When purchasing a business in an asset deal, the consideration is often expressed as a lump sum. However, in order to determine the tax basis of the individual assets comprising the business, a purchase price allocation would be necessary. The buyer would need to know how much of the purchase price is allocated to each asset in order to take calculate appropriate tax depreciation and amortization deduction. The seller is also interested in the purchase price allocation to determine the gain or loss on such assets. Moreover, the buyer and the seller must each disclose such allocation on its tax return for the year in which the transaction occurred.
At this juncture, it is important to note that the tax rules for purchase price allocation are not the same as the accounting rules under Generally Accepted Accounting Principles (GAAP). Given the importance of the purchase price allocation, using the wrong rules to allocate purchase price may result in tax headaches.
Generally, a purchase price allocation is an exercise that identifies each individual asset purchased, tangible and intangible, as well as any liabilities, then the assets are assigned a value. Typically, it is a three-step process:
- Determining the purchase price (total consideration paid)
- Identifying the correct assets acquired and liabilities assumed
- Calculating the fair market value of those assets and liabilities
Total Consideration Paid
Total consideration includes anything that is used to pay for an acquisition, plus liabilities that the buyer assumes. If stock, debt, cryptocurrency, or other forms of payment are used in lieu of cash, an additional valuation may be needed to quantify the form of payment. Also, the calculation of total consideration may need to take into account earn-outs and covenants-not-to-compete. This may require a highly fact-specific analysis as they may represent additional consideration taxed as capital gains to the recipients, or be considered compensation subject to tax at ordinary income tax rates (and will also implicate the withholding and employment tax obligations).
In addition to the tangible assets such as personal property and real property, intangible assets such as customer and business relationships, software and technology, intellectual property like trademarks and trade names must also be identified.
Once each asset is identified, the purchase price is split up, or allocated amongst the assets. For example, a company that produces consumer staples might decide to buy a toilet paper manufacturing for $5 million in a transaction that is structured as an asset purchase. The $5 million figure number would represent the purchase price for all the assets , which would then be allocated among the machinery, inventory, and any other assets that the consumer staples company decides to acquire.
Internal Revenue Code Section 1067 provides for the use of the residual method to allocate the purchase price to the following assets:
Class I: Cash and cash equivalents
Class II: Actively traded personal property, CDs and foreign currency
Class III: Mortgages, accounts receivables and credit card receivables
Class IV: Inventory
Class V: Equipment, land and property
Class VI: Intangibles described under Internal Revenue Code 197, less Goodwill or going concern
Class VII: Goodwill and going concern
The residual method requires the parties to value and then allocate the purchase price to the identifiable assets, with any “excess” value allocated to goodwill (i.e., Class VII).
Depending on the asset class, the seller will be subject to different tax rates on the gain and loss. For instance, gains attributable to assets in Class IV (inventory) are taxed as ordinary gain. By contrast, gains attributable to Class VI (certain intangibles) may be ordinary income or capital gains.
If the buyer and seller enter into an agreement with respect to the purchase price allocation, it is generally binding on the parties.
When to do a purchase price allocation
A purchase price allocation is often done after a deal is completed, since it is required for tax and financial reports. A good practice is to work on the allocation as soon as possible after a deal is completed, while the target company’s management is still engaged and their information more readily accessible. Waiting too long after the deal’s close is often a mistake: records get lost, personnel may leave, or management might shift.
However, buyers and sellers can set themselves up for a successful deal by doing a purchase price allocation early on in the negotiation process, instead of after the deal has concluded. Sellers should approach a purchase price allocation prior to the deal as an opportunity to make their business more attractive to potential buyers. It is common practice to create a pitch book for potential buyers, which are much more powerful when presented with the different ways that individual assets can be leveraged by the buyer. For example, a seller might choose to highlight how the depreciation or amortization of a certain asset could impact the buyer’s balance sheets and/or tax profile. In addition, an impartial third party’s independent assessment can help give sellers more credibility and buyers more confidence going into the deal. This early, third-party, asset-specific valuation can help mitigate misunderstandings later on that often arise out of miscommunications regarding the value of specific assets or the business as a whole.
The purpose of doing a purchase price allocation goes far beyond accounting and tax reasons. Buyers, and investors looking at balance sheets, will have a much clearer picture of the individual pieces of the company that they have just bought. Armed with greater knowledge of value drivers, management can scale their business or improve efficiency. Meanwhile, present and future investors want to know why management decided to make that particular acquisition instead of investing elsewhere or spinning off dividends. In particular, investors will pay attention to the amount of goodwill paid relative to the assets acquired, since this is an indicator of risk. Finally, purchase price allocations allow sellers to attract buyers, and buyers benefit from an in-depth analysis of the business that they are seeking to purchase. This is a process that both sides should strongly consider when beginning their due diligence, and is often required for tax and financial reports after the deal is concluded. The end result is a clearer picture by both sides of the long-term consequences of the deal.