In a sale of the assets of a business (or a sale of stock that is treated as a sale of assets), the buyer and the seller must allocate the consideration paid among the business’s assets, including goodwill, and report it to the IRS on Form 8594. This allocation must be made using the residual method. Under the residual method, the business assets are allocated among seven classes in order of priority from Class I to Class VII.
Consideration is allocated to the value of the assets of a class. Any residual purchase price is allocated to the next class in order and so on, beginning with Class I -cash and cash equivalents, then Class II – actively traded personal property, Class III – mark to market assets, Class IV – inventory, Class V – all assets not in included in any other class, Class VI – all Code section 197 intangibles (other than goodwill or going concern value), and Class VII – goodwill and going concern value. In recent years, bonus depreciation has increased the stakes concerning the classification of assets since buyers have greater motivation to allocate to personal property, which is generally adverse to sellers’ interests. A seller prefers to allocate the purchase price to goodwill, which is taxable at a capital gains rate, but goodwill must be amortized over 15 years. By comparison, a buyer prefers to allocate to Class V assets, which may be 60% deductible in the sale year but taxable to the seller at ordinary income rates to the extent of depreciation recapture.
However, there is no requirement that a buyer and seller agree on the purchase price allocation. If the parties agree in writing on the allocation, their agreement will generally be binding on them but not on the IRS. Parties typically agree on an allocation of purchase price in the purchase agreement. This agreement is ideal given the concern that inconsistency in reporting may attract scrutiny in an IRS audit. However, that concern should be mitigated if you are confident in your numbers.
Bottom Line: In situations where the buyer and seller cannot agree on a purchase price allocation, each party has the option of allocating and reporting as they deem appropriate.
“Here is a test to find whether your mission on earth is finished— If you’re alive it isn’t.” — Richard Bach.