Often times the purchase price allocation is looked upon as “something the accountants do” and is one of the last items discussed prior to closing the sale of a business.  However this is a mistake as the purchase price allocation(PPA) can have a major impact on the value received and can impact the negotiation strategy and future relationship between the buyer and seller.  Understanding purchase price allocation and formulating a negotiating plan with your advisors will maximize the value of your business and make for a smoother transition with the buyers.

What is Purchase Price Allocation

Purchase price allocation is the method of assigning the purchase/sale price of a business to various asset classes for purposes of reporting the sale to the IRS and determining the taxes owed.   How the price is allocated to the various classes determines the overall tax rate as each class has an associated tax rate.  Most notably goodwill is taxed at a federal capital gains rate of 20%1 while non-compete agreements or depreciation recapture2 will be taxed at the ordinary rates of up to 39.6%.  How these allocations are made is in part subject to negotiation and having a basic understanding of PPA can have a positive impact on net proceeds.

IRS Definition

The IRS requires buyer and seller to submit a form 8594 which outlines the purchase price allocation.  While the buyer and seller do not have to agree, failure to do so invites the IRS to impose their own allocation. Therefore it is best that both parties to a business sale transaction agree on the allocation. There are seven asset classes defined by the IRS within which the purchase price must be allocated.  These are outlined in brief below.  For more detailed descriptions of each class see the IRS instructions for form 8594 – https://www.irs.gov/pub/irs-pdf/i8594.pdf

Class I – Cash and Equivalents –  (In most transactions cash is retained by the sellers and so this would be zero)

Class II – Securities – Again these are most likely to stay with the seller although there could be exceptions.

Class III – Accounts Receivable –  where the receivables are sold to the buyer the amount should be fairly straight forward subject to doubtful account analysis and working capital price adjustments.

Class IV – Inventory – consider current book value versus value from a physical at closing. Write ups will be at ordinary income rates.

Class V – Fixed Assets – includes equipment, real estate, vehicles etc.  This along with Class VI and VII is the most disputed class.  Buyers want a high value here, sellers want a low value.

Class VI – Intangibles – includes non-compete agreements, trademarks, tradenames, licenses etc.

Class VII – Goodwill – Going Concern Value. Taxed as a capital gain.

The Most Common Issue – Depreciation Recapture

Let’s look at an example: your company has fixed assets with original value of $3 million dollars, the assets have been depreciated to $400,000 net book value.  The buyer wants to value the fixed assets at $2.8 million.  The difference between $2.8 million and $400,000 of $2.4 million is called depreciation recapture and will be taxed at ordinary income rates.  Remember the capital gains rate is 20% while ordinary income rates can be as high as 39.6%.  At the maximum difference, the “additional” tax is about $470,000.  So, as a business seller, you would want to reduce the fixed asset allocation and increase the goodwill and save as much of that $470,000 as possible.  One problem though.  The buyer prefers higher fixed asset values and lower goodwill values because the buyer can depreciate fixed assets in 5 to 7 years versus the 15 year amortization of goodwill.  Buyer and seller have opposing tax benefits.

Other asset allocations such as non-compete agreements can create similar tax variance issues however it is generally the fixed asset depreciation recapture that causes the greatest discord between buyer and seller.  (For a more thorough discussion of depreciation recapture, contact BMI or your CPA for additional information.  An in depth article on the subject is http://www.forbes.com/sites/anthonynitti/2015/07/14/tax-geek-tuesday-the-different-types-of-gain-making-sense-of-sections-1231-1245-and-1250/#5e13e8083db4 )

The problem outlined above centers on the value of the fixed assets and it is this value that buyer and seller must negotiate.  See the table below for a simplified transaction where differences in fixed asset values has a significant impact on the sellers tax bill and net proceeds.

As you can see from this example, the sellers will receive $300,000 less in after tax proceeds if they accept the buyers allocation.

Negotiating Purchase Price Allocation 

Typically purchase price allocation is one of the last items discussed before closing.  However, PPA should be considered before signing the Letter of Intent. At the time of an offer sellers should consult with their tax accountants and M&A Advisors and determine their expected tax bill and net proceeds after the sale.  This is particularly true where the business being sold has a high level of fixed assets that have been mostly depreciated.  After all, at the time of signing an LOI, the sellers should have a good idea of the net proceeds they will realize from the sale and base their acceptance of the LOI on sound assumptions.  Buyers will typically not agree to an allocation this early in the process, however by notifying the buyer of the seller’s assumptions in accepting a specific offer, the buyer understands the expectations going forward.  Certainly, sophisticated buyers such as the larger Private Equity Groups will be making PPA assumptions when drafting the LOI so in these cases having the conversation early is much easier.   On a few occasions we have seen buyers propose the PPA be worked out post closing.

No matter where in the process PPA is discussed it should not be a negotiating item that kills a deal if both parties assume reasonable assumptions and agree to compromise.  When it comes to used equipment, the opinions of value can be wide ranging particularly when you consider in-place value versus the used equipment market or liquidation value.  Sellers should not expect to have zero value recapture and buyers should not expect to book fixed assets at original cost.  By discussing purchase price allocation early and having reasonable expectations, the PPA negotiations can go much more smoothly and one more item of potential conflict can be eliminated.

The article Discuss Purchase Price Allocation Early in the Negotiations is courtesy of BMI Mergers & Acquisitions Blog