As you prepare to sell a business, tax implications should be at the forefront of your mind. In an asset sale, purchase price allocation will determine what you pay in taxes on the profits of your sale.
While taxes themselves are non-negotiable, purchase price allocation is, and it’s an important piece of the puzzle in negotiations.
At MidStreet Mergers & Acquisitions, we’ve helped over 450 sellers sell their business and walk away with favorable tax allocation.
For you to achieve the same outcome, it’s critical that you understand how different allocations can impact your take-home proceeds.
In this blog, we’ll cover what the allocation of the purchase price is, categories of asset allocation, what allocations favor the seller, and what allocations benefit the buyer.
Let’s get started.
What Does Purchase Price Allocation Mean?
When selling your business in an asset sale, the purchaser and seller are required by law to submit IRS form 8594 to report the increase or decrease in value of the assets sold.
Your business is made up of many types of asset classes. There are physical assets like tables, vehicles, and tools; There are intangible assets like your reputation and brand recognition; And then there are assets that you buy or sell as part of the transaction, such as a non-compete.
In the eyes of the IRS, you must report whether you experienced a gain or loss on the sale of each asset class separately.
While the IRS has many asset classes, there are five main categories the purchase price can be allocated to.
Disclaimer: Although effort has been made in providing accurate information, MidStreet does not warrant that accuracy and is not liable for any errors or omissions. MidStreet, nor its employees, are licensed tax professionals or attorneys. Readers are strongly encouraged to confirm tax and legal issues with accountants and attorneys in your respective state or province. The article is based on information as of fall 2021.
5 Categories of Purchase Price Allocation (And How They Are Taxed)
In an asset sale, the total purchase price of the business will generally be allocated into the following categories:
- Furniture, fixtures, and equipment (FF&E)
- Inventory
- Non-competes and other intangibles
- Seller training and transition assistance
- Goodwill
Each category is taxed differently, but ultimately you will pay one of two rates:
Long Term Capital Gains Tax Rate: 0 - 20% depending on income level.
Ordinary Income Tax Rate: 10 - 37% based on income level.
How Each Category is Taxed in a Business Sale
1. Furniture, Fixtures, and Equipment (FF&E)
Furniture, fixtures, and equipment (FF&E) refers to items such as vehicles, machines, desks, chairs, phones, and computers used in the operation of your business.
FF&E in a business sale is taxed at an ordinary income tax rate. However, that is only if you are reporting a gain on the sale of the assets.
The amount that will be subject to taxation for the seller will be based on the amount allocated to the FF&E versus what you have reported the equipment to be worth on your taxes.
For example, if you report that the FF&E you own is worth $100,000, but you allocate $250,000 to FF&E in the sale of your business, your gain of $150,000 will be subject to ordinary income tax at your current bracket.
Since most business owners depreciate or “write-off” some of their FF&E’s value every year (sometimes writing equipment down to $0 in value), paying for a gain on the sale of the asset may be unavoidable at closing.
Understanding that relationship, sellers often push to make the FF&E allocation match the book value of the equipment during the sale process. However, buyers want the value of the FF&E higher because it gives them more to depreciate, especially in the first few years.
Thus, the FF&E allocation is generally negotiated to a “Fair Market Value.” This value is either mutually agreed upon by the buyer and seller, or determined by an equipment appraisal company.
2. Inventory
Inventory includes items that a business has as raw materials, in the process of production, or ready to sell. In most cases, inventory will have no tax liability because the buyer is purchasing the inventory at their cost.
Therefore, since there is no gain for the seller on the sale of the inventory, they are not taxed on this portion of the allocation.
3. Non-Competes and Other Intangibles
A non-compete will specify the restrictions to the seller in regards to performing any work that may be viewed as competing against the buyer after the sale.
Non-competes are considered an asset that the buyer is purchasing in the acquisition, partly because for a non-compete to be enforceable there must be compensation (an exchange of value).
Assets that fall within the category of non-competes and other intangibles will be taxed at ordinary income tax rates.
Other intangibles will cover items that do not fall into FF&E, inventory, training, and goodwill.
4. Training and Transition Assistance
In the sale of the business, the seller and the buyer will agree upon a training and transition period that the seller will provide the new buyer.
Similar to your non-compete, the training agreement must also include some form of compensation to be valid and enforceable.
The asset of training and transition assistance will be taxed at ordinary income tax rates.
5. Goodwill
For the remaining purchase price, there’s Goodwill.
Goodwill represents the intangible value of the company, such as your brand, reputation, relationships, and trade secrets.
Goodwill is taxed at long-term capital gains rate and is generally the largest allocation category in lower middle market business transactions.
An important factor to remember regarding Goodwill: if you purchased the business you are now selling, you should have a basis for the Goodwill of the company. Therefore, you will only pay a long-term capital gains rate on the increase in the value of the asset over your basis.
Most Favorable Allocation For Sellers
The most beneficial allocation for the seller would be to allocate as much of the purchase price towards goodwill as possible and match the FF&E allocation to the book value of the FF&E.
This would allow the seller to get taxed for the goodwill at a long-term capital gains rate, as opposed to an ordinary income tax rate.
Additionally, if the seller matches the value of the FF&E to its book value, they will be able to reduce the amount they are taxed for the sale of the FF&E.
Most Favorable Allocation For Buyers
Buyers will benefit the most if they can have more allocated to FF&E, non-compete, and training since it will allow them to write off more on their taxes early on. That said, buyers are still able to write off goodwill, but it is amortized over a 15-year period.
Buyers should also consider their future basis when determining the Goodwill allocation - since Goodwill is sure to be the largest allocation amount when the buyer eventually sells the business, the higher their Goodwill basis the less they’ll pay in taxes on a gain.
How Allocation Affects Taxes
With the knowledge of how the purchase price is allocated and how each allocation affects your taxation, you will be prepared to negotiate the allocation of the purchase price.
To get the best allocation, consult with your CPA and merger and acquisition (M&A) advisor. Allocations that benefit the seller do not always benefit the buyer and vice versa, so you should take a big-picture perspective and remember allocation is one part of negotiations in your overall deal.
For business owners looking for more information on selling your business, read our blog “How Much Does it Cost to Sell Your Business?”
If you are thinking about buying or selling a business and want to learn more about the allocation of the purchase price and what the overall costs associated are, call us at MidStreet Mergers & Acquisitions today.
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