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by Jacob Orosz (President of Morgan & Westfield)
Executive Summary
Sometimes we find it amazing that deals get done at all, what with so many aspects of a transaction that have to be worked out and agreed to by both parties.
Here’s one that often flies under the radar until very late in the process: allocation of the purchase price.
See AlsoWhat's in Your Portfolio? The Role of Various Asset ClassesAllocating the Sales Price of Assets under the Residual Method5 Golden Rules To Create Your Asset Allocation PlanAllocating the purchase price, or total sale price, of a business among the various assets of the business (asset “classes”) is necessary for tax purposes when a business is sold. This is the case regardless of whether the sale is structured as a stock sale or an asset sale.
Frequently, the allocation of the purchase price can become another area of negotiation after the price, terms, and conditions of the sale have been agreed upon. In most cases, what is good for the seller is bad for the buyer, and vice versa, which can lead to contentious negotiations.
In the end, it’s crucial that both you and the buyer compromise and meet somewhere in the middle to satisfy your respective goals. Once again, an agreement is required because both of your allocations must match and be entered on the IRS form.
Unfortunately, business transactions have been known to come to a halt because a buyer and seller cannot reach an agreement about an allocation of the purchase price. This is more likely to happen when the negotiations have been overwhelming and strenuous. The allocation of purchase price sometimes becomes the final straw causing a buyer and seller to abandon the transaction.
We explore the following questions in this article:
- What is the allocation of purchase price?
- What is the purpose of the allocation?
- Is the allocation of the price legally required?
- Do the buyer’s and seller’s allocations have to match?
- Are allocations different for stock vs. asset sales?
- What are common allocations for some transactions?
- What are the tax implications for different allocations?
- What can the seller do to minimize their tax implications?
Don’t get blind-sided by what is an afterthought until the very end in many negotiated transactions. Arming yourself with the information in this article will help ensure that you don’t.
Why is the Allocation of Purchase Price Necessary?
Before the closing can take place, you and the buyer must agree on how the purchase price is allocated. This is known as the allocation of purchase price.
Both the seller and the buyer are required by law to file Form 8594 with the IRS. IRS Form 8594 requires that both parties allocate the purchase price among the various assets of the business being purchased so the seller can calculate the taxes due upon the sale and the buyer can calculate the new basis in the assets.
This form must be filed with each of your tax returns at the end of the year, and most tax advisors agree that the allocations should match on both the buyer’s and the seller’s designated forms. While there is no legal requirement that the buyer’s and seller’s allocations match, most tax advisors agree that a match will decrease the chances of an audit.
What is the Purpose of IRS Form 8594?
IRS Form 8594 breaks down the assets of the business being purchased or sold into seven classes or categories. Each type of asset is treated differently for tax purposes. It’s important that you carefully consider how you will classify each individual asset, as it can have significant tax and financial implications for both you and the buyer.
Specific allocations are referenced on the IRS form and are broken down as follows:
- Class I: Cash and Bank Deposits
- Class II: Securities, including Actively Traded Personal Property and certificates of Deposit
- Class III: Accounts Receivables
- Class IV: Stock in Trade (Inventory)
- Class V: Other Tangible Property, including Furniture, Fixtures, Vehicles, etc.
- Class VI: Intangibles (Including Covenant Not to Compete)
- Class VII: Goodwill of a Going Concern
The seller usually seeks to maximize amounts allocated to assets that will result in capital gains tax while minimizing amounts allocated to assets that will result in ordinary income taxes.
Stock Versus Asset Sales
Where stock sales are concerned, the majority of the purchase price is normally allocated to the value of the stock, with the remainder being allocated to the value of any non-competition agreements, consulting agreements, or any other assets that are personally owned by the seller and not the entity.
In a stock sale, the buyer doesn’t receive a step-up in basis and inherits the seller’s existing basis in the assets. Most buyers prefer not to structure the transaction as a stock sale because they lose the tax benefit of being able to depreciate the assets. Most assets are fully depreciated, so the buyer has little depreciation to reduce the income taxes that may be due in the business.
For sellers, a stock sale is advantageous because the seller must pay capital gains tax on stocks held for more than one year.
This is one of the reasons that asset sales dominate smaller business sales — because the buyer can deduct (depreciate) the cost of the assets they acquire in the near term, which reduces the buyer’s income taxes. On the other hand, with stock sales, there are no immediate tax benefits to buyers concerning stock purchases.
Common Allocations
Class I: Cash and Bank Deposits
- Allocation: None.
- These assets are not normally included in the purchase. If they are included, they are listed at face value.
Class II: Securities, including Actively Traded Personal Property and certificates of Deposit
- Allocation: None.
- These assets are not normally included in the purchase. If they are included, they are listed at face value.
Class III: Accounts Receivables
- Allocation: None.
- These assets are not normally included in the purchase. The seller normally retains ownership of the accounts receivable as of the closing date, and the buyer receives the outstanding payments and remits them to the seller post-closing.
Class IV: Stock in Trade (Inventory)
- Allocation: Normally valued at the seller’s original cost.
- As a result, there is no gain for the seller and, therefore, no tax due on the amount allocated to this asset.
Class V: Other Tangible Property, including Furniture, Fixtures, Vehicles, etc.
- Allocation: Normally valued at current market value, often “replacement value.” Note that the buyer may have to pay sales tax on the amount of allocation to this class of assets.
- Any gain on the sale of tangible property is taxed based on ordinary income rates to the seller, and the buyer can begin to depreciate these assets based on their stepped-up value.
Class VI: Intangibles (Including Covenant Not to Compete)
- Allocation: Normally less than a few percentage points of the purchase price.
- The seller must pay ordinary income taxes or capital gains taxes based on the amount allocated to intangible assets depending on whether the non-compete is considered compensatory or capital.
Class VII: Goodwill of a Going Concern
- Allocation: The balance of the purchase price is normally allocated to goodwill.
- Goodwill is treated at capital gains tax rates for the seller, and the buyer can amortize goodwill over a 15-year period.
Once the parties agree to the allocation, the allocation is usually attached as a Schedule to the definitive purchase agreement (DPA) and signed at closing. The parties then file IRS 8594 at year-end, ensuring that IRS 8594 matches the allocation provided in the definitive purchase agreement.
Additional Tips for Allocating the Price
Avoid placing a value on the hard assets of the business in the early stages of the transaction, such as in the confidential information memorandum (CIM) or even during due diligence.
For example, a buyer may innocently ask, “What is the worth of the hard assets, such as your equipment?” If you inflate the value, the buyer may later use this against you and argue that the value you provided should also be used for determining the allocation of the purchase price.
And don’t be ashamed about giving the buyer a low or realistic value of your hard assets — remember, you are selling an income stream, not hard assets.
Conclusion
You and the buyer will each have a unique perspective when it comes to the allocation of the purchase price. Each allocation category will have a different effect on you and the buyer.
It’s important to give the allocations careful consideration because these differences can amount to significant tax and financial repercussions for you. You need to weigh the advantages and disadvantages of each allocation because it ultimately affects your bottom line.
