Purchase Price Allocation
M&A transactions trigger a variety of financial and tax implications for both the buyer and seller. One such implication, and the topic of this article, is the requirement to conduct a purchase price allocation. A purchase price allocation (or “PPA”), generally defined, is an allocation of a transaction’s purchase price to the acquired company’s assets and liabilities. Usually prepared in advance of or shortly after the closing of an acquisition, purchase price allocations involve a valuation of the acquired company’s assets with the portion of the purchase above its identifiable assets allocated to goodwill or other intangibles.
PPAs are prepared for both financial reporting and tax purposes. As you would expect, each is governed by two different sets of standards:
Purchase price allocations conducted for the purpose of financial reporting are guided by the Financial Accounting Standards Board’s Accounting Standard Codification (ASC), specifically, ASC 805 Business Combinations and ASC 350 Intangibles – Goodwill and Other (with the standard of value defined under ASC 820 – Fair Value Measurement).
Purchase price allocations conducted for tax purposes are governed by the Internal Revenue Code, specifically IRC §1060 and IRC §338 (and IRC §754 for partnerships and limited liability companies). The standard of value for valuation conducted for tax purposes is Fair Market Value as defined by and Revenue Ruling 59-60 and Treasury Regulations §20.2031-1(b) and §25.2512-1.
There are clear differences between purchase price allocations for financial reporting and tax purposes that are certainly worth discussing; however, the following article will primarily focus instead on the strategy and implications related to purchase price allocations conducted specifically for tax purposes.
A Simplistic Summary of IRC §1060
Purchase price allocations for tax purposes are required when an acquisition is structured as an asset transaction or a stock transaction with an IRC §338 election (or a deemed asset transaction). Under IRC §1060, both the buyer and the seller are required to use the residual method to allocate the purchase price to the specific assets that are being sold in the transaction. The residual method involves identifying and valuing the transaction’s known and identifiable assets with any “residual,” or excess, value allocated to other intangibles or goodwill. Both the buyer and seller must then file the allocated values on IRS Form 8594, detailing the value that has been allocated across seven asset classes:
- Mark-to-market financial assets (including accounts receivable)
- Depreciable assets
- Identifiable intangibles (patents, trademarks, non-competes, etc.)
Any adjustments made to the purchase price after filing the initial Form 8594 (typically as a result of deferred payments or earnout adjustments) must also be filed with the IRS by submitting an amended Form 8594.
The Basics of a PPA Tax Strategy
Generally, any gains or losses involving assets sold from a C-Corporation are treated as ordinary income (exceptions are made for so-called “personal goodwill”, consulting agreements, etc.); however, assets sold from a pass-through entity are slightly more involved and require an understanding of each asset’s tax characteristics. To clarify, the above is specific to asset sales (or stock sales that have made a §338 election to be treated like an asset sale). For reference, pure stock sales are generally treated as a capital gain or loss to the seller with basis carried over to the buyer.
The asset classes the purchase price is allocated to dictates the applicable tax rates on any gains and losses. For example, gains and losses attributable to inventory (Class IV) are treated as ordinary income. Gains attributable to goodwill (Class VII), on the other hand, are treated as capital gains/losses. Gains and losses from identifiable intangibles (Class VI) are a mix of both ordinary income and capital gains/losses. Similarly, depreciable assets (Class V) are also a mixed bag of both ordinary income and capital gains/losses, which is largely driven by the asset reclassification and recapture rules found in IRC sections §1231, §1245 and §1250. The details of these sections are beyond the scope of this article; however, it is important for the seller’s transaction team to fully understand the tax characteristics of its depreciable assets, ideally in advance of receiving any letters of intent.
With this basic understanding, we can begin to see the effects of the purchase price allocation and develop a strategy to minimize the tax liability of an M&A transaction. In most cases, the seller will usually seek to allocate the purchase price into asset classes with more favorable capital gains rates (goodwill, securities, etc.). Buyers, on the other hand, will seek to allocate more of the purchase price into assets that will recoup cost more quickly (i.e. depreciable assets, inventory, etc.). For instance, buyers will receive a larger tax benefit if the purchase price is allocated more to fixed assets that depreciate over 5 to 7 years versus goodwill or non-compete agreements, which will amortize over 15 years (for tax purposes only). With the buyer and seller striving to achieve two opposing tax objectives, the PPA often becomes a central topic to the negotiations, particularly in companies with large fixed assets on the balance sheet.
So, what does this all mean? Let’s look at an example of how two different Purchase Price Allocations might affect the buyer’s and seller’s tax position.
An Example (Simplified and Exaggerated)
A seller of an S-Corporation has received a letter of intent of $10 million (structured as an asset deal). The buyer has also asked for a limited 5-year non-compete, which the seller has agreed to. Soon after receiving the offer, the seller quickly estimates its tax liability based on a favorable allocation of the $10 million purchase price (shown below). The resulting tax liability was estimated at $1.5 million. The seller shows the anticipated PPA to the buyer, who initially agrees without giving much thought to the details. The parties execute the letter of intent and the buyer formally begins its due diligence review.
Four weeks into the buyer’s due diligence, the buyer’s attorney circulates a draft of the Definitive Agreement, which includes a revised version of the PPA. The buyer explains they believe the fixed assets have a higher fair market value than originally estimated (i.e. the buyer wants a bigger step up in the asset’s basis). The buyer’s PPA will create an estimated tax liability of $2.3 million for the seller.
If the seller agrees to the buyer’s PPA, the seller will pay an additional $824,500 in taxes; however, the buyer has also created an additional tax benefit for itself. If the seller wanted to understand the additional benefit created to the buyer, they would compare the present value of the tax savings under the two proposed PPAs (i.e. examining the tax effect of accelerating the buyer’s depreciation and amortization).
There are, of course, several ways to address the dilemma presented in this example, many of which will require one party to give something up. The seller could request a new allocation that meets the buyer somewhere in the middle. For instance, decreasing the $300,000 allocated to the non-compete in the buyer’s PPA has little impact on the buyer’s tax position, but slightly improves the seller’s tax liability (capital gain versus ordinary income of a 15-year intangible). The seller could request an increase in the purchase price to offset the additional tax liability (a tougher proposition). Additionally, the parties could negotiate other aspects of the transaction in favor of the seller (i.e. Service Agreements, Seller Indemnities, Reps and Warranty Insurance, Earn-Outs or Working Capital Adjustments).
Let’s pause briefly for a friendly disclaimer. The above calculation is a simplified example of a complex tax code. The reality is that some of the Class V assets will likely receive benefit from IRC section §1231, which could significantly reduce the seller’s tax liability. Similarly, not all Class VI assets result in ordinary income. Please do not take the above example as tax advice; contact your tax accountant or M&A professional.
Negotiation Topics to Consider
- Understand the tax characteristic of the seller’s assets early in the transaction process, ideally in advance of receiving letters of intent or offers. Do not put off discussions about purchase price allocations. Sadly, PPAs are often not addressed until closing, or worse, after closing.
- Once letters of intent or offers have been received, the seller should begin to more fully understand the tax effect and should articulate its assumptions related to the PPA to the buyer. Similarly, the seller should attempt to understand the buyer’s assumptions. This provides the parties with an expectation of the seller’s tax burden and will make late stage adjustments to the purchase price easier to attain should the PPA be materially altered. Any issues is best addressed early on in the process…not on signing day.
- By understanding the tax characteristics and impact related to section §1231 assets and where section §1245 and §1250 recapture becomes relevant, the seller and buyer may be able to come to a mutually favorable outcome.
- Value is more than a dollar amount. There are other areas of the transaction agreement a buyer or seller can leverage. Don’t let a stalemate on one aspect of the transaction prevent a close, particularly if there are other areas to make it up.
- Sellers should expect to pay taxes on the profit from the transaction; there is no way around it. At the same time, they should not be taken advantage of by the buyer (who may be more sophisticated when it comes to the M&A process). Always get advice.