When selling or purchasing a small business, ownership of the assets not only changes, but both entities also confront tax consequences. When a sale or purchase of a group of assets constituting a business occurs, both entities must file Form 8594, Asset Acquisition Statement with their individual income tax returns.
Both entities must report the total sales price of the business and must agree to the allocation of the total sales price among seven different classes of assets. Using this allocation method, the values are assigned according to the fair market value of the assets at the time of sale.
IRS Form 8594 provides the IRS with the following information:
- The buyer’s depreciable basis in the assets transferred (based on fair market value)
- How the seller determined the gain or loss on the sale
What is Fair Market Value?
Fair market value is the value deemed reasonable with what an asset could receive if offered to the public at large. In the case of Form 8594, fair market value is the gross fair market value unreduced by mortgage, liens, pledges, or other liabilities.
For the purposes of determining the seller’s gain or loss, generally, the fair market value of any property is treated as being not less than any non-recourse debt to which the property is also subject. Additionally, a liability which was incurred as a result of the acquisition of the property is disregarded to the extent such liability was not taken into account in determining the basis in such property.
What is the Residual Method?
After agreeing to a total sales price for the acquisition of assets, the price must be allocated using the residual method. This method has the price allocated to each group of assets in a specific order.
The residual method must be used for any transfer of a group of assets constituting a trade or business and for which the buyer’s basis is determined only by the amount paid for the assets.
The buyer and seller enter into a written agreement as to how the sales price will be allocated among the seven group categories and this is formalized by filing Form 8594. This agreement is binding on both parties unless the IRS determines the amounts to be inappropriate and requires the entities to revise their allocations.
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What are the Form 8594 Instructions on Asset Classes?
Form 8594 instructions list seven classes of assets. For asset acquisitions occurring after March 15, 2001, make the allocation among the following assets in proportion to (but not more than) their fair market value on the purchase date in the following order:
1. Class I – Cash and general deposit accounts
- Cash and general deposit accounts (including savings and checking accounts).
- Excludes certificates of deposit (CDs) held in banks, savings and loan associations, and other depository institutions
2. Class II – Actively traded personal property within the meaning of section 1092(d)(1) and Regulations section 1.1092(d)-1 (determined without regard to section 1092(d)(3)).
- Foreign currency
- U.S. government securities
- Publicly traded personal property (stock and securities)
3. Class III – Assets marked-to-market by taxpayer at least annually for federal income tax purposes and debt instruments.
- Accounts receivable
- Other debt instruments subject to regulations under various tax code sections
4. Class IV – Stock in trade of the taxpayer or other property of a kind which would properly facilitate sales to customers during the ordinary course of its trade or business.
- Any property which would be included in inventory if held on hand at the end of the tax year
5. Class V – All other assets not included in Class I, II, III, IV, VI, and VII assets.
- Furniture and fixtures, buildings, land, vehicles, and equipment, which constitute all or part of a trade or business
6. Class VI – Section 197 intangibles.
- Section 197 intangibles (other than goodwill and going concern value).
- Workforce in place, business books and records, operating systems or any other information base, process, design, pattern, know-how, formula, or similar item
- Customer-based intangibles (e.g., customer, client, patient, or newsletter lists, etc.)
- Supplier-based intangible
- License, permits, or other right granted by a government unit
- Any covenant not to compete entered into in connection with the acquisition of an interest in a trade or business
- Any franchise, trademark, or trade name
7. Class VII – Goodwill and going concern value, regardless if qualifying for section 197 intangible.
Generally, goodwill represents the excess paid for an asset or business over its net asset value (or book value). It may have the following characteristics:
- An intangible value associated with a company’s good reputation, branding, service quality, customer perception, or otherwise good standing in the business or community
- Tied to the ability of a business to continue operating with its existing customers as well as to attract future customers
Oftentimes, the acquirer understands a business is worth more than the net book value of its assets but cannot generally ascribe a specific excess market value to those assets in isolation. When combining the value of the assets and resources which comprise a business and seeing the overall value created, this excess is considered goodwill.
Goodwill is an intangible asset which can only materialize on a balance sheet as part of the acquisition of a business. It is a section 197 intangible whose value is amortized over 15 years for tax purposes by the buyer of a business.
It may not be amortized as a business expense, only as a tax write-off over the designated 15 year period.
Related to goodwill, the going-concern value is thought of from these two items:
- The value attributed to a business entity as an on-going enterprise.
- Focuses primarily on the ability of the company’s assets to generate a return on investment, not simply goodwill.
Residual Method Allocation Order
If an asset described in Class I through VI is included in more than one category, you must include it in the lower number category. For example, if an asset is described in both (IV) and (VI), include it in (IV).
As you will see from the example below, the allocations were assigned in ascending order by class. For assigning the residual method’s allocation order, start with the total sales price paid and reduce it by Class I assets (if any).
From there, allocate the remaining sales price to Class II assets, followed by Class III assets, and so on in ascending order.
Residual Method Allocation Example
Let’s look at a Form 8594 example. Imagine you sold your business for $50,000 and it included no cash or deposit accounts, no securities, but equipment and furnishings and a customer list with fair market values of $30,000 and $10,000 respectively. Additionally, there was inventory or stock on hand with a fair market value of $8,000.
The $50,000 would be allocated as follows:
- $8,000 inventory to Class IV asset
- $30,000 equipment and furnishings to Class V asset
- $10,000 customer list to Class VI asset
- $2,000 to goodwill, a Class VII asset
How is the Sale of a Business Taxed?
The sale of a business is not a sale of one asset. Instead, all the assets which constitute the trade or business are sold together. When this occurs, generally, each asset is treated as being sold separately for determining the gain or loss treatment.
Because businesses have many assets, when sold, when used in the trade or business they must be classified as:
- capital assets
- depreciable property
- real property
- property held for sale to customers (i.e., inventory or stock in trade)
The gain or loss on each asset is calculated separately. The sale of capital assets results in either a short-term or long-term capital gain or loss. The sale or real property or depreciable property held for longer than 1 year results in a gain or loss from a Section 1231 property transaction. Finally, the sale of inventory results in ordinary income or loss.
Does the Seller Care how the Class Allocations are Made?
Because businesses are made up of many different types of assets, how they are treated can determine the different taxable treatment received. In particular, how the assets of a business are identified during their sale can have a significant tax impact on the buyer and seller.
In the case of a seller’s point of view, they would want to designate as many items as possible into classes which will result in a long-term capital gain on sale. This provides the best tax result for the sale because they will pay less than the short-term capital gains rate.
For example, the seller would prefer to designate a significant portion of the sales price to goodwill and minimize any allocations to furnishings and equipment. Under the tax code goodwill is a capital asset, which will be taxed at a maximum rate of 20% (top marginal long-term capital gain rate). While furnishings and equipment can be taxed at a top rate as high as 37% (individual) or 21% (corporate income tax rate).
This differential diminished considerably for businesses as a result of tax reform in 2018, when the corporate income tax rate stood at 35%.
Taking advantage of the preferential tax treatment assigned to long-term capital gains and passive income is advantageous to the seller. Depending on the dollar value of the assets being transferred in the sale, it is possible to pay zero tax on the sale if the gains are treated as long-term capital gains.
Does the Buyer Care how the Class Allocations are Made?
The buyer has different motivations for the allocation of certain items into the seven asset categories used. While the seller wants items designated in categories allowing for long-term capital gains, the buyer has a desire to categorize assets as short-term in nature.
Doing so allows the purchased items to be written-off sooner and reduce the amount of taxes they owe upfront. For example, having a significant portion of the transaction classified as furnishings and equipment would allow these items to be depreciated over a shorter time period using MACRS depreciation tables (5 to 7 years) as opposed to amortizing goodwill over 15 years on their tax return.
The buyer and seller negotiate the allocation as part of the sales agreement. These two motivations lead to an agreement which then becomes formalized by filing Form 8594. Make sure the treatment is handled consistently, otherwise the IRS could make potential adjustments.
Does the IRS Care how the Class Allocations are Made?
The IRS generally has no preference for how the entities allocate the assets into classes so long as the entities use consistent treatment. The Form 8594 documents this allocation and allocates the total sales price into various asset classes.
When the entities file their respective Form 8594 documents, the allocations must be spelled out and show consistent treatment between both documents. Otherwise, the IRS would have issue with the transaction’s treatment.
What if the Form 8594 isn’t Filed on Time?
Both the buyer and seller must attach their Form 8594 documents to their income tax return in the year in which the sale occurred. If the amount allocated to any asset increases or decreases by either party after the sale occurs, the buyer or seller (whichever is affected), must complete Parts I and III or Form 8594.
If either party fails to file a correct document by the due date of their respective tax return and cannot show reasonable cause, penalties may occur. These penalties are stated in sections 6721 through 6724, the failure-to-file penalties or for not providing a social security number where applicable.
Who is Responsible for Filing Form 8594?
Generally, both the buyer and seller must file Form 8594 and attach it to their income tax returns (like Forms W-2, 1040, 1041, 1065, 1120, 1120S, etc.) when there is a transfer of a group of assets which make up a trade or business. This occurs when the buyer’s basis in such assets is determined wholly by the amount paid for the assets.
If the buyer or seller is a controlled foreign corporation (CFC), each U.S. shareholder should attached Form 8594 to its Form 5471, the form used by certain U.S. citizens and residents who are officers, directors, or shareholders in certain foreign corporations.
About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
Some of my favorite things to discuss include investing in index funds, how to save money, travel hacking with help from the Reddit churning community, house hacking and optimizing the benefits of my condo vs. apartment living, and tax topics like the earned income tax credit, common tax deductions, tax reform in 2018, or other useful tax topics. I want this to be a journey for us all to learn how to make a lot of money and pursue the lives we want.
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