ALBUQUERQUE, N.M. — Q: I am selling my business to a larger company. We agreed on a price and I am supposed to get the funds shortly, but the agreement has a clause that we will report the transaction consistently on our tax returns. I have been told this means that we need to agree how the purchase price will be spread among the business assets. This agreement must be finalized before we file our respective 2019 tax returns. My question is whether this is a reasonable clause and what would happen if we did not agree.
The clause that you describe is one that I have seen in many deals, most often when the buyer is a private equity firm that would meet your description of a larger company. I don’t like the clause as you describe it but, again, they are common and I have had several clients who have agreed to these clauses.
How these agreements work out are important, both for the buyer and the seller. And the parties usually have competing interests in how the allocation will be done.
The law requires that both the buyer and the seller report how the total price is allocated among various classes of assets. This is reported to the IRS on a Form 8594 that is attached to the tax return for the year of the purchase (buyer’s return) and sale (seller’s return).
A buyer and a seller rightly consider the total purchase price to be the most important thing to negotiate. How the agreed-to purchase price is allocated among specific assets affects how the parties report for tax purposes.
Obviously this allocation is relevant only when multiple assets are sold. The seller’s gain or loss must be computed asset-by-asset and the tax law often treats the gains and losses differently based on what type of asset was sold.
Gains can be tax favored if they are classified as either capital or “Section 1231.” Losses can be tax favored if they are ordinary or Section 1231. Ordinary gains pay a higher tax rate and capital losses may not be available for use on a current basis.
Buyers don’t report gains or losses when they buy assets but they may get future benefits from depreciation or amortization of purchased assets. They may also sell purchased assets and their gain or loss depends on what they acquired those assets for.
The way asset classifications (e.g., capital, Section 1231, or ordinary) work, and the implications for the type of gains and losses as well as the tax treatment of the asset for the buyer, sellers and buyers often have different preferences for the allocation.
The tax law does not require that a buyer and a seller agree to a consistent allocation. Therefore there is no need for the clause that you describe.
The issue arises because when the buyer and the seller complete their respective Form 8594 to report the allocation to the IRS, they must identify the other party by name and taxpayer identification number.
Because the parties often have competing interests, if they agree to a consistent allocation it will generally have greater weight with the IRS. That means less risk of being challenged.
Filing a “stronger” Form 8594 is why the buyer inserted the consistency clause in your agreement. I generally agree that such a clause is a good idea.
Wait a minute you say. You said you don’t like these clauses! No, I said I don’t like your described clause. The agreement is fine, but the agreed-to allocation should be reached before the parties sign off on the deal.
What you now have is a possible argument that must be resolved by the due date of your respective tax returns. The clauses you describe typically call for hiring one or more appraisers to resolve any debates.
So you may well have handcuffed yourself to future appraisals with deadlines and, of course, with costs. I tend to suspect the big buyer accepts such clauses because they can better afford the cost of a dispute and can then negotiate as the 800-pound gorilla.
Since I normally represent the little guy, I prefer all agreement to be final when the deal closes.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.