Every entrepreneur dreams of the day of making it big. But any potential investor or buyer will perform tax due diligence (fancy words for a thorough scrub down of the financials) to determine whether an investment or purchase is advisable. If your taxes aren't in order, you're bound to lose money. In the case of a purchase, tax problems found during due diligence may cause a "haircut" in the purchase price.

Here are a couple of typical tax problem areas that savvy entrepreneurs can address before hitting the streets for an investor or buyer.

Properly Filed Income, Sales, Property, Withholding, and Value-Added Tax Returns

Entrepreneurs who have been totally focused on building sales often neglect to review the myriad of federal, state, local, and international income, sales, property, withholding, and value-added tax requirements. The majority of taxing jurisdictions determine whether there is a tax filing or collections requirement by using the concept of "nexus." In this situation, the following questions are asked.

  • How did the potential taxpayer make the sale to the customer?
  • Did the entrepreneur send employees into the tax jurisdiction to make the sale?
  • Does the entrepreneur have a regular place of business in the location?
  • Does the entrepreneur own inventory or property in the taxing jurisdiction?

Depending on how the above questions are answered,  the entrepreneur may have nexus and may be required to file a tax return, and in most cases, also withhold income taxes from the sale. Failure to do so often results in penalties and interest. If the entrepreneur has not appropriately filed returns and paid the corresponding tax, the price for doing the analysis, filing the returns, and collecting the tax skyrockets and calls into question the entrepreneur's attention to detail.

Proper Classification of Independent Contractors and Employees

Another area where entrepreneurs cut corners in the startup phase is in treating certain potential employees as independent contractors. Although hiring consultants may save money in the short run, if the process is not managed carefully, the cost savings may evaporate if the proper employee classification rules are not followed. Some questions to ask yourself in determining who is a an employee and who is a contractor include the following:

  • Who controls the work product?
  • Who controls the training?
  • Who provides the tools, and who controls them?

Internal Revenue Publication 1779 does a good job of walking the company through the tangled rules regarding this subject.

Knowledgeable Tax Personnel

Up until this point in the company's history, the tax function is typically performed by a lower-level tax person. But potential investors and buyers will be looking for quick and qualified responses to their tax questions. With the increased complexities of public company financial statement reporting requirements, the company should either hire a high-level tax director or outsource the tax function to a qualified accounting firm. The key to finding the right person is to ask about his or her specific experience in your industry and his or her specific experience in working with similar growth companies. If he or she doesn't have the appropriate experience, then you need to broaden your search.

The old adage "An ounce of prevention is worth a pound of cure" is appropriate in all of these scenarios. Savvy entrepreneurs work with their advisers long before the investment or sale occurs to ensure that the entrepreneurs' hard-earned success is maximized.