Q: I recently purchased a small lawn maintenance business. I paid cash and purchased some equipment and the routes from a guy who is retiring. I am now trying to set up my books, but I am confused. I know what I paid, but do I just show this as an expense or what?
A: When the assets of a business – whether a small lawn maintenance operation or a multimillion-dollar company – are purchased, a detailed analysis should be made of the transaction. A portion of the purchase price is usually for “tangible” assets that can be identified and valued with relative ease (although it may take a qualified appraiser to determine an accurate value). These assets include the equipment you purchased, but could also include accounts receivable, inventory, real property and many other assets that you can see and touch.
Some assets are not so easy to identify or value. These are the “intangible” assets, such as the lawn maintenance routes you purchased. There are many types of intangible assets, which might include patents and copyrights, customer lists, Internet domain names, trade secrets, and employment and noncompetition agreements. Although a more difficult task, these intangibles also must be identified and valued.
The final category of purchased assets is the catch-all: goodwill. Once you have accounted for all the other tangible and intangible assets acquired, the remainder of the purchase price falls into goodwill. Accountants use this classification to capture any amount paid in excess of the value of all the other assets that were acquired.
Formal accounting under generally accepted accounting principles and normal tax accounting require that you book all the identified assets at their fair market value on the date of acquisition. The remainder is booked to goodwill. Then in subsequent years the buildings and equipment are depreciated and the intangible assets are amortized. Depreciation and amortization (which is derived from the Middle English and Latin words for “kill”) in accounting refer to the systematic allocation of the cost of an asset over the asset’s useful life. This is the amount that is actually taken as an expense on your books (and a deduction on your tax return) each year. This is done to match the expense to the period in which the asset is used.
Under generally accepted accounting principles, goodwill must be evaluated each year to determine if the value should be reduced. For large companies, this is often an important process to properly report the intangible. Many small businesses, however, rely on the tax rules for reporting goodwill, which generally state that goodwill is amortized over 15 years. So if your goodwill calculated to $15,000, you would amortize on your books and deduct on your tax return $1,000 per year. Most other purchased intangibles follow this same methodology using a 15-year period as required by the tax code.
Here’s an example: Assume you paid $50,000 for the equipment and maintenance routes. After some homework (or a formal appraisal), you determined that the fair market value for the mowers, trimmers, and other equipment was $8,000 and a truck that was also purchased had a Kelley Blue Book value of $12,000. That leaves $30,000 paid for the intangibles (routes, business name, etc.). This is the amount you would record as an intangible asset(s) on your books.
The equipment and the truck would be depreciated over their useful life (generally seven years for the equipment and five years for the truck under tax rules). The intangibles would be amortized over 15 years. Interestingly, if part of your agreement was a three-year covenant not to compete with the seller, you would still need to amortize the intangible over 15 years on your tax return, even though the noncompete restriction is only a three-year period. The tax laws don’t always reflect the reality of the remaining life of an asset.
There is no question that accounting for a business acquisition can be confusing. On top of that, the accounting for the acquisition will go on for years and affect your financial statements and tax returns well into the future. So take some time to get it right, and contact someone who has been through it before if you have questions.
Congratulations on your new business! And let me know if you need some practice – my yard awaits.
To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.
Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.
Have a question for Robbins? Email your question to [email protected]. Enter “Talking Tax” in the subject line.