Taxes are a major consideration in mergers and acquisitions (M&As). The parties generally can structure a business purchase as either:
1. An asset purchase. The buyer can purchase all or some of the assets of the business.
2. A purchase of stock (or another ownership interest). The buyer can purchase the seller's ownership interest in the entity if the target business is operated as a corporation, partnership or limited liability company (LLC) that's treated as a partnership or corporation for tax purposes.
In general, buyers prefer asset purchases from a tax perspective. A taxable asset purchase allows the buyer to “step up,” or increase, the tax basis of the acquired assets to reflect the purchase price.
If you buy assets, you'll want to allocate the total purchase price in a way that gives you favorable post acquisition tax results. Here's how to comply with the applicable tax rules — while possibly lowering your future tax obligations.
With an asset purchase, you must allocate the total purchase price to the specific assets that are acquired. The amount allocated to each asset becomes its initial tax basis. For depreciable and amortizable assets, the initial tax basis of each asset determines the postacquisition depreciation and amortization deductions for that asset. Examples of depreciable and amortizable assets include:
- Furniture and fixtures,
- Buildings and improvements,
- Software, and
- Intangibles (such as customer lists, patents and goodwill).
When you eventually sell a purchased asset or convert it into cash, you'll have a taxable gain or taxable income if the amount received from the sale or conversion into cash exceeds the asset's tax basis. The formula for an asset's tax basis is:
|Initial purchase price allocation|
|+||Any postacquisition improvements|
|–||Any postacquisition depreciation or amortization|
If you operate the newly acquired business as a C corporation, the corporation pays the tax bills from postacquisition operations and asset sales. All types of taxable income and gains recognized by a C corporation are taxed at the same federal income tax rate, which is currently a flat 21%.
Conversely, if you operate the newly acquired business as a so-called “pass-through” entity, postacquisition gains, losses and income are “passed through” to you and reported on your personal federal income tax return. Examples of pass-through entities include:
- Sole proprietorships,
- Single-member LLCs treated as sole proprietorships for tax purposes,
- Multimember LLCs treated as partnerships for tax purposes, and
- S corporations.
For depreciable or amortizable assets, gains attributable to postacquisition depreciation or amortization deductions will be taxed at higher ordinary-income rates. The current maximum federal rate on ordinary income recognized by individual taxpayers is 37%.
For depreciable real property held for more than one year, gains attributable to depreciation deductions are taxed at a maximum federal rate of 25%.
Remaining gains from real property, depreciable and amortizable assets, and most other business assets held for more than one year are generally treated as lower-taxed long-term capital gains. The current maximum individual federal rate for long-term capital gains is 20%.
Gains from selling receivables, inventory and other assets held for one year or less are taxed at higher ordinary-income rates.
You have a tax loss if the amount received for the sale of a business asset is less than its tax basis. Losses are passed through to you, and you can usually deduct them on your personal return for the year the sale occurs.
Allocating the Purchase Price
With an asset purchase, the most important tax-saving opportunity revolves around how you allocate the total purchase price to the specific assets that are acquired.
To the extent allowed, you want to allocate as much of the price as possible:
- To assets that would generate higher-taxed ordinary income when converted into cash (such as inventory and receivables),
- To assets that can be depreciated quickly (such as furniture and equipment), and
- To intangible assets (such as software, customer lists and goodwill) that can be amortized over 15 years.
And you want to allocate as little of the price as possible:
- To assets that must be depreciated over long periods (such as buildings), and
- To land (which can't be depreciated).
Residual Allocation Method
Under the federal income tax rules, you must use the so-called “residual method” to allocate the total purchase price to the specific assets that you acquire. This method can be simplified to the following four steps:
1. Cash and equivalents. Allocate the purchase price (dollar for dollar) to any cash and CDs included in the deal and to the fair market value (FMV) of any government securities, other marketable securities and foreign currency holdings. (These kinds of assets aren't usually included in asset purchase deals, so you may be able to skip this step.)
2. Receivables and tangible assets. Allocate the remaining price to receivables and tangible business assets included in the deal, such as inventory, furniture and fixtures, equipment, buildings and land. These allocations are made in proportion to each asset's FMV but can't exceed FMV.
3. Identifiable intangibles. Allocate any remaining price to identifiable intangible assets other than goodwill. Such intangibles can include:
- Covenants not to compete,
- Technology and knowledge-based intangibles,
- Secret processes,
- Specialized software and business systems,
- Customer lists and favorable contracts,
- Workforce in place,
- Copyrights, and
You can amortize the cost of purchased eligible intangibles over 15 years. Allocations in this step are made in proportion to each asset's FMV but can't exceed FMV.
4. Goodwill. Allocate any remaining price to goodwill. Goodwill usually can't be valued with precision. Therefore, there's no FMV cap on purchase price allocations to goodwill. For tax purposes, you can amortize the amount allocated to goodwill over 15 years, because purchased goodwill is considered an intangible.
Important: The accounting rules for amortizing goodwill under U.S. Generally Accepted Accounting Principles (GAAP) differ from the tax rules. In general, businesses must evaluate the fair value of goodwill at least annually for impairment, rather than amortize it, under GAAP. Impairment happens when the book value of goodwill exceeds its current fair value. When this occurs, the business must report an impairment write-off on its GAAP-basis balance sheet and income statement.
However, private companies and not-for-profit entities can elect an alternative method of reporting goodwill under GAAP. Entities that choose this alternative can amortize goodwill over a period not to exceed 10 years, rather than perform annual impairment testing. Contact your CPA for more details.
Range of Values
Here's a hypothetical example to illustrate how to allocate the purchase price in an asset acquisition deal with taxes in mind: The owner of Tax-Wise Allocators (TWA) has tentatively agreed to sell its business assets to you for $1.5 million.
The owner (seller) wants to minimize the purchase price allocated to the receivables and fully depreciated assets, because gains from those assets will be treated as ordinary income and taxed at the maximum 37% federal rate on the owner's personal return. Gains from the other assets will be long-term capital gains that will be taxed at only 20% or 25%.
The seller obtains an appraisal from a qualified valuation professional who estimates the following FMVs for TWA's assets:
|Fully depreciated furniture, fixtures and equipment||$100,000|
|Total appraised value of tangible assets||$1,100,000|
|Total appraised value of tangible assets and identifiable intangibles||$1,275,000|
Under the residual method, the owner must allocate the first $1.1 million of the purchase price to the receivables and tangible assets in the amounts shown. The next $175,000 must be allocated to the customer lists. The remaining $225,000 is allocated to goodwill.
The allocation based on these FMVs works out well for the seller. She's happy, because 77% of the total purchase price will be allocated to lower-taxed capital gains assets (building, land, customer lists and goodwill).
As the prospective buyer, you want to allocate as much of the purchase price as possible to:
- Receivables (which will be quickly collected and written off for tax purposes),
- Furniture, fixtures and equipment (which can be depreciated quickly for tax purposes), and
- Eligible intangibles (which can be amortized over 15 years for tax purposes).
You want to allocate as little as possible to the building (depreciable over 39 years) and the land (nondepreciable). You hire a different qualified professional appraiser who values the assets as follows:
|Fully depreciated furniture, fixtures and equipment||$175,000|
|Total appraised value of tangible assets||$1,050,000|
|Total appraised value of tangible assets and identifiable intangibles||$1,250,000|
It's not unusual for qualified appraisers to arrive at different conclusions, because valuation is an inexact science. In this case, the second appraisal offers better tax results for you (the buyer) than the first one. Why? Under the second appraisal, more of the purchase price is allocated to receivables, depreciable assets and amortizable intangibles, including $250,000 of goodwill.
The owner agrees to accept the second appraisal, because it seems reasonable and 70% of the purchase price is still allocated to lower-taxed capital gains assets (building, land and intangibles).
Important: Purchase price allocations can be an important part of M&A discussions. It's important for the parties to agree to a reasonable allocation under the residual method prior to closing. The tax consequences could affect the amount a buyer will pay or a seller will accept in an asset purchase deal.
When you purchase business assets, the total purchase price must be allocated to the acquired assets. The allocation process can affect the parties' post acquisition tax results. During the negotiation process, your tax advisor can help you structure a deal that complies with tax law and minimizes your post acquisition tax obligations.
Avoiding Unwanted IRS Attention
The buyer of business assets and the seller must independently report to the IRS the purchase price allocations that both use. This is done by attaching IRS Form 8594 to your respective federal income tax returns for the tax year that includes the transaction.
The IRS may inspect the forms that were filed to see if you and the seller used different allocations. If the IRS discovers that different allocations were used, it might increase the odds of being audited — and the investigation might expand beyond just the asset purchase transaction. So, it's in your best interest to ensure that both parties use the same allocations. Consider including this requirement in your asset purchase agreement.