The Allocation of the Purchase Price in a Sale of an Agency
Once the agreement is made and the buyer and seller of an agency feel that the transaction is complete, a twist occurs that must be addressed to avoid a shocking discovery at closing. This “twist” has to do with the allocation of the agreed-upon purchase price between stock, the value of a specific asset, the value of Covenants Not to Compete, the value of Consulting or Training Agreements and the value of Goodwill associated with the agency such as the logo, image, advertising, phone number, signage, etc.
The professionals who value agencies specify an amount for each of the components based on the logical value of each. The IRS demands consistency between the reporting of allocation of the Buyer and of the Seller They also say that the allocations must be defensible. In fact, using simple 10%, 20% or any other Rule of Thumb allocation will likely draw IRS scrutiny because the allocations must be driven by the specific case in question, not by any generalities previously considered “average”.
Whether you sell the agency for $1,000,000, for $2,000,000 or for $15,000,000, someone has to address how the sale price is allocated in order to determine how the taxation will occur to the seller and how much the buyer can write off as an expense every year. Moreover, the allocation must be treated the same way by the buyer and the seller in order to avoid IRS involvement after the transaction has been completed.
All of our comments refer to federal taxes only. State tax considerations differ and must be treated individually.
If a buyer purchases the stock of an agency, the entire amount may be qualified to be taxed at the Capital Gains rate in effect at the time of the transaction based on the growth in value of the Company from the time the current owner acquires (or starts) the venture until he sells it. In other words, if you buy an agency’s stock for $1,000,000 and sell it for $2,000,000, you presumably have $1,000,000 of Capital Gains; taxed at 15% at this writing. This is obviously advantageous to the seller since most will have personal tax rates in excess of the Capital Gains rate at the time of the transaction.
However, the Buyer will not be excited since he will have NO WRITE-OFF whatsoever and the assets he has bought must be accepted at the current book value (the value of the assets less depreciation through the date of acquisition).
If there is a Covenant Not To Compete engaged with the Seller, the value of that Covenant is taxed to the Seller as ordinary income and that value can be amortized by the Buyer over 15 years (1/15th of the value can be deducted as amortization in each of the next fifteen years). The value of the covenant depends on the issues in the specific case at hand. If the owner has died, is aged or infirm beyond a productive future or is moving to another State, no value will be acceptable in a Covenant Not To Compete (the Seller isn’t available to logically compete with the Buyer). However, if the Seller is vibrant and available to compete, the value ascertained should be logical to assure the Buyer that the Seller would be penalized by a court based on the value exchanged in the Covenant if he competed with the Buyer on the accounts or in the business for which the Covenant was created. In other words, the value of the Covenant must sufficiently reasonable that a court would hold in favor of the Buyer if the Seller violated the terms of the Covenant. $100 Covenants are not effective.
If the Buyer also asks the Seller to Train or Consult with the agency after the sale, the value of that portion of the price is taxed to the Seller as ordinary income and can be fully expensed in the year that it is paid by the Buyer.
If a Buyer purchases the Assets from an agency, that means that if the agency is a corporation or LLC, it remains such under the ownership of the Seller, but without the assets that it has sold to the Buyer. The price negotiated will certainly include the presumed value of the book of business (the asset being purchased). This implies the net income stream that the expirations are expected to provide to the Buyer (after taxes for a specified period of time). In addition, the Buyer may transact a Covenant Not To Compete and/or a Consulting or Training Agreement for a specified period, each of which carries a separate and specific value.
For a full listing of Section 197 Intangible Assets, see our website. By clicking on the link, you will be brought right to that area and can see every category that qualifies as a Section 197 Intangible Asset.
The acquisition costs of purchasing goodwill and any other Section 197 intangible assets are amortized over a 15 year period. Please be aware that Goodwill (new caused by the acquisition), going concern value, workforce, business records, intangibles like customers, licenses and appointments with carriers, names AND COVENANTS NOT TO COMPETE are ALL considered Section 197 intangible assets.
This means that you can NOT take a three year non-compete and amortize its value over three years under IRS rules.
However, if a part of the purchase prices is a consulting agreement in which the retiring owner does actual work or devotes time (not his availability from Hawaii or his summer home), that consulting agreement can be fully expensed in the year of its use (and the amount is regular income to the seller).
If you seek to take anything out of the 15 year property category, please have a defined statement of value for each category and be aware that anything that is able to be expensed is taxable to the seller at higher than capital gains treatment. SOMEONE WILL BE TAXED.
So as long as you’re not trying to “cheat” Uncle Sam and not pay your just due, common sense will rule what is deductible, what is amortizable and what can be treated as a capital gain by the seller.