You own a lollipop store and want to increase sales. What should you do? Unfortunately, many small companies miss the opportunity to grow their businesses by acquiring other companies. This technique is relatively easy and inexpensive, compared to the traditional approach of incremental growth through marketing.
Invariably, businesses are acquired for their intangible assets (goodwill, location, customer lists, databases, location, name recognition, trademarks) rather than tangible assets (inventory, supplies, furniture or equipment).
All small-business acquisitions involve three main tax issues: (1) How much of the purchase price may be deducted by the purchaser? (2) Over what period of time must the purchase price be deducted? and (3) What are the tax consequences to the seller?
If the seller is a corporation and you purchase the shareholders stock, generally none of the purchase price is deductible because you didnt purchase the actual business assets. Consequently, most small corporate acquisitions are structured as asset sales, rather than stock sales. In addition, an asset purchase generally insulates the purchaser from the existing debts and liabilities of the selling corporation.
Assuming the transaction is an asset sale, then the purchaser must deduct the entire purchase price over time. Because the purchase of a business is a capital expenditure, payments cannot be deducted when made.
Also, the purchase is not of the business itself, but rather the components that comprise the business. In short, taxpayers who purchase or sell a business are actually engaged in a multiple asset transaction and must allocate the payment among all the assets. Thus, each category of asset (inventory, furniture, goodwill, covenant not to compete) must be allocated a portion of the purchase price.
Most assets have a useful life of more than one year, so they must be depreciated or amortized (deducted ratably) over a period established by the tax law. Intangibles must be amortized over 15 years. Unfortunately, for small businesses buying intangibles, this lengthy write-off period is often undesirable.
IRC Sec 1060 requires that sellers and purchasers adopt and maintain a consist allocation method for tax purposes. Taxpayers use a "residual allocation" method for purchases and sales of businesses (reported to IRS on Form 8594). This method determines both the buyers basis in the assets, and the sellers gain or loss.
Whether the purchase is made with a single payment or in installments, the business assets will be divvied up into five class allocations (see Chart) with variable tax consequences.
The Class I allocation is dollar-for-dollar for cash and bank accounts. Allocations within classes II, III, and IV are based on the fair market value (FMV) of each asset to the aggregate FMVs of all assets within the class. The remaining amount, if any, falls into Class V. Thus, goodwill and going concern value are not determined by the FMV; they receive the residuary allocation.
For example, if you buy a mail-order lollipop business for $50,000 that has $5,000 of lollipops in inventory (Class III) and a customer list worth $15,000 (Class IV), the residuary allocation to goodwill (Class V) would be $30,000 ($50,000 minor $20,000 in Class III and IV assets = $30,000).
The inventory purchase is not currently deductible; you will recover your outlay as the lollipops are sold. However, you will deduct the $45,000 allocated to classes IV and V at the rate of $3,000 a year for 15 years, even if you paid $50,000 upfront. Note: If you borrowed the funds, the interest will be immediately deductible in the year paid or incurred.
Traditionally, buyers allocated a portion of their purchase price to a "covenant not to compete" (covenant). A covenant was currently deductible when paid (say, over a one to three-year period), but the seller received ordinary income for those payments. Because covenants are now a Class IV intangible, they must be amortized over 15 years. As a result, covenants have become a lose/lose proposition for both parties ordinary income to the seller, 15-year write-off to the buyer.
Instead of using a covenant, buyers have turned to consulting agreements with the seller to more rapidly deduct a portion of the purchase price. A short-term consulting agreement permits the buyer to deduct consulting fees upon payment, with the seller declaring the payments as ordinary income.
A consulting agreement could have advantages to the seller, because he is now in the consulting business. He can maintain a Keogh retirement plan, and is permitted ordinary and necessary business expenses, including a home-office deduction. Consulting agreements and other forms of compensation paid to the seller are reported on IRS Form 8594, which could trigger an audit.
Growing your business through acquisitions can be advantageous. However, purchasing intangibles while avoiding the lag of a 15-year amortization takes careful planning. When appropriate, buyers should consider a consulting agreement for part of the purchase to generate a faster write-off.
Understanding the tax consequences of a business purchase and how to minimize them will go a long way toward improving your bottom line.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**