How do you allocate the purchase price when you buy a business?

Allocating the purchase price means splitting what you pay for a business across its assets in the seven classes the IRS names on Form 8594, starting with cash and ending with goodwill. Cash goes first, goodwill and going concern value take whatever is left, and each other asset is capped at its fair market value. Buyer and seller each file the form with the return for the year of sale.

The IRS instructions for Form 8594 were last revised in November 2021, and the form is still the current one. The statute behind it, 26 U.S.C. 1060, says the same split decides both your tax basis in what you bought and the seller's gain or loss. Below is the worksheet to copy, the opening IRS definition of each class quoted from the instructions, and two fictional examples that show how the split behaves.

What does allocating the purchase price mean?

Allocating the purchase price means assigning every dollar of consideration to a specific asset or class of assets you are buying, so that the total across the worksheet equals the total you pay. The IRS asks for the assignment because the split feeds the buyer's basis and the seller's gain or loss, and both sides report it.

Under 26 U.S.C. 1060(a), the consideration in an applicable asset acquisition is allocated among the assets acquired, and that allocation is used to determine both the buyer's basis in the assets and the seller's gain or loss. An applicable asset acquisition is a transfer of assets that make up a trade or business where the buyer's basis is set wholly by what the buyer paid. The Treasury regulation says what counts as a trade or business: under 26 CFR 1.1060-1(b)(2), a group of assets qualifies if goodwill or going concern value could under any circumstances attach to it, or if using the assets would be an active trade or business under section 355.

An operating small business usually has goodwill that could attach to its assets, so most purchases of one meet that test. The Form 8594 instructions say that generally both the purchaser and the seller must file the form and attach it to their income tax returns. Whether your own deal is an asset purchase at all depends on how it is structured, which is a question for your attorney and tax adviser before the letter of intent is signed. Our letter of intent walkthrough shows where the structure and the price get written down.

Which seven asset classes does the IRS use?

The IRS sorts the assets in a business purchase into Class I through Class VII, and each class has a fixed definition in the Form 8594 instructions. The middle column quotes the opening sentence of each definition exactly as the instructions print it. The instructions go on to list exclusions for Class II and Class III and examples for several classes, which the table leaves out, so read the full text with your accountant. The example in the last column is ours and not the IRS's.

If the seller's accounts receivable transfer with the business, the Class III definition puts them in Class III, not in Class V with the equipment.

The instructions list among section 197 intangibles "any covenant not to compete entered into in connection with the acquisition of an interest in a trade or a business". Class VI covers all section 197 intangibles except goodwill and going concern value, so a covenant of that kind is a Class VI asset. Section 197 of the Internal Revenue Code also names goodwill, going concern value and covenants restricting competition among the intangibles it covers, and 26 U.S.C. 197(a) allows the amortization of such an intangible over a 15-year period. What each line is worth to you in tax terms is a question for your accountant, and the worksheet below is built so they can answer it line by line.

How does the residual method fill the classes?

The residual method fills the classes in order, from Class I to Class VII, and puts into Class VII whatever consideration is left after the first six classes are full. The instructions for Form 8594 tell both parties to use the residual method under 26 CFR 1.338-6 and 1.338-7, with consideration standing in for the amounts those rules name.

Three mechanics matter when you fill in the sheet. They come from 26 CFR 1.338-6.

1. Class I comes off the top. The total is reduced by the amount of Class I assets first.
2. The remainder is allocated to Class II, then Class III, then Class IV, then Class V, then Class VI, and finally to Class VII, in that order. Within a class, the amount is divided in proportion to the fair market values of the assets in it.
3. The amount allocated to an asset other than a Class VII asset cannot exceed that asset's fair market value. Class VII is the only class with no ceiling.

The consequence is that goodwill is never a number you pick. It is the difference between the total price and what the other classes absorb at fair market value. A higher estimate for inventory or equipment lowers the goodwill line by the same amount, and the reverse is also true. That makes the fair market value evidence for Classes IV through VI the part of the sheet worth the effort.

The parties can also put the split in writing. Under 26 U.S.C. 1060(a), if the buyer and the seller agree in writing on the allocation of any consideration, or on the fair market value of any of the assets, the agreement is binding on both of them unless the Secretary of the Treasury determines the allocation or value is not appropriate. A signed schedule in the purchase agreement is therefore more than a formality, and so is the evidence behind each number on it.

What does a worked allocation look like?

A worked allocation takes the total price, subtracts each class at fair market value in order, and shows the rest as goodwill. The two examples below are fictional. They describe an invented buyer and an invented business, and none of the figures is a benchmark, a market price or a real deal.

Example A: the price is above the assets. An illustrative buyer agrees to pay $500,000 in total consideration for a business. The seller keeps the bank account, so Class I is $0. The buyer and seller support these fair market values: inventory $60,000, equipment and fixtures $90,000, and a covenant not to compete of $20,000.

The residual is $500,000 minus $170,000, or $330,000. Goodwill is 66 percent of the price in this invented case, which is not a typical figure for any industry.

Example B: the price is below the assets. The same illustrative buyer instead pays $120,000 for the same assets. The order still holds, and the ceiling still holds.

Example B shows why the check line exists. When the price is lower than the combined value of the assets, goodwill is zero and the later classes are filled short, so a schedule that lists goodwill anyway does not add up. That result is the regulation, not an assumption: 26 CFR 1.1060-1(c)(2) tells the buyer and the seller to use the residual method of 26 CFR 1.338-6, which fills the classes in order (paragraph (b)(2)(i)) and caps every class except Class VII at fair market value (paragraph (c)(1)), so nothing reaches Class VII until Classes I through VI are full. The covenant still counts as an asset of the deal, because 26 CFR 1.1060-1(b)(7) treats a covenant the seller enters into as an asset transferred as part of the trade or business. It is allocated $0 here only because the price runs out first. Check the total line against the purchase agreement every time.

How do you fill in the allocation worksheet before you sign?

Fill in the worksheet in the same order as the classes, with a source for every fair market value and a total that ties to the purchase agreement. Copy the table below into a spreadsheet and complete it with your accountant before the closing date, while the price is still being negotiated.

Three habits keep the sheet usable. Put the fair market value and the evidence for it beside every class, not only the allocated amount. Ask the seller to agree the same sheet in writing, since both sides file Form 8594. And date each version, because the schedule normally changes as the price and the asset list change.

If you ran the revenue reconciliation worksheet and the due diligence checklist, the inventory and equipment lists you need here are already in your file. The startup cost builder can total the other costs of the purchase that are not part of the price.

What happens if the price changes after closing?

If the consideration increases or decreases after the original filing, the instructions require a supplemental statement in Part III of Form 8594, filed for the year the increase or decrease occurs, that reallocates the change among the classes. The rule behind the reallocation is 26 CFR 1.338-7, the second regulation the instructions name: the redetermined amount is allocated again under the rules of 1.338-6, and the difference for each asset is added to or subtracted from its original allocation. Keep the schedule on file after closing, and ask your accountant whether a later change in the price, such as an adjustment in the purchase agreement, counts.

Filing matters for another reason. The instructions state that if you do not file a correct Form 8594 by the due date of your return and cannot show reasonable cause, you may be subject to penalties under sections 6721 through 6724. This worksheet is a working aid, not tax advice. It does not replace your accountant, your tax adviser or your attorney, who should see the numbers before anything is signed. For the seller's side of the same filing, read the seller due diligence checklist, and for how the price itself is set, the guide to valuing a small business.