Purchase or Sale of a Business

Due Diligence

Whether purchasing an existing business or starting one “from scratch”, there are many risks attendant to the process. Buying an existing business can be a much less risky and a more quickly profitable venture than starting a business from scratch, but depending on how you choose and evaluate an existing business will in all likelihood determine its success. Unfortunately, many people buy businesses based solely upon their gut instinct, without securing an independent appraisal, and without conducting a proper investigation.

The investigation conducted at the outset is not a substitute for an in-depth “Due Diligence” investigation which should be conducted by professionals as part of the purchasing process. For most businesses, we recommend that you review the following as part of your initial review and determination, and that you engage legal counsel before executing any documents, such as a letter of intent or a purchase and sale agreement: 

1.    Financial Statement for 3 to 5 years with have been audited by a Reputable CPA Firm You should not rely on “in house” financials or simple compilations which are not always trustworthy. Obviously, profitable businesses are usually more in demand than unprofitable ones.
2.   Tax Returns for 3 to 5 Years  The financial statements provided should match the tax returns. If adjusted figures are provided to account for excess benefits to owners, be sure the information is accurate and precise. Your accountant should review the financial statements, tax returns, and any adjusted financials. 
3.   Accounts Receivable and Accounts Payable  A careful, albeit skeptical, analysis of the aging of the accounts receivable and accounts payable on an account by account basis should be done. You should know who the customers are and how they are paying their bills, as well as how quickly the business has been paying its vendors after being invoiced. A strong cash flow and good credit are important aspects of running a business. Obviously if there are any liens, lawsuits, or judgments filed against the company, that is another important factor in determining whether the company is just struggling to stay alive, or is well able to stay afloat.
4.   Key Employees  Many businesses have key employees which are critical to the operation. You need to know whether these key people will be staying on board, and what their requirements will be. It is also recommended that you actually examine each employee file to determine their length of employment and payroll history, and other related factors. With respect to sales personnel, there are other issues to contend with, including whether their customers will remain with the company. Finally, if the owner is a key employee, a careful analysis must be made as to whether the owner can be easily replaced. Your attorney will probably recommend that non-competition clauses and various other protections be included in the final agreement.
5.   Other Factors  There are a host of other factors to consider, including the location and appearance of the business, the terms of the premises and equipment leases, signage, intellectual property rights, insurance coverage, the condition and status of the inventory, furniture, fixtures, equipment and leasehold improvements, transferability of licenses, whether there are parking problems, existing security agreements and outstanding loans, the status of banking relationships, credit card facilities, zoning problems, what the competition is doing, and the overall image of the business in the community.
6.   Purchase Price  The purchase price of the business is not something that should be taken lightly. Most businesses can be purchased for less than the asking price, and there should be extensive negotiation regarding the price and terms (including tax aspects). In addition, a professional business appraiser may provide insights into the final valuation. Moreover, to the extent that statements about various positive aspects of the business are made, these should properly be included as warranties in the final purchase and sale agreement. 

7.   Additional Considerations. The sale of a business usually is not a sale of just one asset. Instead, all the assets of the business are sold. Generally, when this occurs, each asset is treated as being sold separately for determining the treatment of gain or loss for tax purposes.

A business usually has many assets. When sold, these assets must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. The sale of capital assets results in capital gain or loss. The sale of real property or depreciable property used in the business and held longer than 1 year results in gain or loss from a section 1231 transaction. The sale of inventory results in ordinary income or loss.

The sale of a trade or business for a lump sum is considered a sale of each individual asset rather than of a single asset. Except for assets exchanged under any nontaxable exchange rules, both the buyer and seller of a business must use the residual method to allocate the consideration to each business asset transferred. This method determines gain or loss from the transfer of each asset and how much of the consideration is for goodwill and certain other intangible property. It also determines the buyer's basis in the business assets.

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Tax Advice Disclosure: To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of: (1) avoiding penalties under the Internal Revenue Code; or (2) promoting, marketing or recommending to another party any matters addressed herein.

The information on this page is intended to give you a basic understanding of some of the considerations in buying or selling a business, but this does not constitute legal advice and it cannot substitute for a thorough review with an attorney who is well versed in these matters. Tax considerations must be discussed with qualified professionals, and the various other aspects of the purchase or sale of a business similarly requires the advice and guidance of knowledgeable and experienced legal professionals.

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