When a business is sold, the most important overall aspect of negotiations between a cautious buyer and determined seller may be due to the agreed-upon purchase price for the business. However, when the buyer is purchasing just the assets of the business, the allocation of the purchase price among its various assets is necessary for tax purposes and often receives little to no attention until closer to closing. Before a closing can occur, a seller and buyer should agree on how the purchase price is allocated, and purchase price allocations are not always straightforward. While only one part of the effort to negotiate a larger transaction and its purchase price allocation, the portion of the purchase price allocated to income producing real property comes with some traps for the unwary. This article aims to break down purchase price allocations, to explain why purchase and sale agreements need to address them, and to share best practices for allocating purchase price when it comes to income producing property.

Purchase Price Allocation

Purchase price allocation is the process by which a seller and buyer agree to assign the total purchase price of a business to each individual asset sold for the purposes of determining taxes owed by the seller and correctly reporting the sale to the Internal Revenue Service (“IRS,”). The Internal Revenue Code of 1986, as amended (the “Code”)[1] requires both buyers and sellers to submit a purchase price allocation on IRS Form 8594[2], which allocates the total selling price of the business to seven different asset classes using something called the “residual method”. These seven asset classes are[3]:

• Class I Assets – Cash and general deposit accounts.
• Class II Assets – Actively traded personal property, certificates of deposition, and foreign money. It also includes U.S. government securities and publicly traded stock.
• Class III Assets – Debt instruments, accounts receivable, and other assets.
• Class IV Assets – Stock in trade, taxpayer’s property held in inventory or for sale to customers in the course of its trade or business.
• Class V Assets – All assets that are not classified in Class I, II, III, IV, VI, or VII, including furniture, fixtures, buildings, land, vehicles, and equipment.
• Class VI Assets – All Code section 197 intangibles other than goodwill and going-concern value.
• Class VII Assets – Goodwill and going-concern value.

The residual method works as follows to allocate consideration: the parties first reduce the purchase price by the amount of Class I assets (although sellers often retain those as part of the transaction in an asset sale). The parties then allocate the remaining purchase price to each asset class and then allocate purchase price among the assets in each class in proportion to their fair market values on the purchase date, up to the fair market value of each asset. If the purchase price exceeds the values of the first six asset classes, the excess is allocated to the “residual” category of goodwill and going concern value. The way the purchase price is allocated can significantly impact the tax liabilities for both the buyer and the seller. For instance, allocating more value to depreciable assets, like buildings, can provide the buyer with greater tax deductions through depreciation, reducing taxable income. While a seller and buyer can submit different purchase price allocations (often a common misconception that they can’t), this may lead the IRS to challenge one or both allocations, and it is a best practice for both parties to include language in their asset purchase agreements that requires cooperation and agreement on purchase price allocations, whether this occurs before closing in a schedule attached to the purchase agreement, or within a specified amount of time thereafter.

How to Allocate

In a perfect world, buyers and sellers of businesses would be free to allocate a purchase price among the various assets of a business however they wanted to maximize tax savings. However, as discussed above, both the IRS and the Code require purchase price allocation to be based on the “fair market value”[4] of the assets (meaning, the price the assets would sell for on the open market without compulsion to buy or sell and reasonable knowledge of the material facts)[5]. Different types of assets have preferred methods of valuation. Valuing land, for example, typically involves obtaining some type of real estate appraisal or comparing the land to similar, recently sold properties in the surrounding or competing area (specifically looking at prices paid for land that has a similar use and comparable zoning as the subject property for estimating the fair value). Likewise, tangible personal property (such as furniture, fixtures & improvements, machinery and equipment) is valued using the most appropriate methodology for the specific type of asset.

What If Real Property Produces Income?

A majority (but not all) of modern real estate transactions involve both land and an improved component. A typical example of land and land improvements can be found in rental property. Assume an owner of property buys a plot of land in 1980 for $100,000, built a two-bedroom, two-bathroom home in 1990, and sells it for $650,000 in 2020. Both the improvements (and good old inflation) increased the fair market value of the property by $550,000. That said, it may be a result of negotiations between the parties that a buyer and seller end up allocating $200,000 to the land and $450,000 to the home.

When negotiating the purchase of the assets of a business, however, there is a twist. If that plot of land was improved with real property used in a business, such as an office building, hardware store, a bank, or a grocery store, the purchase price allocation can appear more daunting. When the improvements to land produce income, the Code allows for depreciation deductions that account for a reasonable allowance for exhaustion and wear and tear on the building. Except for land, Class V assets are depreciable for federal income tax purposes, although the depreciation method and the useful life may vary.[6]

Going even further in allocations, owners of commercial businesses such as shopping centers, hotels, nursing homes and health care facilities benefit tremendously from comprehensive purchase price allocations, particularly within Class V, between real and personal property, between land, buildings and other improvements, and among the various depreciation lives for personal property. These types of business also may have substantial goodwill (Class VII) associated with their operations that has nothing to do with the value of the real and personal property itself and therefore should not be subject to any ad valorem taxation. Buyers must be cautious, as an overvaluation of real property will lead to an increase in property taxes down the road.

Allocation of purchase price also can impact transfer taxes and title insurance premiums. If the parties allocate too little to real estate, then the title policy insuring the buyer (or its lender) is written for less than the real value of the real estate, and the title insurer could assert they are only responsible for the proportional title risk equal to the percentage of which the property was under-insured. Similarly, most state and local governments collect transfer tax or documentary stamp tax at closing based on the purchase price of the real estate. In the same way that overvaluation can lead to increased property taxes, underreporting the value of real estate means underpayment of such transfer taxes, which in turn may lead to challenges (and interest and penalties).

Takeaway

As previously highlighted, allocations of the purchase price of a business for tax purposes must be based on the fair market value of each asset. More importantly, if a party to a sale is audited by the IRS, the burden of proof in self-allocation will fall on the taxpayer. Allocating the purchase price should be part of due diligence for any transaction and not wait until after closing. Because an asset sale or business acquisition is generally an arm’s-length transaction, a thorough and well-documented closing (including separate conveyance documents for each major asset) offers a great opportunity to support the parties’ agreed-upon value of the various business assets in the event of an audit. Buyers and sellers alike should make sure their tax, corporate and real estate attorneys are well versed in the complexities involved in purchase price allocation.

[1] All references in this article to sections are to sections of the Code, unless otherwise indicated.

[2] https://www.irs.gov/pub/irs-pdf/f8594.pdf

[3] https://www.irs.gov/pub/irs-pdf/i8594.pdf

[4] https://www.irs.gov/pub/irs-pdf/i8594.pdf

[5] https://www.irs.gov/pub/irs-pdf/p561.pdf

[6] https://www.irs.gov/publications/p946#:~:text=publications%20and%20forms.,What%20Property%20Can%20Be%20Depreciated%3F,%2C%20copyrights%2C%20and%20computer%20software.

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