What is a purchase allocation and why would I need one?
Too often, when negotiating the terms of the sale or purchase of a business the purchase allocation is ignored until after the sales contract is executed. The seller offers the stock of a business so they can limit their tax liability to capital gains. Usually the buyer refuses to purchase the stock of a closely held corporation. A stock purchase is usually a bad idea for the buyer because the buyer cannot deduct any of the purchase costs through depreciation or amortization, also the corporation retains liability for claims that may have not yet surfaced. So typically, a deal is struck for the assets of the company. A purchase contract is drawn up and a list of the tangible assets is prepared. Often the allocation is ignored completely and the contract is for the purchase of all of the assets of the business tangible and intangible. The contract usually calls for these assets to be valued at their “Fair Market Value.“ The contract calls for the seller to sign a covenant not to compete and often no specific value is assigned to that covenant. Usually, personal or professional goodwill is ignored which in some circumstances can be amortized by the buyer and are capital gains to the seller.
Later the buyer and the seller contact their accountants to get their tax returns prepared. If the tax preparer is on the ball the first question is “Where is the purchase allocation?” At this point the purchase contract is produced. When a business is sold as a group of assets and liabilities the buyer and seller are required to report the transaction on IRS form 8594 “Asset Allocation Statement” The buyer and the seller’s form 8594 should have the same allocations.
Why are the amounts on this form so important?
Because different assets are depreciated or amortized (reducing taxable income reported) by the buyer over different periods. Some assets such as land are never expensed. In addition, depending on the circumstances the allocation can have a dramatic effect on the seller’s income tax liability. It is usually in the buyer’s best interest to allocate as much of the price to short lived assets such as inventory or equipment. The remaining value is allocated to identifiable intangible assets such as the trade name or customer lists. Finally, after the purchase price is allocated to identifiable intangible assets, whatever cost is left over is allocated to Goodwill. Intangible assets acquired in the purchase of a business are amortized (deducted) by the buyer over fifteen years. A good allocation can reach a compromise that gets the best deal for both the buyer and seller.
While allocation of the purchase price to inventory, plant and equipment usually produces the fastest write off period for the buyer, they also result in the highest tax rate for the seller. Any premium for inventory over the carrying value results in ordinary income. The depreciation taken by the seller on the fixed assets in previous years is recaptured as ordinary income. Any value assigned to a covenant not to compete is also ordinary income.
What’s the solution to this mess?
Get a CPA who is experienced in these matters before you sign the deal. Your CPA’s goal will be to structure the deal so that it is the most tax efficient that it can be for both parties. We look at the assets in the business and consider the effect on both parties’ income taxes. We have a variety of tools at our disposal to help structure the best deal possible.