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April 24, 2008

Allocating Sales Price - Sale of Business

Re: Disposing of a Business - Allocating Sales Price

When the assets of a going concern are sold to a single buyer, the buyer and seller generally must allocate the purchase price among the tangible and intangible assets that are being sold. As the seller, you will want to allocate as much of the purchase price as possible to assets that yield capital gains, rather than ordinary income. The buyer's interest, on the other hand, will be to allocate as much of the purchase price as possible to assets that do not have to be fully capitalized, and can be written off quickly.

These tensions are at play in all business asset sales, but they vary with changes in the parties' circumstances and in the tax laws. Since you plan to sell the assets of your business, we want to give you an overview of how the allocation process required by the Internal Revenue Code works.

The mandated method is called the "residual allocation method," which has a hierarchy of four categories:

Class I assets: These are cash, and cash equivalents, such as demand bank accounts.

Class II assets: These are items such as certificates of deposit, government securities, and other readily marketable securities.

Class III assets: These consist of all assets other than Class I, II, IV and V assets, goodwill or going concern value, whether tangible or intangible. This includes furniture and fixtures, land, buildings, equipment, inventory, accounts receivable, and covenants not to compete.

Class IV assets: These are all Section 197 intangibles other than goodwill and going concern value. This class includes business books or records, patents, formulas, licenses, etc.

Class V: Section 197 intangibles in the nature of goodwill and going concern value.

Allocations are made first to the top category of assets, then to the second, and third. Whatever is left unallocated automatically is allocated to intangible assets in the nature of goodwill and going concern value.

Buyers and sellers will try to the extent possible to make allocations that serve their own tax interests. While no asset can receive an allocation greater than its fair market value, that value cannot always be determined with mathematical precision, so there often is some room to maneuver. The buyer and seller, however, both must use whatever allocation they finally agree to.

Until a couple of years ago, sellers wanted to allocate as much as possible to goodwill and going concern value, because it gave them capital gain. Buyers hated allocations to these assets, because they couldn't be written off. Now, however, they can be written off over 15 years.

Many other purchased intangible assets, such as covenants not to compete, that buyers used to write off over their terms, now can't be written off over less than 15 years. So buyers may want to enter into consulting agreements to shift some allocation away from the covenant not to compete and to get more immediate tax benefit from their expenditures. Although covenants not to compete and consulting fees both are taxable as ordinary income, sellers have to remember that consulting agreements generally will require them to perform services, while covenants not to compete do not.

We hope this overview of the allocation requirements is helpful to you in your negotiations. If you need additional advice on this complex subject, please call for an appointment.

If you found this article of interest and would like to find out how LBO can help you acheive your tax, insurance, and financial planning goals, please give us a call at 631.864.5206, or simply fill out our information request form and an LBO representitive will contact you as soon as possible.