Purchase Price Allocation and IRS Form 8594 for Small Business Buyers

What is Form 8594 and who has to file it?

Form 8594, the Asset Acquisition Statement, implements section 1060 of the Internal Revenue Code. It applies when a group of assets that makes up a trade or business changes hands and the buyer's basis in those assets is determined by what it paid. That covers a typical small business asset purchase.

According to the IRS instructions, both the buyer and the seller generally attach Form 8594 to their income tax returns for the year in which the sale took place. Each side reports the total price, the allocation among the asset classes, and whether the parties agreed the allocation in writing, along with any related agreements such as a non-compete or consulting arrangement. The form is not required in a few situations, including a like-kind exchange under section 1031 to the extent section 1031 applies.

A stock purchase usually does not use Form 8594, because the buyer acquires shares rather than the assets themselves, unless an election treats the deal as an asset purchase for tax purposes.

What are the seven asset classes?

The price is allocated using the residual method. It is first reduced by Class I assets, then allocated to Classes II through VI in order, up to each asset's fair market value, and whatever is left goes to Class VII, goodwill and going concern value.

How does the asset purchase agreement tie to Form 8594?

The link is section 1060(a). If the buyer and seller agree in writing on the allocation of the price, or on the fair market value of any asset, that agreement is binding on both of them unless the IRS determines the allocation is not appropriate. In practice the asset purchase agreement contains an allocation schedule, or a clause saying how and by when the schedule will be agreed, and both sides promise to file Form 8594 and their returns consistently with it.

A well drafted clause does three things. It fixes the allocation, or a method such as an independent appraisal for equipment, before signing or by a short deadline. It names a tie-breaker, usually an independent accountant, if the parties cannot agree. And it says how later price adjustments will be allocated, so the supplemental filings match too.

This is why the allocation clause deserves attention before signing. Once you agree it in writing, you generally cannot take a different position on your own return because your accountant later prefers a different split. If the agreement says nothing, each side may file its own allocation, which can lead to inconsistent returns and questions from the IRS.

Why do buyers and sellers want different allocations?

The buyer wants to recover its cost through tax deductions as fast as possible. Inventory is recovered as it is sold. Equipment can often be depreciated quickly, sometimes in the first year. Class VI intangibles and goodwill are amortized evenly over 15 years under section 197. So the buyer prefers more of the price on inventory and equipment and less on goodwill.

The seller wants to pay the lowest rate. Gain on goodwill held for more than a year is generally long-term capital gain for an individual seller of a pass-through business. Gain on equipment up to prior depreciation is usually recaptured as ordinary income. Payments for a non-compete or a consulting agreement are ordinary income to the seller. So the seller prefers more on goodwill and less on equipment, non-compete and consulting.

The tension is real but bounded. Allocations must be reasonable and generally cannot put more than fair market value on an asset in Classes II through VI. An inflated equipment value or a token amount for a valuable non-compete can be challenged.

A worked example: one price, two allocations

Take a $600,000 purchase of a service business where the seller keeps the cash and receivables. In the buyer's preferred allocation, $60,000 goes to inventory, $180,000 to equipment and vehicles, $40,000 to a seller non-compete and the remaining $320,000 to goodwill. In the seller's preferred allocation, inventory stays at $60,000, equipment drops to $100,000, the non-compete falls to $10,000 and goodwill rises to $430,000.

Under the buyer's version, an extra $80,000 sits in equipment the buyer may be able to depreciate within a few years instead of amortizing it over 15. Under the seller's version, more of the gain is treated as goodwill, which is usually taxed at long-term capital gain rates, and less as ordinary income from depreciation recapture and the non-compete. The total price is identical; only the tax result changes.

Neither version is automatically correct. The equipment figure should be supportable, for example by an appraisal or used equipment prices, and the non-compete figure should reflect what the covenant is worth. A compromise near the supportable values, written into the agreement, is usually better for both sides than leaving the question open.

How much should be allocated to the non-compete?

A seller non-compete signed as part of a business purchase is a section 197 intangible, so the buyer amortizes the amount allocated to it over 15 years, even if the covenant lasts only three. For the seller, that amount is ordinary income rather than capital gain. As a result, buyers have little tax reason to push for a large non-compete allocation, and sellers want it small.

The allocation should still reflect reality. Some sellers ask for a nominal figure, but if the non-compete is valuable and the seller later breaches it, a tiny allocated value can weaken the buyer's damages argument. Agree a reasonable figure with your accountant, and make sure the non-compete itself is stated in the agreement and Form 8594 lists it as a related agreement where required.

What happens if the price changes after closing?

Many small business deals have a price that moves after closing: an inventory true-up, a working capital adjustment, an earnout, setoff against a seller note or an indemnity payment. When the consideration increases or decreases in a later year, the IRS instructions require each party to file a supplemental Form 8594, completing Part III, for the year the change is taken into account, explaining the reason and reallocating the change among the classes under the same residual method.

The purchase agreement should say how adjustments will be allocated, usually to goodwill unless they relate to a specific asset, so both sides file supplements consistently. Earnout payments in particular are often treated as additional price allocated to goodwill when paid, with a portion treated as interest under the tax rules for deferred payments.

What are the consequences of getting it wrong?

The IRS instructions say a party that fails to file a correct Form 8594 by the due date of its return, without reasonable cause, may be subject to penalties under sections 6721 through 6724. The bigger risk is usually not the form penalty but an inconsistent or unsupported allocation: an audit can move value between classes, reducing the buyer's deductions or turning the seller's capital gain into ordinary income, with interest.

Buyers also sometimes forget that the allocation feeds state taxes. Some states charge sales or use tax on the portion of the price allocated to tangible personal property such as equipment and furniture, and transfer taxes can apply to real estate and vehicles. The allocation schedule should be reviewed with that in mind.

Finally, keep the support. An equipment appraisal, inventory count sheets and the reasoning for the non-compete figure cost little to file away at closing and are hard to rebuild years later if the IRS or a state auditor asks how the numbers were reached.

Checklist for the allocation clause

Use this list on the allocation section of your purchase agreement. The Business Purchase analyzer flags whether the draft contains an agreed allocation and which liabilities and price adjustments could affect it; your accountant should confirm the figures.

• Is the allocation attached as a schedule, or is there a binding method and deadline for agreeing it?
• Does each class reflect a defensible fair market value, especially equipment and inventory?
• Is a reasonable amount allocated to the seller's non-compete and any consulting agreement?
• Do both parties agree to file Form 8594 and their returns consistently with the schedule?
• Does the agreement explain how post-closing adjustments, earnouts and indemnity payments will be allocated?
• Is there a process, such as an independent accountant, if the parties cannot agree the allocation?
• Have you checked sales, use and transfer taxes that depend on the allocation in your state?