Allocation issues are very important to the selling/buying a business process.
Andy Dobrov with Premier Business Opportunities in Los Altos California discusses allocation issues with my blog readers . . . .
"Allocating the purchase price is always required prior to close of escrow and often becomes a last minute fire drill with buyer and seller scrambling to figure the tax implications. Buyer and Seller usually consult their accountants and have the accountants work directly together to agree on how to split up the total purchase price amongst the different categories like “Taxable Fixtures & Equipment”, “Goodwill”, “Covenant not to Compete”, “Inventory”, “Value of Lease”, etc.
The most common question that comes up during allocation is how much should the buyer allocate towards taxable fixtures and equipment, because buyer pays sales tax on that amount into escrow prior to close. Many buyers need operating capital and want to minimize any tax paid up front, but the more tax they pay towards fixtures and equipment, the more of a tax write-off they get by Depreciating the value of fixtures and equipment over the next 5-years. Many buyers aren’t focused on depreciation and future tax write-offs when trying to close a deal because they are focused on immediate cash needs to run the business. These buyers look to minimize the value of taxable fixtures and equipment without going so low that it raises questions by the State Board of Equalization. The interesting thing is that there is no truly objective way to determine the current value of fixtures and equipment because the buyer is purchasing used fixtures and equipment that he or she could theoretically buy on the secondary market for pennies on the dollar. So the current value of the fixtures and equipment that seller uses for tax purposes only serves as a loose guideline to the buyer and is not a requirement by any means. However, that said, I am hearing from escrow companies that the State Board of Equalization will ask for supporting documentation and clarification from the buyer if they choose a value that is perceived as ridiculously low.
In my recent experience, I see clients and their accountants select a wide range of values for fixtures and equipment. Out of 22 Quiznos Franchises that I have sold, I have buyers allocate as much as $75,000 towards equipment and as little as $5,000 when the purchase price for each business was identical at $220,000. Of course, one Quiznos can be a lot older than the next and the equipment can vary quite a bit, but those differences do not account for this huge variation. The main factor that buyers use in valuing fixtures & equipment is how much they are willing to pay up front in sales tax in return for obtaining a 5-year tax write-off through depreciation. Some accountants advise their clients to place more value on the equipment because of the long-term tax benefit of depreciation, but the amount itself varies tremendously depending on the buyer. As a side note, the buyers in both cases allocated the balance of the purchase price towards Goodwill, which is about customers and cash-flow of the business.
That said, my understanding is that Sellers really are not impacted by the amount the buyer chooses to value the fixtures and equipment, and that the most significant category for the Seller is the value placed on “Covenant not to Compete”. This is the value placed on the fact that Seller agrees not to compete with the business he is selling, which typically covers a 10-mile radius over 5-years. The covenant not to compete is typically an escrow document and signed regardless of whether or not any money is allocated towards the non-compete agreement, so the buyer is theoretically protected in full whether they allocate money towards the covenant or not. However, my understanding from talking to several accountants is that any money allocated towards the covenant is taxed as regular income as opposed to capital gains. That means that the seller pays more tax when the buyer allocates money towards the covenant so sellers typically like to keep that category to a minimum."
Andy can be reached at 650-988-1820 if you are thinking of buying or selling a business in the San Francisco Bay Area.
Posted on April 2, 2008 | 
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