What is purchase price allocation? Definition, formula and example

This is for buyers and owners who have agreed on a price and now have to say what that price paid for. By the end you will know what purchase price allocation means, the order the IRS uses, what a split looks like on paper, and where it can go wrong. This post explains the rules. It is not tax advice.

The definition in plain words

When you buy a business through an asset sale, you do not buy one thing. You buy a pile of things: trucks, stock on the shelves, money owed by customers, a phone number, a brand and the reputation that brings people back. Purchase price allocation is the list that says how much of the price went to each of them.

The split matters because the IRS treats the sale of a business as the sale of each asset on its own. The IRS says so on its sale of a business page. Each asset can be taxed in its own way, for the seller and for the buyer.

The law behind it is Section 1060 of the tax code. The text of Section 1060 says that when the buyer and seller agree the split in writing, the agreement binds both of them, unless the IRS finds it is not appropriate.

The formula and the seven classes

The IRS instructions for Form 8594 set out seven asset classes. The price is filled into them in order, like water poured into a row of glasses. Each glass holds no more than the asset's fair market value. What is left over at the end is goodwill.

Goodwill (Class VII) = purchase price − fair market value of Classes I to VI

The IRS calls this the residual method. If an asset could fit two classes, it goes in the lower-numbered one.

Illustrative example

Here is an illustrative home-services business sold for $2,000,000 in an asset sale. The seller keeps the cash, so Class I is zero. The figures are made up but add up.

Goodwill = $2,000,000 − ($150,000 + $100,000 + $450,000 + $300,000) = $1,000,000.

Now move $100,000 from trucks to goodwill. The price is the same. But the tax result for each side can change, because trucks and goodwill are treated differently. For example, Section 197 has a buyer write off goodwill, customer lists and non-competes over 15 years. Equipment follows other rules. That is why buyers and sellers often want different splits.

Where it shows up in a deal

The split is often first sketched in the letter of intent, then written into the purchase agreement as a schedule. Leaving it to the last week is how deals stall.

At closing, the buyer and the seller each file Form 8594, the Asset Acquisition Statement, with their tax return for the year of the sale. The IRS instructions say a filer who misses a correct form by the due date may face penalties. If the price changes later, for example through an earn-out, the instructions ask for an updated filing for the year of the change.

Lenders look at the split too. An SBA lender will often check the equipment value against an appraisal. Talk to a CPA and a lawyer before you agree any numbers.

In a stock sale the buyer buys shares, not assets, so Form 8594 does not apply in the same way. Some deals are taxed as asset sales even though shares change hands. That is a question for a tax adviser.

Common mistakes

Two different forms. The buyer's and the seller's Form 8594 should match. When each side fills in its own numbers after closing, the IRS can see the gap. Agree one schedule and both use it.

Values that cannot be backed up. Each class is capped at fair market value. Putting $600,000 on trucks worth $300,000 does not hold up. Use an appraisal for big equipment and real estate.

Forgetting the non-compete. A non-compete is its own line in Class VI. Money for it can be taxed differently for the seller than money for goodwill. Price it on purpose, not by accident.

Leaving it to the accountants after closing. The split changes what each side keeps. It is a deal term, so negotiate it with the price. Our guide to enterprise value covers how that headline price is built.