If you are currently in the market to acquire a business or may consider such a move later, you will want to carefully consider intangible assets in your business valuation. While these assets have value you don’t want to ignore, you will also want to ensure you account for them in the most tax-favorable way you can.
Intangible assets, such as patents, trademarks, and copyrights have long existed. In more recent years, other types of intangible assets have gained legal recognition, such as internet domains and social media presence.
The categories of intangible assets, with examples, include:
- Marketing-related – (e.g., trademarks, trade names, brand names, logos)
- Technology-related – (e.g., process patents, patent applications, technical documentation, technical know-how)
- Artistic-related – (e.g., literary works, musical compositions, copyrights, maps, engravings)
- Data processing-related – (e.g., proprietary computer software, software copyrights, automated databases)
- Engineering-related – (e.g., industrial design, product patents, trade secrets, engineering drawings and schematics, blueprints, proprietary documentation)
- Customer-related – (e.g., customer lists, customer contracts, customer relationships, open purchase orders)
- Contract-related – (e.g., favorable supplier contracts, license agreements, franchise agreements, noncompete agreements)
- Human capital-related – (e.g., trained and assembled workforce, employment agreements, union contracts)
- Location-related – (e.g., leasehold interests, easements, air rights, water rights)
- Goodwill-related – (e.g., institutional goodwill, professional practice goodwill, personal goodwill, celebrity goodwill, business going-concern value)
The typical situation
In general, when a business broker or investment banker structures the sale of a company, the selling price is often allocated into tangible value (i.e., building, equipment, furniture, fixtures, and improvements) and intangible value (i.e., goodwill). It is common to have all intangible value allocated to goodwill. However, equating all intangible value with goodwill is neither accurate nor appropriate. As you can see from the list above, there are many different intangible assets other than goodwill. Nonetheless, this practice is quite common. One reason is that determining the value of identifiable intangible assets requires a business appraiser to perform an analysis to arrive at a conclusion for each intangible asset’s value.
Buyer’s dilemma
First, if a buyer does not consider categories of intangible assets other than goodwill, they may consummate a transaction for something other than market value and pay too little or too much for the business. For example, perhaps much of a business’ success depends on an existing patent that is expiring in three years. Without considering this specific intangible asset and its nature, one could assume in error that the business’ earnings and cash flow will continue for an indefinite period. The reality may be that without legal protection the business could start losing sales to rival products after the patent expires.
Also, accounting rules require the recording of goodwill and intangible assets that are acquired in a business combination. A buyer will need to have values allocated to these for accounting (“GAAP”) purposes. US GAAP requires that intangible assets be amortized over their useful life, whereas goodwill is not amortized but tested annually for impairment. Overstating the value of goodwill will leave the buyer with an amount recorded for GAAP purposes that is overstated and may result in subsequent impairment testing and write-downs.
Taxation – how you structure the purchase is key
Business purchases can be structured as an asset purchase or a stock purchase. In an acquisition structured as a stock transaction, the buyer steps into the shoes of the seller from a tax perspective. Thus, the tax basis in all the seller’s assets carries over to the buyer. As a result, there is no step up in the asset values to the purchase price for tax purposes even though purchase accounting adjustments may still be made for GAAP purposes. This can be advantageous to the seller, but for a buyer there can be some significant disadvantages. These include: (1) fixed asset values, tax lives, and methods continue from the seller, which results in lower depreciation and subsequent tax savings and (2) intangibles acquired are not tax deductible.
For buyers, asset transactions offer considerable advantages. Buyers receive a step up in value in all the assets they acquire as part of the transaction. Other advantages resulting from this may include the ability to take depreciation on the values paid for buildings, equipment, furniture, fixtures, and improvements, including an opportunity to take bonus depreciation or Section 179. Additionally, goodwill and other intangible assets are deductible on a straight-line basis.
A new outlook
This article has highlighted the fact that someone contemplating a business acquisition needs to exercise care in the way they think about the business and the assets they are acquiring. With these points in mind, buyers can move forward and consider aspects of the acquisition that need review to ensure the best possible outcome.
For a deeper dive into the role of intangible assets in your personal circumstances, you may find it helpful to read this article, which discusses the perspective of business sellers.
R&A CPAs has highly qualified professionals—including experts in business valuation—to assist you. Give us a call.
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