Business
For example, assume you are interested in increasing your sales by purchasing a competitor ("Target"). Target's seller wants $80,000 for his business, which has $5,000 of inventory. You have decided that Target's intangibles, consisting of its Yellow Page advertisement, customer lists, name recognition in the community and telephone number, are worth purchasing. After negotiations, you buy the business for $65,000, payable in two years at $3,000 a month, including interest. The purchase price is allocated as follows:
Inventory: $5,000
Yellow Page Ad: $15,000
Customer list: $15,000
Telephone number: $5,000
Covenant not to compete: $1,000
Balance as goodwill: $24,000
All business acquisitions involve three main issues: (1) What amount of the purchase price may be deducted by the purchaser? (2) Over what period of time must the purchase price be deducted? and (3) What are the tax consequences to the seller?
Purchase of Stock vs. Assets
If the seller's business is incorporated, the buyer has a choice of purchasing the stock of the seller's shareholders or the assets of the business. It is preferable to purchase business assets, rather than stock, for two reasons.
First, purchasing stock means that the purchaser "steps into the shoes" of the seller, and acquires all existing and potential liabilities associated with the business. These liabilities includes corporate taxes owed, pending or threatened lawsuits, and any claims involving the corporation's business.
Second, if the corporation is a C corporation (a separate taxable entity) a purchase of stock does not permit the buyer to write off any of the purchase price. Assume in our example that the purchaser bought the seller's stock. The seller would receive a capital gain (or loss) on the sale, however, the buyer would not be permitted to write off the business assets because he did not buy them directly.
Note: Purchasing a C corporation's assets may cause problems for the seller since the corporation is taxed on the sale and then the shareholders are taxed again on the distribution of proceeds from the corporation. The lesson: Sellers who plan to eventually sell their businesses should avoid operating as C corporations whenever possible.
Asset Purchase
The purchase of a business is a capital expenditure, which means that it cannot be deducted in the year of purchase but must be depreciated over the useful life of the assets acquired or--in the case of intangibles (which do not have a useful life)--amortized over a period established by the tax law. The purchase is not of the business itself, but rather the components that comprise the business. Thus, each category of asset (inventory, furniture, goodwill, covenant not to compete) must be allocated a portion of the purchase price.
Taxpayers who purchase or sell a business are actually engaged in a multiple asset transaction and must allocate the payment among all the assets.
With an asset purchase, the issue becomes the length of time used for the deductions, and that depends on the classification of assets. Under prior law, goodwill could not be deducted, so purchasers went to great lengths [next page]