Allocating the Purchase Price for a Business Acquisition
| Publication year | 1991 |
| Pages | 1205 |
| Citation | Vol. 20 No. 6 Pg. 1205 |
1991, June, Pg. 1205. Allocating the Purchase Price for a Business Acquisition
Allocating the purchase price for a business can have dramatic tax consequences for both buyer and seller. With the differential between capital gains and ordinary income taxes now minimal(fn1) and, in the case of corporations, nonexistent, sellers and buyers are no longer subject to the constant tension between the allocation of purchase price to capital assets versus ordinary income-producing assets. This article discusses the primary considerations of sellers and buyers in negotiating the purchase price allocation in the sale of a business.
Corporate sellers of assets often wish to allocate a large portion of the purchase price to deferred compensation or covenants not to compete, payable directly to the owners of a selling corporation. This sort of payment will be taxable only once, at the shareholder level. In contrast, amounts paid to the corporation will be taxable once at the corporate level and again when paid out to shareholders, unless the payments can be justified as deductible compensation by the selling corporation.(fn2)
Because of the threat of double taxation, owners of a selling corporation have a strong incentive to press for a stock sale. Nonetheless, asset sales remain frequent because many buyers seek a "fresh start" basis in the business assets and are concerned about potential liabilities in stock acquisitions. The buyer's chief concern is to allocate the purchase price to assets that can be written off, through depreciation and amortization, over the shortest possible period of time. The buyer also is concerned with avoiding an allocation to nondepreciable goodwill or going concern value.(fn3)
Internal Revenue Code ("Code") º 1060 was enacted as part of the Tax Reform Act of 1986 and subjected to further refinements in the Revenue Reconciliation Act of 1990 ("1990 Act"). Code º 1060 forces both buyers and sellers to make specific allocations of purchase price in their acquisition agreements or risk an attempt by the Internal Revenue Service ("IRS") to allocate greater amounts to goodwill than the buyer might wish. It requires the purchase price to be allocated among classes of assets in accordance with their respective fair market values at the time the sale closes.(fn4) Any purchase price in excess of the fair market value of the assets must be allocated to the fourth asset class, goodwill. In the past, taxpayers were sometimes permitted to allocate purchase price to assets in amounts that exceeded their fair market values.(fn5)
Code º 1060 compels both buyer and seller to provide informational reports on the allocation to the IRS.(fn6) Owners often percent or more of a business who receive (1) employment contracts, (2) covenants not to compete and (3) royalties or lease agreements in connection with the sale of an interest in the entity are required by the 1990 Act to report information concerning the transaction to the IRS.(fn7)
The 1990 Act greatly expanded the scope of the required information reporting on business sales. In addition, the law now requires that parties be bound by their written agreement on allocation of purchase price, thus assuring uniformity, subject to the ability of the IRS to determine that the allocation "is not appropriate."(fn8)
The expanded reporting requirements and the likely focus by the IRS on attempts to avoid the corporate level tax through the use of creative techniques (such as lucrative employment agreements, deferred compensation agreements and covenants not to compete) will increasingly force buyers and sellers to make an allocation in contracts. Allocation is, therefore, likely to continue to be a significant bargaining point. The most likely area of concern, and of IRS inquiry, is the portion of the purchase price allocated to intangible assets, including noncompetition covenants, leases and other contractual agreements.
The buyer will be concerned that the purchase price is allocated to intangible assets that may be amortized as rapidly as possible.(fn9) Therefore, the bulk of this article focuses on the various types of intangibles that may exist in business acquisitions, as well as the likelihood of their being amortizable.
To take annual amortization deductions for intangible assets, a taxpayer must demonstrate (1) that the intangible
assets actually have a separate existence apart from the goodwill or going concern value of the business and (2) that the asset in question has a limited useful life.(fn10) The better an intangible item is defined in a purchase agreement, the greater the buyer's chances of...
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