Two allocations of the same illustrative 2,000,000 asset purchase, valued from both sides of the table.
In an asset purchase, the price is split across classes of assets, and each class is deducted by the buyer and taxed to the seller on a different schedule, so the allocation has a value that can be calculated from both sides. On an illustrative 2,000,000 deal, moving 200,000 from goodwill to equipment is worth 24,121 in present value to the buyer and costs the seller 34,000. The total deduction never changes, only its timing and its tax rate, so a shift is worth pressing only when one side gains more than the other loses.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A buyer acquires the assets of a small business for 2,000,000. The seller proposes the first allocation below; the buyer, with an equipment appraisal in hand, proposes the second. Both put the same 150,000 on inventory at cost and 100,000 on a non-compete, and leave the residual in goodwill, as the residual method requires. All tax rates and figures are illustrative, and none of this is tax advice for a particular transaction.
| Asset class | Seller's proposal | Buyer's proposal | Buyer's deduction |
|---|---|---|---|
| Inventory (Class IV) | 150,000 | 150,000 | As sold, year 1 |
| Equipment (Class V) | 250,000 | 450,000 | Year 1 (assumed fully expensed) |
| Non-compete (Class VI) | 100,000 | 100,000 | 15 years, Section 197 |
| Goodwill (Class VII) | 1,500,000 | 1,300,000 | 15 years, Section 197 |
| Total | 2,000,000 | 2,000,000 |
The buyer pays tax at 30 per cent and discounts at 10 per cent. The seller is an individual, or a pass-through entity taxed at the owner's rates, paying an illustrative 37 per cent on ordinary income and 20 per cent on long-term capital gains, before any state tax; it has a tax basis of 50,000 in the equipment, which originally cost more than either allocation, so every dollar of gain on it is recapture, and none in the goodwill it built. Equipment is assumed written off in year 1, as bonus depreciation allows for qualifying property when it is available; check the rules for the year of purchase.
For a US asset acquisition, Section 1060 requires the residual method, and both parties report the result on IRS Form 8594. The price is assigned to seven classes in order, each class up to the fair market value of its assets, and whatever is left falls into the last one:
Section 197 intangibles, Class VI and VII alike, are amortised by the buyer straight-line over 15 years, 180 months starting with the month of acquisition, whatever their economic life; a three-year non-compete is still written off over 15. The calculation below assumes a purchase at the start of a tax year, so each class gets 15 equal annual deductions. The room to negotiate is therefore narrower than it looks: Classes I to VI must be supportable at fair market value, and only the judgement within that range, here the equipment appraisal, is in play. This is the tax allocation; the accounting goodwill booked under purchase accounting is a separate exercise, set out in how to calculate goodwill in an acquisition.
Every dollar of the price is eventually deducted, so undiscounted the tax saving is 600,000 under either allocation. The difference is timing. A dollar deducted in year 1 saves 30 cents a year from now; a dollar of goodwill saves 2 cents a year for 15 years.
PV per dollar, year-1 deduction = 30% / 1.10 = 0.2727
PV per dollar, 15-year amortisation = 30% / 15 × annuity factor 7.6061 = 0.1521
Excel: =Tax/15*PV(10%,15,-1)
| Asset class | Seller's proposal | Buyer's proposal |
|---|---|---|
| Inventory | 40,909 | 40,909 |
| Equipment | 68,182 | 122,727 |
| Non-compete | 15,212 | 15,212 |
| Goodwill | 228,182 | 197,758 |
| Total | 352,485 | 376,607 |
The buyer's allocation is worth 24,121 more: 200,000 times the 0.1206 difference per dollar. Put differently, the after-tax cost of the business falls from 1,647,515 to 1,623,393.
For the seller, the class decides the rate. Inventory sold at cost produces no gain. Gain on equipment, up to the depreciation already claimed, is recaptured as ordinary income. A non-compete payment is ordinary income. Goodwill the seller built is normally a capital gain. That 17-point gap exists only for an individual or pass-through seller: a C corporation selling its assets pays the same corporate rate on every class, so for it the allocation fight is mostly about timing on the buyer's side, while its shareholders face a second tax when the proceeds are distributed.
| Asset class | Rate | Seller's proposal | Buyer's proposal |
|---|---|---|---|
| Inventory | 37% | 0 | 0 |
| Equipment (gain over 50,000 basis) | 37% | 74,000 | 148,000 |
| Non-compete | 37% | 37,000 | 37,000 |
| Goodwill | 20% | 300,000 | 260,000 |
| Total tax | 411,000 | 445,000 | |
| Seller's net proceeds | 1,589,000 | 1,555,000 |
The shift costs the seller 34,000: 200,000 times the 17-point gap between 37 and 20 per cent. In this case the seller loses more than the buyer gains, so together they are 9,879 worse off under the buyer's allocation.
Whether a shift creates joint value depends on the seller's ordinary rate and the buyer's discount rate. Net joint effect of moving 200,000 from goodwill to equipment:
| Seller ordinary rate | Buyer at 8% | Buyer at 10% | Buyer at 15% |
|---|---|---|---|
| 24% | 13,318 | 16,121 | 20,784 |
| 32% | -2,682 | 121 | 4,784 |
| 37% | -12,682 | -9,879 | -5,216 |
When the net is positive there is a deal to be made: the buyer can raise the price to compensate. With a seller at 24 per cent, the seller needs 10,000 more (8,000 of extra tax, grossed up for the 20 per cent tax on the extra price), and the buyer can afford up to 28,449 once the extra price's own goodwill deduction is counted. With a seller at 37 per cent, the seller needs 42,500 and the buyer can pay at most 28,449, so no price adjustment works and the seller's allocation should stand.
The allocation must also be defensible. Equipment value needs an appraisal, inventory a count, and the non-compete a value related to what it protects. Both parties report the allocation on Form 8594, and an allocation one side cannot support invites an adjustment on audit. Everything here is an illustration of the arithmetic, not tax advice: rates, bonus depreciation and state rules change, and a real allocation should be settled with a tax adviser before the purchase agreement is signed.
Buyers often argue for the allocation that maximises their own deductions, as if it were free. It is not: the seller's tax bill moves the other way, and a seller who understands the arithmetic will ask for the difference in price or refuse. The opposite error is to treat the allocation as a formality because the total deduction is 600,000 either way. Timing alone is worth 0.1206 per dollar moved here. Value each proposal from both sides before negotiating, and offer to share a joint gain rather than claim it.
How the seller values its own side of the bargain, in cash and over time, is set out in what a seller-financed price is worth in cash. The free workbook for this case carries the book's acquisition through ten years of tax with bonus depreciation and allocates the exit by asset class.
Because equipment can be written off much faster than goodwill, which is amortised straight-line over 15 years for US tax. The total deduction is the same, 2,000,000 either way, but earlier deductions are worth more. Here each dollar on equipment is worth 0.2727 in present tax saving against 0.1521 on goodwill.
Gain on equipment up to the depreciation already taken is recaptured as ordinary income, and a non-compete payment is ordinary income too, while goodwill a seller built is usually a capital gain. At an illustrative 37 per cent ordinary rate and 20 per cent capital gains rate, each dollar moved from goodwill to recaptured equipment costs the seller 0.17.
In US asset sales both sides report the allocation to the IRS on Form 8594, and an allocation agreed in the purchase agreement generally binds both. That is why it is negotiated, not chosen. If the seller's cost of a shift exceeds the buyer's gain, as here with 34,000 against 24,121, no price adjustment makes both better off.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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