 | VALUATIONS / PRACTICE APPRAISAL
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Creative Allocation Options
Whether you settle on an asset purchase or a stock transaction
there are ways to mitigate the tax consequences for one or
both sides. Very few deals are cut and dried anymore, with
both buyers and sellers becoming more and more creative. Recognizing
that the IRS prefers simple over creative, it is important
to obtain professional advice regarding the risks that are
being taken by both sides when portions of the purchase transaction
are allocated to various non-capital components. Remember
that whenever you do something that will take money away from
the government you are rolling the dice. As with all gambling
it is important to know in advance what the odds are.
There are several primary types of allocations, each with
its own tax treatment. Most of these allocations have been
summarized below although some will not apply to every situation
and others may not be reasonable under certain circumstances.
Along with professional advice, you will need some good old-fashioned
common sense to come up with an appropriate strategy.
Goodwill: In the asset purchase of a going
concern agency there is generally some goodwill acquired with
the name, reputation, and people. This item can comprise 10%
or more of the total deal when the entire practice is being
sold. Goodwill is also treated as capital gains for the seller
and is also subject to the double taxation. Thanks to relatively
recent changes in the tax law, it can now be amortized over
fifteen years by the buyer. Although goodwill may be acquired
in a stock purchase it is not generally treated as a separate
item in that structure.
Covenant not to Compete: The ability of
the purchaser to restrict the seller's right to compete for
the accounts that have been sold is often a valuable asset
and a critical component of the price that is being paid.
As a general rule, it is important that separate negotiations
be made for the covenant, placing a specific value on the
cost of eliminating the competition (seller) within described
geographic boundaries for a certain pre-defined period of
time.
Covenants cannot be so restrictive that they interfere unreasonably
with the interest of the public. They must also be reasonable.
If the restrictions extend for ten years and include all family
members of the seller within a thousand miles of the agency
location you may have a difficult time getting the contract
as well as the deduction to hold up. A covenant not to compete
must also be based in economic reality. Allocating a large
portion of the purchase price to a covenant from a seller
who is 85 years old, in poor health, and moving five states
away would be pushing the envelope a little too far.
The IRS could be expected to insist that this covenant was
simply a disguised part of the purchase price for other assets,
designed primarily to avoid the double taxation problem. On
the other hand, if the seller is sixty years old and planning
to remain in the vicinity a very good argument can be made
for allocating a good part of the deal to the covenant. Most
transactions now allocate from 35% to 50% of the purchase
price to covenants with the sellers.
From a tax point of view the covenant is treated as ordinary
income for the seller so it is advantageous to stockholders
of "C" corporations but will be taxed at a higher
rate than capital assets for "S" corporation owners
or partnerships. It used to be that the buyer could deduct
the covenant over its life, which made it quite attractive.
Now covenants related to a sale must be written off over the
same excessive fifteen year period as expirations and goodwill.
Balance Sheet/Fixed Assets: In an asset
purchase where the buyer is acquiring a select list of assets
the furniture, fixtures, computers and other equipment may
also be coming along with the transfer. Since fixed assets
can be depreciated over a five year period they are more attractive
for the buyer from a tax point of view than goodwill or covenants.
If the value of the fixed assets is set as the book value
on the balance sheet of the seller, the seller will not pay
any tax. If the buyer wants to allocate more to this component
under the argument that the market value of these items is
higher than the book value, the seller will have to pay capital
gains tax on the difference.
Interest: Any payments that are made over
time must be accompanied by an allocation for interest. If
interest is not spelled out in the contract, the IRS will
impute it. Interest is tax deductible to the seller and ordinary
income to the buyer so it can be advantageous for both sides.
Offsetting some of the purchase price by a slightly higher
interest rate could be attractive. Even in a retention based
structure the fact that the payments are being made over time
makes it qualify as an installment sale. The transaction could
be set up to allocate some of the payments to a reasonable
but slightly high level of interest, thereby' reducing, the
amount allocated to the purchase of capital assets.
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Copyright © 1999-2003 Gatto McFerson
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