6 May 2024: Selling a Business: Price Allocation
When buying or selling a business in the United States, buyers and sellers are required by the tax authorities to allocate the purchase price among the assets bought or sold based on the fair market value of those assets. These purchase price allocations have significant tax consequences to both buyers and sellers.
(Such regulations exist in other countries, as well, and brokers, sellers and buyers are advised to see competent counsel on this topic.)
Allocation of the purchase price is a significant part of the negotiations as the mpact of what asset class is assigned what portion of the purchase price can have considerable tax consequences for both seller and buyer. The parties to the transaction must be prepared for this aspect of the transaction and should fully understand their respective tax ramifications prior to agreeing to any purchase price allocation.
Given that most of our work is on behalf of the seller, the first part of that last sentence – being prepared for the conversation and subsequent negotiation – is our responsibility; our oft-repeated phrase, “managing the client’s expectations”. If we want to make the sale of a business as smooth – and with the highest chance of success – as possible our clients need to know what’s coming with every step in the process. When selling a business, allocating the purchase price among the various classifications is something we have to prepare them for.
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The following is from an April 2023 article attributed to the law firm KerrRussell and posted to the legal website JDSUPRA. It provides a basic outline of price allocation in the sale of a business.
U.S. tax regulations require “…that buyers and sellers use what’s referred to as the “residual” method to allocate the purchase price, which includes not only the cash consideration paid but also assumed liabilities. Pursuant to the “residual” method, taxpayers allocate the purchase price for tax purposes among the assets being acquired or sold starting with the first class and the remainder of the purchase price being allocated to goodwill. In other words, taxpayers allocate the purchase price to the extent of those assets in that class and then to the following classes in the order below. The classes and a brief description of the assets included in those classes are:
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- Class I: Cash
- Class II: Marketable Securities
- Class III: Accounts Receivable and other assets for which the seller is required to use mark-to-market valuation annually
- Class IV: Inventory
- Class V: Machinery, equipment, land, building and other assets not otherwise described in the other classes
- Class VI: Intangible assets other than goodwill
- Class VII: Goodwill
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We’ve broken our Flagship into six separate modules (or module groups) to give you all the flexibility you need to learn only what you want to learn – and we’ve moved them all over to the new Brokers Academy in The Brokers Roundtable℠ . The Flagship is still available but the modules are now available individually.
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“The amount of the Purchase Price allocated to each category has significant tax consequences to buyers and sellers.
“One of the most disputed categories revolves around Class V, machinery and equipment. From a buyer’s perspective, a buyer would like to allocate as much of the purchase price as possible to machinery and equipment because 80% of the amount allocated to machinery and equipment would be immediately deductible by the buyer. Assuming all other values are the same, any amount not allocated to machinery and equipment would be added to goodwill, which is amortized over 15 years.
“However, to sellers that are taxed as subchapter S corporations, partnerships (including limited liability companies) or sole proprietorships, the gain on machinery and equipment could be taxed as high as 37% versus goodwill, which would be taxed at a rate of 20%. Normally, sellers have little or no taxable basis in their machinery and equipment because they have already fully depreciated those assets using bonus depreciation.
For subchapter C corporations, all gain is taxed at the same rate, currently 21%, and the character of the gain will only impact subchapter C corporations that have unique tax attributes, such as capital loss carry-forwards.
“Sellers should also beware of amounts allocated to a covenant not to compete versus goodwill. To a seller, a covenant not to compete is taxed at ordinary income tax rates which could be as high as 37%. However, from a tax perspective, this usually is not that controversial because a covenant not to compete is amortized over the same period as goodwill, 15 years.
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Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
“Because of a desire for certainty by both buyers and sellers, and to avoid post-closing disputes, many buyers and sellers will agree to a methodology on the manner of allocating the purchase price. Until the purchase price for tax purposes is finally determined, however, it is impossible to allocate the purchase price with precision. The purchase price for tax purposes will vary because the amount of assumed liabilities such as accounts payable and accrued liabilities will not be finally determined until the closing date working capital is finally determined. Notwithstanding that uncertainty, the parties may agree to a methodology at closing.
“In the event that the parties fail to agree on a purchase price allocation methodology or if they agree to allocate the purchase price post-closing but cannot agree on the methodology, Internal Revenue Service Form 8594 (Asset Acquisition Statement Under Section 1060) does permit buyers and sellers to claim different purchase price allocations. However, some claim that a mismatch on the allocation may trigger an IRS audit.”
The Bottom Line
The vast majority of our clients are “first time sellers” who’ve never sold a business before. We – and most of you – know that selling a business is a process chock full of potential pitfalls and speed bumps. Our clients are blissfully unaware of most of this and often equate selling a business with selling a house.
It’s imperative that sellers are prepared for the arcane aspects of selling, including the inevitable issue of how to allocate the purchase price among the various classes. Otherwise, when they’re advised by their accountant of their tax bill, they will rightfully feel blind-sided by someone involved; and usually that someone ends up being the broker.
Sellers deserve to know from the get-go what to expect as they’re heading into what is likely the most significant financial event of their life and brokers who adhere to that maxim will be doing their clients a great service.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at
jo*@Wo*******************.com
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If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at
jo*@Wo*******************.com