Fundamentals of Sale Contract of Business
Selling a business, as with any other business transaction, involves a series of steps that must be addressed. While considering these steps, one must also consider the risk for the parties involved in the sale. Involved parties will be required to negotiate the price of sale, the allocation of sale price to the assets involved, and the tax ramifications of such assets, just to name a few of the steps involved. Due to the intricacies of selling a business, the seller and purchaser should be careful and thoughtful in evaluating the transaction in order to avoid and mitigate risk. Hiring a lawyer who specializes in corporate law can be extremely helpful in this process. This post will dive into a deeper understanding of the main aspects and risks.
1. Description of Property or Lack Thereof
All properties and assets belonging to the business should be included in the Sale Contract as part of the sale price being transferred, and those that are not. The exchange of leasehold interest needs to be passed through the landlord who controls the lease, as they may not allow the assignment of the lease to the purchaser. If that is the case, the purchaser may need to take action to indemnify the seller. Additionally, the Sale Contract needs to enumerate the conditions of each asset.
2.The Amount of Purchase Price
The knowledge and expertise of a financial expert, rather than a lawyer, is required to determine the purchase price for the business. The examination of the books and records of the business used to determine the price should also be used to ascertain the risks and liabilities of the business, which should be included in the Sale Contract as well.
3.Allocation of Purchase Price in the Sale Contract
For tax purposes, the parties involved in the transfer of a business should accurately allocate the decided purchase price among the various assets involved. The allocation of assets helps the seller of the business determine whether there are any losses or gains on the assets being sold. It also helps the purchaser determine the proper basis in the assets that they are acquiring.
When it comes to taxes, there are certain restrictions in the allocation of the purchase price of a business. Parties must allocate the purchase price based on “residual method of accounting”
and not just to suit their needs. This method of accounting classifies assets into categories which are computed to come to the purchase price. Purchase price should first be allocated to the categories of the highest class, then sequentially as one class has been fully allocated.
This residual method of accounting applies to any asset in which direct or indirect asset transfer involves:
- Assets constituting “trade” or “business”; AND
- Assets’ basis for the purchaser is entirely ascertained by the buyer’s consideration for the assets.
Therefore, under the “residual method of accounting”, the asset purchase price is allocated and reduced in the following order:
- “CLASS I ASSETS”: Class I assets consists of cash, demand deposits and similar accounts in bank, savings and loans associations and other items designated by IRS in its bulletin.
- “CLASS II ASSETS”: Class II assets are certificates of stock, US government securities, readily available stock or securities, foreign currency and other items designated by the IRS applicable bulletin.
- “CLASS III ASSETS: Class III assets encompass all the other assets not specified in this list, to some extent.
- “CLASS IV ASSETS”: Class IV assets encompass all the intangibles with the exception of the intangibles in the nature of goodwill and going concern value.
- “CLASS V ASSETS”: Class V assets encompass all the intangibles in the nature of goodwill and going concern value.
It is essential to note that each involved party is bound to the written agreements as to the fair market value of purchased assets including goodwill and going concern value, unless determined improper by the IRS.\
4.Assumption of Liabilities
When purchasing a business, one assumes the liabilities accumulated by the business, unless stated otherwise. In the state of California, voluntary acceptance of the benefit of a transaction also carries all liabilities known to the buyer at the time of the transaction. This is based on the fact that if the buyer is aware of all the liabilities of a business as it appears in the books, then they should be able to fairly negotiate the price to negotiate the accumulated liabilities.
The contract must state the date and location of closing. Usually, the signing and transferring of the title will happen simultaneously, however it is possible for the parties to sign the contract and intend for the title to be transferred at a later date. For this reason, it is imperative for the contract to specify the rights and obligations of each party if the signing and closing occur separately.
