Anatomy of an Asset Purchase Agreement Part 1: Allocation of the Purchase Price
When you are negotiating an asset purchase agreement, either to buy or sell an existing practice, there are provisions that may seem innocuous or appear to be standard boilerplate terms. However, these terms can have considerable financial and legal impacts, regardless of whether you are the buyer or seller. This series of blog posts will identify some of these provisions, and explain their significance, in order to help you make an informed decision.
Usually, the first of these provisions you will see as you read the asset purchase agreement is the provision regarding the allocation of purchase price. This may seem unimportant, since you and the other party have agreed on the overall purchase price. However, the method in which that price is allocated between equipment, goodwill, and possibly the non-compete agreement, can have significant consequences.
From the Buyer’s Perspective
If you are buying a practice, you will likely want to allocate as much of the purchase price as possible to equipment for several reasons. Among them, many lenders insist that most of the purchase price be attributable to tangible physical assets like equipment, rather than the intangible, and often difficult to quantify, assets like goodwill. This has been especially true over the last few years, as credit tightened up after the 2008 financial crisis and lenders have become increasingly concerned with maximizing recovery in the event of a foreclosure. Therefore, the more you can allocate to equipment, the less you will have to pay as a down payment and the more financing options you will have.
Additionally, purchased equipment can often be deducted (up to a certain dollar amount) under Section 179 of the Internal Revenue Code, resulting in an immediate tax saving. To the extent equipment does not qualify under Section 179, it can still be depreciated over a period of only five to seven years, whereas goodwill must be depreciated over 15 years. This allows the buyer to see more immediate tax savings.
Of course, any allocation of the equipment must be based on defensible estimates of value in order to satisfy both potential lenders and the IRS. Therefore, you may be limited in how much of the practice you can apportion to equipment. However, you have every incentive to maximize the allocation of the purchase price to equipment and minimize the amount attributable to goodwill.
From the Seller’s Perspective
Conversely, if you are selling your practice, you want to apportion as much of the sale price to goodwill as possible, rather than equipment. Much of your equipment has likely been mostly or fully depreciated for tax purposes by the time of the sale. Therefore, any amount allocated to equipment that exceeds the book value of that equipment will be taxed at an ordinary income rate, possibly as high as 39.6%. Goodwill, on the other hand, is taxed at the much lower capital gains rate of 15 to 20%.
Additionally, many buyers want sellers to apportion part of the purchase price to the non-compete agreement in order to ensure that the non-compete is binding and enforceable. However, if you are selling your practice, you will want to apportion as little as possible to the non-compete agreement because it will all be taxable as ordinary income.
To see the difference that the allocation of purchase price can have on the tax liability for the seller, consider the following examples:
| Sale 1 | Sale 2 | Sale 3 | |
| Purchase Price: | $500,000 | $500,000 | $500,000 |
| Equipment: | $200,000 | $300,000 | $400,000 |
| Goodwill: | $250,000 | $150,000 | $ 50,000 |
| Non-Compete: | $ 50,000 | $ 50,000 | $ 50,000 |
| Seller’s Tax Liability:[1] | $149,000 | $168,600 | $188,200 |
| Net Proceeds: | $351,000 | $331,400 | $311,800 |
Therefore, the difference in allocation in Sale 3 resulted in an increased tax liability of nearly $40,000, more than 25% higher than Sale 1, despite the overall purchase price remaining the same. Although the allocation of the purchase price can be a hurdle in negotiating the purchase price, it can also present opportunities for win-win situations. For example, the seller can agree to a lower overall purchase price, in exchange for a more favorable allocation.
In the example above, the seller could agree to take a total price of $480,000, but allocate $350,000 to goodwill, $100,000 to equipment and $30,000 to the non-compete. His total tax liability would only be $121,480, meaning his net from the sale would be $358,520. The buyer would pay $20,000 less, and would still be able to depreciate the goodwill, albeit over a longer time frame.
Every transaction is unique, and these are just a few of the issues that can present themselves in the allocation of the purchase price. However, regardless of whether you are buying or selling a practice, you should consider how best to allocate the purchase price, in consultation with experienced professionals, before finalizing the asset purchase agreement.
[1] Assuming a 39.6% marginal tax rate and 20% capital gains rate, as well as equipment that has been fully depreciated by the seller.