In an asset sale, the buyer and seller split the total business price across equipment, inventory, intangible assets, and goodwill. A purchase price allocation valuation assigns a value to each of these categories. The value each asset receives in the allocation of business purchase price then sets the buyer’s tax basis for that asset. Below, we explain how the allocation works and how an appraiser sets each value.
As a professional appraisal firm, Peak Business Valuation frequently prepares purchase price allocation reports. In short, these reports help both parties make informed decisions during the PPA process. If you have questions about how we can assist, schedule a free consultation below.
What is Purchase Price Allocation?
Purchase price allocation assigns a fair market value to each asset a buyer acquires. In fact, Section 1060 of the Internal Revenue Code requires this step in an asset sale. The process starts with identifying assets and liabilities for a purchase price allocation. From there, an analyst values each item. They also provide the reasoning behind every figure in a report. As a result, this document gives the buyer a credible tax basis in each asset.
Why Allocation of Business Purchase Price Matters for Buyers
The allocation of business purchase price controls how fast a buyer recovers the money spent. In general, each asset class carries its own recovery schedule. Equipment, furniture, and vehicles fall under depreciation rules. Current law allows a 100% first-year deduction for most qualifying equipment. This includes used equipment that is new to the buyer. Inventory becomes a deduction as it sells. On the other hand, buyers write off intangible assets and goodwill over 15 years under Section 197. Moreover, land is not depreciable at all.
Because of these schedules, a dollar in equipment may produce a deduction this year. The same dollar in goodwill is deducted across 15 tax years. As such, buyers generally prefer more value in the shorter-lived classes.
Understanding the Seven Asset Classes in PPA
The IRS sorts every acquired asset into one of seven classes on Form 8594, Asset Acquisition Statement. In addition, the IRS caps each class besides Goodwill. It cannot exceed the fair market value of its assets. Below, we outline what each class covers.
- Cash (Class I): Cash and general deposit accounts transfer at face value, while certificates of deposit do not belong here.
- Actively Traded Property (Class II): Certificates of deposit, foreign currency, publicly traded stock, and government securities fall into Class II.
- Receivables (Class III): Accounts receivable, mortgages, and similar debt instruments make up Class III.
- Inventory (Class IV): Inventory and other property held for sale to customers belongs in Class IV.
- Tangible Property (Class V): Equipment, furniture, vehicles, land, and buildings sit in Class V.
- Section 197 Intangibles (Class VI): Customer lists, trademarks, licenses, and non-compete agreements form Class VI.
- Goodwill (Class VII): Goodwill and going concern value receive whatever remains after the first six classes.
The allocation of business purchase price takes place in the order of the above classes. As such, value allocated to the earlier classes reduces the amount left for goodwill.
How an Appraiser Determines Fair Market Value for Each Class
Fair market value comes from an independent valuation, not from the purchase agreement. An expert applies accepted valuation approaches to each class. The analyst then records the support behind every figure in a valuation report. This record helps the IRS review the allocation of business purchase price. Below, we outline how the appraiser values the three largest asset categories.
Tangible Assets
Equipment, vehicles, and furniture are usually valued through a machinery and equipment appraisal. These engagements typically involve two approaches. Under the market approach, an appraiser compares recent sales of similar used equipment. Under the cost approach, the appraiser starts with replacement cost. From there, the appraiser deducts for age, wear, and obsolescence. An equipment valuation for buying a business also accounts for details such as the make, model, and condition of each asset.
Intangible Assets
Class VI intangibles must be separately identifiable and capable of being valued on their own. Customer relationships are often valued under the income approach, which projects the earnings tied to those customers and discounts them to present value. In contrast, a non-compete agreement is valued by comparison. The appraiser looks at the business with the agreement in place versus without it. Each of these figures needs a written methodology behind it.
Goodwill
Goodwill is not appraised directly. Under the residual method, it receives whatever value is left after every other class is filled. As a result, the goodwill figure is only as reliable as the values assigned to Classes I through VI. Sometimes an earlier class carries a number that no analysis supports. In these cases, value shifts into or out of goodwill for no credible reason.
For a reliable allocation of business purchase price, it is best to work with a certified business appraiser. At Peak Business Valuation, we often work with buyers. We take careful measures to provide credible PPA valuation reports. Schedule a free consultation below to get started.
Common Disputes on the Allocation of Business Purchase Price
Buyers and sellers rarely want the same allocation of business purchase price. The buyer typically wants value in equipment and inventory, which produce faster deductions. In contrast, the seller usually wants value in goodwill. This is because goodwill is taxed at long-term capital gains rates, while equipment carries depreciation recapture, which is taxed as ordinary income for the seller.
Disputes also surface after the deal closes. Both parties file Form 8594 with the return for the year of the sale. The IRS then compares the two filings. Mismatched numbers draw attention to both returns. In addition, the IRS may challenge an allocation that no analysis supports. A credible purchase price allocation report provides support to help avoid this issue.
PPA Negotiation Tips for Buyers
Allocation is often heavily negotiated and deserves the same attention as price. Buyers who ignore it until closing often accept the seller’s allocation. As part of negotiating a purchase price of a business, the allocation belongs in the letter of intent. Below, we offer several tips for buyers preparing for negotiations.
- Start Early: Buyers should address the allocation at the letter of intent stage, before other terms are settled.
- Order Appraisals First: An equipment appraisal finished before discussions gives the buyer a credible report to work from.
- Value the Non-Compete: A non-compete agreement is a Class VI intangible, and buyers should confirm it carries a stated value.
- Trade Price for Allocation: If the seller resists a favorable split, buyers can offer a slightly higher purchase price for a better split.
- Put It in Writing: The purchase agreement should state the allocation, which binds both parties unless the IRS finds an error in the amounts.
In each case, early preparation gives the buyer a stronger position.
Conclusion
The allocation of business purchase price sets the buyer’s tax basis in every asset acquired. It also shapes deductions for years after closing. By understanding the seven asset classes and preparing early, buyers can negotiate a favorable split.
As a trusted business appraiser, Peak Business Valuation is here to support you. We can provide a credible PPA valuation report that stands up to scrutiny. If you have questions about how we can assist, schedule your free consultation with Peak Business Valuation today.
