Buying or Selling a Business? Negotiate the Deal with Taxes in Mind!

Last week, a client called to let me know he was thinking about selling his business and asked what the tax consequences would be.  If there is one way to impress a CPA, this is how you do it.  We are CPA’s and part of what we do is help you make the right decision.  But once the decision is made, often times there is very little we can do except comfort the client in his distress.

There were a number of ideas I brought to the table but the one I want to share with you is a little known and often overlooked step in selling a business:   Filing IRS Form 8594, “Asset Acquisition Statement.”   

For those do it yourselfers out there, failure to pay attention to this part of the process can cost you thousands of dollars depending on the size of the sale.

So if you are thinking about buying or selling a business or know of someone who is, here is some guidance that could help save you some money.

What is the purpose of Form 8594?

When buying or selling a business it is very common that only the assets of the business are sold or purchased.  Not surprisingly, the IRS is very interested in the sale as it effects how the gain or loss on the sale of the assets is taxed.  Form 8594 is the way to report this information to the IRS.

Most businesses are made up of different types of assets and the IRS treats each asset as being sold separately in order to determine a gain or loss.  Form 8594 allocates the purchase price to various classes of assets and reports it, in writing, to the IRS.   Here are the seven classifications:

Class I – Cash and Bank Deposits
Class II – Actively Traded Personal Property & Certificates of Deposit
Class III – Debt Instruments
Class IV – Stock in Trade (Inventory)
Class V – Furniture, Fixtures, Vehicles, etc.
Class VI – Intangibles (Including Covenant Not to Compete)
Class VII – Goodwill of a Going Concern

It is through the allocation of purchase price using the above classifications reported on Form 8594 that the IRS taxes the transaction.

Example: Bill is selling his medical supply business for $300,000.  The fair market value (FMV) of assets being sold are $25,000 cash, $75,000 inventory, $130,000 equipment, $50,000 non-compete covenant.   The purchase price of $300,000 must be allocated to the different classes of assets based on their FMV.  FMV of all the assets being sold is $230,000 ($25,000 + $75,000 + $13,000 + $50,000).  That leaves a difference of $70,000 to still account for ($300,000 - $230,000).  Where does it get allocated to?  Goodwill, also known as Blue Sky, class VII.

Both buyer and seller need to agree to the allocation and file Form 8594 with their individual return.  The IRS typically doesn’t care how the class allocation is made so long as both the buyer and the seller use consistent treatment.   Filing inconsistent Forms 8594 will likely trigger an IRS audit.

What difference does it make how the purchase price is allocated?

It’s important because different classes of assets are taxed differently.  Some asset sales receive capital gain treatment and are taxed at historically low 15% rates.  Other assets get taxed at the taxpayer’s ordinary income tax rates, which can be as high as 35%.  

Usually what you’ll find in the allocation process is that the buyer and seller have competing interests - meaning what’s good for the seller is often times bad for the buyer, and vice versa.  For example, a seller would prefer to designate a major portion of the sales price to goodwill (a capital asset taxed at a maximum of 15%) and minimize any allocation to machinery and equipment (can be taxed as high as 35%). 

On the other hand, the buyer would prefer just the opposite.  He wants to see as much as possible designated as machinery and equipment since this classification can be expensed or written off over a shorter period of time (usually 5 or 7 years) as opposed to a 15-year amortized write-off of the goodwill.

Planning Tip: 

What CPA’s see all too frequently is there is no allocation agreed to at the time of the contract and because of the competing interests of the parties involved obtaining such an agreement after the sale has taken place proves difficult.  So whether you are a buyer or seller, do not leave the allocation of purchase price to chance. 

Negotiate the allocation as part of the sales agreement.    Attach the Form to the sales agreement or state in the body of the agreement what the assets are and use reasonable, agreed upon allocations.  By doing this, both parties will know exactly what their tax consequences will be.  If you don’t, you could easily end up with inconsistent treatment and potential adjustments by the IRS. 

Unless you have a working knowledge of this area of tax law, I suggest getting your CPA involved sooner than later.  After the fact, there is little we can do.

Are there any penalties for failure to file Form 8594?

Form 8594 is considered an information return.  Penalties for failure to file an information return on the prescribed date is generally $50 per return, but in the case of intentional disregard, the penalty becomes the greater of $100 or 10% of the “aggregate amount of items required to be reported” without limitation. Since the entire amount of consideration must be reported on Form 8594, the penalty for intentionally disregarding the filing requirement could be enormous.

If you are anticipating a sale, please call me so I can assist you in structuring the transaction in your best interest.  My contact information is on my website