How to Treat Inventory When Selling Your Business

Inventory in Business Sales

Inventory is often a key component in the sale of many retail-related businesses. A business’s inventory must be properly valued and negotiated in order to facilitate a smooth business sale. Because inventory fluctuates (often dramatically), it is usually appropriate for the asking price of a business to not include inventory. Rather, inventory is separately purchased at closing for a negotiable sum. Inventory is valued at cost but the actual price paid is often negotiable.  Both buyers and sellers of businesses with a significant amount of inventory should also be aware of the federal and state tax implications prior to closing.

What is Inventory?

Inventory refers to the goods produced by a business that is available for sale, as well as the raw material (such as flour used by a bakery) used for the production of available goods. Work-in progress inventory simple refers to half-finished goods (such as a partially completed boat on the factory floor). Prior to being sold, inventory is reflected on the balance sheet as a current asset. Once sold, this amount is transferred as ‘cost of goods sold’ on the income sheet. Sometimes sellers of businesses confuse inventory. Equipment is not sold to a third party. An accurate representation of a company’s inventory is critical to establishing a proper valuation of a business.

Determine Average Age of Inventory

The average age of inventory is the average number of days it takes for a business to sell off its inventory. This is a key metric for many retail-related businesses in the clothing, convenience store, or auto sales industries. The more quickly the inventory is turned over, then the higher profit margins the business will have.  In contrast, a business with high amount of ageing inventory faces obsolescence risk.  This leads to higher discounts and lower profit margins in order to turn the inventory over more quickly.

Valuing Inventory

When a retail-related business has a high amount of inventory, it is first necessary to properly value the inventory. The seller should always determine the cost of the inventory (rather than its retail price) as the valuation baseline. Then an inventory ageing report should be produced that verifies the the date the inventory was purchased as well as the cost for each inventory item. The inventory’s carrying cost (or inventory storage costs) are not included in the valuation.

Valuation of Inventory Negotiable

Often times, a buyer of a business may not want to purchase all of the inventory. For example, many buyers of retail clothing stores may want to focus on selling different product lines and thus may not want to purchase all of the business’s existing inventory at the time of sale. Moreover, a business with ageing inventory or inventory that the buyer deems largely unsaleable (absent major discounting) can not typically expect to receive its full value (at original cost).  The valuation of the inventory will thus be negotiated between the buyer and seller, and typically a buyer will agree to pay at closing a percentage of the inventory’s original cost.

Tax Implications of Selling Inventory

The tax implications of buying and selling a business with a significant amount of inventory must first be addressed by establishing the allocation of the purchase price in the final purchase agreement. The sale of a business (when using the typical asset purchase structure), when viewed through the eyes of the Internal Revenue Service (IRS), is really the sale of the individual components of the business (such as its tangible physical assets, depreciated real property, goodwill, or inventory). The sale of capital assets – including goodwill, property, or equipment – results in a capital gain or loss. The sale of inventory, however, is treated by the IRS as ordinary income or loss. Unfortunately, ordinary income tax rates are significantly higher than capital gain tax rates, so sellers should be aware of this potential tax liability.

Negotiate Allocation of Inventory In Purchase Agreement

  • Both buyers and sellers should be advised by their attorney or accountant of the tax implications before closing on a business with a significant amount of inventory.
  • In practice, the parties should be encouraged by the professional business broker to negotiate the allocation of the purchase price in the asset purchase agreement.
  • This is critical to avoid a dispute or different reporting to the IRS after the closing in regards to the allocation.
  • The seller will want to limit their tax liability while the buyer will want to classify the allocated assets in a way that shortens the depreciable life of the purchased assets while limiting their own future tax liability.
  • For example, buyers prefer an allocation toward fixed assets (such as equipment) which have a depreciable life of 5-7 years.
  • This allows the buyer to quickly depreciate this asset (depreciation charges offsets income for tax purposes).
  • By contrast, goodwill (the premium of the business beyond its tangible assets) generally has a 10- 15 year depreciable life.
  • Inventory has no depreciable life since inventory is not a capital asset meant to have a useful life for more than one year.

Florida Resale Certificate

Buyers and sellers of businesses with a significant amount of inventory will want to avoid paying state sales taxes for the allocated portion of inventory in the deal, A way for a Florida buyer and seller of a business to avoid this possibility is for the buyer of the business to obtain a Florida resale certificate. This document allows a business to purchase goods tax-free from suppliers. By having a Florida resale certificate in place, the sale of the inventory in a business transaction should not be subject to state sales tax. Of course, it is always recommended to consult with an attorney or accountant to ensure full compliance with the law.

Inventory is a key component of many retail-oriented business sales. It is essential to properly value the inventory, clarify whether the inventory is included in the asking price for the business, and negotiate the price ultimately paid for the inventory as well as its taxable allocation in the purchase agreement.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.

Leave a Reply