When a buyer and seller complete an asset acquisition — or a transaction that is treated as an asset acquisition for tax purposes, such as one in which a Section 338(h)(10) or Section 336(e) election has been made — the purchase price must be allocated among the acquired assets under the rules of Section 1060 of the Internal Revenue Code. This allocation has significant tax consequences for both the buyer and the seller, and the interests of the two parties in this allocation are often directly opposed. Understanding how allocation works, what the rules require, and what the negotiating dynamics look like is important for any business owner involved in an asset deal.
The Seven Asset Classes
Section 1060, together with the regulations promulgated under it, requires that the purchase price be allocated among the acquired assets using the residual method, in a prescribed order of priority. The assets are grouped into seven classes, and the allocation proceeds from Class I through Class VII, with each class receiving its fair market value before any remaining purchase price is allocated to the next class.
Class I assets are cash and cash equivalents. Class II assets are actively traded personal property (for example, publicly traded securities, certificates of deposit, and U.S. government securities). Class III assets are assets that the seller marks to market for tax purposes, including accounts receivable. Class IV assets are inventory and dealer property. Class V assets are all assets other than those in Classes I through IV, VI, and VII — this is the catch-all category that captures tangible assets such as equipment, furniture, and machinery, as well as certain intangible assets not specifically identified in a higher class. Class VI assets are Section 197 intangibles other than goodwill and going concern value — this is the category that captures customer lists, covenants not to compete, patents, trademarks, trade names, franchises, and workforce in place. Class VII assets are goodwill and going concern value.
The residual method works as follows: the purchase price is first allocated to Class I assets (cash) at face value, then to Class II assets at fair market value, and so on through each class in order, until the entire purchase price has been allocated. Any purchase price in excess of the fair market value of all the identified assets flows to Class VII goodwill. Since goodwill is by definition the residual value of the acquisition that cannot be attributed to specific identifiable assets, it is often the largest single component of the allocation in a transaction involving a successful, established business.
Tax Consequences for Buyers
From the buyer’s perspective, the allocation among asset classes determines the tax basis in each acquired asset and therefore the rate and period over which the buyer can depreciate or amortize those assets. Assets in Classes I and II are cash-equivalent and generate no future depreciation. Class III assets (receivables) are collected and not depreciated. Class IV assets (inventory) flow through cost of goods sold as the inventory is sold. Class V assets (equipment and machinery) are depreciable under the applicable MACRS life, which ranges from 3 to 39 years depending on the asset type.
The most valuable depreciation and amortization — from the buyer’s perspective — comes from Classes VI and VII. Section 197 of the Code allows buyers to amortize intangible assets in Classes VI and VII over a 15-year period on a straight-line basis, regardless of the intangible asset’s actual economic useful life. This means that even if a customer list or covenant not to compete has an economic life of only 3 years, the buyer amortizes it over 15 years. More importantly, goodwill — which can be a very large component of the purchase price — is also amortizable over 15 years under Section 197. The buyer therefore has a strong preference for allocating as much of the purchase price as possible to Classes VI and VII, because the resulting amortization deductions shelter future income.
Tax Consequences for Sellers
For sellers, the allocation affects the character of the gain recognized on the sale. Gain attributable to different asset classes may be taxed at different rates. Tangible assets that have been depreciated below their tax basis (for example, equipment that has been fully depreciated) will generate ordinary income to the extent of prior depreciation deductions (this is referred to as depreciation recapture, governed by Sections 1245 and 1250). Inventory gains are treated as ordinary income. Gains on Class VI intangible assets (such as customer lists and covenants not to compete) and Class VII goodwill are typically taxed at long-term capital gains rates if the assets have been held for the required holding period.
The seller therefore generally prefers allocations that maximize goodwill and long-term capital gain assets (Classes VI and VII) and minimize ordinary income assets (Class IV inventory and depreciation recapture on equipment). The buyer, as described above, also wants Class VI and VII allocations for amortization purposes. On the surface, this might suggest that the parties have aligned interests in allocating to goodwill and Section 197 intangibles, but the alignment breaks down on the specific identification of individual intangible assets within Class VI.
The Buyer-Seller Conflict in Allocation
The most significant conflict between buyers and sellers in the allocation negotiation arises within Class VI. The buyer wants to allocate as much value as possible to intangibles that have a shorter economic life than goodwill, because the IRS or a tax court might conclude — if the buyer amortizes customer lists over 15 years while they are economically only useful for 3 years — that the buyer is generating artificial amortization deductions. In practice, however, Section 197 guarantees a 15-year amortization period for all qualifying intangibles including short-lived ones, so the buyer can benefit from this regardless.
The seller’s perspective on Class VI allocations is more complex. Covenants not to compete, for example, are included in Class VI and generate ordinary income to the seller (because they are treated as compensation for agreeing not to compete rather than as a capital asset). A buyer who wants to allocate $3 million of the purchase price to a covenant not to compete is effectively arguing that $3 million of the purchase price is really compensation income to the seller, taxable at ordinary income rates rather than capital gains rates. Sellers resist high allocations to covenants not to compete for exactly this reason.
Form 8594 and the Obligation to File Consistently
Both the buyer and the seller are required to file IRS Form 8594 (Asset Acquisition Statement) with their respective tax returns for the year of the acquisition, reporting the agreed allocation. The IRS requires the buyer and seller to report the same allocation, and if there is a disagreement between the parties about the allocation, both parties are required to disclose the disagreement on their respective returns. Filing inconsistently without disclosure can expose a party to tax penalties.
The purchase agreement should include a provision requiring the parties to use reasonable efforts to agree on a final allocation prior to the filing of their respective tax returns, along with a dispute resolution mechanism (often an accounting expert) to resolve disagreements if negotiation fails. The allocation provision should also specify that neither party will take a tax position inconsistent with the agreed allocation without the other party’s consent.
Post-Closing Depreciation and Amortization
The allocation of purchase price is not merely a tax filing exercise; it has real economic consequences for the buyer for the next 15 years. A buyer who allocates $30 million to Class VI and VII intangibles will generate $2 million per year in amortization deductions against taxable income, representing significant tax savings at applicable corporate rates. These deductions are one of the most tangible economic benefits of the stepped-up tax basis that buyers receive in asset deals, and they play a role in the overall economics of the transaction.
For sellers, the allocation affects the federal income tax return for the year of the sale, when the gains are recognized. Working with qualified tax advisors to model the after-tax consequences of different allocations before agreeing to the purchase price allocation schedule in the definitive agreement is essential. The tax consequences can differ significantly depending on the seller’s specific tax situation — including the availability of net operating losses, the character and amount of depreciation recapture, and applicable state and local tax rules — and those consequences should be understood and factored into the negotiation.