Purchase Price Allocation (PPA) a Neglected Negotiating Tool by Gaurav Malhotra

May 3, 2023

Gaurav Malhotra

I remember being on call with my client and his legal counsel two days before closing.  We were reviewing the disclosures furnished by the seller.  We were not happy to find out that the operating facility would need $3 million in repairs soon.  The client wanted to adjust the purchase price for this surprise item, and the attorneys had their marching orders.  We had arrived at this point after months of complex diligence and negotiations, and it felt like this straw might break the camel’s back.  During the transaction, I developed a good working relationship with the client’s tax and accounting teams.  I asked the client if I could ask them to allocate an additional $6 Million toward fixed assets.  This would allow us to depreciate these assets in year one and save $3 Million in taxes.  I was able to get an extra $10 million allocated towards fixed assets, and my client saved $5 million in taxes.

A lot of emotions swirl around closing net working capital, EBITDA adjustments, and the like.  PPA gets set aside as something for tax accountants and valuation experts to contemplate.  Most purchase agreements have some vague language about the buyer and seller agreeing to the PPA before filing their respective tax returns.  Before I get into how one can use the PPA to negotiate a better deal, let me walk you through some basics.

In an asset transaction, the buyer will pay money to acquire the business’s assets.  These assets will generally fall into the following categories:

  • Easily Valued – Cash, Accounts Receivable, Inventory, Prepaids, etc.
  • Fixed Assets- Machinery, Equipment, improvements, and others
  • Intangibles- Customer lists, brand, and a catch-all for goodwill

The purpose of PPA is to allocate the purchase price into these three categories.  One starts by allocating the purchase price to categories 1 & 2 above, and the remaining usually gets assigned to goodwill. The allocation has real cash flow consequences for the buyer and the seller in the form of taxes.

One cannot choose how to allocate into the 1st bucket as these amounts are easily determined.  Things get slightly tricky while allocating the purchase price to fixed assets.  It is common to find that the sellers have fully depreciated most of their assets.  Any purchase price allocated to fixed assets results in the seller paying ordinary income tax rates on the allocated portion compared to capital gain tax rates.  In other words, the sellers want this allocation minimized because they don’t want to pay more taxes.  In most transactions, the buyers agree to allocate a minimal amount to this asset category to avoid conflict.  However, I would caution buyers not to take this position without contemplation.

From the buyer’s point of view, they would like a greater amount allocated to fixed assets.  This is because Federal tax rules have allowed buyers to fully depreciate (80% now) these assets in year one.  In comparison, any assets allocated to intangibles get amortized over 15 years.  All things being equal, I like my tax deductions now, therefore a greater allocation to fixed assets vs. intangibles.

Given this set of facts, we are at a stalemate, and the seller will always insist on minimal allocation to fixed assets, while the buyer would like a heavy allocation to fixed assets.  However, one needs to consider the following examples:

  • Net Operating Losses (NOL):If the seller has unused NOLs from the past, they could be amicable to a greater allocation to fixed assets.  These NOLs can originate from the entity being sold and perhaps from other owned entities.  It does not hurt to ask.
  • Pass-Through Entity Tax (PTET):It has been traditional for the seller to ask the buyer to pay for any additional tax burden related to a 338(h)(10) election or an F reorg.  We are finding that in states where PTET has been enacted, sellers save money on taxes when an F reorg or 338(h)(10) election is requested.  It might be an opportunity for the buyer to ask for an additional allocation to fixed assets to share in that tax benefit.

These are just two examples to demonstrate that both the buyer and seller can benefit if they work together to find the best way to allocate the Purchase Price.  It helps to dig a bit deeper and get creative.