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The most common deal structure of small business acquisitions is an asset purchase. In an asset purchase, the buyer takes ownership of the underlying assets of the target without assuming any or all of its liabilities. Theoretically, this type of acquisition deal can be structured so that any liabilities actually assumed by the purchaser are specifically identified in the agreement and reflected in the purchase price.
For the buyer, there are several focal points of the deal that directly affect its value. There are also a few opportunities to increase the seller’s value, without any detriment on the buyer’s end of the deal. This post will address those matters from the buyer’s perspective.
The buyer’s primary tax-minimizing concern is to maximize the allocation of the purchase price to the assets or asset classes expect to depreciate the quickest. This approach is driven directly by Section 167 of the Internal Revenue Code, which allows a buyer to deduction depreciation of certain property from taxable gross income. Consequently, the buyer receives this benefit more quickly the shorter the depreciation period is. Typically, a buyer will analyze each asset and prioritize it accordingly.
Inventory and fixed goods comprise the principal asset category. The is the category of assets the buyer wishes to maximize, from a tax perspective. The cost of inventory assets can be expensed as soon as the inventory is sold, reducing the buyer’s taxable gross income from sales. Fixed goods including equipment used by the business are depreciated over a seven year period. For these reasons, a buyer typically prefers to apportion as much of the purchase price as possible to inventory and fixed goods.
The next asset category is intangible assets. This includes both goodwill and covenants not to compete. These assets have a longer required period of amortization, which is more or less the analog of depreciation that applies to assets that are intangible. Pursuant to the Internal Revenue Code, goodwill and covenants not to compete must be amortized over a 15 year period. This causes a buyer to want to limit the apportionment of the purchase price for goodwill and non-competes.
There are of course some legal restrictions on the buyer’s ability to allocate the purchase price. First, both parties to the transaction must agree on how to structure the purchase price allocation or to the fair market value of each asset being transacted. Second, federal law provides for a residual allocation method but imposes a 7 class asset hierarchy that is designed to prevent the entire purchase price being allocated to one asset, or other flagrant attempts to unreasonably appropriate the purchase price solely for some tax benefit without regard for the realities of the underlying transaction. Inventory often ranks highest in the residual allocation hierarchy in an asset sale, making the fair market value of the inventory assets the first amount allocated from the purchase price. The remainder then can be allocated to the agreed fair market value of the fixed goods, with the residual going to non-competes and then goodwill.
A key negotiation point in some transactions is the amount allocated to goodwill. The buyer is indifferent from a tax perspective as to the values assigned to goodwill and to any non-compete agreements. In a transaction that includes both, this is an opportunity for the buyer to benefit the seller. From the seller’s side of the transaction, goodwill represents a capital asset that would generate a more favorable capital gains tax than any non-competes. Non-compete agreements would instead be taxed as ordinary income, incurring a higher rate of taxation.
These points offer only brief and general insight into the structure of asset purchase transactions. The specific factual circumstances of any particular transaction will generate many other considerations that must be weighed to determine the most beneficial arrangement for the deal.