Tax & Business Insights

Allocation of Business Sale Purchase Price

Volume 20 Issue 2 --  March/April 2008

Dee Sieve owns PetVet LLC, a one person LLC, and wants to sell the business to Ina Rapido.  PetVet has been in existence for a little more than a year. Dee has sold businesses before and knows that different classes of assets are taxed differently.  For example the gain on some assets such as Good Will, Furniture and Office Equipment will be taxed at lower long-term capital gain rates. Other assets such as inventory, receivables, and non-competition agreements are taxed at higher, ordinary income rates.

Ina, the buyer, on the other hand, is inexperienced and eager to buy PetVet.  Her lack of business acumen is demonstrated by her insistence on changing the business name to PetDrool, Drool being her maiden name.  Ina’s advisor will be her cousin Melvyn, a criminal lawyer who cares little for business law and has never been involved in a sales transaction.

Dee suggests allocating the $500,000 purchase price among the assets in the following manner:

  1. Good Will     $300,000
  2. Equipment     $100,000
  3. Furniture       $100,000.

Ina and Melvyn do not know, or care, that this unrealistic allocation greatly favors Dee Seive. The equipment, mostly trucks and pet supply processing equipment, is actually worth $400,000 and there is $100,000 of inventory.  After the sale, Ina and her new accounting firm, Anything’s OK, allocate $400,000 to the trucks and equipment and depreciate them on Ina’s Schedule C.  Is there a problem?  Since Dee and Ina are taking inconsistent positions on their respective tax returns with regard to the assets purchased, there is clearly a problem.

Apart from the “whipsaw” effect on the IRS of such practices (see our newsletter, Newland’s Business Notes,  July-Aug. 2002, Vol. 6, Issue 4), some years ago Congress passed IRC § 1060 which requires both the buyer and the seller of a business to use the same purchase price allocation. To implement this requirement, the IRS created Form 8594 (Asset Acquisition Statement). The form requires that the buyer and seller allocate the purchase price among seven classes of assets to which the IRS assigned Roman numerals I through VII.

In this example, using Dee’s allocation, Dee would receive capital gains treatment on the sale of her business to Ina, except to the extent of depreciation recapture. Ina would receive very unfavorable tax treatment if she abided by such allocations.  For example, under IRC § 197 Good Will must be amortized over 15 years. Allocating a larger portion of the price to depreciable assets like trucks and equipment would allow Ina a much more rapid write-off of her investment.

The need for both buyer and seller to use the same allocation is more than just a tax compliance requirement. It is also a tax planning and client service opportunity.

How the purchase price is allocated can greatly increase or decrease both Dee’s gain on the sale as well as Ina’s taxable income in the years following the sale. Moreover, if, as happens all too frequently, there is no allocation agreed to at the time of the contract, obtaining such an agreement after the sale has taken place can often be difficult.

How can this problem be avoided by a diligent buyer and seller? One of the best ways of avoiding the problem and a likely IRS audit is to attach to the sales agreement (or state in the body of the agreement) what the assets are and use reasonable, agreed-upon allocations (not like those of Dee).   In some cases, it makes sense for both parties to fill out Form 8594 and accept it at the closing on the sale. By so doing, the question of the asset allocation and values will be eliminated and both parties will know exactly what their tax consequences will be.

In addition to obtaining certainty with regard to the amounts to be assigned to the assets, the sales agreement should describe assets clearly.  As a practical matter, it is fairly common to see sales agreements which lump a variety of different types of assets together. For example, it is not unusual to see Good Will and intangibles grouped together on the same line of a sales agreement.  In completing Form 8594, however, intangibles and Good Will are in two different asset classes. The sales contract does not have to use the Roman Numeral system of IRS Form 8594 but it helps to have the system in mind when negotiating the purchase price allocation.

In many instances, the attorneys who draft the sales agreements are unaware of the need to allocate the purchase price among the various IRS asset classes. As a result the tax practitioners who prepare returns are left with the task of sorting out the allocations and values as best they can.

For more information, you may also want to look at the Business Purchase Checklist, available on our website or contact us.

Copyright 2008
By Tax and Business Professionals, Inc.
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