Deal Structure and Taxes

Sometimes it’s amazing that deals get done at all. There are many aspects of every transaction that must be worked out and agreed to by the parties. Here’s an important one that often flies under the radar until quite late in the process – how the purchase price is allocated for tax purposes.

Allocating the purchase price, or total sale price, of a business among the various assets of the business – or asset “classes” – is necessary for tax purposes when a company is sold. This is the case regardless of whether the sale is structured as a stock sale or asset sale. 

The allocation of the purchase price can become a contentious area of negotiation after the price, terms, and other conditions of the sale have been agreed to. In most cases, what’s good for you is bad for the buyer, and vice versa, which can lead to disputes. In the end, it’s crucial that both you and the buyer meet somewhere in the middle to satisfy your respective goals. An agreement has to be reached because both allocations should match, and a discrepancy can trigger an audit.

Unfortunately, many transactions have been known to come to a halt because a buyer and seller can’t reach an agreement about the allocation of the purchase price. This is more likely to happen when the negotiations have been more intense. The allocation of the purchase price sometimes becomes the final straw, causing a buyer and seller to abandon the transaction altogether. Don’t get blindsided by an afterthought at the end of negotiations. 

The allocation of the purchase price is a contentious area of negotiation. In most cases, what’s good for the seller is bad for the buyer, and vice versa, leading to disputes.

Why the Allocation of Purchase Price is Necessary

Before the closing can take place, you and the buyer must agree on how the purchase price will be allocated for tax purposes. After coming to an agreement about the purchase price, both parties are required by law to file Form 8594 with the IRS. This form must be filed with each of your tax returns at the end of the year. While there is no legal requirement that the buyer’s and seller’s allocations match, most tax advisors agree the chances of an audit are increased if the allocations differ.

The Purpose of IRS Form 8594

IRS Form 8594 breaks down the assets of the business being purchased or sold into seven classes. Each class of asset is treated differently for tax purposes. It’s therefore important that you carefully consider how you’ll classify each 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:

• 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

As the seller, you should generally seek 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.

Stock vs. Asset Sales

Where stock sales are concerned, most 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 you personally own, or sold by you (i.e., John Smith, not Acme Incorporated), and not your entity.

In a stock sale, the buyer doesn’t receive a stepped-up basis in the value of the assets, but instead inherits your 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 at a higher, stepped-up value. 

For you, a stock sale is advantageous because you must pay the lower capital gains tax rates on stock held for more than one year, as opposed to the higher ordinary income tax rates. This is one of the reasons asset sales dominate smaller business sales – because the buyer can depreciate the cost of the assets they acquire, which reduces the buyer’s income taxes. On the other hand, with stock sales, there are no immediate tax benefits to the buyer.

Common Allocations

Here’s a description of the major classes of assets and common allocations for each:

Class I: Cash and bank deposits

• Allocation: None. 
• Notes: These assets aren’t usually included in the purchase. If they are included, they’re listed at face value.

Class II: Securities, including actively traded personal property and certificates of deposit

• Allocation: None. 
• Notes: These assets aren’t typically included in the purchase. If they are included, they’re listed at face value.

Class III: Accounts receivables

• Allocation: None. 
• Notes: These assets aren’t normally included in the purchase. You typically retain ownership of the accounts receivables as of the closing date, and the buyer receives the outstanding payments and remits them to you post-closing.

Class IV: Stock in trade (inventory)

• Allocation: Normally valued at your original cost.
• Notes: As a result, there’s no gain for you and, therefore, no tax due on the amount allocated to this asset.

Class V: Other tangible property, including furniture, fixtures, vehicles, etc.

• Allocation: Usually valued at current market value, often “replacement value.” Note that the buyer may have to pay sales tax on the amount allocated to this class of assets.
• Notes: Any gain on the sale of tangible property is taxed based on ordinary income rates to you, and the buyer can depreciate these assets based on their stepped-up value.

Class VI: Intangibles, including covenant not to compete

• Allocation: Normally less than a few percentage points of the purchase price.
• Notes: You must pay ordinary income taxes or capital gains taxes based on the amount allocated to intangible assets depending on whether the non-compete is considered compensatory or capital.

Class VII: Goodwill of a going concern

• Allocation: The balance of the purchase price is typically allocated to goodwill.
• Notes: Goodwill is treated at capital gains tax rates for you, and the buyer can amortize goodwill over a 15-year period.

Once the parties agree to the allocation, the allocation is usually attached as a schedule to the purchase agreement and signed at closing. The parties then file IRS Form 8594 at year-end, ensuring that IRS Form 8594 matches the allocation provided in the purchase agreement.

Additional Tips for Allocating the Price

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 or even during due diligence. 

For example, a buyer may innocently ask, “What’s the value 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. 

Also, don’t be ashamed about giving the buyer a low or realistic value of your hard assets – remember, you’re selling an income stream, not a collection of hard assets. You and the buyer will each have a unique perspective when it comes to how to allocate the purchase price. Each asset class will have a different effect for you and the buyer. It’s important to give the allocation 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 significantly affects your bottom line.