Purchase Price Allocation--a Case Study

As this blog develops, I plan to alternate between theory and practice. Today's post is very much on the practical side, as it has been happening over the past few days. This example demonstrates the importance of following a tried and true process when selling a business. I outlined our business sale process in my last post.

We just closed escrow on the sale of a service and retail business in Southern California. Unfortunately, the State Board of Equalization will not allow the Escrow Company to distribute the sale proceeds to the Seller until two issues are resolved.

First, the seller must file a final sales tax return. It is not enough that all of the sales taxes have been paid. The State of California also requires a final sales tax return to be filed before the seller receives funds from escrow. The State wants to make sure that it receives what is owed before the seller gets away with all of the cash. So this issue is easily resolved by the Seller, just by completing and submitting a simple form to the State Board of Equalization.

The second issue is a bit more complex. The State Board of Equalization has also instructed escrow to also hold the Seller's funds until the Seller proves the value of fixtures and equipment being sold. When the assets of a business are sold, the buyer and seller, and usually their accountants, must agree during escrow, and report to the State,how the purchase price should be allocated among the various assets--such as fixtures and equipment, inventory and goodwill. The allocation is important because it affects the taxes of buyers and sellers. For example, the buyer pays sales tax on the value of the fixtures and equipment through escrow, but then can use that value in depreciating the assets after the sale.

The fixtures and equipment are supposed to be at market value--not what they cost new, nor the book value, but the actual market value. Until this past week, I had never seen the State question this purchase price allocation, so long as it appeared reasonable. But in this case, the State is holding funds because the buyer and seller valued the fixtures and equipment at just $10,000, which is probably not far from the actual market value. This small retail store just has a computer, printer, cash register, and shelves. However, the State believes that the equipment to worth closer to $80,000. The State has never seen the business or its equipment!

Apparently, when the Seller bought the business two years ago, there was no escrow. Consequently, the current owner did not agree on a purchase price allocation with the prior owner, who somehow reported to the State that the fixtures and equipment were worth $80,000. This was probably what the prior owner had INVESTED in the business, rather than the MARKET VALUE at the time. But now it is in the State records, and the State does not believe that it could have depreciated more than 20% over the two years since the last sale.

Although the issue has not been resolved yet, the State now wants the Seller to hire a business appraiser to determine the current value of the fixtures and equipment. The seller might have to spend several hundreds or even thousands of dollars to do this.

What can buyers, sellers and brokers learn from this story?

1. A business asset sale, which is the most common method of selling a small business, should always go through escrow. This protects the buyer, seller and broker.

2. Sellers should complete and file state sales tax returns immediately upon the close of escrow, to ensure timely distribution of escrow funds.