Allocation of purchase price: Overview, definition, and example
What is allocation of purchase price?
Allocation of purchase price refers to the process of dividing the total purchase price of a business, asset, or property among various components or assets involved in the transaction. In mergers, acquisitions, or asset sales, the buyer and seller agree on how to allocate the overall purchase price to individual assets such as real estate, equipment, inventory, intellectual property, goodwill, and other tangible and intangible assets.
This allocation is crucial because it impacts the tax treatment of the transaction for both parties. Different assets may have different tax implications—for example, certain assets may be depreciated over time, while others may be subject to capital gains tax. Proper allocation can help the buyer optimize deductions and the seller minimize tax liabilities.
Why is allocation of purchase price important?
The allocation of purchase price is important because it has significant financial and tax consequences for both the buyer and the seller. By carefully allocating the purchase price to specific assets, both parties can manage their tax liabilities more efficiently and structure the deal in a way that aligns with their financial goals.
For the buyer, allocating the purchase price strategically can result in tax benefits, such as the ability to depreciate certain assets over time. For the seller, allocating the purchase price in a way that minimizes capital gains tax and maximizes deductions can improve the financial outcome of the sale.
For businesses, understanding how to allocate the purchase price ensures that the transaction is conducted in compliance with tax regulations and allows both parties to plan their financial strategies accordingly.
Understanding allocation of purchase price through an example
Imagine a company that is selling its business for $5 million. The buyer and seller agree to allocate the purchase price among various assets of the business, such as:
- $2 million for tangible assets, like inventory and equipment
- $1.5 million for intangible assets, like intellectual property and goodwill
- $500,000 for real estate
- $1 million for other assets, including contracts and customer relationships
This allocation will affect the seller’s tax obligations and the buyer’s ability to claim depreciation on the purchased assets. The seller may want to allocate more of the price to goodwill (which could potentially result in a lower tax liability), while the buyer may want to allocate more to tangible assets to benefit from depreciation deductions.
In another example, when acquiring a commercial property, the buyer and seller may allocate the total purchase price to land, buildings, and equipment, which will be depreciated differently for tax purposes.
An example of an allocation of purchase price clause
Here’s how an allocation of purchase price clause might look in a purchase agreement:
“The Parties agree to allocate the total purchase price of $10,000,000 as follows: (i) $5,000,000 for tangible assets, including inventory and equipment; (ii) $2,000,000 for intangible assets, including intellectual property and trademarks; (iii) $1,500,000 for real property; and (iv) $1,500,000 for goodwill and customer relationships. The Parties acknowledge that this allocation will be used for tax purposes and agree to file all tax returns consistent with this allocation.”
Conclusion
Allocation of purchase price is a key component of business transactions, particularly in mergers and acquisitions. It impacts how both the buyer and the seller handle taxes and financial planning. Properly allocating the purchase price to different assets can lead to tax advantages and financial benefits for both parties. By carefully considering the allocation, businesses can ensure that the transaction is structured in a way that aligns with their financial and tax strategies.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.