Structuring the Sale
Asset Sales: Allocation of the Purchase Price
The sale of a business is not considered to be the sale of a single unit or interest. Instead, it is treated as the sale of the separate assets that, taken together, constitute the business. Therefore, the purchase price must be allocated to the separate assets being sold.
First, you have to examine each asset sold and classify it into one of several asset groups (such as, cash and cash-like assets; securities; accounts receivable; inventory; other tangible property including buildings, furniture and equipment; covenants not to compete and other intangibles; and goodwill). Then you have to allocate a portion of the purchase price to each asset group (and to reduce the chance of IRS scrutiny to the manner in which you allocated the purchase price among the various assets, it is best if the buyer and seller agree on the allocations and incorporate them into the Purchase and Sale Agreement because this allocation must be reported to the IRS on Form 8594, Asset Acquisition Statement, filed by the Buyer and Seller).
Finally, you must determine the gain or loss on the sale of each asset or asset group. Depending upon the particular asset group and the type of taxpayer involved, either the ordinary income tax rates, the long or short term capital gain tax rates, the recapture income tax rates or the corporate income tax rates can apply; thus, there is often a huge incentive to assign as much of the sales price as possible to certain groups and not others.
Thus, determining the character of gain or loss on the sale of a business will typically reflect the tax interests of the buyer and seller, even though those interests may conflict under certain circumstances. For example, the characterization of gain from the sale of a business as capital rather than ordinary is advantageous for high income non-corporate taxpayers. For these taxpayers capital gains are taxed at lower rates than those applicable to ordinary income. No similar advantage, however, is available to corporate taxpayers selling a business. For corporate taxpayers, the tax rate for capital gains is the same as those for ordinary income.
To characterize gain from the sale of a business as capital gain, a seller would want to allocate as much of the purchase price as possible to goodwill or other intangibles such as trademarks or trade names, going concern value, or covenants not to compete, which are usually treated as capital assets.
A buyer, on the other hand, is likely to want to allocate the bulk of the purchase price to inventory or depreciable fixtures, machinery, or equipment. This allocation provides higher immediate deductions either because of an increased cost of goods sold or increased depreciation deductions. This type of allocation, however increases the ordinary income to the seller (stock in trade, inventory and depreciable business property are not capital assets). Even though a buyer who acquires goodwill in a business may be eligible to amortize the cost, the 15 year amortization period makes the amortization deduction less attractive than depreciation or cost of goods sold deductions which provide more immediate relief.
As you can see, tax planning is essential as you negotiate for the sale of your business. This is particularly so because the most advantageous manner of structuring the sale from the perspective of the seller, which contains the best tax strategies (potentially resulting in huge tax savings) may not be what is in the best interests of the buyer. Therefore, it may be prudent to offer a slight discount in the purchase price to ensure the transaction is structured in a manner that yields a substantial tax savings to you, the seller.
