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

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.

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Recognition of Team Dedication and Client Trust

Thomas Kerchner, Managing Director at BMI, commented, “This recognition highlights the dedication and effort our team puts into every transaction. Each BMI advisor is committed to helping clients reach their goals, and it’s an honor to have our work acknowledged in this way.”

Specializing in sell-side advisory for lower middle market businesses, BMI Mergers & Acquisitions has earned a reputation as a trusted partner. Our advisors combine industry knowledge and hands-on experience to guide clients through the M&A process with confidence and clarity, always focused on maximizing value and honoring each client’s goals.

This recognition from Axial wouldn’t be possible without our clients’ trust in us. We’re honored to support these owners as they take steps toward new beginnings.

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Bardot Plastics was founded in 1973 by J. Lee Boucher and has since established itself as a trusted leader in custom injection molding. For over fifty years, Bardot Plastics has upheld its commitment to “making it right the first time” by utilizing engineered and non-engineered resins. Today, the company continues to blend advanced engineering with high-volume production capabilities, earning a reputation for excellence in quality and innovation.

“Bardot Plastics has built an excellent reputation with its customers, largely due to the foundational principles set by Lee Boucher and sustained by the Boucher family over the decades. This acquisition reflects our investment philosophy not only operationally but also culturally in how we conduct business,” said Clark Stapelfeld, President & CEO of New Pendulum Corporation.

Reflecting on the transaction, former owners Rick and Jim Boucher shared, “The entire process was incredible! Working with David and Tom from BMI—from crafting the CIM, meeting potential buyers, receiving LOIs, and ultimately finding the right buyer that aligned with our father’s vision for Bardot Plastics—BMI helped us achieve the ideal exit strategy for our family and our business’s future.”

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What is Seller Financing?

Seller financing, or a “seller note,” is where the seller provides a loan to the buyer to cover a portion of the business purchase price. With banks tightening lending, sellers are increasingly asked to step into this role to bridge financing gaps. This approach is common in today’s high-interest, cautious lending environment, especially in deals under $10 million.

Why Consider Seller Notes?

While seller notes come with risks, they can offer strategic benefits:

• Potential for Higher Sale Price: Offering seller financing can attract more buyers and potentially raise the total sale value.
• Tax Deferral: By structuring payments, sellers may defer taxes.
• Operational Advantages: Buyers who are operationally strong but financially limited may still be able to purchase, benefiting from your industry insights and experience.

Common Risks and Mitigation Strategies

Though useful, seller notes have inherent risks. Key risks include:

• Second Position: Seller notes are usually subordinated to bank loans, meaning repayment comes second to the primary lender.
• Unsecured Loans: Prime lenders often secure all available collateral, leaving seller notes unsecured.

To mitigate these risks, consider the following:

• Perform Thorough Due Diligence: Evaluate the buyer’s financial history, operational skills, and any co-investors or partners.
• Request Guarantees: Seek personal guarantees or liens on business assets.
• Regular Financial Reporting: Require quarterly financial updates from the buyer to monitor their financial stability.

When to Avoid Seller Financing

Not every deal is suitable for seller financing. For example, when buyer capital is minimal or their financial strength is questionable, seller financing may introduce unnecessary risk. It’s critical to weigh these factors and consult with M&A advisors and legal experts before proceeding.

Summary

Seller financing has long been a part of private business sales, adapting with economic shifts but remaining a valuable transaction tool. Although seller notes carry significant risks, they can be instrumental in maximizing sale value under the right circumstances. Business owners should carefully assess the benefits and risks to make a well-informed decision that aligns with their financial and strategic goals. For a confidential discussion on your business sale options, reach out to our experienced M&A team.

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Originally from Atlanta, GA, Greyson Tavolacci relocated to Raleigh, NC in 2005. Beginning his professional career in commercial real estate brokerage, Greyson assisted in guiding business owners through leasing, acquisition, and asset disposition. His team orchestrated transactions totaling $6B+ in volume. Evolving his career trajectory, Greyson transitioned into Mergers & Acquisitions – Investment Banking. Here, his objective shifted towards empowering business owners to unlock the full potential of their enterprises by employing strategic growth tactics and meticulous exit-planning methodologies. Embodying the ethos of “Start with the end in mind,” Greyson injects an entrepreneurial spirit into every endeavor, navigating challenges with ingenuity and foresight.

With a relational approach at the core of his methodology, Greyson delves deep into understanding his clients’ aspirations and objectives. This holistic comprehension enables him to craft bespoke plans that align with their goals and pave the way for creating their legacy.

Greyson holds a Bachelor of Business Administration degree from the Miller School of Entrepreneurship at East Carolina University. Raleigh, North Carolina, is home base.

His favorite mantra, “The only wealth which you will keep forever is the wealth you given away,” encapsulates his belief in the enduring value of generosity and philanthropy.

For further inquiries, contact Greyson at the Raleigh office at 919-455-3995.

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Private equity played a significant role, adding competitive pressure and driving up valuations for companies with strong AI and analytics capabilities. Cross-border deals were also prominent, consolidating regional players.

Looking ahead, a rebound is expected as buyers seek assets aligned with emerging technologies. Valuations are anticipated to stabilize for innovative companies in AI, big data analytics, and cloud consulting. Expect renewed M&A activity in 2024, with a focus on scalability and innovation.

For a detailed analysis of the 2023 technology services M&A landscape and insights into the 2024 outlook, download our comprehensive market report.

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What type of corporate entity matters:

• S corporation or other pass-thru structure such as an LLC
• The main difference is the C corporation pays income tax at the corporate level while at S corporations the income tax is paid by the individual shareholders.

What type of sale matters:

• Stock or asset sale
  • Stock sales – the buyer purchases the shares of the company and thus owns the legal entity. 
  • Asset sale – the buyer purchases all the assets of the company but not the legal entity.

C- Corporation:

• Because the entity is taxed on its income and then the individual shareholder is taxed on dividends, an asset sale of a C corporation results in a very high tax bill. Combined federal rates will easily exceed 40%.
• Therefore, owners of C corporations need to have stock sales where a majority of the taxes will be capital gains at 20% federal for active owners. Note there are variations of stock deals where the transaction is taxed as an asset deal.  But these are still far better than a straight-up asset sale. 

S-Corporations and other pass-thru entities:

• In many cases the tax bill on an S corporation sale will be lower than in a stock deal vs an asset deal, however, the difference is usually not so dramatic that it affects the likelihood of a completed deal.

Taxes in an asset deal – C corporation:

• Assets on the books such as inventory, AR and net book value of fixed assets have zero tax.
• Most other assets will be taxed at the corporate federal tax rate of 21%.
• To obtain the proceeds, the shareholders will have to declare a dividend which will be taxed at 20% for each individual.
• Thus, a minimum combined 41% tax rate for a majority of the purchase price.
• In some cases, there is the possibility of assigning some value to personal goodwill which eliminates double taxation on that part.  However, this is often not available to middle market owners and if so, requires a separate detailed discussion.
• State corporate income taxes also apply and can be up to 11.5% although most are much lower.  Rates are also subject to change as Pennsylvania’s tax is on a declining schedule through 2031 to 4.99%. North Carolina – 2.5%, New York – 7.25%
• An asset sale of C corporation should be avoided.

Taxes in an asset deal – S corporation or pass-thru:

• The key here is the purchase price allocation.  This is negotiated and determines both the seller’s tax bill and the buyer’s annual depreciation and amortization write-offs.
• Basic components:

• As you can see the ideal tax structure for a seller is to reduce gains on fixed assets and minimize the non-compete allocation.  The fixed asset allocation is usually the most heavily negotiated part.  Non-competes are usually easily agreed to at a reasonably low number.
• In many cases, especially for businesses with low fixed assets, the tax bill on an asset sale can approach that of a stock sale.

Taxes on a stock sale:

• If it is a stock sale and treated as a stock sale, then the shareholders pay capital gains tax on the value received over their basis.  You will need to obtain your basis from your accountant, but a quick rule of thumb would be the equity value of the company.
• Only two components:

• Pretty simple and low tax rate but….
• Buyers don’t like this because they cannot depreciate assets or amortize the balance of the purchase price thus, they get no tax deductions going forward. 
• Therefore, in many cases, buyers will ask for a 338(h)(10) or an F reorganization which allows them to purchase the shares but have the parties treat it as an asset sale for tax purposes. 
• Whether you have a C or an S corporation the treatment is the same as the tax calculation noted above for asset deals with an S corporation.  This is because it is still a stock deal.

State taxes on asset deals:

• Many states tax capital gains the same as ordinary income.
  • Examples:
    • New York – up to 10.9%
    • California – up to 13%
    • Pennsylvania – 3.07%
    • North Carolina  – 4.99%. 

Conclusion

The tension between stock and asset deals is more common at the smaller end of the market with deals under $10 million in value.  As deals become larger, the companies become more complicated and only stock deals make sense from a practical standpoint. There are many exceptions for a variety of reasons, but the key takeaway here should be to have a basic understanding of the workings of tax regulations in the sale of your business and consult with competent tax experts.

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Founded in 1985 by two industry veterans from Bethlehem Steel, Milton Smith, and James Hahn, SmitHahn Company has evolved into a premier metal fabricating enterprise. What began as a part-time partnership leveraging their metal manufacturing skills has flourished into a thriving business serving diverse industrial customers.

For 38 years, SmitHahn Company has been a prominent figure in the mechanical contracting industry, offering a wide array of services such as welding, fabrication, erection, rigging, millwright, and engineering. Their expertise extends to design-build, maintenance, repairs, and emergency services, making them a trusted partner in industrial and commercial projects. SmitHahn has built enduring relationships with clients across diverse sectors including Chemical, Plastic, Metal, Pharmaceuticals, Power, Cement, and more, demonstrating their versatility and commitment to meeting their clients’ needs.

GMAC Holdings is a family investment company with holdings in Pennsylvania.

About BMI Mergers & Acquisitions:

BMI Mergers & Acquisitions is a leading advisory firm specializing in M&A transactions between $3 and $150 million, offering expert guidance and tailored solutions to clients in various industries including manufacturing. BMI provides clients with customized strategies to achieve their financial and growth objectives.

BMI has been in business for over 15 years and has offices in New York, Charlotte, Raleigh, Philadelphia, and Lehigh Valley. Securities transactions are handled through StillPoint Capital, Member FINRA, and SIPC, which is not affiliated with BMI.

BMI was recently named a Top 10 Lower Middle Market investment bank by Axial.

If you are considering the sale of your business, preparation is key to improving value. To discuss your goals and options with an experienced and professional M&A Advisor, fill out the contact form below or visit our contact page for more details.

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TEV = Transaction Value in $millions.  The range is $10 million to $250 million.

GF Data deal sizes start at $10 million, but we also considered smaller deals provided by DealStats®. These encompass a wider range of deal sizes and involve various types of buyers. The average deal size is $4 to $5 million in revenue, with deal values mostly falling between $1 and $7 million. In 2023, deal volume is down as expected, but EBITDA multiples for valuations are up, possibly for the same reasons as noted above.

Wholesale Distribution Deal Data – Small Deals

While deal volumes are down, the overall number of wholesale distribution deals in the U.S. and Canada in 2023 will exceed 774 transactions as reported by Pitchbook®.  Several deals of note:

Future Electronics, a distributor of electronic components, was acquired by WT Electronics for $3.8 billion or 1.3x revenue. No EBITDA data is available.

Tessco Technologies, a value-added communications technology distributor, was acquired by Alliance Corp., Lee Equity Partners, and Twin Point Capital for $161 million or .36x revenue.

Applied Industrial Controls, a supplier of industrial control and automation products, was sold to Frontenac Company for an undisclosed amount.

Sectors with deals were wide-ranging from jewelry, industrial, technology, oil, and gas to food.

As we start 2024, our activity is healthy, indicating that the upcoming year will be as good as, if not better than, 2023, especially if interest rates start dropping.

If you’re interested in discussing these insights and understanding how they may impact your own M&A plans, feel free to contact us for a confidential conversation here, or to learn more about our M&A team, visit us here.

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Headquartered in New York, Ideametrics is an Oracle-certified gold partner, specializing in streamlining business and IT operations for organizations. They offer core services for Oracle systems, including HCM, ERP, and EPM.

Established in 2005, Smart ERP Solutions offers innovative, customizable, and cost-effective services to address common business challenges, in addition to offering a full portfolio of professional services for its clients. As an Oracle Cloud Services Partner and approved Cloud Standard Implementation Partner, they specialize in enhancing ERP applications, including Oracle Cloud, PeopleSoft, JD Edwards, and E-Business Suite.

Third Century is an Atlanta, Georgia-based private equity firm focused on investing in middle-market founder-led and family-owned businesses in the business services, IT services, and industrial / energy services sectors.

Commenting on the acquisition, Matt Tortora, M&A Advisor at BMI said, “The Ideametrics management team had built a very well-run organization over 16 years and brings a well-established presence not only within the Oracle partner ecosystem but also with clients in the Higher Education space. They found an excellent acquisition partner in Smart ERP. There are a lot of obvious synergies here that should enhance the value and solutions they’re able to provide existing and future clients. It’s a great partnership for everyone involved.”

To discuss the possibility of selling your business, visit our contact page for more details.

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