Purchase Price Allocation for Tax:
The purchase price allocation (PPA) is one of the significant processes of reporting taxes, particularly when there’s a transfer of a group of assets that form a trade or business. PPA’s primary goal is allocating shares of the purchase price (the consideration) to the various assets transferred. This has relevant tax effects both for the buyer and seller. Form 8594, “Asset Acquisition Statement Under Section 1060,” is utilized to report the sale of a collection of assets in which goodwill or going concern value is present, and the basis of the purchaser is only determined by the amount paid for the assets. Why Purchase Price Allocation is Important
For tax purposes, how the purchase price is allocated between the purchaser’s basis in acquired assets and the seller’s gain or loss from the sale is important. Both parties must accurately report the tax obligations on their respective returns. Incorrect or inappropriate allocation may result in penalties or IRS disputes.
Steps to Allocate Purchase Price
- Categorize the Assets: Assets are divided into various categories or classes, with varying tax treatment. The IRS groups assets into the following categories:
- Class I: Cash and general deposit accounts.
- Class II: Actively traded personal property.
- Class III: Assets that are marked to market or debt instruments.
- Class IV: Inventory or property for sale to customers.
- Class V: All other assets, such as tangible property (e.g., equipment, furniture, and fixtures).
- Class VI: Section 197 intangibles (e.g., customer-based intangibles, workforce in place).
- Class VII: Goodwill and going concern value (whether or not they are classified as Section 197 intangibles).
2. Allocate the Consideration: The aggregate purchase price has to be allocated among the different classes of assets in a particular order. The overall process is as follows:
- First, subtract the value of Class I assets from the aggregate consideration.
- Then, apportion the residual consideration to Class II, Class III, Class IV, Class V, and Class VI assets in that sequence proportionally by their fair market values at acquisition.
- Finally, apportion the residual consideration to Class VII assets (goodwill and going concern value).
This apportionment provides that the buyer acquires the proper basis in each property, which will be employed for future depreciation, amortization, or eventual sale.
3. Reallocation on Changes in Consideration: Where there is a rise or fall in the overall consideration subsequent to the date of purchase, the allocation has to be made correspondingly. When the consideration rises, the increased amount is apportioned in the same way as the initial apportionment, starting with Class I assets. When the consideration falls, the allocation decreases starting with Class VII assets and then the other classes in reverse order.
4. File Form 8594: Both buyer and seller are required to file Form 8594 to report the allocation of the purchase price. The form is included with their respective tax returns for income (e.g., Form 1040, 1065, 1120). If the allocation needs to be changed in a later year, a supplementary Form 8594 is to be filed to report the revised purchase price allocation
Important Considerations for Proper Allocation
- Goodwill and Going Concern Value: These intangible assets are assigned as Class VII assets. Their assignment is necessary to establish the buyer’s basis in goodwill, which is amortizable over 15 years under IRS provisions.
- Fair Market Value: Every asset should be valued at its fair market value at the time of purchase, which assists in ascertaining the correct tax basis for both the buyer and the seller. The IRS mandates that the fair market value of any asset be disclosed and cannot be more than its actual fair market value.
- Contingent Payments: Contingent payments should be considered while determining the greatest consideration, in case the purchase price has some contingent payments. The two parties must be willing to modify the apportionment after resolving the contingencies.
Impact of Proper Allocation
The purchase price allocation has a significant effect on the seller’s and buyer’s financial performance. For the seller, it affects the gross profit or loss to be reported on the sale. For the buyer, it determines the basis of the acquired assets, which in turn affects future depreciation or amortization deductions.
Conclusion
Allocation of purchase price is a critical procedure for properly accounting for asset sales involving goodwill or going concern value. Both the buyer and the seller can both ensure accurate tax returns and conformity by adhering to IRS directives and correctly completing Form 8594. Cautious categorization of assets, proper allocation of consideration, and revisions where applicable, especially in the situation of contingent payment or modification in consideration, is crucial.