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.
Allocating 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.
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.
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:
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.
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.
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
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.
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.
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.
Less than a third of businesses on the market actually change hands. So what does this mean for you? Think about it – with a significant amount of your wealth tied up in your business, planning your exit is one of the most critical decisions you’ll make.
Written by Jacob Orosz, President of Morgan & Westfield
For a business to sell for what it’s really worth – or even more – you need to properly prepare. But too many entrepreneurs put off planning the sale of their business until the last moment. Acquired will help you prepare your business for sale and walk you through the sales process, dodging the pitfalls along the way. Planning your exits is one of the most critical initiatives you’ll undertake. Don’t go it alone.
Written by Jacob Orosz, President of Morgan & Westfield
