How to allocate the sales price in a business sale

[Editor’s note:] This memo is part of our “Answers” program where we share some general information that others have paid us to research. Every situation is different and you should consult with us before taking any final action.

MEMO 

Date:     Redacted

To:         Client

From:     David Conley

RE:         Sale of existing business stock vs asset sale

 I thought I’d go ahead and outline a few of the items we have discussed relating to the sale of the company and the related tax effects.

Since your buyer is insisting on an asset sale, both parties will have to agree on an allocation of the sales price to the various assets purchased, both tangible and intangibles. This is done on IRS form 8594 and is included with your tax return.

Allocation of the sales price is done at 7 levels of what the IRS calls classes of assets.

Here’s a very condensed summary:

 Class I assets are cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit held in banks, savings and loan associations, and other depository institutions.

It’s my understanding that corporate cash is excluded from the purchase. 

Class II assets are actively traded personal property within the meaning of section 1092(d)(1) and Regulations section 1.1092(d)-1. In English, this means investment hedging positions that can be publicly valued. This is not a problem in this case.  Class II assets can also include certificates of deposit. Your company would not fall under this classification. 

Class III assets will include Accounts Receivable and any contingent debt. 

Class IV assets will be Inventory and related costs. 

Class V assets will be furniture and fixtures, equipment and other depreciable items and all assets other than Class I, II, III, IV, VI and VII assets. 

Class VI assets are all section 197 intangibles (as defined in section 197) except goodwill and going concern value. Section 197 intangibles include:

  • Workforce in place;
  • Business books and records, operating systems, or any other information base, process, design, pattern, know-how, formula, or similar item;
  • Any customer-based intangible;
  • Any supplier-based intangible;
  • Any license, permit, or other right granted by a government unit;
  • Any covenant not to compete entered into in connection with the acquisition of an interest in a trade or a business; and
  • Any franchise, trademark, or trade name.

 

Class VII assets are goodwill and going concern value. Only in this class can an allocation exceed the cost basis of the corporation. This is also the class that will be considered as capital gain subject to the lower tax rates. Conversely, amounts allocated to covenants not to compete are ordinary income to the seller.

 

The reason for the above class system is that the purchase price must be allocated in Class order (1-7). 

 

Allocation of consideration – here is a summary of the normal procedure.

(a) reduce the consideration by the amount of Class I assets transferred

(b) allocate the remaining consideration to Class II assets in proportion to their fair market values on the  purchase date

(c) allocate to Class III assets in proportion to their fair market values on the purchase date

(d) allocate to Class IV assets in proportion to their fair market values on the purchase date

(e) allocate to Class V assets in proportion to their fair market values on the purchase date

(f) allocate to Class VI assets in proportion to their fair market values on the purchase date

(g) allocate to Class VII assets. If an asset in one of the classifications described above can be included in more than one class, choose the lower numbered class.

 

I have researched some case law on how we might put forth allocations on the covenant not to compete. This is one area that we need to have the lowest possible allocation in order to reduce the ordinary income. Conversely, we will try to have our highest allocations on the goodwill which should be taxed (except to the extent AMT comes into play) at capital gain rates.

 

You and I need to go through the asset list and make sure all retirements, items scrapped, or assets reclassified are off the final list given to the buyer. Simply put, the shorter this list is the more capital gain treatment you are likely to receive.

 

Let me know when you have some time to talk more about these items.