By Graeme Cloutte, CPA
The tax implications of buying and selling a business need to be addressed before coming to the closing table to finalize the carefully structured deal that the FBB Group has put together. One of these key implications is how the transaction is structured for purposes of “asset allocation“.
In what follows, I am assuming that the deal is a sale of assets, rather than of company stock or LLC membership interests.
Asset Sales Compared to Company Stock/Share Sales
The vast majority of deals are asset sales rather that sales of shares of a corporation. There are two main reasons for this. Few buyers are comfortable buying shares, because they would assume all of the liabilities, including those that they don’t even know about, from the seller. Who knows what scary creatures may emerge from the woodwork some months or years after the sale goes through?
Tax Deduction Benefits of Asset Sales
The other reason for the preponderance of asset sales is that the buyer can deduct the cost of the assets he or she acquires over a shorter time frame as depreciation expense. However, with a stock sale, the buyer just “sits” on this cost for years, only getting a tax benefit when he or she sells the business many years down the road.
How the purchase price is to be allocated among classes of assets must be handled consistently between buyer and seller, who each attach Form 8594 to their respective tax returns for the year of the purchase/sale so that the IRS can police this tax treatment.
Here is a table that outlines the various “classes” of assets, as prescribed by the IRS and as shown on Form 8594:
|IRS Asset Class||Seller’s Preference||Buyer’s Preference|
|Class I||Cash and Cash-like assets||No preference as no taxable gain or loss as amount matches tax basis||No preference|
|Class II||Securities||No preference as no taxable gain or loss as amount matches tax basis||No preference|
|Class III||Accounts Receivable||No preference as no taxable gain or loss as amount matches tax basis||No preference|
|Class IV||Inventory||Low amount to minimize ordinary income||High amount as it provides an immediate deduction against ordinary income|
|Class V||Other Tangible Property:|
|Personal property||Low amount to minimize gain treated as ordinary income||High amount as it provides a deduction against ordinary income, but sales tax may have to be paid on these purchases|
|Real Estate||High amount as affords long term capital gain treatment||Low amount as long depreciation term|
|Class VI||Covenants Not to Compete & Other Intangible Property:|
|Covenant Not to Compete||Normally low amount as taxed as ordinary income over term of covenant||Normally low amount is deducted over 15 years, as for goodwill|
|Other Intangible Property||High amount as taxed as long term capital gain||Normally low amount as deducted over 15 years, as for goodwill|
|Class VII||Goodwill & Going Concern Value||High amount as taxed as long term capital gain||Low amount as deducted over 15 years|
Negotiating Buyer & Seller Preferences
Notice that the preferences of the buyer and seller are typically at odds with each other. This requires negotiation between the parties, a process that normally takes place between the letter of intent and the drafting of the purchase contract. Generally, as a buyer, the preference is for assets that can be deducted quickly. For example, inventories can be deducted as a normal operating expense, and much, or all, of the equipment can be deducted in the year of the business purchase under tax code section 179.
- As an example in 2012 up to $139,000 of assets purchased could be deducted under section 179. This amount changes from year to year as a result of the politics of Congress. In 2012 this ceiling of $139,000 applied both to the entity itself, as well as to each owner. Beginning in 2022 however the maximum amount you can elect to deduct for most section 179 properties ceiling rose to $1,080,000.
The wildcard in all this is sales tax. The purchase of fixed assets to be used in the business is subject to sales tax (also known as use tax). In Colorado Springs, the combination of State, county and city sales tax is a rate of 8.20%. Both city and State aggressively seek out businesses that change hands, requiring buyers to submit a “use tax” report listing their purchases of equipment.
Sometimes minimizing use tax (sales tax) trumps the tax deduction of quickly writing off fixed assets.
Each Asset Sale & Situation is Unique
As is true in so many aspects of the tax law, the rules are complex, requiring the close cooperation of the tax advisors of buyers and sellers in order to craft a purchase price allocation that optimizes the tax results for each of them. With careful planning, buyers and sellers can both be “tax winners.”
The above is NOT intended to be tax advice for any particular situation. You are advised to seek competent professional tax advice in a transaction for the purchase or sale of a business.
(originally published in August 2012 eNewsletter)
Graeme Cloutte, CPA, is the founder and principal of Cloutte & Associates, P.C., a Colorado Springs based CPA firm specializing in helping small businesses with tax preparation and tax minimization, QuickBooks set up, and training and profitability enhancement. He can be reached on (719) 633-6150 or firstname.lastname@example.org.