transactions been recognized for state and local tax purposes in separate company jurisdictions? 7. Asset Dispositions a) Has the company disposed of significant assets, divisions or companies in the past? b) How was the calculation of state gain/loss performed (federal versus state basis)? c) Was the gain/loss treated as business or non-business income? d) If business income, how was the gain/loss included in the apportionment factor? e) If non-business income, is contemporaneous documentation of factual support and analysis of the law available? 8. Audit History a) Discuss status of current income/franchise tax audits, appeals, and refund claims b) Review auditor reports and work papers and client responses and protests c) Is the company taking questionable or aggressive filing positions? d) Does the company have contemporaneous documentary support for questionable or aggressive filing positions? e) What are the issues and related tax exposure (or refund opportunities) for current audits? f) Discuss closed state income/franchise tax audits g) Is the company filing consistent with closed audits? h) Are there any pending federal audits or reports of federal audit changes due? 9. Franchise Taxes a) Are the proper items included in the franchise tax base (e.g., capital stock, retained earnings, long-term debt, intercompany debt, reserves, etc.)? Page 8 of 12

9 VII. EMPLOYMENT TAXES b) Are investment in subsidiaries accounted for under the cost or equity method? c) Is a deduction for investment in subsidiaries available? d) Has the apportionment factor been properly calculated? A. Compliance Considerations 1. Registration for new state and local income tax withholding accounts and new state unemployment tax accounts 2. Review requirements for status updates to state workforce agencies related to transfers of employees, unemployment experience, and common control provisions 3. Determine all accounts (active and inactive) a) Consider closure of inactive state and local withholding accounts and state unemployment tax accounts 4. Return/report filing calendar 5. Federal compliance relative to transaction a) Standard procedure Form W-2 filed by both seller and buyer for respective wages paid b) Alternative procedure Single Form W-2 is issued by successor entity for the entire year that includes the closing date and requires reconciliations 6. Are federal FICA and FUTA wage bases continued? Are successor rules satisfied? 7. State and Local compliance issues B. Document Requests a) Review registration and status of all state and local income tax withholding tax and state unemployment insurance tax accounts b) Review and file any required state unemployment insurance tax experience transfer rules and/or applications c) Close any inactive state and local income tax withholding and state unemployment insurance accounts 1. Federal, state and local income tax withholding returns and state unemployment tax returns for all open years 2. Federal, state and local tax notices 3. State unemployment tax rates 4. State unemployment experience rating information 5. Supporting schedules and work papers for returns/reports 6. List of liabilities by federal, state and local jurisdiction 7. List of open audits/reviews identifying jurisdiction, audit periods, issues, status and amounts Page 9 of 12

10 VIII. 8. List of open refund claims 9. List of closed audits identifying jurisdiction, audit periods, issues, status and tax amounts 10. Copies of federal, state and local waivers of statute of limitations/prescriptive periods 11. Copies of federal, state and local tax filing calendars 12. Payroll policies and procedures C. Audit History 1. Discuss status of current federal, state and local withholding tax and state unemployment tax audits, appeals, and refund claims 2. Review auditor reports and work papers and client responses and protests 3. Is the company taking questionable or aggressive filing positions? 4. Does the company have contemporaneous documentary support for questionable or aggressive filing positions? 5. What are the issues and related exposure (or refund opportunities) for current audits? 6. Discuss closed audits 7. Is the company filing consistent with closed audits? D. Closing and Post-Closing Issues 1. Determine reporting requirements by jurisdiction relative to change of ownership, officers, etc. MISCELLANEOUS (BUT IMPORTANT!!!) A. Entity Organizational Documents 1. Review current organizational chart of entities to be acquired or otherwise involved in the transaction 2. Review all entity organization documents and entity governance documents for all entities involved in the transaction 3. Review provisions addressing federal partnership audit issues B. Unclaimed Property 1. Generally, treat much like sales/use taxes (see above) 2. Document Request a) Unclaimed property reports for all open years b) Supporting schedules and work papers for reports c) List of audits (open and closed) and potential liabilities by jurisdiction 3. Audit History a) Discuss status of current audits and appeals b) Review audit reports and work papers and client responses and protests Page 10 of 12

11 c) Is the company taking questionable or aggressive reporting positions? d) Does the company have contemporaneous documentary support for questionable or aggressive reporting positions? e) What are the issues and related exposure for current audits? f) Discuss closed state unclaimed property audits g) Is the company filing consistent with closed audits? C. Regulatory Licenses 1. Obtain listing of all regulatory licenses 2. Determine status of all regulatory licenses IX. 3. Determine whether regulatory licenses are transferable a) If so, identify all necessary documents and procedures necessary to transfer regulatory licenses 4. Prior to closing a) Cancel all non-transferable regulatory licenses b) Obtain all required new regulatory licenses 5. At closing a) Obtain all transferable regulatory licenses and related documentation b) Take all steps necessary to transfer regulator licenses D. Business and Tax Incentives 1. Identify all business and tax incentive agreements 2. Determine status of all such agreements and requirements for maintaining incentives 3. Analyze all claw back provisions (triggers and consequences) 4. Determine whether business and tax incentive agreements are transferable a) If so, identify all necessary documents and procedures necessary to transfer agreements b) Provide for transfers of incentives at closing DUE DILIGENCE MEMORANDUM A. Components 1. Executive summary 2. Business background 3. Areas review 4. Personnel interviewed 5. Documents reviewed 6. Documents not reviewed or otherwise unavailable Page 11 of 12

12 7. Assumptions 8. Testing procedures utilized 9. Reserve calculation 10. Filing adequacy 11. Audit information 12. Material open items 13. Compliance adequacy Page 12 of 12