There are countless considerations businesses should address when merging with another company or acquiring one. Among these is the Purchase Price Allocation, which is the process by which an acquiring company distributes the sale amount into various assets and liabilities that have carried over from a target company. The buyer and seller often have different ideas on how to allocate the purchase price in addition to different responsibilities.
After the buyer and seller have agreed upon the purchase price, each party must allocate the sale amount into the assets and liabilities contained in the business being bought. The value of a company’s assets minus its liabilities is calculated, as well as the Fair Market Value (FMV) of net assets and the business. After this total amount is calculated, it will be subtracted from the purchase price that was agreed upon. The difference will be chalked up to goodwill and non-competition clauses, among other things..
Example of Purchase Price Allocation
Let’s say a company purchases another company for $2 million. The company being acquired has assets that total $500,000 and liabilities that total $250,000. Therefore, the net assets owned by the target company is $250,000. The fair market value of the business (determined by the target company) is $1 million. So, in this case, the goodwill amount is $750,000. All of these specific amounts must be accurately reported to the IRS and other pertinent entities.
Examples and Consequences of Improper Purchase Price Allocation
Improperly allocating purchase price designations can open up the acquiring company to a myriad of violations and monetary penalties. For example, many business transactions include a non-compete clause to be applied to the seller. This can ensure the buyer’s non-acquired business isn’t threatened after forking over a significant amount of money in the sale.
The non-compete clause will be taxed differently for the buyer and seller. The seller is losing money due to the non-compete clause, and so the tax liability for this situation needs to be assessed for the buyer. Other aspects of the sale, including capital gains, are taxed differently for the buyer and seller. These differing tax burdens need to be properly reported to the IRS to avoid potential audits.
Conclusion
Buying and selling a business is not nearly as straightforward as many think it is. Improper purchase price allocation can result is significant penalties being assessed on the buyer or seller; this is one of many reasons it is important to do your due diligence when buying another company.
The Law Offices of Tyler Q. Dahl knows how complicated business transactions can be. Going with an attorney also designated as a Certified Tax Coach means our firm is uniquely qualified to ensure your merger or acquisition satisfies the IRS’s many requirements. Contact us today to see what we can do for you.
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