When buying or selling a business, Section 1060 of the Internal Revenue Code requires buyers and sellers to allocate the purchase price to be allocated among the assets bought or sold based on the fair market value of those assets. These purchase price allocations have significant tax consequences to both buyers and sellers. Therefore, parties should fully understand the tax ramifications prior to agreeing to any purchase price allocation.
Section 1060 and its associated regulations require that buyers and sellers use the “residual” method to allocate the purchase price, which includes not only the cash consideration paid but also assumed liabilities. Pursuant to the “residual” method, taxpayers allocate the purchase price for tax purposes among the assets being acquired or sold starting with the first class and the remainder of the purchase price being allocated to goodwill. In other words, taxpayers allocate the purchase price to the extent of those assets in that class and then to the following classes in the order below. The classes and a brief description of the assets included in those classes are:
- Class I: Cash
- Class II: Marketable Securities
- Class III: Accounts Receivable and other assets for which the seller is required to use market to market valuation annually
- Class IV: Inventory
- Class V: Machinery, equipment, land, building and other assets not otherwise described in the other classes
- Class VI: Intangible assets other than goodwill
- Class VII: Goodwill
The amount of the Purchase Price allocated to each category has significant tax consequences to buyers and sellers. One of the most disputed categories revolves around Class V, machinery and equipment. From a buyer’s perspective, a buyer would like to allocate as much of the purchase price as possible to machinery and equipment because 80% of the amount allocated to machinery and equipment would be immediately deductible by the buyer. Assuming all other values are the same, any amount not allocated to machinery and equipment would be added to goodwill, which is amortized over 15 years. However, to sellers that are taxed as subchapter S corporations, partnerships (including limited liability companies) or sole proprietorships, the gain on machinery and equipment could be taxed as high as 37% versus goodwill, which would be taxed at a rate of 20%. Normally, sellers have little or no taxable basis in their machinery and equipment because they have already fully depreciated those assets using bonus depreciation. For subchapter C corporations, all gain is taxed at the same rate, currently 21%, and the character of the gain will only impact subchapter C corporations that have unique tax attributes, such as capital loss carryforwards.
Sellers should also beware of amounts allocated to a covenant not to compete versus goodwill. To a seller, a covenant not to compete is taxed at ordinary income tax rates which could be as high as 37%. However, from a tax perspective, this usually is not that controversial because a covenant not to compete is amortized over the same period as goodwill, 15 years.
Because of a desire for certainty by both buyers and sellers, and to avoid post-closing disputes, many buyers and sellers will agree to a methodology on the manner of allocating the purchase price. Until the purchase price for tax purposes is finally determined, however, it is impossible to allocate the purchase price with precision. The purchase price for tax purposes will vary because the amount of assumed liabilities such as accounts payable and accrued liabilities will not be finally determined until the closing date working capital is finally determined. Notwithstanding that uncertainty, the parties may agree to a methodology at closing.
In the event that the parties fail to agree on a purchase price allocation methodology or if they agree to allocate the purchase price post-closing but cannot agree on the methodology, Internal Revenue Service Form 8594 (Asset Acquisition Statement Under Section 1060) does permit buyers and sellers to claim different purchase price allocations. However, some claim that a mismatch on the allocation may trigger an IRS audit.
For various reasons and for certainty, buyers and sellers should, prior to executing a purchase agreement, fully understand and model the tax ramifications of a purchase price allocation.
