Section 1060 Purchase Price Allocation: Asset Classes and Form 8594

Under Section 1060 of the Internal Revenue Code, a purchase price allocation splits the total consideration paid for a business across seven defined asset classes using a sequential residual method, and that split determines how much tax the seller pays now and how fast the buyer recovers basis later. Both sides must report the same numbers on Form 8594, and any written allocation in the purchase agreement binds both parties for tax purposes. Because different classes trigger ordinary income, capital gains, immediate deduction, or 15-year amortization, the allocation is where most business sale negotiations get genuinely contentious.

When the Rules Apply

Section 1060 governs any “applicable asset acquisition,” which the statute defines as a direct or indirect transfer of assets constituting a trade or business where the buyer’s basis is determined entirely by what was paid.¹ The trade or business can sit on either side of the deal for the rule to apply.²

The practical test: a group of assets counts as a trade or business if goodwill or going concern value could attach to it under any circumstances. The IRS reads this broadly. If the assets would let a buyer step in and keep operating, you’re almost certainly inside Section 1060, and it doesn’t matter whether the residual method ends up assigning actual dollars to goodwill.² Sole proprietorships, partnership interests treated as asset sales, and corporate divisions where a substantial part of operations changes hands all get pulled in.

What Total Consideration Includes

Before allocating anything, you need the right total. For the seller, consideration is the aggregate amount realized under Section 1001(b). For the buyer, it’s the aggregate cost of purchasing the assets.²

One trap catches people repeatedly: assumed liabilities count as part of the purchase price. If the buyer pays $3,000 in cash and assumes $1,000 of the seller’s liabilities, total consideration is $4,000, not $3,000. The Treasury Regulations make this explicit and use it in the IRS’s own examples.² Miss the assumed debt and every downstream number on Form 8594 comes out wrong.

The Seven Asset Classes and the Residual Method

Total consideration must be allocated across seven classes in order, starting at Class I. Each class receives up to the fair market value of the assets in that class. Whatever is left after Classes I through VI falls into Class VII. Neither party can override this by contractually stuffing a class beyond its fair market value.¹

The classes come from Treasury Regulation 1.338-6:³

Class I is cash and general deposit accounts (checking and savings), but not certificates of deposit. Valued at face and reduces remaining consideration dollar-for-dollar.
Class II is actively traded personal property, including U.S. government securities, publicly traded stock, certificates of deposit, and foreign currency.
Class III covers debt instruments and mark-to-market assets, including accounts receivable. Certain related-party debts and contingent instruments are excluded.
Class IV is inventory and property held primarily for sale to customers in the ordinary course.
Class V is the catch-all for everything else: equipment, machinery, vehicles, buildings, furniture, and land.⁴
Class VI is Section 197 intangibles other than goodwill and going concern value: patents, trademarks, customer lists, covenants not to compete, government-issued licenses.⁵
Class VII is goodwill and going concern value. This is the residual bucket that catches every dollar left over.

A quick example. Total price is $10 million. Combined fair market value of Classes I through VI is $9.2 million. The remaining $800,000 must be assigned to Class VII goodwill. Any premium paid above the collective value of tangible and identified intangible assets ends up as goodwill by default. No discretion.

What Each Side Wants, and Why the Agreement Binds

The buyer wants fast deductions, which pushes value toward Class IV (immediate cost of goods sold) and Class V (accelerated depreciation). The seller wants capital gains treatment, which pushes value toward Class V and Class VII. Both agree on Class V, which is why tangible asset values are usually the least contentious piece of the deal.

The real fight is Class VI versus Class VII. Amounts allocated to covenants not to compete and other Class VI intangibles are ordinary income to the seller but only 15-year amortization to the buyer. Goodwill in Class VII is capital gains to the seller and, again, 15-year amortization to the buyer. The buyer is often indifferent between VI and VII, so the seller has room to push value into VII if the negotiation is handled early.

Whatever the parties agree to in writing sticks. Treasury Regulation 1.1060-1(c)(4) makes any written allocation, or any written agreement on fair market values, binding on both parties for tax purposes.² Escape requires proving fraud, duress, mistake, or undue influence. The IRS itself is not bound and can still challenge the numbers, but neither buyer nor seller can walk it back on their own return. That makes the allocation clause one of the most consequential provisions in the purchase agreement, and it should be negotiated alongside the headline price rather than after it.

Tax Consequences for the Seller

Gain on Class III receivables and Class IV inventory is ordinary income. Bad debt reserves previously deducted come back as ordinary income when receivables are collected above adjusted basis. Inventory sold above cost is ordinary too. Sellers regularly underestimate how much of the total price gets taxed at ordinary rates once these two classes are settled.

Amounts allocated to Class VI covenants not to compete are also ordinary income to the seller. That’s the class buyers most want to load up, and sellers most want to keep light.

Class V tangible assets are generally Section 1231 property, so net gains qualify for long-term capital gains rates. But depreciation recapture claws a chunk back. Section 1245 recharacterizes gain on equipment and machinery up to the amount of depreciation previously claimed as ordinary income; only gain above original cost basis gets capital gains treatment.⁶ For real property, unrecaptured Section 1250 gain (the portion attributable to prior straight-line depreciation on buildings) is taxed at a maximum 25% rate, and gain above original cost basis gets standard long-term capital gains rates.

Class VII goodwill, held long enough, is long-term capital gain. This is why sellers push value toward VII and toward the Class V assets that qualify for capital gains after recapture.

Tax Consequences for the Buyer

The allocation sets the buyer’s basis in each asset, which drives future deductions.

Class IV inventory converts to cost of goods sold as inventory is sold, offsetting ordinary income dollar-for-dollar. The fastest deduction available.
Class V tangible assets are recovered through MACRS depreciation over the applicable recovery period. Equipment often depreciates over five or seven years, and under current rules many assets qualify for bonus depreciation or Section 179 expensing, pulling the deduction into the early years.
Class VI and Class VII intangibles, including goodwill, covenants not to compete, customer lists, and trademarks, must be amortized straight-line over exactly 15 years. No acceleration.⁵

Faster basis recovery means greater present value. That’s the economic logic behind the buyer’s preference for Classes IV and V.

Personal Goodwill as a Planning Angle

In businesses where the owner’s individual reputation, relationships, or expertise carries the value, some goodwill may belong to the shareholder personally rather than to the entity. The distinction is expensive to get wrong and lucrative to get right, particularly for C corporations and S corporations with built-in gains exposure. A sale of entity-owned goodwill produces gain at the corporate level that gets taxed again when distributed to shareholders.

If the goodwill is personal to the shareholder, the shareholder can sell it directly to the buyer in a separate transaction, avoiding the corporate-level tax and receiving long-term capital gains treatment. For this to hold up, the owner generally can’t have a noncompete or employment agreement with the entity that would have effectively transferred the personal goodwill to the company. Courts have recognized personal goodwill where the business depends heavily on the owner’s individual relationships and skills, but the IRS scrutinizes these arrangements closely. Clean documentation and professional guidance are essential.

Earnouts and Later Price Adjustments

Deals rarely stay at the closing number. Earnouts, escrow releases, and other contingent payments change total consideration after the initial sale, and Section 1060 has specific rules for reallocating.⁷ Increases and decreases run in opposite directions.

When the price goes up (an earnout milestone hits, say), the additional consideration is allocated starting at Class I and working down, using the original fair market values from the purchase date. No asset is allocated more than its fair market value. Any excess drops to Class VII.

When the price goes down, you start at the bottom. Reduce the Class VII allocation first, then VI, then V, and so on up. Within a class, the decrease is spread among assets in proportion to their original fair market values, and no asset’s allocation can drop below zero.⁷

If the buyer has already depreciated, amortized, or disposed of the affected asset, the adjustment is picked up in the year it happens under general tax principles for retroactive basis changes, not by amending prior returns. And each year an adjustment occurs, the affected party files a supplemental Form 8594 (Parts I and III), attached to that year’s income tax return, explaining the reason for the change and referencing the tax years and form numbers of the original filing.⁷ A three-year earnout means three supplemental filings.

Reporting on Form 8594

Both buyer and seller file Form 8594 (Asset Acquisition Statement Under Section 1060) with their income tax returns for the year of sale.⁴ Each side files separately, but both must report identical amounts across all seven classes. The form requires the other party’s name and taxpayer identification number, so cross-referencing is trivial for IRS examiners. Any inconsistency between buyer and seller filings is an audit flag.

Form 8594 is an information return subject to penalties under Sections 6721 and 6722.⁸ For returns due in 2026:⁹

Corrected within 30 days: $60 per return.
Corrected after 30 days but by August 1: $130 per return.
Not corrected by August 1, or never filed: $340 per return.
Intentional disregard: $680 per return, with no maximum cap.

The general annual maximum across all information return failures is $3,000,000 per filer, but that ceiling doesn’t apply to intentional disregard.⁸ The IRS can waive penalties for reasonable cause, but “I didn’t know” rarely qualifies in the context of a business acquisition.

Substantiating Your Fair Market Values

The allocation is only as defensible as the fair market values under it. If the IRS challenges the numbers, you carry the burden of producing credible evidence for each class. Under Section 7491, the burden shifts to the IRS only if you’ve substantiated the items and kept proper records.¹⁰ Without documentation, you’re fighting uphill.

For most deals that means independent appraisals of the significant assets, especially real property, specialized equipment, and intangibles. The IRS is not bound by the buyer-seller allocation, and examiners routinely challenge numbers that appear to favor one party at the expense of realistic valuation. A professional valuation prepared at the time of the transaction is the strongest evidence available. Fees scale with size and complexity: expect several thousand dollars even for a straightforward small business, and substantially more for larger deals. That cost is a fraction of the exposure if the IRS reclassifies the allocation.

Keep every appraisal, the purchase agreement with its allocation clause, closing statements, and workpapers showing how fair market values were derived. If the deal includes contingent payments, track each adjustment and the updated allocation calculations for every year a supplemental Form 8594 is filed.

1
Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions
2
eCFR. 26 CFR 1.1060-1 – Special Allocation Rules for Certain Asset Acquisitions
3
eCFR. 26 CFR 1.338-6 – Allocation of ADSP and AGUB Among Target Assets
4
Internal Revenue Service. Instructions for Form 8594
5
Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles
6
Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
7
Internal Revenue Service. Instructions for Form 8594 – Asset Acquisition Statement Under Section 1060
8
eCFR. 26 CFR 301.6721-1 – Failure to File Correct Information Returns
9
Internal Revenue Service. Information Return Penalties
10
Office of the Law Revision Counsel. 26 USC 7491 – Burden of Proof