Purchase Price Allocation and Form 8594: How Your Sale Gets Taxed

What the allocation is

In an asset sale, the IRS requires the buyer and seller to allocate the purchase price among seven classes of assets using the residual method, and to report the same allocation on Form 8594, filed with each side's tax return for the year of the sale. The classes are, in order, cash and equivalents, actively traded securities, receivables and similar items, inventory, all other tangible assets including equipment and real property, intangibles such as customer lists, licenses, non-competes, and trade names, and finally goodwill and going concern value.

The residual method fills the classes in order at fair market value, and whatever price is left after the first six classes goes to goodwill. In most small business sales the meaningful classes are inventory, equipment, intangibles including any non-compete, and goodwill.

What each class means for the seller

Inventory allocated at the seller's cost produces no gain. Allocated above cost, the excess is ordinary income.

Equipment. The seller has depreciated the equipment over the years. An amount allocated to equipment up to the depreciation already taken is depreciation recapture, taxed as ordinary income. An amount above original cost is capital gain. Most small businesses have fully depreciated equipment, so nearly everything allocated to equipment is ordinary income to the seller.

Non-compete. An amount allocated to the seller's non-compete agreement is ordinary income to the seller, taxed at the seller's marginal rate. The buyer amortizes it over fifteen years, the same as goodwill, so buyers gain little from a large non-compete allocation, but their attorneys sometimes propose one anyway.

Consulting or employment agreement. If part of the consideration is paid under a consulting agreement for the seller's transition services, that is ordinary income and subject to self-employment tax. It should reflect the value of the services, not be a place to park purchase price.

Customer lists, trade names, and other intangibles. Capital gain to the seller if held more than a year, which is nearly always the case. The buyer amortizes over fifteen years.

Goodwill. Capital gain to the seller. Amortized by the buyer over fifteen years. For most sellers this is the best class, and for most buyers it is neutral relative to other intangibles and worse than equipment.

What each class means for the buyer

The buyer wants amounts allocated to assets they can deduct fastest. Inventory is deducted as it is sold. Equipment can often be expensed in the first year under bonus depreciation or Section 179, subject to the rules in effect that year. Goodwill and other intangibles are amortized over fifteen years.

So the buyer wants more in equipment and inventory. The seller wants less in equipment, because of recapture, and more in goodwill. The two sides are directly opposed on equipment, and mostly aligned elsewhere.

How it gets negotiated

The allocation is usually agreed after the price and before the purchase agreement is final, and it is written into the agreement as an exhibit. If the two sides cannot agree, they can each file their own allocation, which invites IRS scrutiny of both and is avoided in practice.

Equipment is the battleground. The right answer is fair market value of the equipment, which is what the IRS requires and what an appraisal or a reasonable estimate supports. A buyer proposing to allocate $400,000 to equipment that would sell for $150,000 at auction is asking the seller to pay ordinary income tax on $250,000 to fund the buyer's deductions. The seller's response is an appraisal or a documented estimate and a counter at that number.

Non-compete allocations should be small, since the buyer gains nothing from a large one relative to goodwill and the seller loses. A nominal amount, enough to make the covenant enforceable, is common.

Consulting agreements should reflect the time the seller will spend at a reasonable rate.

Some sellers trade allocation for price. If the buyer insists on a high equipment allocation, the seller can ask for a price increase that covers the additional tax. The buyer's tax benefit from the faster deduction often exceeds the seller's cost, so there is room to make both sides better off.

Entity type changes the math

For an S corporation or LLC seller, the allocation flows through to the owner's personal return and the analysis above applies directly.

For a C corporation, an asset sale is taxed at the corporate level first, then again when proceeds are distributed to shareholders. The allocation still matters, but the bigger issue is the double tax, which is why C corporation sellers push for stock sales or price the difference.

A worked example

A $2 million asset sale of an S corporation. The buyer's first draft allocates $600,000 to equipment, $100,000 to a non-compete, $50,000 to inventory, and $1,250,000 to goodwill.

The seller's equipment was purchased for $450,000 over the years and is fully depreciated. An equipment appraisal comes back at $280,000. The seller counters at $280,000 equipment, $10,000 non-compete, $50,000 inventory, and $1,660,000 goodwill.

Under the buyer's draft the seller has $450,000 in recapture at ordinary rates, $150,000 in capital gain on the equipment above its original cost, $100,000 in ordinary income from the non-compete, and $1,250,000 in capital gain on goodwill. Under the seller's counter the seller has $280,000 in recapture, $10,000 in ordinary income, and $1,660,000 in capital gain. The difference in ordinary income is $260,000, which at combined federal and California rates is roughly $80,000 to $100,000 in tax.

The buyer's benefit from the higher equipment allocation is faster depreciation, worth perhaps $60,000 to $80,000 in present value. The parties settle at the appraised value, and the buyer asks for a $25,000 price reduction for the lost deductions, which the seller accepts because it is less than the tax saved.

That negotiation took one exchange of emails. Left to the closing week, it would have been a fight, or the seller would have signed the buyer's draft without reading it.

Installment sales and allocation

When part of the price is paid over time through a seller note, the installment method lets the seller recognize gain as payments are received, spreading the tax. Recapture is the exception. Depreciation recapture is recognized in the year of sale regardless of when the cash arrives, which can leave a seller with a tax bill on money they have not received. A seller carrying a large note on a business with a large equipment allocation needs to plan for that, and it is another reason to keep the equipment allocation at fair value.

When to do it

Before the letter of intent is signed, the seller's CPA should model the after-tax proceeds under a reasonable allocation so the seller knows what the price is worth to them. The LOI can state the allocation principle, fair market value for tangible assets with the residual to goodwill, and a nominal non-compete, so that the purchase agreement drafting does not reopen it.

We include the allocation in the net sheet we prepare for every seller, so the seller sees what they keep after tax.

This article shares our opinion and general information. It is not legal or tax advice. Always speak with a licensed attorney for legal advice, and a qualified tax professional for tax questions, before you act.