Allocation of Purchase Price
The crucial step of allocating the purchase price is necessary and must meet compliance per the federal tax codes. It is recommended that your CPA be involved in this step of the process when purchasing the assets of a business. For the purpose of this article we will be viewing the allocation through the lens of a main street business. And although I am not a CPA or Tax attorney, as a broker I feel that it is important that both the seller and buyer have a basic understanding of this part of the buying process.
Acquiring the assets of a “main-street” business is preferred over a stock purchase or merger, since the seller remains the legal owner of the entity while the buyer gets the individual assets of the company such as equipment, licenses, customer lists, and inventory. This allows the purchaser to avoid any of the liabilities, known and unknown, related to the business entity. It also allows you to receive a new tax basis, or “step-up”, for the assets being purchased, providing an opportunity for tax deductions for depreciation and/or amortization.
However, it is these tax implications that make it so important to properly manage an asset purchase transaction, particularly with respect to the purchase price. The transaction is the total of the sale of each of the individual assets.
Section 1060 of the I.R.C.
Section 1060 of the I.R.C. holds that in an “applicable asset acquisition” (AAA), which includes Asset Purchase Transactions, the purchaser’s basis in the acquired assets and the seller’s consideration must be allocated among the assets pursuant to the “residual valuation method,” which deducts the costs of the transaction from the anticipated value.
Contrary to popular belief, the I.R.S. does not require any mutually agreeable allocation of the purchase price. Instead, it requires that Asset Purchase Transaction (among other AAA types) must allocate a total sales price among the most common classes of assets:
- Furniture and fixtures,
- Buildings and improvements,
- Software, and
- Intangibles (such as customer lists, patents and goodwill).
With an asset purchase, the most important tax-saving opportunity revolves around how you allocate the total purchase price to the specific assets that are acquired.
To the extent allowed, you want to allocate as much of the price as possible:
- To assets that would generate higher-taxed ordinary income when converted into cash (such as inventory and receivables),
- To assets that can be depreciated quickly (such as furniture and equipment), and
- To intangible assets (such as software, customer lists and goodwill) that can be amortized over 15 years.
And you want to allocate as little of the price as possible:
- To assets that must be depreciated over long periods (such as buildings), and
- To land (which can’t be depreciated).
Allocate any remaining price to identifiable intangible assets other than goodwill. Such intangibles can include:
- Covenants not to compete,
- Technology and knowledge-based intangibles,
- Secret processes,
- Specialized software and business systems,
- Customer lists and favorable contracts,
- Workforce in place,
- Copyrights, and
You can amortize the cost of purchased eligible intangibles over 15 years. Allocations in this step are made in proportion to each asset’s Fair Market Value (FMV) and can’t exceed FMV.
The (seller) wants to minimize the purchase price allocated to the receivables and fully depreciated assets, because gains from those assets will be treated as ordinary income and taxed at the maximum 37% federal rate on the owner’s personal return. Gains from the other assets will be long-term capital gains that will be taxed at only 20% or 25%.
As a Buyer
As the prospective buyer, you want to allocate as much of the purchase price as possible to:
- Receivables (which will be quickly collected and written off for tax purposes),
- Furniture, fixtures and equipment (which can be depreciated quickly for tax purposes), and
- Eligible intangibles (which can be amortized over 15 years for tax purposes).
Important: Purchase price allocations can be an important part of discussions. It’s important for the parties to agree to a reasonable allocation under the residual method prior to closing. The tax consequences could affect the amount a buyer will pay or a seller will accept in an asset purchase deal.