Purchase Price Allocation
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Generally speaking when you purchase another business, you are only buying the assets of that business. In other words, you are not buying the entity. Why not? Well, the entity could have a lot of skeletons in the closet. Using our accounting firm example above, if the previous owner had made a mistake on a tax return and that mistake led to $100,000 in damages for the client, as the new owner do you want that responsibility or exposure? Nope.
There are circumstances where an asset sale is NOT ideal. At times the entity holds a license that is non-transferrable such as a liquor license or the entity has a contract with the government that took 7 years to bid and be awarded, and is also non-transferrable. But for most transactions, you will be executing an asset sale.
Within that asset sale is allocation of assets. Buyers and sellers have competing interests on price of course, but they also have competing interests on tax consequences. And to add to the complication, based on each party’s unique circumstances, a buyer and seller’s interests might be in concert with each other. In other words, an asset allocation might provide a favorable tax position for the buyer because of his or her own tax world, while still providing a favorable or at least neutral tax position for the seller. And these issues can affect the purchase price as well.
As business consultants and tax accountants, WCG (formerly Watson CPA Group) is very aware of these competing interests and how they interplay with price negotiations. Let us help!
Let’s review some basics.
|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|
* Sellers using an accrual method of accounting would not recognize income for the sale of their Accounts Receivable
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. So if the price is $200,000 and all your assets add up to $150,000, then you are also purchasing $50,000 in Goodwill.
Some more notes. Cash and investments are usually kept by the seller in an asset sale. And commonly so is Accounts Receivable- most sellers will say that they earned this income, and it is just a matter of collecting. Buyers are usually accepting since collections can be tough- why pay for an asset that might not fulfill its value. If, however, a seller does transfer his or her Accounts Receivable (AR) to you, that will be considered ordinary income for a seller who is uses the cash method of accounting. Who would have Accounts Receivable yet use a cash method of accounting? Lots. WCG (formerly Watson CPA Group) invoices clients but does not recognize income until payment is made. We use the cash method of accounting, and use our AR as a way to maintain the naughty list and the good list.
Ok. Back to the competing interests.
Generally speaking, the buyer wants as much allocation to items that are currently deductible such as a consulting agreement and to assets that have short depreciation schedules. However, there are always circumstances where the buyer might want to defer deductions to later years, or some other unique scenarios. When people ask us this question it takes about 10 seconds to ask the question, about 30 seconds to give the generalizations, and about two hours of consultation, projection and review to ensure allocation is being handled correctly.
The seller typically wants as much of the purchase allocated to assets that enjoy capital gains treatment, rather than to assets that bring ordinary income. Capital gains max out at 23.8% (including the net investment income tax) where as ordinary income could be as high at 39.6%. Again, there are always scenarios that might make sense to flip this around- perhaps there is a net operating loss from previous years that needs to be used before expiration, or some other situation.
Bottom line is that price and asset allocation must be handled carefully. It is commonly used a negotiation tactic, and to properly negotiate you as a buyer or a seller should know what the other side is thinking. That’s just smart business.
Recapture of Depreciation
Assets that are eligible for depreciation might have two elements of gain. One is recapture of depreciation and the other is capital gain. Let’s say you had $50,000 in furniture that is being sold with the business, and you depreciated it to $10,000. If $65,000 was allocated to furniture, you would have a $40,000 recapture taxed as ordinary income and another $15,000 in capital gains taxed at your capital gains rate. Here is in table format-
|Furniture Purchase Price||50,000|
|Tax Book Value||10,000|
|Price Allocation to Asset||65,000|
|Tax Book Value||10,000|
|Recapture, Ordinary Income||40,000|
|Remainder, Capital Gains||15,000|
Even though non-compete agreements are tough to enforce they still show up in business asset sale and purchase agreements. As an aside, you should consider using a non-disclosure agreement in addition to your non-compete agreement. Typically these are bad for both parties from a tax perspective- non-compete agreements or covenants not to compete, whatever you want to call them, at taxed to the seller as ordinary income but then are amortized over 15 years for the buyer. This is one area that both parties have an interest in keeping low (but you should consult an attorney at to actual value of the non-compete agreement, it might have some repercussions from a litigation perspective).
Sales Tax and Assumed Liabilities
Sales tax might need to be collected on the sale assets, and are usually collected by the buyer. Most sellers will want the buyer to simply back out sales tax from the purchase price. So, if a $500,000 deal would incur $10,000 in sales tax, the buyer is essentially paying $510,000 since the seller still wants $500,000 in proceeds. Sales tax will vary by state and by purchase price allocation, and is only due on certain assets. Again, this needs to be vetted out and modeled by experienced tax accounts- we suggest us.
Of course if the transaction is a stock sale as opposed to an asset sale, then sales tax does not usually apply.
Assumed liabilities. Messy. Try not to do it. There are instances where you must, and it can get complicated beyond the scope of this book.
Employment / Consulting Agreements
Transition between owners is critical. A tax and accounting firm can buy another tax and accounting firm, and even though the work is nearly identical, the seller is usually retained to help with client transition. This is true in most businesses, especially those in the service industry.
The value of the employment or consulting agreement is an instant tax deduction to the buyer, but it incurs ordinary income tax PLUS self-employment tax for the seller. Unless that seller was smart, read our book and elected to be treated as an S Corp. Remember, most deals will be an asset sale, so the seller retains the business entity. And if that entity is an S Corp then that income can be sent through the entity and shelter some of the self-employment tax.
Some more thoughts. At times the buyer and seller will use the employment/consulting agreement as quasi-seller financing without calling it seller financing. This can help with debt ratios, and debt service calculations (more on that later) since the bank will want you to be able to service all debt instruments including their own. These agreements at times can bypass some of that scrutiny.
Also, some attorneys do not like these agreements lasting for more than one year. Some cases have been litigated, and purchase contracts have been considered null and void because there was not an effective transfer of ownership because the seller was under an employment / consulting contract. Seems crazy, but true.
There have been instances where a seller was retained through a consulting agreement, and misrepresented the company to customers. Lawsuits have been successfully litigated resulting in damages being awarded based on the behavior and representations of the seller while contracted as a consultant for the buyer. Be careful.
As a buyer you should get in, use the seller during a short transition, and get going. As a seller, you should help your buyer, defer future client interaction to the new owners, and get out. Transition is one of the toughest things to agree upon, execute and find success. Good luck.
Taxpayer’s Comprehensive Guide to LLCs and S Corps : 2019 Edition
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