Buying or selling a business involves a litany of financial implications that go beyond just what the business sold for. What matters, especially come tax season, is how that number gets divided among the assets being transferred. That process is called purchase price allocation, and it has a significant effect on what both the buyer and the seller owe or save in taxes.
If you’re the seller, how the price gets split up can mean the difference between paying capital gains tax or being hit with ordinary income tax rates. For the buyer, it impacts how and when you can deduct those expenses later. Most deals involving small businesses (especially S Corporations) are structured as asset sales, which makes this step unavoidable. Done right, it keeps everyone in the deal on solid footing. Done wrong, it can turn into an expensive mistake.
Determining the Fair Market Value of Acquired Business Assets
When you sell a business through an asset sale, you’re not just handing over one big package. You’re transferring a mix of assets (equipment, inventory, goodwill, maybe customer lists, maybe a trademark). Each of those pieces needs to be assigned a value, and that value needs to reflect what they’d go for in a fair, arm’s-length transaction.
Cash, receivables, and inventory are pretty straightforward. You can usually take those numbers right off the books. But for assets like machinery, furniture, or any kind of intellectual property, the fair market value might be very different from what’s listed on your balance sheet.
Although not specifically required, that’s where appraisers could come in. They can help pin down a defensible number based on market conditions and current use. That value ends up on IRS Form 8594, which both parties file. It’s one of those situations where getting the numbers right early on saves headaches later.
Where One Party Gains, The Other Offsets
Sellers and buyers often want very different things from this process.
Sellers usually want more of the purchase price allocated to items that will be taxed at the lower capital gains rate; things like goodwill and going concern value. Buyers, however, prefer allocations that give them faster deductions. They’d rather put more value on equipment or other capital assets, since those can often be depreciated over a much shorter time (more on that below).
That difference creates a bit of a tug-of-war. Every dollar one party shifts toward their preferred category usually means the other party gives something up, as the sales have to even out on both sides of the deal. It’s not hostile, but it is strategic. Both sides need to work out an allocation that makes sense and, ideally, keeps the deal moving forward.
Most purchase agreements now include a clause where both parties agree to the allocation ahead of closing, meaning getting the right legal team involved early is crucial. That keeps things consistent and helps avoid any mismatched filings, which the IRS doesn’t take lightly.
Accounting for Depreciation Recapture in the Allocation
Depreciation recapture is one of those tax issues that is often more nuanced and complex than business owners are prepared for. It comes into play when a seller has used depreciation to reduce their taxable income over the years through a depreciation deduction. That’s not a problem by itself. The issue shows up if the asset’s fair market value at the time of sale is a lot higher than what’s left on the books.
Let’s say a company sells for $2.4 million, and part of that price includes $600,000 allocated to equipment that’s been fully depreciated down to zero. That $600,000 is taxed at ordinary income rates for the seller, not the more favorable capital gains rate. If the seller is in a high tax bracket, the difference can be significant.
That tax hit doesn’t mean the seller is being penalized; it just means the IRS is “catching up” on deductions taken in earlier years. Still, it can take a big chunk out of your proceeds if you’re not planning for it.
Make the Right Choices in Allocating Your Newly-Acquired Business Interests
When acquiring or selling a business, how you allocate the purchase price is going to have significant ripple effects on the long-term value and success of the deal. Mistakes or poorly informed choices here can result in unexpected tax consequences or leave deductions on the table. Dahl Law Group works with California business owners to help structure acquisitions in a way that protects both your investment and your future income. Contact our legal team at our offices in Sacramento or San Diego for legal support built around your specific transaction.
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