The Tax Man Cometh

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As is the case with nearly any business deal, when you're buying an existing business, you simply can't afford to ignore the tax consequences. The IRS's position will significantly affect the profitability for you (and the seller) at the time of the sale, during the operation of the business, and when you decide to sell. This is true for the sale of all forms of businesses, but the following discussion is directed toward sole proprietorships, the type of business you're most likely to purchase.

The way that the purchase agreement is written will determine how different aspects of the sale are treated for tax purposes, and you should know right away that your interests and those of the seller are essentially at odds. If you do your homework, you may be able to arrange the deal to your benefit.

From a tax standpoint, there are two basic types of business assets: those that produce ordinary expenses (or income) and those that produce capital losses (or gains). As the buyer, you want as much of the purchase price as possible to be assigned to items that will allow you to take tax deductions as soon as possible. These items are ones that produce ordinary expenses. The seller, however, wants the money he or she receives to be considered capital gains, so that the maximum tax rate will be 20%.

Here's a list—in order of preference for you, the buyer—of some typical types of property that can be assigned value in a purchase agreement: [1] Inventory becomes an expense as soon as it's sold, so it may be worth your while to offer the wholesale price, even though some of the inventory may be obsolete. (The IRS would be unlikely to accept retail value, even if you could get the seller to agree.) [2] Leasehold improvements that you buy, such as counters for a retail business, can be deducted over the course of the lease by amortization. [3] Equipment can be depreciated under Accelerated Cost Recovery (ACR) over a 3-, 5-, or 7-year period, depending on the item. [4J Patents and agreements not to compete can be amortized over their periods of effect. [5] Real property can be depreciated over 15 years under ACR. [6] Goodwill never becomes an ordinary expense but may be a capital gain or loss when you sell the business.

There will obviously be limits to the extremes of values that can be placed on tangible items, such as inventory and equipment. But real benefit can be had by assigning as much value as possible to patents or agreements not to compete instead of goodwill. Your first offer to purchase should state that you will pay a certain amount for inventory (at wholesale value, for example leasehold improvements, equipment, patents, agreements of noncompetition, and real estate. Do not mention goodwill! Subsequent offers and the final purchase agreement should restate these items. This presents evidence of negotiation to the IRS. If the values are realistic and the IRS doesn't smell large amounts of lost revenue, it's likely to accept them. If these documents are realistically determined through negotiation, the IRS is more likely to accept the values, since there's little reason for collusion between you and the seller.

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