IRS Purchase Price Allocation: Reporting on Form 8594

When a business is bought or sold through an asset sale, the Internal Revenue Service (IRS) requires a detailed breakdown of how the total purchase price is assigned to the various assets acquired. This purchase price allocation establishes the buyer’s cost basis in each asset, which dictates future tax deductions. For the seller, the allocation determines the amount and type of taxable gain or loss from the sale.

The allocation must follow specific federal tax regulations, and the process ensures both parties report the sale to the IRS consistently. Discrepancies between the buyer’s and seller’s reported allocations can lead to scrutiny and potential tax adjustments.

The Seven Asset Classes in Allocation

The IRS mandates that the purchase price in an asset acquisition be allocated across seven distinct categories in a sequential order. This classification system ensures that different types of assets are treated consistently for tax purposes.

• Class I: Cash and general deposit accounts, such as checking and savings accounts.
• Class II: Assets that are readily convertible to cash, including certificates of deposit and actively traded personal property like public securities.
• Class III: Debt instruments like accounts receivable and other assets regularly valued at fair market value for tax purposes.
• Class IV: The business’s inventory and stock in trade held for sale to customers.
• Class V: All assets not included in other classes, such as machinery, equipment, buildings, land, and furniture.
• Class VI: Intangible assets defined under Section 197 of the Internal Revenue Code, such as covenants not to compete and customer lists, but excluding goodwill.
• Class VII: Goodwill and going concern value, which represents the value of a business’s reputation and customer base.

Applying the Residual Method

The IRS requires both the buyer and seller to use the “residual method” to allocate the purchase price. This method functions like a waterfall, where the total consideration is allocated to each asset class in sequential order, starting with Class I.

The allocation begins by assigning the purchase price to Class I assets up to the amount of cash transferred. The remaining price is then allocated sequentially to Classes II through VI. The amount allocated to the assets within each of these classes cannot exceed their total fair market value (FMV) on the purchase date.

For example, if a business is purchased for $500,000 and has $20,000 in cash (Class I) and equipment with an FMV of $150,000 (Class V), the allocation starts by assigning $20,000 to Class I. Assuming no assets in Classes II, III, IV, or VI, the buyer would allocate $150,000 to the equipment. This leaves a remaining purchase price of $330,000.

Any purchase price that remains after allocating to Classes I through VI is assigned to Class VII as goodwill. In the example, the remaining $330,000 would be allocated to goodwill. This residual amount is payment for the business’s intangible value, such as its brand and customer relationships.

Information and Form 8594 Preparation

Both the buyer and seller must report the transaction to the IRS on Form 8594, Asset Acquisition Statement Under Section 1060. This form details the allocation of the purchase price across the seven asset classes.

To complete the form, both parties need their legal names, addresses, and taxpayer identification numbers (TINs), along with the sale date. The total consideration must also be established, which includes cash paid, the fair market value of any property transferred, liabilities the buyer assumes, and other relevant costs.

Part II of Form 8594 requires listing the aggregate fair market value and the final purchase price allocation for each asset class. These figures are determined using the residual method. The buyer and seller must agree on these allocation amounts, as the IRS compares the forms filed by both parties.

Discrepancies between the forms can trigger an IRS inquiry. To prevent this, the allocation is often negotiated and included as a schedule in the purchase agreement. This legally binds both parties to report the same figures, ensuring consistency.

Filing Form 8594 with the IRS

Form 8594 is not filed on its own but is attached to each party’s federal income tax return for the year the sale occurred. For example, an individual attaches it to Form 1040, and a corporation attaches it to Form 1120.

The filing deadline for Form 8594 is the same as the due date for the tax return it is attached to, including extensions. Failure to file a correct form by the due date without reasonable cause can result in penalties.

If the total consideration changes in a later tax year, such as from a contingent payment, a supplemental Form 8594 must be filed. The affected party attaches the new form to their tax return for the year the adjustment occurred, detailing the change in allocation.

Tax Implications for the Buyer and Seller

The purchase price allocation has tax consequences for both parties, often creating competing interests that must be negotiated.

For the Buyer

For the buyer, the allocated amounts establish the tax basis for purchased assets, which is used to calculate future deductions. Tangible assets like equipment and buildings (Class V) can be depreciated over a set recovery period, generating annual tax deductions. A higher allocation to these assets can accelerate tax benefits.

Intangible assets, including goodwill, are amortized over a 15-year period. While this recovery period is longer than for many tangible assets, it provides an annual deduction. Buyers prefer to allocate more to assets with shorter depreciation periods to maximize near-term tax savings.

For the Seller

For the seller, the allocation determines the character of the gain or loss on each asset, which dictates how it is taxed. Gain from the sale of inventory (Class IV) or from depreciation recapture on equipment is taxed as ordinary income, which is subject to higher tax rates.

In contrast, gain allocated to capital assets like goodwill (Class VII) is treated as a capital gain, which is taxed at lower rates. This creates a tension where sellers want to allocate more of the price to goodwill for favorable tax treatment, while buyers prefer allocating more to tangible assets for faster depreciation.