Give the Tax Man His Cut – Allocating the Purchase Price

Sometimes it seems amazing that deals get done at all, what with so many aspects of a transaction to be worked out and agreed to by both parties.

Here’s one issue that often flies under the radar until 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, or 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. Negotiations regarding the allocation of the purchase price should happen as early as possible in the transaction. In most transactions, this happens during due diligence while the parties are preparing the purchase agreement and working their way toward a closing.

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. 

You and the buyer will each have a unique perspective when it comes to the allocation of purchase price. 

In the end, it’s crucial that both you and the buyer compromise and meet somewhere in the middle to satisfy your respective goals. An agreement is required because both allocations must match and be entered on IRS Form 8594, which you must file at the end of the year after a sale.

Unfortunately, many transactions have come to a halt because a buyer and seller can’t agree on the 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. Don’t get blindsided by this issue that is often an afterthought until the end of many negotiated transactions.

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 is allocated. This is known as the allocation of purchase price. 

Both you and the buyer are required by law to file Form 8594 with the IRS. This document requires that both parties allocate the purchase price among the various assets of the business being purchased so you can calculate the taxes due upon the sale, and the buyer can calculate their 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.

The Purpose of IRS Form 8594

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 essential 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:

• 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 or Inventory
• Class V: Other Tangible Property: Including furniture, fixtures, vehicles, etc.
• Class VI: Intangibles: Such as a covenant not to compete
• Class VII: Goodwill of a Going Concern

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.

Stock vs. Asset Sales

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 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 write up the assets and begin depreciating them at an inflated value. 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 you pay capital gains tax on shares held for more than one year, as opposed to ordinary income taxes due on gains from selling tangible assets. 

This is one of the reasons that asset sales dominate smaller business sales – because the buyer can deduct, or 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.

Common Allocations 

Here is a list of common allocations for each asset class:

Class I: Cash and Bank Deposits

• Allocation: None 
• Comment: These assets are not normally included in the purchase for smaller transactions. If the business is mid-sized and working capital is included, of which cash is a component, these assets are listed at face value.

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

• Allocation: None 
• Comment: These assets are not normally included in the purchase. If they are included, they are listed at face value.

Class III: Accounts Receivables

• Allocation: None. 
• Comment: These assets are not normally included in the purchase for smaller transactions. The seller normally retains ownership of the accounts receivables as of the closing date, and the buyer receives the outstanding payments and remits them to the seller post-closing. If the business is mid-sized and the accounts receivables are included, they are often at face value.

Class IV: Stock in Trade or Inventory

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

Class V: Other Tangible Property: Including furniture, fixtures, vehicles, etc.

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

Class VI: Intangibles: Such as a covenant not to compete

• Allocation: Normally less than a few percentage points of the purchase price.
• Comment: The seller 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. The buyer can normally amortize this cost over 15 years.

Class VII: Goodwill of a Going Concern

• Allocation: The balance of the purchase price is normally allocated to goodwill.
• Comment: Gains on goodwill are treated at capital gains tax rates for the seller, 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 definitive 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 (CIM) or during due diligence. 

For example, a buyer may innocently ask, “What is 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. 

And 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 hard assets.

You and the buyer will each have a unique perspective regarding the allocation of the purchase price. Each allocation category will have a different effect for both you and the buyer. 

It’s critical to give the allocations careful consideration because these differences can have significant tax and financial repercussions for you. Be sure to weigh the advantages and disadvantages of each allocation because it ultimately affects your bottom line.