Question: While purchasing a telemessaging company, the seller’s attorney asked me to complete the allocation of the purchase price section in the purchase agreement. What is this, and why is it necessary?
Answer: Purchase price allocation is different from receiving the actual funds from the sale of a business. Allocation means, “to set apart for a specific purpose.” In this case, allocation assigns a value to the assets. Shift your perception to general accounting principles. Allocation is required by the Federal Government for taxation (Section 1060). As in all cases of liquidating or claiming assets, the expense (in this case, the purchase or claiming of assets by the buyer) cannot generally be written off in one year, and the liquidation or gain (sale of assets by seller) should not be claimed in one year. Both of these situations can have huge tax consequences for both buyer and seller if not allocated appropriately.
For the sake of simplicity, the purchase price is broken down into descriptions of value, such as equipment, covenant not to compete, goodwill, customer list, training/consulting, and premise lease/leasehold improvements. Each one of these (if applicable to the assets purchased) is given a monetary value, which is a percentage of the purchase price. For example, if the sale of a business (assets only and not stock) is $90,000, the allocation looks like this:
- $25,000 — Covenant Not to Compete
- $10,000 – Equipment
- $55,000 – Goodwill
Prior to completion of the sale of a business, it is critical that both buyer and seller consult with their accountants to determine the allocation. Each party’s tax situation is unique and can only be properly addressed by their accountant. Below is a general breakdown of the amortization applied to the assets. Once the amortization is determined, the accountant can then determine the allocation. For the non-compete, goodwill, and customer list:
Buyer: Amortize value over fifteen years
Seller: Treated as ordinary nonpassive income
Typically, both buyer and seller agree upon the allocation prior to the closing of the sale of the business. Once the sale is complete, both parties must file Form 8594. Allocation can be intimidating, so make sure you give your accountant enough time prior to the closing/purchase of the business to determine what is best for you.