Purchase Price Allocation
August 10th, 2008In research of the process for mergers and acqusitions of a company, I ran across a process for valuations and amortization of assets called Allocation. I have never heard of this term and ran across an excellent article I wanted to preserve, so am reposting. This article was originally here.
In an asset sale, the allocation of the purchase price is the process of breaking down the price paid for a business and of assigning fair values to its major constituting assets and liabilities. Whiles this accounting decision is often left to the last minute, one should keep in mind that it should be implemented similarly on both buyer and seller sides and that it may have significant consequences on the tax liabilities resulting from the sale of the business. So it is strongly recommended to resolve this issue before finalizing the purchase agreement.
The purpose of this article is to prepare buyer and seller for discussing the topic with their advisors. The article presents the main categories of assets that should be considered and to lay out the principles used by the IRS to determine the tax base for each category of assets.
This article discusses the allocation of the purchase price for the asset sale of a non-public company (usually less than $2 million sale price and where the buyer is an individual or a partnership) and the sale of other business entity types, such as sole proprietorships, partnerships, LLC’s and LLP’s.
Asset classification to maximize return and lessen taxes is part science and part art. The buyer and seller are working toward a common goal; the purchase/sale of a business, however, the financial objectives of both parties may put them at odds. When buyers purchase the tangible and intangible assets from a business, whether the existing business is a corporation, sole proprietor, a partnership, an LLC or LLP, the purchase price is usually allocated to some, or all, of the following components:
- Tangible Personal Property (trade fixtures, furniture, equipment)
- Leasehold Improvements
- Value of Premise Lease (if the lease is at below market rent)
- Covenant Not to Compete (include time and distance of covenant)
- Training & Transition (include schedule of time, hours, etc.)
- Registered Vehicles (do not include in Tangible Personal Property above)
- Liquor License (include license type and number)
- Customer List
- Goodwill
- Buildings
- Land
- Inventory
The total value allocated to all of the appropriate assets should equal the total of the purchase price. IRC Section 1060 further delineates specific items included in each of the seven "classes" of assets.
Below is a table with comparisons of how the buyer and seller would treat the assets values allocated to the above listed asset categories:
| Asset Category |
Buyer |
Seller |
| Tangible Personal Property (trade fixtures, furniture, equipment) |
Establishes basis, depreciate per IRS schedules |
If held more than one year, the gains in excess of depreciation are long-term capital gain; otherwise ordinary income |
| Leasehold Improvements |
Establishes basis, depreciate per IRS schedules |
If held more than one year, the gains in excess of depreciation are long-term capital gain; otherwise ordinary income |
| Premise Lease |
Amortize value over 15 years |
If held for more than one year, is long-term capital gain |
| Covenant Not to Compete |
Amortize over 15 years |
Ordinary income as received |
| Training/Consultation (include schedule of time, hours, etc.) |
Expense out as paid |
Ordinary income as received |
| Registered Vehicles (do not include in Tangible Personal Property above) |
Establishes basis, depreciate per IRS schedules |
If held more than one year, the gains in excess of depreciation are long-term capital gain; otherwise ordinary income |
| Liquor License (include license type and number; is an intangible asset) |
Amortize over 15 years |
If held for more than one year, is long-term capital gain |
| Customer List |
Amortize over 15 years |
Ordinary income as received |
| Goodwill |
Amortize over 15 years |
If held for more than one year, is long-term capital gain |
| Buildings |
Establishes basis, depreciate per IRS schedules |
If held more than one year, the gains in excess of depreciation are long-term capital gain; otherwise ordinary income |
| Land |
No immediate tax impacts |
If held more than one year, the gains in excess of depreciation are long-term capital gain; otherwise ordinary income |
| Inventory |
Treated as "cost of goods sold" upon sale of products |
Ordinary income, to the extent that it is over basis |
Taking into consideration the diverse tax treatments for the various asset categories, it becomes obvious that the seller will be motivated to allocate the sales price more heavily in the categories with the preferred tax treatment, those categories allowing capital gain treatment. Meanwhile the buyer will prefer a price allocation that favors categories allowing the most flexibility with the deduction and control of timing of the newly acquired assets.
Consistency between the seller and buyer in their reporting of the allocation is important. Work with professionals (licensed and/or accredited Brokers, CPA’s, attorneys) in these transactions to save you time and money down the line. Tax laws change frequently, so treat this article as a guideline subject to change by the IRS, and subject to interpretation by the appropriate professionals/advisors. Finally, the larger the transaction the more likely there will have to be a formal valuation performed, wherein some, or many of the various asset values may be indicated.