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Allocation of Purchase Price & Taxes When Selling a Business

It’s truly remarkable how deals come together, considering the multitude of factors that must align and gain consensus between parties involved.

One aspect often overlooked until the eleventh hour is the allocation of the purchase price.

When selling a business, it’s imperative to allocate the purchase price, or the total sale value, across the different assets (referred to as asset “classes”) for tax purposes. This holds true whether the transaction is structured as a stock sale or an asset sale.

Surprisingly, the allocation of the purchase price can become a contentious matter even after agreeing on the sale price, terms, and conditions. Typically, what benefits the seller may not be in the buyer’s best interest, and vice versa, leading to challenging negotiations.

Ultimately, finding a compromise that satisfies both parties’ goals is crucial. An agreement is mandatory because both your allocations must align and be reported on the IRS form.

Regrettably, business transactions have been known to grind to a halt due to disagreements over the allocation of the purchase price. This is more likely when negotiations have been intense and strenuous. Sometimes, the allocation becomes the final sticking point that derails the entire deal.

In this article, we will address the following key questions:

  • What exactly is the allocation of the purchase price?
  • What is the purpose behind this allocation?
  • Is it a legal requirement?
  • Must the buyer’s and seller’s allocations match?
  • Are there differences in allocation for stock sales versus asset sales?
  • What are some common allocation scenarios in various transactions?
  • What are the tax implications associated with different allocation strategies?
  • How can the seller minimize their tax liabilities?

Don’t let the allocation of the purchase price catch you off guard; it’s a critical consideration often pushed to the background until the final stages of negotiation. Equipping yourself with the insights from this article will ensure you’re well-prepared.

Why is the Allocation of Purchase Price Necessary?

Prior to the closing of the deal, it’s essential for both you and the buyer to reach an agreement regarding the allocation of the purchase price, a process commonly referred to as “purchase price allocation.

According to IRS regulations, both the seller and the buyer are obliged to complete and file Form 8594. This form mandates that both parties assign the purchase price among the different assets of the business being transferred. This allocation serves two crucial purposes: it enables the seller to calculate the taxes owed upon the sale and allows the buyer to determine the new basis in the acquired assets.

It’s important to note that Form 8594 must accompany your respective tax returns at the end of the year. While there’s no legal requirement for the buyer’s and seller’s allocations to match precisely, it’s widely recommended by tax advisors. Aligning these allocations not only ensures compliance but also reduces the likelihood of triggering an IRS audit.

What is the Purpose of IRS Form 8594?

IRS Form 8594 plays a pivotal role in dissecting the assets within a business undergoing a purchase or sale, categorizing them into seven distinct classes. Each asset class carries unique tax implications that demand careful consideration, given their potential financial significance for both you and the buyer.

These specific asset allocations, as detailed on the IRS form, are structured as follows:

  • Class I: Cash and Bank Deposits
  • Class II: Securities, encompassing Actively Traded Personal Property & Certificates of Deposit
  • Class III: Accounts Receivables
  • Class IV: Stock in Trade (Inventory)
  • Class V: Other Tangible Property, which includes Furniture, Fixtures, Vehicles, and more
  • Class VI: Intangibles, encompassing Covenants Not to Compete
  • Class VII: Goodwill of a Going Concern

It’s important to note that sellers typically aim to maximize allocations to assets that incur capital gains taxes while minimizing allocations to assets subject to ordinary income taxes. This strategic approach can significantly impact the financial outcomes of the transaction.

Stock Versus Asset Sales

In the realm of stock sales, the lion’s share of the purchase price typically finds its allocation within the stock’s value itself. The remaining portion is earmarked for assets that fall outside the entity’s ownership, such as non-competition agreements, consulting agreements, or any assets personally possessed by the seller.

In the context of a stock sale, the buyer doesn’t experience a step-up in basis and essentially inherits the seller’s existing basis in the assets. It’s worth noting that most buyers tend to shy away from structuring deals as stock sales because they forfeit the tax advantage of depreciating the acquired assets. Since many assets are already fully depreciated, the buyer gains little room for offsetting potential income tax liabilities within the business.

For sellers, however, a stock sale carries its own benefits, particularly when it comes to capital gains tax. Sellers are liable for capital gains tax on stocks held for over a year.

This difference in tax treatment is one of the driving forces behind the prevalence of asset sales in smaller business transactions. In an asset sale, buyers can swiftly deduct (depreciate) the cost of the acquired assets in the short term, offering a tangible reduction in their income tax burdens. In contrast, stock sales do not grant immediate tax advantages to buyers in terms of stock acquisitions.

Common Allocations

Asset Class I: Cash and Bank Deposits

  • Allocation: Typically none.
  • These assets are typically excluded from the purchase. If included, they are typically listed at their face value.

Asset Class II: Securities, including Actively Traded Personal Property & Certificates of Deposit

  • Allocation: Typically none.
  • These assets are usually not part of the purchase. In cases where they are included, they are typically reported at their face value.

Asset Class III: Accounts Receivables

  • Allocation: Typically none.
  • Accounts receivables are usually retained by the seller as of the closing date, with the buyer responsible for collecting outstanding payments and remitting them to the seller post-closing.

Asset Class IV: Stock in Trade (Inventory)

  • Allocation: Normally assessed at the seller’s original cost.
  • As a result, there is usually no gain for the seller, and consequently, no tax liability on the portion allocated to this asset.

Asset Class V: Other Tangible Property, including Furniture, Fixtures, Vehicles, etc.

  • Allocation: Typically assessed at the current market value, often referred to as “replacement value.” It’s important to note that the buyer may be liable for sales tax on the allocated amount within this asset class.
  • Any gains from the sale of tangible property are subject to taxation at the seller’s ordinary income rates. The buyer, on the other hand, can commence depreciation based on the stepped-up value of these assets.

Asset Class VI: Intangibles (Including Covenant Not to Compete)

  • Allocation: Usually accounts for less than a few percentage points of the purchase price.
  • Tax treatment for the seller depends on whether the non-compete agreement is considered compensatory or capital, resulting in ordinary income or capital gains taxation.

Asset Class VII: Goodwill of a Going Concern

  • Allocation: Typically represents the balance of the purchase price.
  • Goodwill is typically taxed at capital gains rates for the seller, while the buyer can amortize it over a 15-year period.

Once both parties agree on the allocation, it is typically attached as a Schedule to the definitive purchase agreement (DPA) and signed during the closing. Subsequently, both parties file IRS Form 8594 at the year-end to ensure that it aligns with the allocation specified in the definitive purchase agreement.

Additional Tips for Allocating the Price

It’s wise to refrain from assigning a specific value to the tangible assets of your business in the early stages of the transaction, whether it’s in the confidential information memorandum (CIM) or during the due diligence process.

For instance, a prospective buyer might inquire innocently, “What’s the valuation of your hard assets, like your equipment?” If you exaggerate the value at this stage, it could potentially backfire. The buyer might later argue that the value you initially provided should be the basis for determining the allocation of the purchase price.

There’s no need to feel hesitant about providing a conservative or realistic estimate of your hard assets’ value. It’s essential to keep in mind that what you’re selling is not just the tangible assets themselves but rather an income stream.

Summary

Both you and the buyer bring distinct viewpoints to the table when it comes to the allocation of the purchase price. Each category within the allocation carries its own implications for both parties.

Deliberate consideration of these allocations is crucial, as these distinctions can translate into substantial tax and financial consequences for you. Evaluating the pros and cons of each allocation is paramount, as it directly impacts your overall financial outcome.

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