Once you agree on a final price for the business, the seller and buyer must agree to what portion of the purchase price applies to the tangible assets vs. intangible assets (e.g., goodwill). The allocation of the purchase price will dictate what portion of the sale price the seller can treat as capital gains vs. ordinary income tax. In turn, this could dramatically affect the net proceeds of the seller and future tax treatment for the buyer.
As Robert Kiyosaki once said,
“It is not how much money you make, but how much you get to keep.”
When it comes to selling a business, this statement could not be truer. What is good for the seller’s tax picture is often bad for the buyer and vice versa. Therefore, the allocation of price to various components of the deal is frequently an area for negotiation and compromise. The difference between your tax basis and your proceeds from the sale is what is taxable. The seller’s tax basis is generally the original cost of the asset, minus the accumulated depreciation deductions claimed, minus any casualty losses claimed, plus any additional paid-in capital and selling expenses.
The seller‘s proceeds from the sale generally include the total sales price, plus any additional liabilities the buyer takes over from the seller if any. For example, a transferable liability could be long-term debt in a stock purchase. As the seller, you will probably want to allocate most, if not all, of the purchase price to the capital assets that were transferred with the business. The seller wants to do that because proceeds from the sale of a capital asset, including business property, are taxed as long-term capital gains, which is lower than ordinary income. Long-term capital gains are taxed for most people at 15% for everyone except the super wealthy while ordinary income is taxed at between 10% and 39.6% based on your marginal income tax rate.
After the sale, the buyer will be able to depreciate or amortize most of the assets that were transferred. Because different types of assets are depreciated differently under IRS rules, the buyer will want to allocate more of the price toward assets that can be depreciated quickly and less of the price to ones that must be depreciated over 15 years or longer (e.g., goodwill, buildings, and land). Since most transactions are treated as an asset sale, allocating the sales price between the various assets is a serious negotiation between the buyer and seller. The buyer wants as much money as possible to be allocated to items that are currently deductible, such as a consulting agreement or assets that can be depreciated quickly. This will improve the business’s cash flow and reduce its tax bill.
The seller, however, wants as much money as possible allocated to assets on which the gain is treated as a capital gain rather than assets on which gain must be treated as ordinary income. Given that most small business owners who are successful in selling their company are in a high tax bracket, this rate differential is very important in reducing liability.
It is always a good idea to get tax advice from a CPA with experience in mergers and acquisition when structuring a deal either as the seller or buyer.
How much attention will you pay to the allocation of the sale price?
