Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Hidden Tax Trap in Every Business Sale
Transcript
- Lucas: Let me tell you about a deal that died in due diligence. Michigan industrial packaging company — decent EBITDA, clean books, asking price fourteen million. Buyer signs the LOI, gets three weeks of exclusivity, brings in the tax team. And what they find kills the whole thing. Luna: The numbers weren't real? Lucas: No, the numbers were fine. The problem was Section 197 of the Internal Revenue Code. Intangible asset amortization rules. The seller's accountant had allocated 30 percent of the purchase price to a non-compete agreement. Under the tax code, that non-compete has to be amortized over 15 years. Buyer's tax team flagged it — the IRS could recharacterize the non-compete as a covenant that's essentially ordinary income to the seller, and the buyer loses the step-up in basis on goodwill. Luna: So the seller was trying to turn a capital gain into ordinary income by calling it a non-compete? That's aggressive. Lucas: Exactly. The IRS does look at this. And in this case, they did — a 2024 audit recharacterized the whole thing. The seller owed tax at ordinary rates on the non-compete amount, and the buyer had to capitalize the goodwill over 15 years instead of getting an immediate deduction. The deal fell apart because neither side had planned for the allocation fight. Luna: And just to be clear — most private deals under 50 million are asset sales, right? That's where this really bites. Lucas: Right. Stock sales are simpler — buyer steps into the seller's tax basis, no reallocation. But in an asset sale, which is common for smaller private businesses, you have to allocate the purchase price among all the assets: equipment, inventory, real estate, goodwill, non-competes, customer lists, trademarks. Each class gets different tax treatment. And the IRS has rules about how much you can allocate to goodwill versus other intangibles. Luna: This is the part where I mention that the show stays ad-free because a few listeners chip in monthly at buy me a coffee dot com slash fexingo. It's listener funded, no ads. And if these conversations have helped you navigate a deal, that's the only reason it keeps going. Lucas: Yeah, it's a small group, but it makes a difference. Appreciate it. So back to the allocation — the key insight is that the Tax Cuts and Jobs Act of 2017 actually made goodwill amortizable over 15 years for tax purposes, but only if you buy the assets in a qualified transaction. Before 2017, goodwill was non-amortizable indefinite life. So the buyer has a strong incentive to allocate more to goodwill to get that 15-year write-off. The seller, on the other hand, wants to allocate less to goodwill — because goodwill is taxed as capital gain, but if you allocate too much to a non-compete, that's ordinary income to the seller. Luna: So the seller wants low goodwill and low non-compete? That pushes allocation into hard assets like equipment, which are depreciable faster? Lucas: That's the game. But the IRS has a doctrine called 'consistency' — you have to allocate based on relative fair market values. You can't just stuff everything into equipment and claim it's worth five times what the appraisal says. In that Michigan deal, the seller tried to put a huge value on the non-compete because it's a separate asset class from goodwill, and they thought they could get capital gains treatment on the rest. But the IRS said no — the non-compete was essentially compensation for not competing, so it's ordinary income. Luna: What's the solution? Is there a clause sellers can put in the purchase agreement to protect against this? Lucas: Yes — it's called a seller-side allocation protection rider. It basically says, 'If the IRS recharacterizes any portion of the allocation, the seller is indemnified for the additional tax liability up to a cap, or the buyer has to adjust the purchase price.' Most buyers will push back because they want the tax benefits of a certain allocation. But a smart seller's lawyer will insist on it. I've seen deals where the seller walks away with 90 percent of the allocation benefit, and the buyer takes the risk. Luna: Is that standard in the lower middle market? I feel like many business owners don't even know this exists. Lucas: It's not standard, which is the problem. Most business brokers — no offense to the good ones — they focus on valuation and negotiation of price. They don't think about the tax allocation until the lawyers get involved. And by then, the LOI is signed, the buyer has leverage, and the seller is stuck with whatever allocation the buyer's tax team proposes. I've seen sellers lose hundreds of thousands of dollars because they signed an LOI that said 'purchase price allocation to be determined by buyer's tax advisor in accordance with Section 1060.' That's a huge red flag. Luna: Section 1060 is the asset acquisition allocation rule. So that clause basically gives the buyer total control over how the price is sliced up. Lucas: Exactly. The seller should never agree to that. They should push for a joint allocation schedule attached as an exhibit to the purchase agreement. And they should get their own appraisal — a qualified business valuation that allocates fair market value to each asset class. That way, if the IRS challenges it, you have a defensible position. The Michigan seller didn't do that. They relied on the buyer's appraisal, which allocated almost nothing to goodwill and everything to a non-compete and a customer list. And the IRS said the customer list was essentially goodwill anyway — so no step-up, no amortization, and the seller got ordinary income on the non-compete. Double whammy. Luna: What about the buyer's perspective? If I'm a buyer, I want maximum goodwill allocation for the 15-year amortization, but I also want to avoid an IRS audit. So what's the right balance? Lucas: You want a defensible appraisal. The IRS doesn't care what you want — they look at whether the allocation reflects reality. So if you buy a service business with no hard assets, 80 to 90 percent goodwill is normal. But if you buy a manufacturing company with millions in equipment and real estate, you can't allocate 90 percent to goodwill. The IRS will flag it. A good rule of thumb: get an independent appraiser who does allocation studies regularly. The cost is maybe 10 to 20 thousand dollars on a ten million dollar deal. That's cheap insurance against a six-figure tax adjustment. Luna: And the non-compete — is it ever a good idea to have one in a sale? Or should sellers just avoid them? Lucas: You almost always need a non-compete if the seller is staying involved or if there's a risk they'll start a competing business. But the allocation to the non-compete should be minimal — like 1 to 5 percent of the purchase price. If the buyer insists on 20 percent, that's a red flag. They're trying to shift tax burden to you. In fact, there's a case law from 2009 — 'Commissioner v. Smith' — where the Tax Court said that a non-compete that's essentially a covenant not to compete, rather than a separate asset, should be treated as part of goodwill. So if the non-compete is too big, it can be recharacterized. Keep it small. Luna: So the takeaway for sellers: get your own allocation study before you sign the LOI. Don't let the buyer control the allocation. And include a protection rider. Anything else? Lucas: One more thing: consider a stock sale if you can. In a stock sale, the buyer gets a stepped-up basis in the assets only if they make a Section 338 election, which is rare. But for the seller, a stock sale means all your gain is capital gain — no ordinary income from non-competes. The buyer might push for an asset sale because they want the step-up. So the negotiation is tax benefit versus tax cost. A good broker or M&A advisor can help model both scenarios. But many small business owners don't even know the difference. That's where a good tax advisor comes in. Luna: And that Michigan company — did they ever sell? Lucas: They did, about eight months later, but for eleven million — three million less than the original offer. And the seller ended up with a big tax bill because the new buyer's allocation was even more aggressive. The lesson: the tax structure is as important as the price. You can win on price and lose on taxes. Luna: That's a hard way to learn it. What's the one thing a business owner should do today if they're thinking about selling in the next year? Lucas: Get a tax-oriented M&A advisor. Not just a CPA who does your annual return — someone who specializes in transaction structuring. Have them run a pro forma allocation for a hypothetical sale. See how different allocations affect your after-tax proceeds. Then when you get an LOI, you know what to push for. And honestly, the cost of that advice — maybe five to ten thousand — is trivial compared to the tax you might save or lose. Luna: Sound advice. Thanks Lucas. Lucas: Thanks Luna. If you're in the middle of a deal, I hope this helps you avoid a surprise.