Purchase Price Allocation:
The Tax Clause That Costs Owners Millions

Purchase price allocation is the process of dividing a business sale's total price across IRS-defined asset categories, and it sets the tax treatment for both sides of the deal for years after closing. Your accountant cares about this clause more than almost anything else in the transaction: more than the purchase price itself, more than the indemnification caps, more than the earnout.

The reason: allocation determines the tax treatment of every dollar in the transaction, for both buyer and seller, for years after closing. A $5 million deal with $2 million allocated to goodwill instead of equipment produces dramatically different tax outcomes. Over 15 years, the difference can exceed $400,000.

Most business owners skip this clause. They negotiate hard on price, fight over indemnification, and scrutinize the non-compete, then leave allocation to "mutual agreement after closing." That's like negotiating your salary and letting someone else set your tax bracket.

Section 1060 requires the buyer and seller to allocate the purchase price among seven asset classes using the residual method: value is assigned to Classes I through VI in order, and the remainder falls into Class VII, goodwill and going-concern value (26 U.S.C. 1060(a); Treas. Reg. 1.1060-1(c)(2)). The buyer amortizes goodwill and other Section 197 intangibles over 15 years (26 U.S.C. 197(a)). Purchase price allocation is the process of distributing the total price across those categories for tax purposes.

In every asset purchase (and many stock purchases treated as asset purchases under a Section 338(h)(10) election), IRS Section 1060 requires the total purchase price to be allocated across seven categories of assets using the "residual method." This means you assign value to each asset class in order, with whatever is left over falling into Class VII - goodwill.

Both buyer and seller report the allocation on IRS Form 8594. The two forms should match, because the IRS can compare the two filings.

Here's where it gets adversarial: buyer and seller have directly opposite incentives on how to allocate the price.

Only when a Section 338(h)(10) or Section 336(e) election treats the stock sale as an asset sale for tax purposes. Without an election, a stock sale is not an "applicable asset acquisition," which Section 1060(c) defines as a transfer of assets that constitute a trade or business, so there is no Section 1060 allocation. With a Section 338(h)(10) election, the target is treated as selling all of its assets in a single transaction (Treas. Reg. 1.338(h)(10)-1(d)(3)(i)); Section 336(e) regulations likewise allow a qualifying stock sale to be treated as an asset sale (Treas. Reg. 1.336-1(a)(1)).

This creates a direct negotiation tension that most parties don't even realize exists until their CPAs review the allocation post-closing. By then, one side has already conceded value they didn't know was on the table.

Both the buyer and the seller must file Form 8594 with their own tax returns for the year of the sale, and a written allocation agreed by both binds both of them unless the IRS determines it is not appropriate (Treas. Reg. 1.1060-1(e); 26 U.S.C. 1060(a)). The IRS can compare the two filings, so the buyer and seller should agree on one allocation and file consistent forms.

A filer who does not file a correct Form 8594 by the return due date, and cannot show reasonable cause, may be subject to penalties under Sections 6721 through 6724 (Form 8594 instructions). Put the allocation in the purchase agreement so both sides report the same numbers.