A purchase price allocation or PPA divides the purchase price among the assets the buyer receives. Each asset carries its own tax treatment. As such, the allocation affects both buyers and sellers after closing. To support the allocation, parties often obtain an independent purchase price allocation valuation. Below, we walk through a purchase price allocation example for a small business acquisition. We also explain how the allocation affects tax reporting and negotiations.
Peak Business Valuation is a professional appraisal firm. We often work with buyers and sellers preparing for an acquisition. We can determine the fair market value of the assets and goodwill to support purchase price allocation. If you have questions about how we can assist, schedule a free consultation below.
What is a Purchase Price Allocation?
A purchase price allocation assigns the total price of a business to each asset. It covers every asset that transfers in the sale. As such, the work begins with identifying assets and liabilities for a purchase price allocation. These range from receivables and inventory to equipment and goodwill.
The assigned values affect tax reporting for both parties. The buyer uses these values to establish the tax basis of each asset. The values also determine depreciation or amortization treatment. In contrast, the seller uses the allocation to determine how the gain is classified among ordinary income and capital gain.
Purchase Price Allocation Example: Business Acquisition
Understanding purchase price allocation helps buyers and sellers evaluate how the purchase price affects tax reporting. The following purchase price allocation example shows how the process works in a business acquisition.
Suppose a buyer acquires a small manufacturing company for $2 million. The sale is an asset purchase. Federal tax rules require the residual method for this allocation. As such, an appraiser first assigns fair market value to each asset category. This covers tangible and identifiable intangible assets. Whatever value remains after those assets falls to goodwill.
In this example, the purchase price allocation is as follows:
- Accounts Receivable: The buyer acquires $180,000 in customer invoices the company expects to collect.
- Inventory: Raw materials and finished goods carry a combined value of $220,000.
- Machinery and Equipment: Production equipment, vehicles, and fixtures account for $650,000 based on an independent equipment appraisal.
- Identifiable Intangible Assets: The customer list, trade name, and a noncompete agreement with the seller total $250,000.
- Goodwill and Going Concern Value: The remaining $700,000 reflects the company’s reputation, workforce, and earning capacity (2,000,000 – 1,300,000).
As illustrated above, goodwill absorbs the difference between the purchase price and the value of the other assets.Move to Trash
For a credible purchase price allocation, it is best to work with a certified business appraiser. Peak Business Valuation can value each asset category in an acquisition. We also document the reasoning behind the allocation. Schedule a free consultation below to learn more.
How the Allocation Affects the Buyer and the Seller
Buyers and sellers often have opposite interests in a purchase price allocation. This is because the same dollar produces a different tax result depending on where it lands. Below, we outline how each party views the split and how both report it.
The Buyer’s Perspective
The buyer generally prefers more value in equipment and other short-lived assets. Companies depreciate equipment over five to seven years. They amortize goodwill over 15 years. Faster deductions improve early cash flow. As such, a higher allocation to equipment carries real value for a new owner.
The Seller’s Perspective
The seller generally prefers more value in goodwill. Goodwill usually receives long-term capital gain treatment. In contrast, the seller may pay ordinary income tax on equipment that has already been depreciated. As such, moving value toward equipment can raise the seller’s tax bill even when the purchase price remains unchanged.
Since these interests conflict, the allocation should be brought up when negotiating a purchase price of a business.
Reporting the Allocation on Form 8594
Finally, both parties report the purchase price allocation on Form 8594. They file it with the tax return for the same year of the sale. The IRS expects the buyer and the seller to report the same figures. When the two filings disagree, both returns may be subject to scrutiny. As such, it is important to put the allocation in writing. This keeps the two filings consistent.
How a Business Valuation Supports the Assigned Values
The figures in a purchase price allocation are only as reliable as the analysis behind them. Federal tax rules generally require asset values to reflect fair market value. As such, both parties need support for the numbers they report. A business valuation delivers an independent conclusion of fair market value. It helps determine the value of the company and its intangible assets. Moreover, a machinery and equipment appraisal establishes what the tangible assets are worth on their own.
Peak Business Valuation prepares business valuations and equipment appraisals for buyers and sellers. We work with clients throughout the United States. Schedule a free consultation today if you have any questions.
Conclusion
Understanding purchase price allocation helps buyers and sellers navigate an acquisition. As such, the purchase price allocation example from this guide can be a helpful reference. Both parties should note that the allocation affects their tax reporting and the outcome of the transaction. To avoid future disputes, buyers and sellers should not wait to address the allocation until after closing. This keeps the terms of the deal consistent with what they file on Form 8594.
Peak Business Valuation supports buyers and sellers throughout business acquisitions. If you have any questions about how we can assist with a PPA or purchase price allocation, we are here to help. Schedule your free consultation with Peak Business Valuation below to get started.
