For professionals planning to purchase or sell a financial services book of business, the most common negotiating points are the purchase price, deal structure, timeline, and financing considerations. These are critical points to discuss and finalize before signing on the dotted line.
It’s also important to be aware of the effect of the tax treatment on the deal and know the different tax structures commonly employed.
If not structured purposefully, the tax treatment of a deal may unintentionally favor either the seller or the buyer and can have a significant impact on the total value received/paid. Depending on what’s been negotiated, the majority of the sale proceeds may be classified as ordinary income or long-term capital gains.
Negotiating this early in the process will ensure that the purchase price can be adjusted up or down to balance the benefit. As a result, the tax allocation of the sale proceeds is one of the key elements of a deal structure and should be considered carefully by both parties.
Potential Deal Structures
To decide which tax structure works best for the deal, the parties will enjoy some level of flexibility as long as they remain within the boundaries of current tax laws and the objectives of the transaction.
The first decision that must be made is what exactly is to be sold (assets and/or equity) before discussing how the purchase price should be allocated to a particular asset or equity or both.
The following are the two most common considerations:
Asset sale
In an asset sale, the buyer selects certain individual business assets to be purchased from the seller, with each asset having a specific dollar amount of the purchase price paid for it and allocated as such in the purchase agreement.
This includes the following primary categories (in addition to any tangibles that may be acquired):
- Personal goodwill: client relationships, rights to revenue, the reputation of the business (i.e., the book of business)
- Restrictive covenants: nonsolicitation, noncompete, and/or no-serve agreement with the seller.
- Post-closing transition assistance: services provided by the seller, such as assistance with client meetings, phone calls, emails, letters, etc.
Equity (stock) sale
Rather than buying individual assets, the buyer and seller may elect to make the seller’s business entity (e.g., corporation or LLC) the subject of the transaction and enter into a sale of the seller’s ownership interest in the entity. The transfer of the ownership in the entity allows the seller to transition all assets and the liabilities of the business to the buyer, including all—
- contracts,
- permits,
- licenses, and
- registrations.
Since both an asset sale or stock sale may ultimately result in long-term capital gains tax treatment for the seller, the choice is influenced greatly by the buyer’s preferences and whether there’s perceived value in buying the business entity.
| | Assumption of Liabilities | Tax Treatment |
| Asset Sale | No assumption of seller’s liabilities by the buyer, unless expressly agreed to—even then, the assumption is often limited | Buyer can amortize the purchase price over a 15-year timeframe, depending on the type of assets being purchased |
| Equity (Stock) Sale | Not only the assets but also all liabilities are transferred with the ownership of the stock | Basis is realized only upon the sale of the stock; amortization of the purchase price is available only if certain conditions are met and the assets can be recategorized under IRC section 338(h)(10) or IRC section 336(e) |
Asset Sale: Categories and Tax Treatment
The most common deal structure when buying or selling a financial services practice is a sale of assets, versus an equity-based sale. This does vary based on the size of the transaction; deals involving larger firms will more often employ an equity-based strategy to ensure the acquired business remains a going concern.
When purchasing the assets from a seller, it’s important to ensure that both buyer and seller agree on how the purchase price will be allocated for tax purposes, and such meeting of the minds should be included in the purchase and sale contracts.
Personal goodwill
The majority of the purchase price is typically allocated to personal goodwill—an IRC section 197 intangible asset consisting of the seller’s client relationships, reputation, expertise, and abilities. Year-to-date 2020, the average transaction for financial service professionals allocated 93% of the purchase price to personal goodwill, up from 91% in 2019. For the seller, the sale of personal goodwill should generate long-term capital gains tax treatment and be amortizable over 15 years by the buyer.
Post-closing transition support
Depending on the extent of the seller’s services to the buyer post-closing, compensation for these services can be either included in the purchase price (typically for limited services such as introducing the buyer to the transferred clients) or be paid in addition to the purchase price (for the seller’s expanded involvement post-closing beyond just transitioning clients).
As shown in Figure 1, the average transaction allocated 3% of the purchase price to the seller’s post-closing support, though this allocation tended to be greater on smaller deals. For the seller, they want to ensure only a de minimis portion of the purchase price is paid for their transition assistance, as this portion is labor and taxed as ordinary income, subject to Social Security and Medicare taxes.
The buyer, however, generally seeks to allocate more of the purchase price to the transition support, as this portion provides them a tax write-off in the allocated amount, pro-rated for the year in which the services were provided.
Restrictive covenants
To protect the buyer’s investment, the seller will commonly be required to enter into a restrictive covenants agreement (similar to personal goodwill, this too is an IRC section 197 intangible asset), whereby they promise not to compete with the buyer, solicit the buyer’s employees or vendors, or serve any of the clients the buyer purchased from the seller.
In exchange for this promise, the seller will receive a portion of the purchase price as consideration, resulting in ordinary income for the seller and a 15-year amortization by the buyer. Because this asset doesn’t produce a tax-favorable outcome for buyer or seller (relative to the alternatives previously described), neither party seeks to allocate any more than would be required to ensure the buyer has an enforceable contract.
Year-to-date 2020, the average transaction allocated 3% of the purchase price to restrictive covenants. Not allocating a portion of the purchase price to restrictive covenants may render the provisions unenforceable and otherwise confuse the intended tax result.
Tangible assets
Tangibles assets, such as furniture and equipment, are not commonly part of the deal since there’s often little to no value to them. Most likely, the seller already depreciated them and doesn’t want to be subject to depreciation recapture and the following tax treatment:
| Tax Impact on Seller | |  | | Recapture of previous depreciation; ordinary income taxes; taxes on capital gains (not likely) |
| Tax Impact on Buyer | | | | Depreciation over the lifetime of the tangible asset |
IRS Form 8594 will need to be completed and submitted to the IRS by both buyer and seller for the tax year in which the sale occurred. In most instances, the parties will need to report the portion of the deal allocated to personal goodwill as an IRC section 197 Class VII intangible asset and the portion allocated to restrictive covenants as an IRC section 197 Class VI intangible asset.
To avoid conflicting information on their individual forms, the seller and buyer should negotiate the exact amount of the purchase price allocated to either asset category and capture the same in writing.
Special note: In the event the seller intends to sell a portion of the clients (referred to as a Partial Book Sale), their hourly commitment to transitioning clients to the buyer is often limited compared to a full sale, and the need for noncompete provisions may be significantly reduced to allow the seller to continue their remaining business.
Consequently, the percentage allocation to personal goodwill is often increased while the allocation to the remaining asset classes (transition assistance and restrictive covenants) is reduced. When the business is sold by the spouse of a deceased professional, the seller is usually neither licensed nor part of the business and would therefore not be able to provide transition support or represent a risk to the buyer that would warrant nonsolicitation, noncompete, and no-serve clause.
As a result, transactions entered into by the surviving spouse of a deceased advisor may result in an allocation of up to 100% of the purchase price to personal goodwill.
Stock Sale and Tax Treatment
While less common, there are instances where the parties may agree that the buyer shall purchase the seller’s equity in the business, allowing the buyer to maintain a turnkey business with all of the seller’s existing assets, liabilities, and operations. In this instance, the buyer will typically be subject to using after-tax dollars to purchase the business, as they’ll have basis but won’t have the ability to amortize or deduct the purchase price as in an asset sale.
The seller should receive the proceeds at long-term capital gain tax-rates, assuming they’ve held the equity for at least 12-months. It’s also possible to structure a sale where the seller sells both their personal goodwill in the clients as well as the equity in their business, allowing the buyer and seller to obtain the optimal tax and operational result, though specific conditions must be met.
Net Investment Income Tax
Contrary to many financial professionals' expectations, the net investment income tax doesn’t play a role in the purchase and sale of a book of business. Based on the tax code, the net investment income tax applies only to gains from the following activities, none of which are typical for the sale of a book of business:
- Sale of stocks, bonds, and mutual funds.
- Capital gain distributions from mutual funds.
- Sale of investment real estate.
- Sale of interests in partnerships and S corporations if the owner was passive.
Considerations
Since the tax treatment of the sale of a financial services book of business can be structured in a variety of ways, it’s important for buyer and seller to weigh the different options and choose a particular tax structure tha’is fair to both parties in the context of the deal.
To accomplish this goal, seek the help of an experienced mergers and acquisitions (M&A) professionals, your legal counsel, and your tax counsel to ensure all options have been carefully considered and your purchase and sale documents clearly describe the intended tax structure.
David P. Grau Jr., MBA, is the founder and CEO of Succession Resource Group, and is one of the nation’s leading consultants on valuation, acquisition, and succession planning for financial service firms, and has helped hundreds of professionals buy, merge, sell, and craft their transition plan for the sale of their business. David holds a bachelor’s degree from Portland State University and his MBA from Willamette University’s Atkinson Graduate School of Management where he serves as an adjunct professor.
Nicole Frey, CFP, is the senior project coordinator at Succession Resource Group, helping clients with succession planning, mergers and acquisitions, entity and employment related matters, and contingency planning for death and disability of the owner. Nicole began her upper education at Julius-Maximilian University in Würzburg, Germany, where she passed her First State Examination for her German law degree, finishing her education with a bachelor’s degree from Washington State University.