The Middle Ground

A GUIDE TO DEAL TERMS IN PLAIN ENGLISH


+ Introduction

+ Purchase and Sale

+ Closing

+ Representations & Warranties - Seller

+ Representations & Warranties - Buyer

+ Covenants

+ Conditions to Closing

+ Indemnification

+ Termination

+ Miscellaneous

Purchase Price Allocation


Classification: Moderately Material
Section: Purchase and Sale
Negotiation Time: Substantial
Transaction Costs: Intermediate to Expensive
Major Impact: Deal Value


What is This? The Buyer and Seller are both taxed on the sale of the Business. As part of the taxation process, they must match (or allocate) the Purchase Price and the value of Assumed Liabilities to different asset classes. Both parties must report the same allocation, so they typically agree on it shortly after Closing in accordance with this provision.

The Middle Ground: This section indicates where the Allocation Schedule can be found, which party is responsible for preparing it, when it must be completed, and a dispute resolution procedure in case the parties cannot agree on the allocation scheme. It also states that the tax returns of both parties must be filed in accordance with the Allocation Schedule.

Purpose: How the Purchase Price is allocated directly affects the taxes paid by both parties, and allocations that benefit the Seller typically work against the Buyer (and vice versa). While this dynamic can cause some tension and lead to a lengthy negotiation, the issue is unlikely to derail the entire transaction. That is, in part, because the parties do not have the ability to allocate the Purchase Price as they see fit; their allocation must be within the bounds of the law, which essentially means it must reflect the reality of the situation. Each party has some latitude to negotiate, but neither party will get a “perfect scenario,” and disagreements can usually be resolved by making the allocation that most closely mirrors the actual value of the assets.

Buyer Preference: One of the major benefits of an asset sale is the Buyer’s ability to receive a “stepped-up” tax basis in depreciable and amortizable assets. A higher tax basis on those assets means greater depreciation and/or amortization, which translates to a lower tax bill. Thus, allocating the bulk of the Purchase Price to those assets effectively lowers the price paid for the Business.

Seller Preference: The Seller wants the same benefit from the allocation as the Buyer hopes to achieve – a lower tax bill. In order for the Seller to accomplish that, it will want to allocate as much of the Purchase Price as possible to capital assets (such as land) so that it is taxed at the capital gains rate rather than the ordinary income rate.

Differences in a Stock Sale Transaction Structure: This section is not necessary in a stock sale structure (unless the parties opt to make a 338(h)(10) election) because the Purchase Price will be treated as capital gains to the Seller and the Buyer will assume the Seller’s tax basis in the assets, which limits the benefits it receives from depreciation and amortization.


DISCUSSION

We want The Middle Ground to be an ongoing dialogue for and resource to the lower middle market M&A community. The outline above is generally applicable, but there is always specific case law and nuance around certain industries that can be useful in helping buyers and sellers come together. If you are a lawyer or deal professional, we encourage you to add your perspective below.