Purchase Price Allocation: The Tax Bill Nobody Warns Sellers About
The purchase price your buyer agreed to and the amount you actually keep after taxes are two very different numbers — and the gap between them is determined almost entirely by a negotiation most sellers do not realize is happening: the allocation of that purchase price across different asset classes. Get this wrong, and the IRS takes a larger share of your exit than your buyer did.
Purchase price allocation is the process of assigning the total consideration paid in a business sale across the individual assets — or deemed assets — being transferred. It is required by IRC Section 1060 for any asset sale. It is also the source of one of the most significant and least-discussed tax conflicts in M&A: buyers and sellers have directly opposing interests in how the price gets allocated, because different asset classes are taxed at different rates and generate different tax benefits on each side of the transaction. Understanding this conflict — and knowing how to negotiate it in your favor — can be worth more than moving the headline price by half a turn of EBITDA.
How purchase price allocation works and where the tax money lives:
- Asset sales and stock sales create fundamentally different tax outcomes. In an asset sale, the seller is deemed to sell each individual asset — inventory, equipment, customer lists, goodwill, non-compete agreements — and each is taxed according to its class. In a stock sale, the seller sells stock, and the entire gain is typically a capital gain. Buyers almost always prefer asset sales because they get a step-up in basis on all acquired assets, allowing them to depreciate or amortize those assets going forward. Sellers almost always prefer stock sales because the capital gains rate is lower than ordinary income rates. Most small business deals are structured as asset sales because buyers insist — but the tax cost of that structure is borne largely by the seller.
- IRC Section 1060 imposes a mandatory allocation cascade. The IRS requires that consideration in an asset sale be allocated through seven classes in a specific order: Class I (cash), Class II (marketable securities), Class III (AR and marked-to-market assets), Class IV (inventory), Class V (depreciable operating assets), Class VI (intangibles subject to amortization under Section 197 — customer lists, non-competes, assembled workforce), and Class VII (goodwill and going-concern value). The seller and buyer must file consistent allocation on their respective tax returns using Form 8594. Inconsistency triggers IRS scrutiny of both parties.
- Goodwill is capital gains for sellers but amortized over 15 years for buyers. For the seller, gain allocated to goodwill is typically long-term capital gain — taxed at 15% to 20% plus net investment income tax (3.8%), for a combined rate around 23.8% for most taxpayers. For the buyer, goodwill is amortized over 180 months (15 years) — a slow write-off that reduces the tax value of the allocation. Buyers therefore prefer to allocate as little as possible to goodwill and as much as possible to depreciable assets like equipment (which they can depreciate under bonus depreciation rules in the first year) and amortizable intangibles with shorter useful lives.
- Covenants not to compete are ordinary income for sellers but amortizable over 15 years for buyers. This is the most dangerous allocation category for sellers. A covenant not to compete paid as part of the purchase price is ordinary income — taxed at rates up to 37% federally, plus state income tax. The tax cost is dramatically higher than goodwill. Buyers are largely indifferent between goodwill and non-competes (both amortize over 15 years) but sellers absolutely should be. Allocation to a non-compete agreement over goodwill can cost the seller 15 to 20 percentage points of effective tax rate on those dollars.
- Section 338(h)(10) elections let an S-corp stock sale be treated as an asset sale for tax purposes. When a buyer acquires an S-corporation and both parties agree, they can elect under Section 338(h)(10) to treat the deal as an asset purchase for tax purposes while maintaining the legal form of a stock transfer. The buyer gets the asset step-up they want. The seller typically pays more tax than in a pure stock sale but can sometimes negotiate a price premium from the buyer to compensate. 338(h)(10) elections require both parties to consent and file Form 8023 — they cannot be done unilaterally.
- How allocation is negotiated in the purchase agreement. The purchase agreement should contain a specific exhibit setting out the agreed allocation across each Class I through Class VII category, along with covenants requiring both parties to file consistent returns. Buyers will push hard to maximize allocation to equipment (Section 179 or bonus depreciation) and away from goodwill. Sellers should push in the opposite direction — more to goodwill and less to non-competes and equipment recapture. Depreciation recapture on equipment (taxed as ordinary income, not capital gain) is a frequently overlooked seller tax cost that follows the same logic.
- A CPA can legitimately shift allocation to the seller's advantage. There is real flexibility within the Class structure. The same deal can be allocated in ways that are more or less favorable to the seller while still being consistent with the actual assets in the business. A CPA who understands M&A allocation can identify which Class V assets are eligible for favorable treatment, which intangibles genuinely qualify as goodwill rather than separately amortizable Section 197 intangibles, and how to structure the non-compete agreement to minimize its allocation — potentially shifting the seller's effective tax rate on the deal by 5 to 10 percentage points.
- The gap between gross proceeds and net proceeds after tax is almost always larger than sellers expect. A seller who closes a deal at $5M and expects to net $4M after a rough 20% capital gains estimate is often surprised to find that the actual after-tax proceeds are closer to $3.2M to $3.5M once depreciation recapture, non-compete ordinary income, state taxes, and net investment income tax are all applied to the correct allocation. Running the allocation waterfall with a CPA before signing the purchase agreement — when the allocation is still negotiable — is worth real dollars.
What it costs to ignore purchase price allocation until after signing: an allocation set by the buyer's lawyers, ordinary income rates on dollars that could have been capital gains, and a net proceeds number that is materially lower than the one you planned your post-sale life around.
What it earns you to engage with allocation before the deal is papered: negotiated allocation that minimizes ordinary income exposure, a realistic after-tax proceeds model that drives your pricing strategy, and a closing statement that does not contain surprises.
We help business owners model the after-tax economics of their deal before they sign, identify favorable allocation positions, and negotiate purchase agreement language that protects their net proceeds.