In an asset sale, agreeing on the purchase price is only the first step for buyers and sellers. A purchase price allocation assigns that price across the specific assets in the deal. This allocation carries tax consequences for both sides. For the buyer, it sets the tax basis for future depreciation and amortization deductions. For the seller, it determines if the tax code treats the gain as ordinary income or capital gain. Below, we explain when a purchase price allocation for tax purposes is required. We also discuss the IRS residual method and how the allocation affects each party.
Peak Business Valuation regularly supports buyers and sellers with independent valuation reports. We can determine the fair market value of the equipment, real estate, and intangible assets in the sale. Both parties can use these figures to support purchase price allocation. If you are preparing for an asset sale, we are happy to answer any questions. Schedule a free consultation below to get started.
What Is a Purchase Price Allocation for Tax Purposes?
A purchase price allocation for tax purposes divides the purchase price among the acquired assets. Under Section 1060 of the Internal Revenue Code, this allocation sets the buyer’s tax basis in each asset. It also determines the tax treatment of the seller’s gain or loss. Generally, both parties must report a matching purchase price allocation to the IRS.
Once the allocation is complete, the buyer can know how to depreciate or amortize each asset. This applies to future tax returns. In contrast, it helps the seller know how the proceeds of the sale are taxed. The proceeds may count as ordinary income or as capital gain. To ensure a credible purchase price allocation, an independent fair market value analysis is crucial. This gives both parties a report that can withstand scrutiny.
When to Perform a Purchase Price Allocation for Tax Purposes
The IRS requires a purchase price allocation whenever a transaction counts as an asset sale. This requirement applies in a few common situations for small business transactions:
- A Direct Asset Sale: The buyer acquires the business’s assets directly, and goodwill could attach to those assets.
- A Deemed Asset Sale: Sometimes, the tax code treats other transactions as asset sales. Certain stock purchases are common examples of deemed asset sales.
- A Price-Based Basis: Instead of carrying over the seller’s basis, the buyer’s basis is determined by the amount paid for the acquired assets.
When these conditions apply, both parties must file Form 8594 for the year of the sale. They attach it to their federal income tax returns.
How the Residual Method Allocates the Purchase Price
Section 1060 requires buyers and sellers to allocate the purchase price using the residual method. This method works through seven asset classes in a fixed order. The price is first allocated to cash and general deposit accounts. The allocation to each class cannot exceed the fair market value of its assets. Any remaining value then moves to the next class.
Below, we highlight the three classses where negotiation and an independent valuation are crucial:
- Equipment, Furniture, and Real Estate (Class V): These assets receive an amount equal to their fair market value. An equipment appraisal for tax reporting often supports this figure.
- Identifiable Intangible Assets (Class VI): This class includes customer relationships, trade names, and non-compete agreements. These Section 197 intangibles receive the next portion of the price.
- Goodwill and Going Concern Value (Class VII): Any amount left after the first six classes goes to goodwill. This asset is amortized over 15 years for tax purposes.
The buyer and seller may agree to the purchase price allocation in the purchase agreement. If they do, both parties must use that allocation for tax reporting purposes.
If you need a credible purchase price allocation, work with a certified business appraiser. Peak Business Valuation can determine the fair market value of equipment and intangible assets. This helps the purchase price allocation hold up under IRS review. Schedule a free consultation below if you have any questions!
How Purchase Price Allocation Affects Buyer and Seller Taxes
The purchase price allocation directly impacts what each party owes in taxes. This is why buyers and sellers often have opposing interests during negotiation. For instance, a buyer generally prefers a larger share allocated to equipment and other Class V assets. These assets may qualify for bonus depreciation or Section 179 expensing. Both produce faster deductions than the 15-year amortization schedule for intangibles and goodwill.
In contrast, a seller often prefers a larger allocation to goodwill. Gain on Class VII assets is generally taxed as a long-term capital gain. On the other hand, gain on equipment can trigger depreciation recapture taxed at ordinary income rates.
This difference is one reason a purchase agreement should set the allocation directly. Waiting until later in the acquisition process often complicates negotiations.
Key Documentation for a Purchase Price Allocation
A business appraiser needs specific records to provide reliable support. Gathering the following documents early helps promote a more efficient valuation and negotiation process:
- The Purchase Agreement: The agreement often includes a preliminary allocation schedule that the appraiser reviews first.
- Fixed Asset Records: Equipment lists, depreciation schedules, and any prior machinery and equipment appraisal help establish Class V values.
- Financial Statements: Several years of historical statements and any financial projections support the overall valuation.
- Intangible Asset Details: Customer contracts, lease agreements, and non-compete agreements help identify Class VI assets.
These records give the appraiser what they need to calculate the fair market values used in a purchase price allocation for tax purposes.
Conclusion
A purchase price allocation for tax purposes sets the buyer’s basis. It also determines the seller’s tax treatment for each asset in the sale. As such, it is vital to ensure that the allocation reflects reliable fair market value estimates for the acquired assets. Buyers and sellers can support these estimates by engaging a certified appraiser and providing key records.
Peak Business Valuation is a professional appraisal firm. We support buyers and sellers with independent valuations for purchase price allocation. If you have questions, we are here to help. Schedule your free consultation with Peak Business Valuation below.
