Purchase price allocation in a business sale: what Form 8594 decides

Your closing checklist includes a purchase price allocation exhibit, and one side wants numbers the other side does not like. Before anyone treats that as a fight, it helps to see what the exhibit actually controls, why the two sides start from different numbers, and how many dollars separate the reasonable positions.

The short version: the allocation is a required tax filing, the categories are capped at fair market value, and in a typical small-business sale the defensible range moves a few thousand dollars of tax, not tens of thousands. It deserves a conversation with each party's CPA. It rarely deserves a stalled closing.

What the allocation is

Most small-business and franchise resales are asset sales. Federal tax law requires the buyer and seller in an asset sale of a going business to divide the total purchase price among seven classes of assets and to report that division to the IRS on Form 8594, filed with each party's return for the year of sale.126 U.S.C. §1060 requires the residual allocation method in an applicable asset acquisition and directs both parties to report the allocation as the IRS prescribes, which is Form 8594.

The allocation does not change the price the parties agreed to. It decides how that price is categorized, and each category carries different tax treatment for each side.

One caution for anyone researching the term: "PPA" in most online material means a post-closing purchase price adjustment in a large merger, which is a different concept entirely. This guide is about the purchase price allocation.

Why the closing file needs it before funds move

The buyer's Form 8594 and the seller's Form 8594 report the same transaction, and the IRS can compare them. Inconsistent filings invite examination of both parties. The form also asks whether the allocation was set in the sales contract or another written document signed by both parties. A signed allocation exhibit at closing lets both sides answer yes.2The IRS Instructions for Form 8594 describe the seven-class residual method, the written-agreement question, and the supplemental statement filed when consideration changes after the year of sale.

The alternative is worse than it sounds. If the deal closes without an agreed allocation, each side's tax preparer fills in numbers months later, without coordination, and the two forms rarely match. One signed page at closing prevents that.

How the seven classes fall in a typical store transfer

Most of the seven classes are zero in a typical small-business or franchise store sale. The dollars concentrate in four: inventory, furniture, fixtures, and equipment (often shortened to FF&E), the covenant not to compete, and goodwill.

Exhibit · Where the price lands in a typical store sale

The method is residual. Inventory, equipment, and the covenant are valued first, each at no more than fair market value, and goodwill absorbs the remainder. Because a going business usually sells for more than its hard assets are worth, goodwill is usually the largest number. The classes must total the purchase price, and the closing file should reconcile that before signing.

Why the two sides start from different numbers

The buyer and seller face mirror-image tax rules on the same figures, so their preferred allocations differ even when both are acting reasonably.

The buyer cares about how fast the price becomes a deduction. Inventory and equipment are recovered quickly, equipment often in the first year. Goodwill and the covenant not to compete are written off over 15 years. Buyers therefore prefer larger inventory and equipment numbers.

The seller cares about the character of the gain. Goodwill is generally long-term capital gain, the most favorable federal treatment. Equipment dollars mostly become depreciation recapture, taxed at ordinary rates. Sellers therefore prefer larger goodwill.

Opposite incentives on the same numbers make the allocation a negotiated term. It also means a neutral escrow holder cannot choose the figures for the parties. Each side should review the exhibit with its own CPA.

How many dollars are actually in play

Consider a $300,000 store sale where the used equipment could defensibly be valued anywhere from $40,000 to $80,000. Across that entire range, the difference between the most buyer-favorable and most seller-favorable allocations comes to roughly:

• For the seller: about $8,000 of permanent federal tax difference, from income shifting between ordinary and capital-gain rates.
• For the buyer: about $11,000 of deductions arriving sooner. The buyer eventually deducts the full $300,000 under either allocation, so the benefit is timing, worth a few thousand dollars in present value.

Those are real dollars and a legitimate item to settle alongside the other deal terms. They are not a reason to derail a $300,000 transaction, and they do not suggest the other side is extracting a hidden windfall. Once both parties see the actual figures, most allocations settle quickly, often in a single call between the two CPAs. The example is illustrative and rounded; your CPA should run your numbers.

What keeps the numbers within a range

The rules already limit how far either side can push. No class may be valued above fair market value: ten-year-old shelving is worth what used shelving sells for, not whatever produces the best tax answer. Values without support, such as equipment far above any appraisal or a zero-dollar covenant sitting next to a real non-compete clause, invite examination, and an adjustment on audit can land on both parties. Mismatched forms are the easiest flag of all to avoid, which is the point of signing one agreed exhibit.

In practice, the genuinely negotiable territory is the supportable value range for the equipment and the size of a modest covenant figure.

The covenant not to compete and franchise rights

The covenant not to compete is tax-unfavorable to both sides at once: ordinary income to the seller and a 15-year write-off for the buyer. It is customarily a small number, but it should rarely be zero when the agreement contains a real covenant, and Form 8594 requires a brief statement describing it.

Franchise rights usually sit outside the allocation entirely. In a typical resale, the seller does not sell the franchise agreement. The franchisor terminates the seller's agreement and issues the buyer a new one, and the buyer pays the transfer fee directly to the franchisor. Confirm how your deal is structured with your advisor, and see the franchise transfer escrow guide for how franchisor approval fits the closing.

California closings: the allocation also sets sales tax

In California, the sale of a business's fixtures and equipment is a taxable sale of tangible personal property. The tax is calculated on the amount allocated to fixtures and equipment, at the combined rate for the store's location, and handled at closing. Inventory transferred for resale is exempt when the buyer timely provides a valid resale certificate. Goodwill and other intangibles are not taxed.3CDTFA Publication 74, "Sales of Business Assets," addresses taxable fixtures and equipment, resale inventory, and valuation. Use CDTFA's address-based rate lookup for the current rate.

This creates a trade-off the buyer's CPA should price. A larger equipment number means faster depreciation and more sales tax at closing. In the example above, $80,000 of equipment at a 9 percent rate is $7,200 of tax; $40,000 is $3,600.

California escrows also commonly hold back part of the price until CDTFA issues a certificate of tax clearance, because state law can make the buyer liable for the seller's unpaid sales taxes. The holdback is security, not an extra charge, and it releases when the clearance issues. The CDTFA clearance guide covers that process in detail. California matters are handled via co-counsel.

What each party hands its CPA

Two documents answer most allocation questions: the seller's most recent depreciation schedule and the equipment list. Add the blank allocation exhibit and this guide, and the CPA conversation will be short and specific. The seller's CPA can quantify recapture across the range; the buyer's CPA can weigh depreciation timing against any sales tax at closing.

If the price changes after closing

Form 8594 is not always one filing and done. If the consideration changes after the year of sale, for example when a seller-carried note is compromised or additional amounts are paid, the form's supplemental statement reports the change and the redetermined allocation in the year it occurs. Sellers carrying a note should flag this for their tax preparer.

Allocation checklist before signing

1. Is the deal an asset sale of a going business, so that Form 8594 applies to both parties?
2. Do the seller's depreciation schedule and the equipment list support the proposed equipment value?
3. Is inventory supported by a count near closing?
4. Does the covenant not to compete carry a modest, non-zero value with the required description?
5. Do the classes total the purchase price exactly?
6. Has each party's own CPA reviewed the exhibit?
7. For California closings, has sales tax on fixtures and equipment been calculated at the current location rate, and is the resale certificate in the file?
8. Does the signed agreement or exhibit let both parties answer yes to the form's written-agreement question?

Where the escrow holder fits

The escrow holder confirms the exhibit is signed, reconciles it to the purchase price, and reflects any resulting sales tax or holdback on the closing statement. What a neutral escrow holder does not do is recommend the figures themselves. Those are negotiated terms with tax consequences that run in opposite directions for buyer and seller, and each party should set them with its own CPA or tax advisor.