Corporate & Securities Blog

Allocations of Purchase Price: A Zero-Sum Game?

Allocations of purchase price are critical tax-related aspects of asset sale transactions. However, these allocations often do not receive much attention from the parties until the transaction process is well underway, and possibly not until the eve of closing or after closing when associated tax reporting is required. At that point, a buyer’s or seller’s ability to negotiate a more favorable result can be significantly limited. Consequently, buyers and sellers should become familiar with the potential federal income tax considerations of purchase price allocations and strive to address those considerations at the beginning of a transaction.1

Allocations in the Asset Sale Context

Purchase price allocations are primarily relevant for asset sales where a buyer is directly purchasing assets (and assuming liabilities) from a seller.2 This includes transactions that are structured as an equity purchase but nonetheless result in a deemed asset sale for federal income tax purposes. Examples of deemed asset sales include: (1) an acquisition by a buyer of equity interests of either a limited liability company that is treated as a disregarded entity for federal income tax purposes or a partnership, including if the partnership has made (or will make) an election under Internal Revenue Code (IRC) Section 754 (a 754 election)3; and (2) an acquisition of the stock of a target corporation where an election is made under IRC Section 338.4

Tax Implications and Requirements

If a transaction is considered an asset sale for federal income tax purposes, it will be treated as a sale of each acquired business asset in exchange for an applicable portion of the aggregate purchase price.5 As a result, the aggregate purchase price needs to be allocated among all such transferred assets in order for the seller to determine its gain or loss with respect to the transaction (and character thereof — i.e., ordinary or capital) and for the buyer to calculate its tax basis in the acquired assets immediately following the close of the transaction. Furthermore, if the transaction qualifies as a sale of a business for federal income tax purposes (which is often the case), the parties must adhere to special allocation rules under IRC Section 1060.6 These rules require the purchase price to be allocated among the acquired assets based on seven different asset classes in sequence based on fair market value. This means that the purchase price is allocated first to Class I assets, then if any purchase price is remaining, to Class II assets and so on, with any final amounts allocated to Class VII assets. The buyer and seller must also separately report a purchase price allocation to the Internal Revenue Service by filing IRS Form 8594.

Generally, the asset classes can be described as follows:

  • Class I: Cash.
  • Class II: Marketable securities and government bonds.
  • Class III: Accounts receivable and certain debt instruments.
  • Class IV: Stock in trade (e.g., inventory).
  • Class V: Other fixed or tangible assets (e.g., property, plant, equipment, vehicles).
  • Class VI: IRC Section 197 intangibles, including covenants not to compete but excluding goodwill and going concern value.
  • Class VII: Goodwill and going-concern value.

 

Practical Impact on the Parties

Buyers and sellers typically have competing interests when it comes to how the purchase price should be allocated among the above categories. Generally, a non-corporate seller wants to maximize recognition of capital gain and minimize recognition of ordinary income. For a non-corporate seller, ordinary income is taxed at a maximum federal income tax rate of 37%, while capital gain that qualifies for the preferential rate on long-term capital gains is only taxed at a federal rate of 20% (although an additional 3.8% tax on net investment income might also apply to such capital gain).7 Accordingly, such a seller would prefer to allocate the purchase price to assets that generate preferentially taxed long-term capital gain such as goodwill and going-concern value, and allocate as little as possible to assets that may generate ordinary income, such as accounts receivable, inventory or fixed assets.8

In contrast, a buyer typically prefers to allocate the purchase price to accounts receivable or inventory (which are expected to turnover relatively quickly), or assets that have a shorter useful life.9 This would permit a buyer to recover its tax basis faster — either by reducing income that would be recognized when accounts receivable is collected or inventory is sold, or generating depreciation deductions more quickly.

Common Considerations and Approaches

As a result of these competing interests, it would be advisable for the parties to take steps early in the transaction (such as at the letter-of-intent stage) to get ahead of potential conflicts that may arise when it comes time to prepare the purchase price allocation. This is especially relevant if the rules under IRC Section 1060 apply, in which case it would be in the interest of both parties to agree to an allocation such that buyer and seller do not report inconsistently to the IRS, which can increase the risk of a tax audit.

A seller, for example, can require in the letter of intent that the buyer pay an additional purchase price. Such additional purchase price can be calculated explicitly to provide a tax “gross-up” such that the seller will receive proceeds on an after-tax basis that puts the seller in the same economic position as if all the recognized income or gain was taxed as long-term capital gain. The additional purchase price could also be calculated as a proportion of the net present value of tax savings that the buyer anticipates recognizing as a result of achieving a basis step-up in the acquired assets.

Alternatively, the letter of intent could provide that the parties will simply cooperate in good faith to mitigate any adverse tax impact to the seller from recognizing ordinary income. This approach would be less explicit but can, at the very least, give support for the seller to request changes to the transaction structure or ask for a tax gross-up later once the anticipated tax cost can be more clearly estimated.

From the buyer’s perspective, the letter of intent could clearly state that the buyer expects the transaction to result in a tax basis step-up with respect to the acquired business or business assets and that the buyer’s proposed purchase price has factored in such tax result. This approach would help set expectations between the parties and can also be used to counter any request by the seller for additional purchase price either based on a tax gross-up or sharing of the buyer’s anticipated tax benefits.

Sale transactions are complex and the parties must often tackle many different business and other critical issues to successfully complete a deal. As a result, it may be tempting to focus less attention on issues that are viewed as more procedural or compliance-oriented, such as allocations of purchase price. However, planning for the purchase price allocation in the early stages of the transaction can help the parties avoid potentially difficult or contentious negotiations later in the deal process, obtain certainty as to anticipated federal income tax treatment, and possibly extract additional economic value.

1 Unless otherwise specified, all sections referenced herein are to the Internal Revenue Code of 1986, as amended (the IRC) or the U.S. Department of the Treasury regulations promulgated thereunder.

2 While beyond the scope of this discussion, an allocation of purchase price can also be necessary where multiple entities are acquired as part of the same transaction. In that case, the aggregate consideration may need to be assigned among the multiple targets, which can be especially important from a non-U.S. tax perspective where the target companies are organized in different jurisdictions.

3 A 754 election results in a tax basis adjustment to the underlying assets of the partnership that are represented by the acquired partnership interests pursuant to IRC Section 743. Regardless of a 754 election, a purchase price allocation can also be relevant if all of the equity interests of the partnership are being acquired or under the “hot asset” rules contained in IRC Section 751.

4 Most commonly, such a transaction would involve the purchase of 80% or more of the stock of an S corporation where the buyer and seller agree to make an IRC Section 338(h)(10) election.

5 For federal income tax purposes, any assumption of liabilities by a buyer would be considered an additional purchase price in addition to any cash or non-cash property actually received by the seller.

6 Given their prevalence and the certainty these rules can provide both parties, as a practical matter, buyers and sellers often also follow the IRC Section 1060 allocation rules for transactions that may not strictly be considered the sale of a business.

7 Corporate sellers may be less concerned because their ordinary income and capital gain are taxed at the same 21% federal rate. However, recognition of capital gain versus ordinary income may still be relevant, for example, if such a seller has significant capital loss carryovers, which cannot be used to shelter ordinary income.

8 Gain recognized on fixed assets can generate ordinary income to the extent of depreciation previously claimed for federal income tax purposes (commonly referred to as depreciation recapture).

9 Equipment and other fixed assets can often have a useful life of only three to seven years (and may also qualify for bonus depreciation). On the other hand, goodwill (to which any residual purchase price would be allocated) is amortized straight-line over 15 years.

 

Meet the Author

Kenneth C. Wang

Kenneth Wang uses his many years of experience in both private practice and in-house tax departments for Fortune 200 companies to counsel clients on all aspects of U.S. tax law, including mergers and acquisitions, partnerships and joint ventures, fund formation, financing transactions, real estate transactions, business restructurings and reorganizations and international tax.

kwang@stradley.com | 212.812.4129

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