When selling and buying a business, it is almost always necessary to allocate the purchase price to various categories of assets for tax and accounting purposes, whether this is a transfer of all the assets of the business or an actual stock sale of the business entity (i.e., corporation or LLC). While specific rules need to be followed, it also requires creativity and finesse borne from education and experience; the parties definitely should seek appropriate professional advice.
This discussion considers allocation issues encountered in the vast majority of business sales, those where the buyer is taking over all the assets of the business but not the entity itself.
The effect on the buyer and the seller may be different for each allocation category, and those differences can amount to significant tax and financial consequences for each party.
The general rule is that the value of the assets of the business should be the “fair market value;” for the most part, the allocation is based upon negotiation between the parties and a compromise of their respective advantages and disadvantages. The buyer is determining what upfront taxes are to be paid at closing and the "book value" of the new business that will establish the amount of depreciation and amortization that can be used to decrease taxes in the future. The seller, if selling for a gain, is establishing how much will be taxed at capital gains rates and how much at ordinary income rates—or, perhaps, not taxed at all.
Precision regarding the specific value of each asset is NOT necessary; what is most determinative is an "arms length" negotiation between the two parties with disparate interests and objectives. Just as the actual fair market value of the business is determined by negotiation, so is the fair market value of each of the components of the business assets. Keep in mind, these are complex matters that could amount to a lot of money, and a certified public accountant (CPA) should be consulted. The business broker(s) should be involved as well to continue to help the buyers to negotiate constructively, creatively, cooperatively, and in good faith.
While there can be certain categories used in specialized situations, by far the usual ones are tangible personal property (or “FF&E”), registered motor vehicles (part of “FF&E”, but listed separately), leasehold improvements, covenant not to compete, training and transition (“consulting”) services, customer list, inventory, and good will. (If there is a liquor license involved, there are special rules for its tax treatment as a separate allocation item.)
TANGIBLE PERSONAL PROPERTY, a.k.a. FURNITURE, FIXTURES, & EQUIPMENT (“FF&E”): Typically, this asset class has a “life” of seven years for depreciation purposes (although certain equipment can be depreciated over just five years). [See IRS publication 946.] For example, if $210,000 is allocated toward FF&E, then the straight line depreciation “write off” would amount to $30,000 per year, for each of seven years.
For the Buyer: Obviously allocating a large amount to this category can be very advantageous to the buyer, with one caveat—the buyer will have to pay state and local sales tax on this amount, generally ranging from 8.75% to 9.25%, through the escrow agent at the closing. (The California State Board of Equalization requires that this amount be at least the seller’s current depreciated book value.) Even though a high allocation to FF&E can result in a significant initial cost for sales tax, it can result in considerable tax savings over time through depreciation, particularly if a large amount can be allocated to a five-year-life equipment category.
For the Seller: If held for over a year, gains exceeding previously-deducted depreciation are long-term capital gain; otherwise it is non-passive ordinary income.
REGISTERED MOTOR VEHICLES: While technically part of the FF&E, motor vehicles should be listed separately because the sales tax is not paid through the escrow at closing; instead, it is paid by the buyer to the DMV when the vehicle title transfer occurs. And, the value of the vehicle(s) for sales tax purposes should not be some arbitrary amount determined by the parties; rather, it should be based on a fair market value from some reputable source, such as Kelley’s Blue Book.
LEASEHOLD IMPROVEMENTS: Long-term improvements made by the seller to the building (not repairs and maintenance) can be allocated; but, they have the longest depreciation term—29.5 to 39 years, depending on the circumstances and the accountant. Since most leases are for less than this term and most businesses have leased premises, in my opinion there is rarely any advantage to either party to use this category and it should be avoided.
COVENANT NOT TO COMPETE: No matter how long it is, the covenant not to compete has a tax “life” of 15 years.
For the Buyer: Approximately 6.67% (1/15) can be amortized (“written off”) each year.
For the Seller: Treated as non-passive ordinary income.
TRAINING AND TRANSITION (“CONSULTING”) SERVICES:
For the Buyer: Can be fully deducted as a current year expense.
For the Seller: Considered ordinary earned income, also subject to self-employment (social security) tax, approximately 15%.
CUSTOMER LIST: Does not need to be separately allocated. 15-year tax “life.” In my opinion, this category should be avoided, and the value of the customer list included in good will.
For the Buyer: Approximately 6.67% (1/15) can be amortized (“written off”) each year.
For the Seller: Considered ordinary income.
INVENTORY: Inventory consists of the value apportioned to that part of the current assets that will be sold to customers or will be converted into product(s) to be sold (e.g., stock on the shelves of a retail store, raw materials in a factory, food in a restaurant); the “stock in trade.”
For the Buyer: This is considered “cost of goods sold” upon the eventual sale of the inventory. There is no sales tax payable as long the business buyer has a valid tax certificate and the inventory is actually purchased for resale.
For the Seller: To the extent that the value exceeds the cost basis of the inventory (which is rare), that excess is ordinary income.
GOOD WILL: What is “good will”? Basically, it is what is left over after everything else is allocated. My preferred definition is: “the enterprise value; the current ability of the business to generate profit in the future.”
For the Buyer: This is a15-year amortization item, approximately 6.67% (1/15) can be amortized (“written off”) each year.
For the Seller: If held for over a year, treated as long-term capital gain.
This information is provided to be educational, but not to be specific professional advice for any particular transaction. While an escrow agent or a business broker can suggest the options for purchase money allocation, only a CPA or other qualified tax accountant can provide professional advice to be relied upon.
About This Contributor: Tim Cunha is a business broker in the San Francisco Bay Area. He has managed and sold several businesses of his own, Tim offers business sellers extensive personal experience and professional expertise in building business value, planning a successful exit strategy, "packaging" and promoting the sale, and coordinating a successful and profitable transition. Phone Tim Direct at 650-600-3751.
|Helpful Resources To Assist In Selling And Buying California Businesses|
|Elizabeth McGovern: Escrow Services - SF Bay Area
McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.
|Janet Carrera - Escrow & Bulk Sale Services - SF Bay Area
Redwood Escrow Services, Inc. is a full service, licensed independent escrow company. We are EAFC Fidelity bonded, fully insured & licensed with the Department of Corporations. Committed to offering our clients the most comprehensive variety of escrow services available. Phone Janet at 510-247-0741.
|Diane Boudreau-Tschetter: Escrow And Bulk Sale Services
California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.
|Timothy Cunha, JD - Business Broker, SF Bay Area
I am an experienced entrepreneur, attorney, & business professor. I & my EvergreenGold team offer business owners sound advice & expertise to build business value & achieve profitable sales. Call me today for a FREE business evaluation & SWOT analysis for your business anywhere in the USA.
|Matt Sadati, Business Broker, SF Bay Area, Northern CA
I have Engineering and Law, JD degree, with over 30 years of experience in all phases of entrepreneurship. During the past 15 years my concentration has been in business of mergers and consulting. I have owned and operated over 33 businesses each having one to 30 branches.
|Michael Floorman, Business Broker, BTI, San Francisco Bay Area
Business Team, San Jose (Campbell) located in the Pruneyard Towers at Bascom and Hamilton. Established in 1981 Business Team with over 6600 sales to date has 1000 business listings to choose from, paid Google advertising. We offer highly trained and experienced professionals.
|Taj Randhawa, Business Broker Specialist - Gas Stations, Liquor Stores
If you are interested buying or selling a gas station, liquor store feel free to phone me for a consultation. My vast experience & specialization in gas stations & liquor stores helps me in serving my clients with full confidence, trust & sincerity. Serving Central Valley, SF Bay Area. 559-259-4247.
|Matt Weiler, Business Broker: Gas Station Specialist
Business Broker Specializing in primarily gas stations. Geographic area of focus: San Francisco Bay Area to Sacramento and as far South as Monterey, California. To sell or buy a small or large gas station phone Matt (gas station business broker specialist) direct at 408-623-0920.
|Related Articles, Events, Blog Posts, Discussions, Videos, Interviews|
|6 Simple Things To Increase Business Value Before Offering It For Sale
How do you value a small business before putting it on the market? Tim Cunha, JD offers 6 items all business owners should consider. Other advisors and business brokers also weigh in on this very important topic especially when over 70% of small businesses never end up selling (due to pricing).
|How Do I Determine the Value Of My Small Business? Or The One I Want To Buy?
How do you determine the value of your business when you go to sell or even buy a business? There are so many factors and that is usually one of the first items serious buyers inquire about. Tim Cunha JD (SF Business Broker at 650-600-3751) initiates this Discussion On BizBen with other Advisors.
|Selling Your SF Bay Area Business: 3 Keys To Better Financial Statements
When you are selling your business, your presentation, for the most part, is going to be your financial statements. Everything begins there. SF Bay Area Business Broker Rob Hartman discusses how to best present your financial statements and what should be included when selling.
|BizBen Index: Weekly Results - 274 California Businesses Sold 5/21 - 5/25
For the week of 5/21 thru 5/25, 274 California small businesses were sold by business owners, business brokers, and agents. In 2017 16,956 CA small businesses were sold. So far this year (2018) 3,896 small to mid-sized California businesses have sold so far by business owners, agents, and brokers.
|5 Dangerous Trends Small Business Seller/Owners Should Consider When Selling
Business brokers and other Advisors on BizBen discuss key areas small business owners should think about before they sell their small to mid-sized business. Topics include: Commodization, Amazon, Big Box Stores, Rules and Regulations, and Baby Boomers. Rob Hartman, SF Bay Area Intermediary explains.
|Preparing Your Bay Area Business For Sale: Accounting & Financial Statements
The first thing you should start working on when selling your business is getting your financial statements in order. Having correct, easy to read, simple financial statements Is key in showing interested buyers. Rob Hartman (SF Bay Area Business Broker) shares his experience.
|Getting An SBA Loan To Buy A Small Business: Dispelling Some Major Myths
When seeking SBA loan financing many potential business buyers have wrong information about the process of securing the best financing to buy a business. Peter Siegel, MBA (at 925-785-3118) a business purchase financing expert delves into the myths and facts regarding SBA loan financing.
|An Alternative Approach To Finding And Buying An Absentee Run Small Business
As a SF Bay Area business broker (Rob Hartman), the phrase I hear often from my buyer clients is, "I am looking for an absentee run business." Since it is such a popular topic, let me offer an alternative method of business selection. There are a couple things to keep in mind as you search.
|See All News, Tips And Events|