Determining The Allocation Of The Purchase Price In An Asset (Non-Stock) Business Sale

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 a 15-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.

Categories: Deal And Escrow Issues, How To Sell A Business, Selling A Business

Contributor:

Timothy Cunha JD, Business Broker: SF Bay Area

Areas Served: San Francisco Bay Area

Phone:  650-600-3751 Cell, 650-600-3751 Text

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Contributor: Due Diligence, Valuations Advisor

Purchase price allocations , as previously stated, can have serious impacts on the tax position of both buyer and seller. Transactions work best when both buyer and seller take tax advice early in the process and agree the purchase price allocation in writing.

There are issues not previously mentioned that are significant in the tax planning process for both buyer and seller:

1) Buyer is entitled to expense, in the year of acquisition, 100% of the cost of (most) equipment, up to a cap of $500,000 under Section 179 of the Internal Revenue Code. The deduction is limited to their taxable income ( from all business interests) not just the business purchased. Any unused deduction in the year of purchase can be carried forward. The deduction is limited for California income taxes is $25,000.

2) Seller must recapture depreciation taken on equipment as ordinary income . In other words if seller bought a machine for $100,000 and it is fully depreciated any dollar amount allocated to that machine ( assuming this is less than cost) is going to be ordinary income and not capital gain to the seller. The rules are different for real property.

Personally, I never allocate anything to leasehold improvements. My argument is that leasehold improvements belong to the landlord.

I am using simple examples of complicated tax rules and readers should take professional advice and explore these concepts within their entire tax picture.

Contributor: Transactional Attorney

Great post, Tim. It's a good idea to be thinking ahead about the consequences well before execution of the APA.

Surprisingly, allocation provisions are lacking in some of the most widely-used form agreements. When allocation is included it's often left to vague clauses in the asset purchase agreement that leave a lot to the buyer and seller to mutually agree on. Whether you're buying or selling a business it's important to understand the impact of allocation of purchase price up front. It's equally important to put what you agree to in writing or at least have a provision that gives you a straightforward way to resolve any differences if you can't come to an agreement. Something as simple as calling for an independent accountant to make the determination if the parties can't agree on allocation can help you avoid issues down the line.