Purchase price allocation is a key process in a sale, and it involves assigning the total purchase price to the individual assets being sold. This affects your tax liability as the seller and the buyer's tax basis in the acquired assets. Generally, sellers prefer to allocate as much as possible to capital gain assets and intangibles, while buyers often want to allocate to depreciable assets. Therefore, the allocation is often a negotiated part of the sales agreement. Both parties should submit a purchase price allocation, and it's best to agree on it before closing to avoid potential issues with the IRS. In an asset sale, the purchase price is first allocated to tangible assets, with the remainder allocated to intangible assets such as goodwill.
Purchase price allocation assigns the total consideration in an applicable asset acquisition to the assets that changed hands. Section 1060 requires both buyer and seller to use the residual method. Each party files Form 8594 with the tax return for the year of the sale.
The residual method fills seven IRS classes in order. You cannot allocate more than fair market value to any class except Class VII. Class I is cash and general deposit accounts. Class II is actively traded personal property, certificates of deposit, and foreign currency. Class III is accounts receivable and similar debt instruments. Class IV is inventory. Class V is other tangible assets, including furniture, equipment, vehicles, buildings, and land. Class VI is section 197 intangibles other than goodwill and going-concern value, such as a covenant not to compete, customer lists, and workforce in place. Class VII is goodwill and going-concern value. If an asset could sit in two classes, use the lower-numbered class.
The allocation sets your gain or loss on each asset. It also sets the buyer's tax basis. Inventory and receivables produce ordinary income for you. Depreciated equipment can produce section 1245 recapture, which is also ordinary income. Goodwill and going-concern value are generally capital gain for the seller. The buyer amortizes most section 197 intangibles, including goodwill, over 15 years.
That is why the parties negotiate the schedule. You want more of the price in capital-gain classes. The buyer wants more in assets it can deduct sooner. Write the agreed allocation into the purchase agreement and match it on both Form 8594 filings. If the numbers diverge, the IRS can challenge both returns.
A later price change, such as an earnout, requires a supplemental Form 8594. Allocate an increase starting at the lowest classes. Allocate a decrease starting at goodwill.