Thinking of selling your business? Before making this important decision, it is critical to consider the implications of this transaction on your tax bill. The sale of a business typically involves the sale of all business assets, and when this occurs, each asset is evaluated separately to determine the gain or loss.
Allocation of Consideration
The buyer’s consideration is the cost of the assets acquired, while the seller’s consideration is the amount realized from the sale. When selling a business for a lump sum, each asset is considered separately, except assets exchanged under nontaxable exchange rules, such as with real estate that is acquired through a “like-kind” exchange. Both the buyer and seller must allocate the sales price to the assets of the business under a process referred to as the residual method. The residual method determines the buyer’s basis in the business assets, the seller’s gain or loss from the transfer of each asset, and how much of the consideration is for goodwill and/or intangible assets.
The residual method must be used for any transfer of a group of assets that constitutes a trade or business and applies to both direct and indirect transfers. Assets are considered trade or business assets if goodwill or going concern value is attached and/or the use of the assets would constitute an active trade or business. This method provides that the consideration be reduced first by cash or deposit accounts (Class I Assets) and the remaining consideration be allocated between each asset below fair market value on the date of purchase. To prepare IRS Form 8594, Asset Acquisition Statement, the consideration must be allocated between the assets based on their class, in order:
- Class I Assets: Cash and general deposit accounts, excluding certificates of deposit
- Class II Assets: Certificates of deposit, U.S. government securities, foreign currency, and actively traded personal property
- Class III Assets: Accounts receivables, other debt instruments, and annually marked-to-market assets
- Class IV Assets: Property included in inventory or held by the taxpayer for sale to customers
- Class V Assets: All other assets including furniture and fixtures, buildings, land, vehicles, equipment
- Class VI Assets: Section 197 intangibles not including goodwill and going concern value
- Class VII Assets: Goodwill and going concern value
If an asset can be classified as more than one of the above, it should be included in the lower-numbered class.
The buyer and seller of a business each file Form 8594 based upon a written agreement as to how the sales price will be allocated among the assets. The form is attached to each party’s income tax return in the year of the sale and is considered binding unless the IRS determines the amounts improper and changes the allocations.
An alternative to a strict asset sale is a qualified stock purchase (QSP). Under this election a business is acquired through a purchase of stock. For federal tax purposes, however, the purchase is treated as if it were a purchase of assets. While this alternative is not covered in detail in this article, the tax benefits from this treatment to both the buyer and seller are similar to a straight asset sale. The necessary purchase price allocation, however, will be calculated and presented a little differently.
Whether you are buying or selling your business in the upcoming tax year, it is important to ensure that all allocations of sales price are correctly classified and reported on Form 8594 using the residual method.
If you would like to speak with a PYA tax professional about the tax implications of the sale of your business or tax planning and strategy, one of our executive contacts would be happy to assist. You may email them below or call (800) 270-9629.