Allocating Sales Price between Buyers and Sellers
By Michael W. Blitstein, CPA
In our experience, virtually all sales of dental practices are documented as an asset sale rather than a stock sale. When the assets of the practice are sold, the buyer and seller must allocate the purchase price among the tangible (equipment, furniture, computers, etc.) and intangible assets (goodwill, customer lists, covenants not to compete, etc.) that are included in the transaction. An allocation of the purchase price must be made to determine the purchaser’s basis in each acquired asset and the seller’s gain or loss on the transfer of each asset.
Sellers will want to allocate as much of the purchase price as possible to assets that yield capital gain treatment, rather than ordinary income, to take advantage of the preferred capital gains tax rates. Buyers, on the other hand, will want to allocate as much of the purchase price as possible to tangible assets that can be depreciated over a shorter time period. Intangible assets generally are amortized over 15 years. Most tangible assets are generally depreciated over 5 years.
These conflicts are at play in all business asset sales, but they vary with changes in the parties' circumstances and in the tax laws. Both buyer and seller must use Form 8594 to report the allocation of sales price to the IRS on the income tax return for the year in which the sale date occurred. Failure to file a correct Form 8594 may be subject to penalties.
Tax law requires assets to be grouped by classes, which has a hierarchy of categories. Here’s an overview of how the allocation process required by the Internal Revenue Code works.
Class I assets: These are cash and general deposit accounts (including savings and checking accounts) other than certificates of deposits held in banks, savings and loan associations, and other depository institutions.
Class II assets: These are actively traded personal property, as well as certificates of deposit and foreign currency. Examples of Class II assets include U.S. government securities and marketable securities.
Class III assets: These are assets that the taxpayer marks to market at least annually for Federal income tax purposes, including accounts receivable, not including debt instruments issued by related parties, most contingent debt instruments, and convertible debt instruments.
Class IV assets: These are stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the tax year, or property held by the taxpayer primarily for sale to customers in the ordinary course of business.
Class V assets: These include all assets other than Class I, II, III, IV, VI, and VII assets
Class VI assets: These are all intangibles (generally intangible assets transferred with the sale of the business, except for certain assets such as stock and partnership interests), except goodwill and going concern value.
Class VII assets: These are goodwill and going concern value.
The amount allocated to an asset, other than a Class VII asset, cannot exceed its fair market value on the purchase date. Allocations are made first to the top category of assets, then to the second, and third, etc. Whatever is left unallocated is allocated to goodwill and going concern value.
Buyers and sellers will try to the extent possible to make allocations that serve their own tax interests. While no asset can receive an allocation greater than its fair market value, that value cannot always be determined with mathematical precision, so there often is some room to negotiate. The buyer and seller, however, both must use whatever allocation they finally agree to, as Form 8594 must be identical for filing with IRS.
Although many purchased intangible assets, such as covenants not to compete, can be amortized over 15 years, buyers may want sellers to enter into consulting agreements to shift some allocation away from the covenant not to compete and to get more immediate tax benefit.
Even though covenants not to compete and consulting fees are both taxable as ordinary income, sellers have to remember that consulting agreements generally will require them to perform services, while covenants not to compete do not.
Whether you are a buyer or a seller of the practice, you need to address the requirements of asset allocation. Be sure to negotiate the allocation as part of transaction. Omission of such could result in unintended consequences and possible scrutiny by IRS.
Michael W. Blitstein, CPA is a partner with the firm of CJBS, LLC, in Northbrook, Illinois. For more than 30 years, Michael has worked closely with the dental community and is intimately familiar with the unique professional and regulatory challenges of creating, running and maintaining a successful dental practice. Michael advises his clients on tax, business and retirement planning, developing short and long-term strategic plans designed to achieve success for dental practice principals and their businesses.
He can be reached at firstname.lastname@example.org
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