Asset Sales: Purchase Price Allocation
By Oren Glass, CPA, Partner and Christopher Migliaccio, JD, Partner
In the sale of a business, a purchase price is created for the various asset classes involved in the transaction. The categorization of each asset class can have a major impact on tax considerations for both the seller and buyer. It’s a zero-sum game, meaning any benefit gained by the seller will be lost by the buyer and vice versa, although that is not always the case. Read on for key tax considerations for purchase price allocations.
Background
Our recent article, Sale of a C Corporation, noted that a purchase price allocation may be necessary for transactions that are considered stock sales for legal purposes but are treated as an asset sale for federal tax purposes (e.g., F reorganizations, Section 338(h)(10) transactions). They are also necessary for the purchase of partnership interests, as the taxation of a partnership sale can be impacted by the valuation of certain partnership assets. Not all states conform to these federal treatments, and there can be significant tax consequences if the buyer or seller has a high apportionment percentage in that state.
Asset Sale – Preferences for Seller and Buyer
The seller in an asset sale prefers to allocate as much purchase price as possible toward asset classes that will be subject to capital gains tax treatment (e.g., goodwill). Sellers prefer to minimize the amounts allocated to assets that will result in income taxed at ordinary rates, such as:
- Accounts receivable (for a business using the cash method of tax accounting)
- Inventory
- Fixed assets (collectively referred to in the partnership sale context as “hot assets”)
- Covenants not to compete
The impact for sellers can be significant – capital gains are taxed at a 20 percent maximum federal rate, while ordinary income can be taxed at a rate as high as 37 percent.
Conversely, the buyer prefers to allocate as much purchase price as possible to asset classes that can be deducted quickly against their company’s income (e.g., fixed assets). For example, a buyer would rather have more purchase price allocated to five-year assets, such as computers and seven-year assets, such as furniture, rather than 15-year assets like goodwill.
PKF O’Connor Davies (PKFOD) Observation: Two assets, in particular, can create specific issues between the buyer and seller.
- Accounts Receivable: For many cash basis taxpayers, the conversion of accounts receivable from cash method to accrual method is a significant pain point. Buyers require conversion to accrual method before the transaction so that they are not paying tax on income from prior to their acquisition. Many are unwilling to compensate sellers for the additional tax paid on the conversion to accrual method. Generally, there is no significant debate about the accounts receivable amount for a purchase price allocation – it is the amount on the date of the transaction.
- Fixed Assets: Many businesses have fixed asset basis of close to zero due to bonus depreciation available since the Tax Cuts and Jobs Act of 2017. Thus, any value allocated in the purchase price allocation would generate ordinary income for the seller from depreciation recapture. As partial bonus depreciation is still in place, a higher value on fixed assets can be a significant benefit for the buyer. The buyer and seller should discuss whether the buyer will use book value for the fixed assets or look to do a full valuation, which could lead to a higher allocated value. Valuation of machinery, for example, can yield surprisingly high numbers and can increase seller tax.
Now in many transactions we typically come across, the target company whose assets are being sold is not capital-intensive. Therefore, we often see a substantial portion of the purchase price being allocated to goodwill and/or other intangibles. For any amount allocated to goodwill (i.e., Class VII assets), the amount should be capitalized and amortized using the straight-line method with a 15-year useful life. The intangible asset should appear on Form 4562 of the purchaser’s tax return. The first-year amortization deduction will be prorated based on the time of year the transaction occurred.
Asset Classes – Form 8594 and IRS Regulations
The different asset classes are presented on Form 8594, Asset Acquisition Statement Under Section 1060. Typically, both the buyer and seller will need to attach this to their income tax return in the year of the transaction and the numbers should match each other. This means that the buyer and seller must cooperate in developing the purchase price allocation. The asset classes are as follows:
Asset Class | Description | Value |
Class I | Cash and cash equivalents, (e.g., bank deposits), includes savings and checking accounts. | Face value |
Class II | Securities, U.S. government securities and publicly traded stock, foreign currency and certificates of deposit. | Face value |
Class III | Accounts receivable | Current amounts owed by customers |
Class IV | Inventory (stock in trade) | Cost |
Class V | Fixed assets, or other tangible property that does not fall under Class 1-4 assets (subject to depreciation recapture for seller at ordinary tax rates). This class also includes building, land, and vehicles. | Fair market value |
Class VI | Intangible assets other than goodwill including covenant not to compete. For tax purposes, it depends on the facts and circumstances of each case whether the non-compete agreement is considered compensatory (ordinary) or capital in nature. | Remaining consideration to be allocated |
Class VII | Goodwill and going concern value | Remaining consideration to be allocated |
The purchase price allocation must follow the order of the classes, with goodwill being the remainder.
PKFOD Observation: Since goodwill is the remainder of purchase price, after the other assets have been allocated, there is generally no valuation of this asset for tax purposes. Generally, if the purchase price is spread over multiple years, the non-goodwill assets will be purchased in the first year, leaving only goodwill to increase with the later payments. This means that in any installment sale transaction spread over multiple years, the seller should be aware that all depreciation recapture is immediately taxable as ordinary income in the year of the sale.
The purchase price allocation is typically calculated and negotiated between both the seller and buyer. Its terms (e.g., timetable for completion, who is responsible for preparing the calculation and other ancillary items) should be delineated in the purchase agreement. Agreeing in advance on the process can save significant headaches post-closing.
While the purchase price allocation is negotiated between both parties, it also must follow certain IRS regulations. None of the asset classes, other than Class VII assets, can exceed its fair market value.
Conclusion
There are major tax implications for both the buyer and seller based on the classification of each asset in an asset sale. Therefore, it is critical to consult with your tax advisor who can help calculate the purchase price allocation to help ensure the most tax-efficient result possible.
Contact Us
If your business is considering an asset sale or purchase, or if you have questions, contact your PKF O’Connor Davies client service team or:
Oren Glass, CPA
Partner
oglass@pkfod.com
Christopher Migliaccio, JD
Partner
cmigliaccio@pkfod.com