Purchase Price Allocation: How It Affects Your Taxes When Selling Your Business

To maximize the after-tax proceeds from the sale of your business it’s important to understand how different structures will impact your tax consequences. There are two main choices for structuring the sale: an asset sale and an equity sale. For more about the differences, see Asset Sale vs. Equity Sale: Key Considerations When Selling Your Business.

This post focuses on how the purchase price allocation (PPA) in an asset sale dictates the business seller’s tax liability. This post describes the tax consequences of an asset sale to the seller assuming the business entity is structured as a flow-through entity, most commonly an S Corporation or an LLC taxed as a partnership.

Understanding How Purchase Price Allocation Impacts Your Taxes

When you sell your business as a sale of its assets, the PPA will determine the split between how much of the gain will be taxed at ordinary income tax rates and how much will be taxed at capital gain tax rates.

In 2024, the top federal income tax rate for capital gains is 20%, while the tax rate for ordinary income tops out at 37%. In general, buyer and seller have different goals for the PPA. Later we’ll explore methodologies for negotiating the PPA that result in a win/win for both buyer and seller.

How the IRS Requires the Purchase Price Allocation be Determined

Section 1060 of the Internal Revenue Code requires buyers and sellers to allocate the purchase price among the assets sold based on the relative fair market values of those assets. The PPA must be reported by both buyer and seller on IRS Form 8594. Ideally, buyer and seller will agree on the PPA so that their Forms 8594 match, reducing the possibility of audit.

Buyer and seller must use the residual method to allocate purchase price. The starting point is total proceeds. Total proceeds include both cash paid and the business’ liabilities assumed by the buyer. There are special rules for determining total proceeds when there is an earnout.

Once total proceeds are determined, they are then allocated among the assets sold in a prescribed hierarchy according to these classes from the tax regulations:

Class I: Cash
Class II: Marketable Securities
Class III: Accounts receivable
Class IV: Inventory
Class V: Machinery, equipment, land, building and other assets not specified
Class VI; Intangible assets and other than goodwill
Class VII: Goodwill

A detailed description of the classes can be found in the instructions to Form 8594 https://www.irs.gov/forms-pubs/about-form-8594

How Each Class is Taxed: Ordinary Income or Capital Gains Tax Rates

Class I | Cash — It’s unlikely there will be any gain or loss when cash is included in the business assets that are transferred to the buyer. You may wonder why cash is included at all. Typically, cash is included so that the buyer has adequate working capital to operate the business immediately after the sale. Sometimes there is no cash included if the buyer has other sources of liquidity.
Class II | Marketable Securities, Bonds — Most likely, any gain or loss realized on Class II assets would be capital gain or loss. If the marketable securities have been owned for less than 12 months, it will be short-term capital gain or loss which is taxed at ordinary tax rates.
Class III | Accounts Receivable — If your business uses the cash basis of accounting for income tax purposes, then the fair market value of accounts receivable will be hotly negotiated. Any purchase price ascribed to the A/R will be all ordinary income for a cash basis business. Most service type businesses use the cash basis of accounting for tax purposes. Most businesses that have inventory as a material income-producing factor use the accrual basis of accounting for purchases and sales of inventory. If your business uses the accrual basis of accounting for tax purposes, then it’s likely there will be a loss on the sale of the A/R representing the amount of A/R that is uncollectible. This loss is deductible against ordinary income of the business in the year of sale.
Class IV | Inventory — For a business with inventory, the fair market value of inventory could be less than its cost because of obsolete inventory or slow-moving inventory. Any gain or loss on inventory is taxed at ordinary tax rates.
Class V | Machinery, equipment, land, building and other assets not specified — This is the catch-all class, and its actual definition is anything that is not included in one of the other Classes. From a practical perspective, Class V will be mostly the company’s property, plant, and equipment, also known as its fixed assets.

The tax treatment of the sale of any depreciable property is tricky and requires knowing the original cost of the property and its accumulated depreciation at the time of the sale. Original cost minus accumulated depreciation is called net tax basis. Due to bonus depreciation, a company’s federal net tax basis of most equipment, office furniture, and computers is zero.

The proceeds allocated to a particular depreciable asset less its net tax basis equals the gain or loss on sale. If it’s a gain, then any gain to the extent of accumulated depreciation is taxed at ordinary tax rates. This is called depreciation recapture. Any gain that exceeds the previously taken depreciation is generally taxed at capital gain tax rates. If there is a loss, then generally the loss is allowed to offset the ordinary income of the business in the year of sale.

Buildings are treated slightly differently. A building used in the business that is sold at a gain is subject to a special tax rate on the previously taken depreciation. Your tax advisor should prepare an analysis of the tax implications of the sale of your fixed assets as part of the process of planning for the sale of your company.
Class VI and Class VII | Intangible assets and Goodwill — In general, for tax purposes, we don’t care about the allocation of sales proceeds as between these two categories. The bottom line is the proceeds not allocated to any of the other classes will be allocated to Class VI and Class VII. Unless the business previously acquired the business of another company, it likely has no tax basis in intangibles or goodwill. In this situation, all of the proceeds allocated to Class VI and Class VII will be taxed at capital gain tax rates.

If your company did do a prior asset acquisition, then there may be goodwill or other intangibles that are currently being amortized for tax purposes over a 15 year period. In this case, any prior amortization taken will first have to be recaptured and taxed at ordinary income tax rates. Any gain in excess of prior amortization of intangibles is taxed at capital gain tax rates.

The Impact of Purchase Price Allocation on Installment Sale Treatment

Often some of the proceeds from the sale of a business are contingent on meeting certain targets for revenue, profits, or EBITDA. And often these contingent payments are due in the tax years after the tax year of sale. In most cases, the seller will want to take advantage of the installment method and not pay tax on those deferred proceeds and gains until the year the seller receives the payments.

The PPA has an impact on the seller’s available benefit from using the installment sale method. Certain assets, such as receivables, inventory, and fixed assets, do not qualify for installment sale treatment. This means that if a significant portion of the purchase price is allocated to these assets, you may end up with a larger upfront tax bill and inadequate cash to pay the tax.

The Divergent Interests of Buyers and Sellers in Purchase Price Allocation

Now that we’ve established the fundamental principles behind PPA, let’s explore why Buyers and Sellers often have different preferences when it comes to allocating the purchase price.

Buyers typically prefer to allocate more of the purchase price to shorter-lived assets, such as inventory and equipment. This is because a higher allocation to these assets allows them to benefit from faster tax write-offs, for example as the inventory is sold and as the equipment is depreciated. These deductions can result in substantial tax savings for the Buyer over time.

On the other hand, the seller is motivated to allocate more of the purchase price to assets that qualify for capital gains treatment, most notably goodwill. This strategy can significantly reduce the seller’s overall tax liability, leading to higher net after-tax proceeds from the sale of the company. Therefore, there is often a natural tension between the interests of Buyers and Sellers when it comes to the PPA.

Why Sellers Should Model Different Purchase Price Allocations

Given the divergent interests of buyers and sellers, modeling out different purchase price allocations is crucial in the planning process of selling a business. Modeling different PPA scenarios allows sellers to explore options that maximize after-tax proceeds.

Sellers can engage in more informed negotiations with potential buyers when they have a clear understanding of the tax implications of various PPA scenarios. In some cases, buyers might be willing to gross up the proceeds if more of the purchase price is allocated to shorter-lived assets. The buyer could qualify for bonus depreciation or better financing with different purchase price allocations.

The only way the seller can know how much of a gross-up yields the same or better after-tax proceeds is by having a tax professional experienced in business sales run a number of scenarios.
Modeling different PPA options helps eliminate surprises that could impact the seller’s ability to use the installment method and therefore increase the cash required to pay taxes in the year of the sale.

Conclusion

As a business owner planning to sell your company, it’s essential to recognize the critical role that Purchase Price Allocation (PPA) plays in determining the amount and timing of taxes you’ll pay on an asset sale. The intricate dance between Buyers and Sellers, each with their own tax objectives, underscores the importance of careful consideration and modeling of different PPA scenarios.

You should seek out an experienced business advisor who specializes in M&A tax advice and M&A tax planning for business owners so you can navigate this complex process with confidence. By understanding the nuances of PPA and its impact on your taxes, you can make informed decisions that ensure you maximize your after-tax proceeds from the sale of your business.