Most businesses are made up of different types of assets, and those assets get different treatment for tax purposes. How those items are identified at the time of the sale/purchase can have a significant tax impact on both the buyer and the seller. A seller will, of course, want to designate items into classes that will yield a long-term capital gain on sale and thus provide the best tax result from the sale, whereas the buyer will generally want to designate the purchased items into classes that provide the biggest up-front write-offs.
The IRS generally does not care how the class allocations are made so long as both the buyer and the seller use consistent treatment. That is where IRS Form 8594 comes in. The form allocates the entire purchase/sale price of the business into the various classes of assets; both the buyer and the seller are required to file the form with their tax returns. It is also very important that allocations be spelled out in the sale/purchase agreement and that the treatment between the buyer and seller is consistent.
Generally, assets are divided into the seven categories very briefly described below:
Class II – Actively Traded Personal Property & Certificates of Deposit
Class III – Debt Instruments Class IV – Stock in Trade (Inventory)
Class V – Furniture, Fixtures, Vehicles, etc. Class VI – Intangibles (Including Covenant Not to Compete)
Class VII – Goodwill of a Going Concern
A seller would prefer to designate the major portion of the sales price to goodwill and minimize any allocation to furnishings and equipment. Why, you ask? Because goodwill is a capital asset, the sale of which for federal purposes will be taxed at a maximum rate of 20% in 2013, while furnishings and equipment can be taxed as high as 39.6 percent. On the other hand, the buyer would prefer to have as much as possible designated as furnishings and equipment, since they can be expensed or written off over a short period of time (usually 5 or 7 years) as opposed to a 15-year amortized write-off of the goodwill.
Whether you are the buyer or the seller, don’t leave the asset allocations to chance. Negotiate the allocation as part of the sales agreement. If you don’t, you could easily end up with inconsistent treatment and potential adjustments by the IRS.
If you are anticipating a sale or purchase, please call this office so the transaction can be structured to your best benefit.
Payments for services, noncompete covenants and personal goodwill
In the context of selling a business, Form 8594, Asset Acquisition Statement Under Section 1060, asks – even for a stock sale – whether ancillary agreements were negotiated with the sellers in addition to the related stock or asset sale agreement.
Employment or consulting agreements may attract the new 0.9 percent Medicare tax. But they should not be subject to the 3.8 percent unearned income Medicare contribution tax because payments would not constitute net investment income. Noncompete payments should not be subject to either of the new taxes since they are neither self-employment income nor net investment income.
The sale of personal goodwill creates a capital gain that may be subject to the active trade or business exceptions to the 3.8 percent tax.