Understanding Purchase Price Allocation when buying and selling a business

One of the hidden and sometimes very surprising scenarios which buyers and sellers of a business experience, comes when there is a need for both parties to agree on the Purchase Price Allocation. The surprise comes into play as most buyers and sellers have not heard of the Purchase Price Allocation and when it needs to be agreed upon, both buyer and seller can find it emotionally challenging, especially if the negotiations have been long and difficult.

So what is the Purchase Price Allocation? The Purchase Price Allocation is a tax-reporting requirement on the sale of a business. Both the buyer and the seller must report their own understanding of the Purchase Price Allocation and the IRS can and does check to make sure both parties report the same information.

So where does the challenge come into play? The challenge comes into play because the buyer has a different tax need to the seller. That is, it’s the seller’s preference to sell his stock of the company to the buyer, as he does not need to pay back any taxes they have claimed as a deduction when operating the business. The buyer wants the exact opposite in that they want to buy assets, not stock, so they can start to depreciate the assets and thereby lower their tax bill.

The general process is for the seller to list the business for sale at a specific price. The buyer does their research, makes an offer and if all goes well, both parties come to an agreement, perform due diligence and close escrow. Just prior to closing escrow is when the Purchase Price Allocation must be agreed upon. If an escrow company is handling the transaction for both parties, they will require an agreement from both parties on what the Purchase Price Allocation should be. It’s not too common, but it does happen, where the buyer and seller have spent months working together on this transaction and then it falls over because they simply cannot come to an agreement on the Purchase Price Allocation. This happens when the negotiations have been stressful and difficult and the frustrations simply come to a head at this point with the Purchase Price Allocation being the catalyst.

The solution to prevent this happening is simply education. If the buyer and seller are aware of what the Purchase Price Allocation requires, then it can be handled quickly and cleanly. There is a need for both parties to give; just like all the other items they have negotiated. Plus, one of the best places to start is with the initial inquiry of the buyer. If the seller has decided he wants to only sell their stock and not do the transaction as an asset sale, by stating this upfront it can lessen that problem.

A lot of buyers are unwilling to buy the stock of a company for two reasons. The first reason is that if they buy the stock of the company they are liable for any previous actions of the seller. This liability can be mitigated through seller personal guarantees and insurances but it still makes a buyer uneasy. The second reason is that the buyer doesn’t get to depreciate the assets from a new tax basis, that is, they simply continue the depreciation rates the company currently gets. If assets have therefore been fully depreciated, the buyer gets no new tax benefit.

Buying and selling a business is more complicated when the tax costs and benefits come into play. It’s the wrong approach to take when buying or selling a business that there is a need to win each negotiation. By definition a negotiation means each side giving. If the goodwill to negotiate is not there, there is little likelihood the transaction will close.