"Allocating the Purchase Price" When Selling or Buying a Business

Cliff Ennico
Posted: Feb 09, 2011 12:01 AM
"Allocating the Purchase Price" When Selling or Buying a Business

"I have been running a successful online company -- a limited liability company -- for several years, with a number of different lines of business. Another company has made an offer to buy one of my lines of business for a very attractive price, and I'm inclined to accept.

The problem is taxes. My accountant is telling me that the purchase price for this line of business will be taxed to me at long-term capital gains rates, which I understand to be about 20 percent in my case. The buyer, however, is telling me that the purchase price will be taxed to me at ordinary income rates, which in my case would be about 35 percent.

I'm a little nervous that the 'pros' don't seem to be able to agree on this, as there should be a black-or-white answer, right?"

When it comes to taxes, nothing, and I mean NOTHING, is black or white. There is always an exception to every rule, and an exception to each exception, and often an exception to each exception to each exception.

How you will be taxed depends on whether the sale of your business is structured as a sale of assets or a sale of equity (your membership interest in your LLC). If you are selling the assets of this business (which is how most of these sales are structured), and assuming you have been operating this business for more than one year, your accountant is mostly right: The bulk of the purchase price should be treated as long-term capital gains and taxed at the lower rate.

There are, however, some exceptions. If you are selling inventory (for example, if the business is an eBay Store), that portion of the purchase price that is allocated to inventory -- more on that later -- will be taxed to you at the higher ordinary income rates. Also, if you are giving the buyer a noncompete agreement (basically agreeing that you won't go back into that line of business for a couple of years), that portion of the purchase price allocated to the noncompete agreement will be taxed to you at ordinary income rates as well.

If you have taken depreciation on certain assets in excess of so-called "straight line depreciation," you will have to recapture that excess depreciation and pay tax on the recapture amount at ordinary income rates. Because an LLC is a "pass through" entity, all of the tax would flow through to your personal tax return.

The concept of "allocation" is a tough one for folks to wrap their brains around, but it's really very simple. When you sell or buy the assets of a business, you are buying a "bundle" consisting of different types of assets -- equipment, inventory, intellectual property (such as a trademark or trade name), interests in real estate, automobiles, accounts receivable, and so forth.

Some of these assets can be deducted outright as business expenses. Other assets have to be depreciated (written off) over a period of years which can be three, five, seven or even 15 years depending on what the things are. The IRS divides business assets into seven different asset classes: (1) cash and cash equivalents; (2) actively traded personal property; (3) accounts receivable and debt instruments; (4) inventory; (5) all other assets not previously classified (such as furniture, fixtures, equipment, land and motor vehicles); (6) so-called "section 197 intangibles" (think patents and trademarks); and (7) goodwill and going-concern value.

When you sell or buy a business, you are required to "allocate" the purchase price to each of these seven different asset classes. So, for example, if the purchase price is $200,000, you might allocate $30,000 to equipment, $20,000 to inventory and $50,000 to intangibles, with the $100,000 balance allocated to goodwill. The amount allocated to each asset class is usually the subject of negotiation between the seller, the buyer and their lawyers or accountants. At the closing, the seller and buyer will be required to fill out IRS Form 8594 confirming the purchase price allocation and file it with the IRS. They will then have to make sure that the allocation is reflected on their tax returns for the year.

However the allocation is done, it will have to bear some relation to business reality. If you're selling the assets of a gymnasium (consisting of lots of equipment and inventory) and you allocate 100 percent of the purchase price to "goodwill," the IRS is not likely to buy it.

The allocation of purchase price may also have state and local tax consequences. A number of states (such as New York) have a "bulk transfer" law requiring purchasers of business assets to pay state and local sales taxes on the equipment and inventory they purchase. With most state sales taxes in the 5 percent to 8 percent range, an allocation of $100,000 to equipment may create a big sales tax surprise for the buyer.