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The following is a simplified overview of the need for documentation to support an allocation of the purchase price of a business. In most purchases, the agreement contains a schedule of allocated value to the assets, agreed upon by the buyer and seller.

Purchase of Stock

  1. Basis or net asset values of acquired company carried over to new company. An allocation will be required for financial accounting purposes, if the transaction is considered a purchase.
  2. Portion of the purchase price may be attributed to covenant not-to-compete and consulting agreement with Seller(s). Arbitrary amounts assigned these two intangibles are usually disallowed by Internal Revenue Service (IRS). Required: specific support for value of each. Buyer receives new tax basis for amortization. Seller may receive some premium for this economic benefit to Buyer.
  3. When the transaction involves the sale of stock of a subsidiary unit of a surviving company, the Buyer can step-up the basis of all acquired assets via Internal Revenue Code Section 338(h)(10). The selling company pays tax on the gain as an asset sale, but the second tax (to shareholders) is deferred so long as the surviving company remains in business. Any NOL from the subsidiary sold offsets the tax on the asset sale to the surviving company.
  4. For a C corporation Seller, it is important to determine the value attributed to personal goodwill, separate from business goodwill. The amount of personal goodwill in excess of basis is subject to capital gains tax, not ordinary rates. Thus, individuals with attributed personal goodwill pay less taxes. Careful analysis is required to separate from total goodwill that portion directly attributable to a key employee-owner.

Purchase of Assets

  1. Buyer must determine market value of each tangible and intangible asset acquired. Thus, new depreciable/amortizable basis is established. Particularly important may be the value assigned to identifiable intangible assets (not goodwill) which were not on the Seller's balance sheet. Seller may negotiate some purchase premium for the economic benefit received by Buyer.
  2. Value is ascribed to all tangible and intangible assets. Key is value ascribed to goodwill, which is not amortized for book purposes. Apparent initial benefit to a public company for a large goodwill amount (no depreciation expense) may be offset by SEC challenge and future impairment loss (writedown).
  3. For tax purposes, goodwill is deductible.
  4. C corporation Seller generally will pay double tax – one at corporate level based on gain in asset values; other at stockholder level (amount received less basis in stock). Double whammy (taxes) may be reduced by creating deferred compensation agreement paid by sale proceeds. Also, S corporation in existence for at least 10 years pays only one level of tax on sale (shareholder) and does not pay built-in gain tax if company were converted from a C corporation.
  5. Higher valuation of inventory and non-complete agreement help in Buyer's allocation, but is ordinary income to Seller.
  6. If the entity being sold is not a C Corp but a pass through tax entity, there remains a great probability that the negative tax effect will be on the seller if the deal is structured as an asset sale. In an asset sale the IRS requires that the purchase price for the assets purchased be allocated to the individual assets at fair market value. This "step-up" in basis to fair market value at the time of transfer from the historical carrying cost of the seller provides a tax benefit to the buyer in the form of an additional depreciation write-off. Before this depreciation can be determined, the IRS requires that the assets are divided into seven asset classes: (1) cash and cash equivalents (2) actively traded personal property (3) accounts receivable and debt instruments (4) inventory (5) all other assets not previously classified (furniture, fixtures, equipment, land, vehicles, etc.) (6) section 197 intangibles (7) goodwill and going concern value. The classification of each asset determines how quickly or slowly the buyer can depreciate the stepped-up asset and offset his/her operating income.