Tax Due Diligence Checklist
LLC Tax Due Diligence Checklist
Tax review items a buyer or seller in an LLC transaction should expect to gather. Items vary based on whether the LLC is a single-member disregarded entity, a partnership for tax, or has elected corporate treatment.
Why a LLC-Specific Checklist
- •An LLC's tax classification (disregarded, partnership, S-Corp, or C-Corp) drives most of what diligence will look for.
- •Capital accounts, member basis, and 754 election history rarely match up cleanly across years and need reconstruction.
- •Single-member LLCs taxed as S-Corps face reasonable compensation review even though they are technically LLCs.
- •State nexus issues (sales tax, franchise tax, CAT) are concentrated in operating businesses and often unaddressed.
The Checklist
Items a buyer or seller in a llc transaction should expect to request, produce, or review.
1. Tax Classification and Election History
Establish how the LLC has been taxed in every year of operation. Mistakes here unwind everything else.
Form 8832 entity classification election history
Original classification, any changes, and the effective dates. Confirm that elections were timely filed and consistent with subsequent return positions.
Form 2553 if S-Corp election made
Date filed, IRS acceptance letter, and confirmation of eligibility (number of members, types of members, single class of equity).
Default classification rules verified
If no election made, confirm SMLLC (disregarded) vs. multi-member (partnership) treatment is supported by member count and timing.
Inadvertent termination history
If LLC has elected S-Corp status, identify any potentially disqualifying events (transfers to ineligible holders, second class of equity issues).
Check-the-box treatment for foreign owners
If any member is non-US, document classification consequences and any foreign reporting (Form 5472).
2. Federal Income Tax Returns and Filings
Form 1065 (partnership) or Schedule C (SMLLC) for last 4-6 years
Complete returns including all schedules, K-1s, and supporting workpapers.
Reconciliation of book to tax
Schedule M-1 / M-3 reconciliations and supporting detail for each year.
Section 754 election history and 743(b) / 734(b) basis adjustments
Date of election, member transfers and distributions that triggered adjustments, and basis allocation schedules by asset.
Section 704(b) capital account schedules by member
Annual capital account roll-forward, distributions, contributions, allocations of income and loss, and 704(c) layers tracked separately.
Section 704(c) layers for contributed property
Property contributed with built-in gain or loss, method elected (traditional, traditional with curative, remedial), and remaining unallocated layer.
Member outside basis schedules
Each member's tax basis in their interest, separately tracked from capital account, with adjustments for guaranteed payments, debt allocations, and distributions.
Allocations of liabilities (recourse, qualified non-recourse, non-recourse)
Section 752 allocations and supporting partner-by-partner debt-share calculations.
Disguised sale review
Contributions paired with distributions within two years, especially leveraged distributions and debt-financed contributions.
Section 707 payments to members
Guaranteed payments, payments for services, payments for property use, and confirmation of consistent character treatment.
3. BBA Partnership Audit Regime
Partnership representative designation
Form 1065 designation of partnership representative for each year, and any changes in designation.
Push-out election history
Any push-out elections under Section 6226 in prior audits and supporting calculations.
Opt-out elections (small partnerships)
If 100 or fewer K-1s and all eligible partners, document any 6221(b) opt-out elections.
Pending or threatened partnership audits
Notices of administrative adjustment, examination correspondence, and final partnership adjustments not yet pushed through.
4. Reasonable Compensation (S-Corp LLCs)
Only applies to LLCs that have elected S-Corp treatment. Reasonable compensation is the most common adjustment in S-Corp examinations.
W-2 history for member-managers
Annual W-2 amounts, distribution amounts, and ratio of compensation to distributions for each year.
Industry comparables and supporting analysis
Documentation supporting that compensation was reasonable for services performed (job description, hours, comparable salary surveys).
Payroll tax filings (Form 941, 940, state UI) for last 4-6 years
All payroll returns, tax deposits, and any reconciliation issues.
Distributions vs. wages historical pattern
Workpaper showing the trend; sharp shifts in ratio often draw IRS attention.
5. State and Local Tax
State income, franchise, and CAT registrations and returns
All states where the LLC has filed, including Michigan CIT/MBT history, by year.
State nexus analysis (income, sales, payroll)
Where customers, employees, contractors, inventory, and assets are located. Compare against state nexus thresholds.
Sales and use tax registrations and returns
Each state where economic nexus thresholds were crossed (post-Wayfair) and registration status. This is the highest-exposure area for most small businesses.
Voluntary disclosure agreement (VDA) history
Any prior or pending VDAs with state tax agencies.
Personal property and Michigan local tax returns
If applicable.
State tax credits claimed (R&D, hiring, investment)
Substantiation files for each credit and confirmation of recapture exposure.
6. Payroll, Worker Classification, and Benefits
Form 941, 940, W-2, and W-3 for last 4-6 years
Reconciled to general ledger payroll expense.
1099-NEC issuance history
Total 1099 spend by year and contractor, with engagement documentation.
Worker classification analysis
Any workers paid as 1099 who arguably should be W-2 (control test, ABC test in applicable states).
Retirement plan compliance
Form 5500 filings, plan documents, top-heavy and nondiscrimination testing if applicable.
Health and welfare benefits compliance
ACA reporting, COBRA, and Section 125 plan documents.
7. Specialty Federal Issues
Employee Retention Credit (ERC) claims
Original claim documentation, supporting wage analysis, government order or revenue test analysis, and any IRS correspondence. Expect heavy scrutiny on any ERC claim.
R&D credit claims
Section 41 documentation, contemporaneous records of qualified research activities, and project-by-project allocation.
Section 199A QBI tracking
Member-by-member computation, SSTB classification, W-2 wages and UBIA tracked through K-1.
Section 163(j) interest expense limitation
Adjusted taxable income calculations and any disallowed interest.
Foreign reporting (Form 8865, 5471, 5472, FBAR)
Any foreign members, foreign subsidiaries, or foreign accounts and corresponding informational filings.
PPP loan forgiveness and accounting treatment
If applicable.
8. Open Tax Matters and Exposure
IRS audits, examinations, and appeals (open and closed last 6 years)
Notices, RARs, closing agreements, and statute extensions.
State tax audits and examinations (open and closed last 6 years)
Including sales tax audits, which are increasingly common.
Tax sharing or allocation agreements among members
Any contractual agreements about how members bear tax cost of allocations.
Pending refund claims
Federal, state, payroll.
Net operating losses and other carryovers
By year, by member, with any limitation history.
Statute of limitations status by tax type and year
Open years, extensions, and any reasons (e.g., omitted income).
Frequently Asked Questions
Why is the LLC tax DD checklist different from a corporation's?
LLCs taxed as partnerships have a fundamentally different tax architecture: capital accounts under Section 704, partner-level basis tracking, allocations of income and loss, and special anti-abuse rules like 707, 752, and 704(c). None of that exists for a corporation. An LLC taxed as an S-Corp uses the corporate framework with some LLC-specific wrinkles. The checklist needs to match the tax classification of the actual entity.
What is a Section 754 election and why does it matter to a buyer?
A 754 election lets a partnership adjust the inside basis of its assets when a partnership interest is transferred or when a partner receives a distribution. For a buyer of partnership interests, a 754 election (combined with Section 743(b)) means the buyer gets a step-up in inside basis for tax depreciation and amortization. Without it, the buyer pays for assets at fair value but cannot fully recover that basis through depreciation. Whether a 754 election was made and is still in effect is a major issue in any partnership interest acquisition.
Do I need this much detail for a small LLC acquisition?
The depth of diligence should match the deal size and the complexity of the target. For a sub-million-dollar acquisition of a simple operating LLC with two members and no foreign or multi-state issues, the scope is much narrower. The full checklist applies more to multi-member LLCs with state operations, retained earnings, and meaningful payroll. The structural questions (classification, capital accounts, basis) apply to any partnership-taxed LLC regardless of size.
What if the LLC's records are a mess and we cannot reconstruct capital accounts?
This is common. Many small LLCs' capital accounts have drifted from K-1 reporting over the years, or were never properly maintained. The buyer's options are usually to require reconstruction at the seller's expense before closing, to structure the transaction as an asset purchase to avoid inheriting the issue, or to escrow part of the purchase price against future tax exposure. Identifying this early is the entire point of running diligence in advance.
How does this checklist apply to a single-member LLC?
An SMLLC is disregarded for federal income tax: the income and expenses flow directly to the owner's return (Schedule C for individuals, or to a parent return). Many of the partnership-specific items do not apply. State franchise/CAT and sales tax items still apply directly to the LLC. If the SMLLC has elected to be taxed as an S-Corp, the S-Corp section applies in full.
Pillar Pages
Sell-Side Tax Due Diligence
For family business owners going to market. Surface and fix tax exposures before a buyer finds them and discounts your price.
Buy-Side Tax Due Diligence
For small businesses growing through acquisition. Understand what you are buying, who carries the exposure, and how to structure the deal.