Often, purchase price allocation is viewed as “something the accountants do” and is one of the last items discussed before closing the sale of a business. However, this is a mistake, as purchase price allocation (PPA) can significantly impact the value received and influence the negotiation strategy, as well as the future relationship between the buyer and seller. In some cases, buyers suggest addressing the allocation post-closing, but this is the worst approach for a seller, who, at that point, has almost no leverage. Understanding purchase price allocation and formulating a negotiating plan with your advisors can maximize the value of your business and facilitate a smoother transition with the buyer.
What is Purchase Price Allocation?
Purchase price allocation is the process of assigning the purchase/sale price of a business to various asset classes for reporting the sale to the IRS and determining the taxes owed. How the price is allocated among these classes determines the overall tax rate, as each class has a different associated tax rate. Notably, goodwill is taxed at a federal capital gains rate of 20%, while non-compete agreements and depreciation recapture are taxed at ordinary income rates of up to 39.6%. These allocations are partly subject to negotiation, and having a basic understanding of PPA can positively impact net proceeds.
IRS Definition
The IRS requires both the buyer and seller to submit Form 8594, which outlines the purchase price allocation. While the buyer and seller do not have to agree, failure to do so invites the IRS to impose its own allocation. Therefore, it is best for both parties to agree on the allocation. The IRS defines seven asset classes, within which the purchase price must be allocated. These are outlined briefly below. For more detailed descriptions, see the IRS instructions for Form 8594.
Class I—Cash and Equivalents:
In most transactions, cash is retained by the seller, so this would usually be zero.
Class II—Securities:
Typically, these remain with the seller, although there may be exceptions.
Class III—Accounts Receivable:
If receivables are sold to the buyer, the amount should be straightforward, subject to doubtful account analysis and working capital adjustments.
Class IV—Inventory:
Consider the current book value versus the value from a physical count at closing. Write-ups will be taxed at ordinary income rates.
Class V—Fixed Assets:
Includes equipment, real estate, vehicles, etc. This, along with Classes VI and VII, is often the most disputed. Buyers want high values here, while sellers prefer lower values.
Class VI—Intangibles:
Includes non-compete agreements, trademarks, trade names, licenses, etc.
Class VII—Goodwill:
Represents going concern value and is taxed as a capital gain.
The Most Common Issue – Depreciation Recapture
Service-based businesses with minimal hard assets rarely face this issue, but for manufacturing or other asset-heavy businesses, depreciation recapture can significantly affect the seller’s tax bill. For example:
Your company has fixed assets with an original value of $3 million, depreciated to a net book value of $400,000. The buyer wants to value these fixed assets at $2.8 million. The difference of $2.4 million is considered depreciation recapture and will be taxed at ordinary income rates. Since capital gains are taxed at 20%, while ordinary income can be taxed up to 39.6%, the tax difference could be as much as $470,000. Therefore, as a seller, you would want to reduce the fixed asset allocation and increase goodwill to save as much of that $470,000 as possible.
However, the buyer prefers higher fixed asset values and lower goodwill values because fixed assets can be depreciated in 5 to 7 years, compared to the 15-year amortization period for goodwill. This creates opposing tax benefits for the buyer and seller.
Other allocations, such as non-compete agreements, can create similar tax discrepancies. However, depreciation recapture generally causes the most significant discord between buyer and seller. (For more details on depreciation recapture, consult BMI, a tax attorney, or your CPA.)
A Simplified Example – Purchase Price Allocation in a Business Sale
| Buyer Allocation | Assumed Tax Rate | Buyer Allocation Tax | Seller Allocation | Seller Allocation Tax | |
|---|---|---|---|---|---|
| Purchase Price | $ 5,000,000 | $ 5,000,000 | |||
| Fixed Assets | $ 3,000,000 | $ 1,000,000 | |||
| Net Gain on BV of $200k | $ 2,800,000 | 35% | $ 980,000 | $ 800,000 | $ 280,000 |
| Inventory | $ 100,000 | 0% | $ 0 | $ 100,000 | $ 0 |
| Non-Compete | $ 20,000 | 35% | $ 7,000 | $ 20,000 | $ 7,000 |
| Goodwill | $ 1,880,000 | 20% | $ 376,000 | $ 3,880,000 | $ 776,000 |
| Total Tax | $ 1,363,000 | $ 1,063,000 | |||
| Tax Difference | $ 300,000 |
As shown, the seller would receive $300,000 less in after-tax proceeds if they accepted the buyer’s allocation.
Real Estate in a Business Sale
Related real estate in a business transaction could also have depreciation recapture. However, this is usually more of a calculation than a negotiation. The ordinary income tax rate on depreciation recapture is capped at 25%, while the gain on the original cost basis is taxed at the capital gains rate.
Negotiating Purchase Price Allocation
Typically, purchase price allocation is one of the last items discussed before closing. However, PPA should be considered before signing the Letter of Intent (LOI). At the time of an offer, sellers should consult with their tax accountants and M&A advisors to determine their expected tax bill and net proceeds. This is especially important for businesses with significant fixed assets that have been largely depreciated.
By notifying the buyer of the seller’s assumptions in accepting a specific offer, the buyer understands the expectations going forward. Sophisticated buyers, such as larger private equity groups, often make PPA assumptions when drafting the LOI, making early discussions easier. Increasingly, buyers propose that PPA be worked out post-closing, but this should never be accepted.
While PPA should not be a dealbreaker, reasonable expectations and compromise can prevent it from derailing a transaction. By discussing PPA early and maintaining realistic expectations, the negotiations can proceed more smoothly, reducing potential conflicts.
Note: This summary provides a general overview. Prospective sellers should consult an experienced CPA, tax attorney, and M&A advisor.