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Losing $75K in 7 Seconds: Purchase Price Allocation 101

Last month our business valuation department was engaged by a pest control client, Kevin, owner of XYZ Pest Control, to advise him on setting up a stock gifting program. His goals are to gift stock annually to his children over the next 10 years or so, taking advantage of the Federal Annual Gift Tax exemption as a vehicle for saving for their college education. When we reviewed the financial and operational documents on XYZ, we realized that Kevin had made a few acquisitions over the last few years. XYZ’s most recent was the acquisition of a competitor - the purchase of the assets of an S corporation for $1,050,000. Upon digging into the numbers a little deeper, we realized something quite peculiarly, though not particularly surprising. The buyer and seller had allocated a very large portion of the purchase price, $480,000 to be exact, to a non-competition agreement. In this article, you are going to learn why this alarmed us and what you can do to avoid tax mistakes while doing deals.


Allocate What, Where?

Let’s take a quick sidebar and discuss exactly what the allocation of purchase price is and why it is important. The extreme majority of acquisitions in the pest control industry are structured as asset sales as opposed to stock sales. With that, comes the duty of every buyer and seller to agree on the allocation of the purchase price to various classes of assets and report it, in writing, to the IRS using Form 8594 - which becomes binding upon buyer and seller for tax purposes unless the IRS determines that it is “inappropriate.” It is through the allocation of purchase price reported on Form 8594 that the IRS taxes the transaction.

The allocation of purchase price is a very important part of the acquisition process because it can have a dramatic effect on the net after-tax proceeds to the seller and net after-tax cash flow to the buyer, irrespective of whether the business is organized as an S corporation or a C corporation. While a lot of mistakes are made by the “do-it-yourselfers” who are out there buying and selling businesses without the advice of a competent tax advisor, I have also seen mistakes made by large pest control companies being sold to national acquirers with the aid of an accountant who is little more than a bookkeeper. In these situations, the seller often doesn’t know his bottom line until the tax bill is calculated post-close, and by that time, it’s too late to rectify the thousands of dollars lost due to tax mistakes that could have easily been avoided.

In our example above, I called Kevin and I asked him to fax me over the Form 8594 used to report his last acquisition to the IRS. He faxed over a sheet that showed the following allocation of purchase price:

Inventory: $20,000
Equipment: $150,000
Non-Compete $480,000
Goodwill / Intangible $400,000
Total $1,050,000

Generally, when purchase price is allocated, tax accountants utilize the residual method by: (1) valuing all of the assets acquired, (2) determing the amount to be allocated, and (3) assigning values to the seven asset classes beginning with Class I (cash) and moving down to Class VII (goodwill).

When I asked Kevin why $480,000 was allocated to a non-competition agreement, he told me, “I don’t know, the attorneys did that, I am not even sure what it means.”

What difference does it make how purchase price is allocated? It’s important because different classes of assets are taxed differently, and the allocation process has long been viewed as a zero-sum game - what’s good for the buyer is bad for the seller, and vice versa (though sometimes it’s bad for both). The allocation of purchase price is often done as an after-thought to the signing of the purchase agreement which is a major contributing factor to tax surprises and failed deals.

One of the first things that a seller should do when reviewing a letter of intent or offer to purchase is draft a preliminary allocation of purchase price on Form 8594. Two of my favorite business appraisers Frank Evans and David Bishop echo this sentiment in their landmark book, Valuation for M&A:

“Too frequently, parties reach agreement on price, terms, financing, and even discuss the concept of purchase price allocation without confronting the related tax consequences. Misunderstanding of the purchase price allocation often has been the source of a failed transaction and hard feelings at the end of deal negotiations.”

One of the first things that I do when I receive an Offer to Purchase, or Letter of Intent, on behalf of one of our clients is ask for clarification on purchase price allocation. Unlike many other transaction advisors in this industry, we are focused on after-tax proceeds. The minute the Letter of Intent comes in, it is reviewed with the client’s accountant to determine the effect of the deal’s structure on the proceeds available to the seller after all taxes are taken into consideration. Whether you are a buyer or a seller, never negotiate purchase price without a vigilant eye on tax ramifications. Just as a seller can inflict serious damage to his wallet by tax negligence during negotiations and documentation, a buyer, by not understanding the tax deductibility and amortization of acquired assets can not appropriately manage his net after-tax cash costs of the acquisition.

Confused? You’re not alone. I sent the question below to the head of acquisitions of one of the largest pest control companies on the planet right after receiving a letter of intent on behalf of our client:

“I would like to seek some clarification on the ultimate allocation of purchase price to be reported on IRS Form 8594 (under section 1060 of the Code). I would like to make certain upfront that you intend to allocate substantially all (or a significant majority) of the $4,514,000 classified on the LOI as Commercial & Residential Customers as a Class VI or VII intangible.”

The director of acquisitions had absolutely no idea what I was talking about, and put me on the phone with their tax counsel, who informed me that they “usually deal with allocation issues after both parties have signed the purchase agreement.”
Well, I’ve got news for you, the difference between allocating $480K or $25K to a non-compete agreement versus goodwill comes out to an extra $75K in taxes for my client. So allocation is just as meaningful to me as is the purchase price and I would never advise a client, buyer or seller, to sign a letter of intent (let alone a purchase agreement) without doing a preliminary allocation of purchase price and having it reviewed by a tax advisor.

Back to Kevin

Why would anyone want to allocate $480K to a non-competition agreement and not to goodwill on a million dollar S corporation asset purchase? That’s a fantastic question, and the answer is, no one would. However, things like this still happen every day of the week for a variety of reasons. The most common reason I have seen is that sellers tend to get their accountants involved after the deal is structured. Or, they work with an attorney lacking deal experience who believes that just about everything should be allocated to the non-competition agreement - perhaps to “give it teeth” in the eyes of a judge. However, in the case of Kevin’s acquisition, XYZ was able to amortize the non-competition agreement over 15 years, just as he would have, had it been allocated to goodwill. The seller, however, was not so lucky. Instead of getting long-term capital gains treatment on the $480K, he was taxed at his ordinary income tax rate, most likely causing him to pay $75K more in taxes than he should have. Had Kevin been cognizant of this fact, he may have been able to pay the seller $50K less and had him allocate a more appropriate $25K to $50K to the non-competition agreement, thereby saving them both a chunk of money in the deal. Or, if the seller’s advisors were doing their jobs, the seller would have paid $75K less in taxes and the buyer would have been no better or worse off. The worst part of this whole situation is that both the buyer and the seller had an attorney and an accountant working with them. As well, the seller had hired a former pest control operator, who is now a business broker, to sell his company.

Final Thoughts

My intention in writing this article is not to give you tax advice, but to warn you that all lawyers, accountants, business brokers and investment bankers are not created equal, and that at the end of the day, you are responsible for your own fate - so choose your advisors wisely. I write these articles not to turn you into deal guys, per se, but to help you be better CEOs. As corporate officers and owners, you have an underlying duty to the business to stay focused on maximizing shareholder value whether it is through internal growth, acquisition or sale. I am not suggesting that you dust off section 1060 of the Internal Revenue Code and become an expert on allocation of purchase price, but with a competent tax advisor by your side, you can use the allocation of purchase price to your advantage when negotiating the purchase or sale of corporate assets, and at bare minimum, protect yourself from making costly mistakes and paying the IRS any more of your hard-earned money than it is already taking.

Just because your attorney went to law school doesn’t make him a transaction expert. Just because your accountant files your tax returns, does not make her an expert in the disposition or acquisition of corporate assets and securities. And just because a former pest control operator has sold a few pest control companies and is now brokering deals, does not make him a deal expert - in this case, the seller would have been better off finding Kevin in the Yellow Pages… along with an accountant and attorney who knew more about transactions than himself.

Interested in learning more about valuation and mergers & acquisitions in the pest control industry? The Potomac Pest Control Weekly is written the most prominent business appraiser and mergers & acquisitions specialists in the pest control industry and is packed with tutorials, case studies, and interviews with industry insiders. Subscribe to Potomac Company commentary and research on the Pest Control Industry today by completing the form below.


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4 Responses to “Losing $75K in 7 Seconds: Purchase Price Allocation 101”

  1. John Says:

    I am looking for information on how to allocate the purchase price of an acquisition that i am making. The IRS does a horrible job of describing the process and my accountant is no better. Do you have any informaton on how to determine the tax ramifications of different allocations? I like your article, but it doesn’t really give me the information that I need. Any help you can provide would be great.

    thanks,

    John

  2. Imrul Huda Says:

    I think this article was misleading. The buyer, which is Kevin, is always indifferent with allocation of purchase price between non-compete or goodwiill, primarily because under IRC section 197, both non-compete and goodwill are amortizable for 15 years. The seller, on the other hand, is affected because non-competes are treated as ordinary income (taxed at 40%), whereas goodwill is taxed at capital gains (15%). Seller has the incentive to allocate as much as he can on goodwill. So your client, Kevin (buyer), really didn’t lose any money for allocating more into non-compete. However, if he could reallocate some of the non-compete into consulting, maybe then he could save some money since consulting agreements are treated as current deductibles.

  3. Dale Karney Says:

    I agree with Imrul to the extent that a buyer shouldn’t necessarily be concerned whether a portion of purchase price is allocated to goodwill versus non-compete. However, I don’t believe that was the point of the article. My reading of this article is that if the buyer understood how the allocation worked, there may have been an opportunity for him to use that to his advantage. He could have allocated more to goodwill and perhaps paid less for the business in total purchase price (a negotiation) or did what you suggested and allocated away from non-compete and into consulting agreement thereby taking a real-time deduction.

  4. Bipin Says:

    Does anyone know if there is a test as to what a fair allocation for a non-competion agreement would be? I am buying a business and the seller’s lawyer wants to put $3,000 into a five year non-compete. The purchase price for the business is $1 million, and I was thinking that at least $50,000 or $75,000 should go to non-compete. Does the IRS scrutinize this? I don’t want to make it so small that it doesn’t make sense.

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