Asset sales typically dominate the small business acquisition space due to the key benefits they provide to buyers. First, buyers take a higher basis in the assets purchased, which is beneficial to the buyer due to their ability to depreciate certain assets and lower taxable income. Additionally, in asset sales, buyers can pick and choose what assets to purchase. This provides a liability shield for the buyer as the buyer only takes on the identified assets and does not assume the liabilities of the seller, unless it chooses to. One often overlooked process in an asset acquisition is the purchase price allocation.

Purchase price allocation is the process of assigning the consideration paid by the buyer of a business to the assets sold in the transaction. In certain business acquisitions, Section 1060 of the Internal Revenue Code requires both buyers and sellers to report a purchase price allocation on Form 8594 and attach it to their income tax returns for the year in which the acquisition occurred. Most tax advisors agree that the allocations submitted by the buyer and seller should match, as inconsistent allocations can increase the risk of an IRS challenge or audit and impose its own allocation. To ensure the buyer and seller submit matching purchase price allocations, many purchase agreements contain language requiring agreement on the purchase price allocation.

The Internal Revenue Code and associated regulations outline the rules for making a purchase price allocation, known as the residual method. Under the residual method, the purchase price is allocated among seven classes of assets in a specific sequence, starting with Class I assets and ending with Class VII assets:

• Class I includes cash and general deposit accounts.
• Class II includes actively traded personal property, CDs, and foreign currency.
• Class III includes accounts receivables.
• Class IV includes inventory.
• Class V includes real estate and other fixed assets.
• Class VI includes all IRC Section 197 intangibles, such as non-compete covenants, except goodwill and going concern value.
• Class VII includes goodwill and going concern value.

Under the residual method, the purchase price is first allocated to Class I assets, then if any purchase price is remaining, to Class II assets and so on, with any residual amount allocated to Class VII assets. If an asset could qualify for multiple asset classes, it should be allocated to the lower numbered class. To be compliant with these allocation rules, buyers and sellers must allocate the purchase price to assets based on the “fair value” of the assets.

Purchase price allocations to Classes V, VI and VII are usually the most contested and negotiated. Purchase price allocation negotiations are often a zero-sum game in that allocations that benefit the buyer are typically detrimental to the seller and vice versa. The following sections discuss buyer and seller considerations regarding purchase price allocation negotiations. 

Buyer Considerations

The primary objective for buyers is to allocate as much of the purchase price as possible to assets that can be deducted quickly against future income by allocating to assets that are depreciable or amortizable over short periods, leading to accelerated tax deductions that improve cash flow in the near term. Depending on the specific asset, buyers may be able to depreciate the purchase price allocated to fixed assets over five- or seven-year periods. Goodwill and other Section 197 intangibles, on the other hand, are amortizable over a longer period of 15 years. Thus, one of the main goals of a buy side negotiation is to reduce the amount of the purchase price allocated to Section 197 intangibles in asset Class VI and the Class VII assets of goodwill and going concern value. 

Buyers should also ensure that allocations to goodwill are reasonable and defendable to reduce the risk of future goodwill impairment. Additionally, buyers typically want inventory to be allocated its full fair value because purchased inventory can quickly be converted into cost of goods sold when sold, which reduces taxable income. 

Seller Considerations

The primary concern for sellers is how the allocation impacts their immediate tax liability arising from the sale of assets. Because certain assets receive tax treatment as ordinary income and other assets receive tax treatment as capital gains, the purchase price allocation directly impacts the effective tax rate of the seller for the transaction. Greater seller tax liability reduces the value sellers receive for the sale of their business while reduced tax liability increases the value sellers receive for the sale of their business. Simply, a seller’s goal is to maximize allocations to asset classes taxed at capital gain rates and minimize allocations to asset classes taxed as ordinary income. 

In sell side negotiations, one of the main goals is to shift allocation away from depreciable assets and assets taxed at ordinary income rates upon a sale, and towards goodwill and going concern value, which is taxed at preferential capital gain rates. Sellers should also engage in purchase price allocation discussions early in the deal process. Some buyers may suggest addressing purchase price allocation post-closing, but this is not a beneficial approach for sellers because the sellers may have nearly no leverage by that point in the deal process. 

Conclusion

Whether on the buy side or sell side, effective handling of purchase price allocation can mitigate risks and optimize tax impacts for the parties. Because the allocation directly influences the tax basis of assets for buyers and determines the character of income for sellers, it can have a material impact on both immediate and long-term tax liabilities. For these reasons, parties should address purchase price allocation early in the deal process to prevent future disputes that could stunt the deal process. The purchase agreement should include language describing any agreed upon allocation methods and an agreement to submit consistent allocations on Form 8594. Inconsistent allocation filings can draw the attention of the IRS and lead to increased scrutiny and potential reallocation. 

To mitigate the risk of IRS challenges, both parties should maintain robust documentation, outlining any third-party assessments, and explanations for how allocations were determined. Finally, collaboration with qualified professionals, such as tax advisors, attorneys, appraisers, and other valuation experts, is essential to ensure compliance with the Internal Revenue Code and reduce the risks for both parties to the deal. An informed and well-executed purchase price allocation strategy is not just a compliance requirement but can be a key component of maximizing the economic value of the deal.