#RVABizLaw Tip of the Day: Purchase Price Allocation in Small Business Acquisitions
For various reasons (to be discussed in another blog post), most small business acquisitions are structured as a purchase of assets (as opposed to the purchase of corporate stock or LLC membership interests) because buyers typically prefer it that way. One of the many items to negotiated between seller and buyer is how the purchase price will be allocated for tax purposes.
In asset sales, both parties are required to file IRS Form 8594 with their respective income tax returns for that year allocating the purchase price among seven different classes or categories of assets. Needless to say, both filings need to be consistent; therefore, the purchase price allocation is typically one of the issues negotiated as part of the deal into the Asset Purchase Agreement.
Sellers and purchasers can have conflicting incentives when it comes to negotiating the purchase price allocation. First tip is to be sure you get your accountant’s input when addressing this issue. Ideally, your accountant or tax advisor is working alongside your business attorney throughout the acquisition process anyway, but his or her input on this topic is especially important.
Second tip is to understand how the IRS categorizes the different classes of assets in this context. It is actually pretty straightforward. The IRS breaks assets into classes, and essentially once you’ve allocated everything to Class I thru Class VI, whatever is left over is then considered goodwill.
| Asset | Priority | Buyer | Seller |
| Cash | Class I | NA | NA |
| Investments | Class II | NA | NA |
| Accounts Receivable | Class III | NA | Ordinary Income |
| Inventory, Book Value | Class IV | NA | None |
| Fixed Assets | Class V | Amortized, Varies | Recapture / Gain |
| Intangibles | Class VI | Amortized, 15 Years | Capital Gain |
| Goodwill | Class VII | Amortized, 15 Years | Capital Gain |
| Non-Compete | NA | Amortized, 15 Years | Ordinary Income |
| Consulting Agreements | NA | Expensed | Income + SE Tax |
So if the purchase price is $200,000 and all the hard asset values add up to $150,000, then the buyer is purchasing $50,000 in goodwill.
Cash, investments, and accounts receivable are usually retained by the seller in an asset sale, so Classes I-III don’t often factor into the purchase price allocation analysis.
Generally speaking, the buyer wants as much of the purchase price as reasonably possible to be allocated to items that are currently deductible such as a consulting agreement and assets that have short depreciation schedules.
The seller typically wants as much of the purchase price as possible allocated to assets that enjoy capital gains treatment, rather than assets that will be taxed as ordinary income.
Assets that are eligible for depreciation might have two elements of gain. One is recapture of depreciation and the other is capital gain. For example, if the deal includes $50,000 in furniture that is being sold with the business, and the seller had depreciated it down to $10,000, and then $65,000 was allocated to furniture in the Asset Purchase Agreement, the seller would have a $40,000 recapture taxed as ordinary income and another $15,000 in capital gains taxed at seller’s capital gains rate.
If the deal includes a post-closing employment agreement or consulting agreement to ensure seller’s assistance during a transition period, that agreement is an instant tax deduction to the buyer, but it is results in ordinary income tax and possibly self-employment tax for the seller. At times the buyer and seller utilize the employment/consulting agreement as an indirect form of seller financing without calling it that. This can help with debt ratios, and debt service calculations.
If you are ready to buy or sell a small business in Virginia, reach out to Perkins Law for help!
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