Did I Purchase What You Sold?

Preface: Buyers are well-advised to give appropriate attention to asset allocations for tax purposes with transactions to avoid being pressured by uncooperative sellers after signing.

Did I Purchase What You Sold?

By Jacob M. Dietz, CPA

Sometimes a hardworking entrepreneur decides to move on to new adventures. The new adventure could be another enterprise, it could be mission work, or it could be a slower lifestyle and grandchildren. When this happens, there may be a sale of the business. When selling a business, make the allocation of the price a part of the agreement of the sale.

The Case of the Missing Allocation

Imagine if a custom chopping business owner named Reuben decided to sell his business, ABC Custom Chopping, LLC to another custom operator, Henry. He is selling the entire business including the equipment, the customer list, the employees, etc.

They agree to sell it for $750,000. In June, Henry writes a check (with the help of a bank loan) and takes over the business. Everything seems great until February.

In February, Reuben goes to his accountant and says he sold the business for $750,000. His accountant asks for an allocation schedule showing how much was paid for different asset categories. Unfortunately, no such allocation was ever created.

Purchase Price Allocation to Assets

What is an asset allocation, and why does it matter? IRS Form 8594, Asset Acquisition Statement, lists 7 classes of assets. A full treatment of this form is beyond the scope of this blog, but in certain cases when a business sells both the buyer and seller must fill out form 8594, which shows how the price of the business is allocated among asset classes.

Ignoring most of the classes, let’s look at class V and class VII. Class V includes various items, including equipment. Class VII includes goodwill. Goodwill has also been referred to as “blue sky” and can be the amount of the purchase price not allocated to other items.

Back to Reuben and Henry. How should they allocate the purchase price? Henry hopes to allocate as much as possible to the equipment, which is class V. Why? Equipment can be depreciated quicker than goodwill is amortized, and with accelerated depreciation Henry may even be able to deduct it all in year 1. Goodwill (class VII) on the other hand, is amortized (expensed) over 15 years.

Reuben, however, may want to allocate more to goodwill. Why? All or part of the sales price allocated to equipment will be subject to ordinary income treatment. The price allocated to goodwill can be subject to capital gain treatment. Ordinary income is often taxed at a higher rate than capital gain income.

Unfortunately, Reuben and Henry are motivated in opposite ways on how to allocate the purchase price, and they lack a business incentive to compromise. Henry has the business. Reuben has the money.

Agree when Negotiating

What could have been done differently? They could have agreed on an allocation before the deal was signed. When they were still negotiating the price, then they would have had a business incentive to compromise.

For example, assume Henry wants to allocate $700,000 of the purchase price to equipment, and Reuben wants to allocate $600,000 to equipment. They could perhaps meet in the middle, and agree to $650,000.   Alternatively, perhaps Reuben could agree to Henry’s number, $700,000 for the equipment, but negotiate an additional $10,000 or so to the sales price.

Although it may seem like one extra hurdle to selling the business, make sure your purchase agreement includes an asset allocation. What is purchased should be the same as what is sold. If there is disagreement, it is better to compromise at the time of the sale instead of trying to agree months later when the business incentive to compromise is no longer present. Months after the sale is a good time to enjoy the new adventure, but it is not a good time to argue over the allocation.

Leave a Reply

Your email address will not be published. Required fields are marked *