IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family businesses. The following content has been provided by Jeffrey Bryan. Mr. Bryan is a senior M&A intermediary on the IBA team. He worked in both the construction and automotive industries prior to joining the firm in 2007 and has successfully facilitated numerous transactions in those business sectors and multiple others involving as diverse a set of industries as wineries, distilleries, pleasure boating, and dog boarding facilities.
Asset Allocation 101 for Buyers and Sellers of Privately Held Companies
The business brokerage marketplace in three of the industry sectors, construction, transportation and alcohol manufacturing, that I work in as a professional intermediary is currently robust with strong buyer demand for the quality companies I bring to market. An area where I get a lot of questions from sellers and buyers after reaching preliminary agreement on a LOI based on my nearly fifteen years of experience facilitating transactions and need to collaborate with their CPA or find them an accountant with relevant knowledge and experience relates to asset allocation strategies for tax purposes in deals involving privately held companies and family businesses. The following is an overview of some of the elements of that conversation in a business purchase & sale transaction.
Asset Allocation is how the company value is divided up to report the sale to the federal government, and where applicable state government, for tax purposes in a business purchase & sale transaction. As it affects taxation on the sale of a business, Asset Allocation has a larger impact on the Seller than it does on the Buyer. While tax allocation can impact a Buyer’s depreciation and amortization schedules (how quickly they can write off the purchase price) it can make as much as a 25% difference in the Seller’s net proceeds from the sale of their business.
There are six common tax allocation categories business assets can be divided into: Equipment (Furniture, Fixtures, and Equipment or FF&E), Non- Compete, Inventory, Training/ Transition, Leasehold Improvements, and Goodwill. All have distinct tax impacts on both Buyers and Sellers of businesses.
Equipment (FF&E) and Vehicle values are one of the most common categories that buyers and sellers have different motives in a business sale. Sellers are inclined to place a lower value on FF&E because they can be forced to pay recapture on fully depreciated assets that are sold above book value. Buyer’s accountants often push to place a higher value on the equipment, especially in states like Oregon with no or low sales tax rates, because the FF&E assets fully depreciate over 1 – 7 (Note: Don’t forget Section 179 Section 179 Deductions: What Are They? (thebalancesmb.com) ) years as opposed to 15 year amortization for Goodwill and/or Seller Non-Competition Agreements. The one caveat is that the Buyer will pay Sales Tax on every additional dollar at closing (~10% in the State of Washington). For vehicle values we recommend that Buyers and sellers find the lowest defendable values. That’s a $10,000 price premium up front for every $100,000 in asset value for the buyer.
I once spent 6 hours on a Saturday with both Buyer and Seller researching values for a fleet of 40 vehicles to save the Seller $250,000 in recapture expense (18% tax savings = $45,000) and the buyer $21,750 in vehicle excise (8.7% sales) tax. Remember to save your researched values in a file in case of a state or federal audit.
Non-Compete is the allocated portion of the sales price that the Buyer pays to the Seller for a safe harbor of operation in the geographical area of operation for the company. The Non-Compete is usually described in the Purchase and Sale Agreement as a restriction by geographic area (e.g., state, county, city, etc), mile diameter surrounding the business location, or by specific business role (ownership or management of a similar business type). Attorneys giving buyers council will sometimes push for a prescribed amount (aka $250,000) that can be enforced if the seller violates the non-competition agreement. It has recently (last 5 years) become the more common practice for counsel to place no value or inclusive terminology in the PSA so that damages are not limited by a tax strategy should the seller compete against the business. Buyers can amortize Non-Competition values over the same time period as Goodwill (15 years). Sellers will pay at their personal income tax level minus FICA taxes (reference webpage: Handling tax issues related to noncompete agreements (thetaxadviser.com ) on any dollar amounts placed in the Non Competition category.
Inventory consists of the dollar amount allocated to the salable goods or wares of a business that will be sold to customers/clients. Inventory is typically a floating number during the course of the business sale, often reconciled the day before closing. For the Buyer inventory is considered a Cost of Goods Sold (COGS) upon the sale of the business and generally a pass through expense with no sales tax collected. For the Seller inventory is typically a pass-through expense with little to no income and sales tax implications since no profit is made on the sale of this asset.
Training and Transition (Consulting) Services has traditionally been an included portion of the sale of the business, unless there are circumstances which necessitate the Seller’s longer term involvement post-sale. Then Buyer and Seller will negotiate a daily, monthly, annual or project rate of compensation in the PSA. For the Buyer any dollars allocated to Training and Transition will be deducted as a current year expense. For the Seller any compensation will be considered Ordinary Income and subject to their personal income tax bracket (which can be inflated in a business sale year).
Leasehold Improvements are a less commonly used category recognized in tax and PSA documents. In approximately 15 years helping Sellers retire from their businesses, I have never seen a single dollar allocated to this category. Long-Term Improvements are considered “Sunk Costs” by tenants and landlords. A new roof on a building has a cost and value, but neither are really transferable to a buyer leasing the property. The IRS gives these expenses the longest possible depreciation schedule at 29.5 to 39 years, making it far more advantageous for Buyers to put the dollars into either Goodwill (15 year) or FF&E (1-7 year) with more favorable depreciation schedules.
Goodwill is often equated to as “The Blue Sky” or the reputation, market share, staff infrastructure, and cash flow earning potential of the business. It covers the intangibles of the business like customers, corporate culture, processes and practices of the business that helps its owners earn their living. It is the How and Why that makes people do business with the company. Goodwill is commonly the largest tax allocation category in a transaction involving a quality business. Buyers can depreciate their Goodwill value at a rate of 6.67% annually over 15 years. The Seller’s Goodwill value enjoys favorable tax treatment at their Long-Term Capital Gains rate (currently 23.8% at a federal in the United States).
More often Tax Allocation negotiations between Buyers and Sellers come down to Goodwill vs. FF& E with a few dollars sprinkled over the other categories to make the rest look good to the IRS. Yes, this does impact the Seller more than the Buyer, so some give and take from both sides generally makes good common sense. It is always a good idea to have your Tax Specialist or CPA help with the Asset Allocation element of a deal as ultimately the this element of the negotiation will need to be reported to the IRS on form 8594 About Form 8594, Asset Acquisition Statement Under Section 1060 | Internal Revenue Service (irs.gov). It is STRONGLY recommended that both the Buyer & Seller report the transaction identically to the IRS, as failure to do so has a strong potential to trigger an audit of the transaction. IBA business brokers are always happy to help with quality professional referrals.
If you have questions relating to the content of this article or selling a privately held company or family business Jeffrey Bryan would welcome the opportunity to talk with you. Mr. Bryan can be reached at (425) 454-3052 or jeff@ibainc.com.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.