What Is Purchase Price Allocation?
Purchase price allocation is the process of assigning value to all the assets and liabilities associated with the sale of a business. Purchase price allocation (PPA) is crucial when buying and selling a business since it determines the tax a seller will pay on the sale and the buyer’s tax basis for the acquired assets.
That means it’s important for both buyers and sellers to understand how to allocate the purchase price when it comes to business transactions.
Here’s what you need to know about purchase price allocation.
Definition of Purchase Price Allocation
When the sale of a business is conducted as an asset-based sale, the IRS requires that both the buyer and seller assign the sales price to the individual assets and liabilities of the acquiring company.
Purchase price allocation is the process of assigning a value to a target, or acquired, company's individual assets and liabilities.
The Purpose of Purchase Price Allocation
Since the purchase price is one lump sum figure, the purpose of purchase price allocation (PPA) is to determine the value of the items that make up the purchase price.
When purchasing a company’s assets, you buy:
- Accounts receivable
- Inventory
- Machinery
- Real estate
- Cash balances
- Prepaid expenses
But how do you allocate a $1 million purchase price between these different asset types?
A PPA helps buyers determine the asset and liability values to record on their financial statements.
These figures will become the acquired business’s new basis in the individual assets and the carrying value of the acquired assets on the balance sheet.
Additionally, a PPA will help both the seller and buyer know the amount of goodwill on the business sale, if any.
Goodwill is usually the difference between the total purchase price and the allocated amounts of the assets and liabilities.
A PPA will determine the seller’s tax liability to the IRS.
How to File for Purchase Price Allocation
Generally, both the buyer and seller are required to file Form 8594, Asset Acquisition Statement, provided the sale meets the following two conditions:
- The deal created goodwill
- The acquirer’s basis in the assets is determined exclusively by the amount paid for the assets.
Remember, Form 8594 is only applicable for sales structured as asset sales, not stock sales.
Categories of Purchase Price Allocations
The following are the categories used in a purchase price allocation:
- Class 1: Cash
- Class 2: Marketable securities
- Class 3: Market-to-market assets and accounts receivable
- Class 4: Inventory
- Class 5: Assets not otherwise classified (buildings, equipment, vehicles)
- Class 6: Section 197 intangible assets (trademarks, customer relationships, employment contracts)
- Class 7: Goodwill and going concern
Previously, the IRS left it to the seller and buyer to determine which amounts to assign to each asset class, depending on the purchase agreement amount. This led to unusual business valuations.
But today, it requires allocation based on fair market values, with goodwill making up the difference.
How Purchase Price Allocation Affects Taxation
- Classes 1-3: Allocations made to Classes 1-3 don’t have taxable gains because they are already recorded in the books at their fair market value. The buyer and seller will allocate the fair market value as the purchase price, so there are no tax implications.
- Class 4: Regarding inventory, a Class 4 asset, the seller will pay tax at ordinary income tax rates, which can be as high as 37% on any gain above the inventory book value.
- Class 5: These assets include tangible assets, are generally taxed at favorable long-term capital gains tax rates, and may be subject to depreciation recapture.
- Class 6: For tax purposes, Class 6 items are generally taxed at capital gains tax rates. One notable exception is non-compete agreements, which are taxed at ordinary income rates.
- Class 7: Class 7 assets are generally taxed at capital gains tax rates.
Pros and Cons of Asset Sales
Buyers choose asset sales to step up the basis of acquired assets. This maximizes future tax benefits through higher depreciation, like bonus depreciation, resulting in greater after-tax cash flows. In addition, buyers can avoid certain liabilities (like lawsuits that might not be discovered during due diligence) that may arise later and not be known at the acquisition date.
However, asset sales can result in higher taxes for the seller due to ordinary income classification for some asset classes.
Because of these differing motivations, it provides both parties with negotiating opportunities. For example, the seller can ask for a higher purchase price if there are large amounts of inventory or significant non-compete agreements. Or the seller could suggest an installment sale to defer gains and taxes.
Ensure compliance with tax laws and regulations by working with an accountant to help navigate the complexities of buying and selling a business. Visit the BizBuySell Taxes Learning Center to learn more about tax considerations involved in the sale of a business.