Purchase Price Allocation Under Section 1060: The Residual Method

Purchase price allocation under Section 1060 divides the total consideration in a business acquisition across seven ranked classes of assets using the residual method: the price fills each class up to its fair market value in order, and whatever is left over lands in goodwill. Both buyer and seller must report the same allocation on Form 8594 attached to the tax return for the year the sale closes. Where the dollars land controls the buyer’s future depreciation and amortization deductions and the character of the seller’s gain, so the numbers are worth negotiating carefully.

When Section 1060 Applies

Section 1060 governs an “applicable asset acquisition,” which requires two conditions to both be true: the transferred assets make up a trade or business, and the buyer’s basis in those assets is determined entirely by the price paid.¹ The second condition is the technical way of saying the buyer bought the assets outright rather than receiving them through a tax-free reorganization or gift.

The assets also have to be the sort that goodwill or going concern value can attach to, meaning they function together as an ongoing enterprise. Buying a single piece of equipment does not trigger Section 1060. Buying a going operation with inventory, customer relationships, equipment, and staff almost certainly does.

The statute reaches certain stock purchases too. When a buyer makes a Section 338(h)(10) election in a qualifying stock purchase of a subsidiary or S corporation, the transaction is recast as a deemed asset sale that follows the same residual method allocation and the same Form 8594 reporting.

The Seven Asset Classes

The IRS groups acquired business assets into seven classes, ordered roughly from most liquid to most intangible.²

Class I: Cash and general deposit accounts such as checking and savings. Certificates of deposit are excluded.
Class II: Actively traded personal property, including U.S. government securities, publicly traded stock, certificates of deposit, and foreign currency.
Class III: Debt instruments and assets marked to market annually, including accounts receivable.
Class IV: Inventory and stock in trade held for sale to customers in the ordinary course of business.
Class V: All tangible and intangible assets not covered by the other classes. This catch-all typically holds furniture, fixtures, equipment, vehicles, land, and buildings.
Class VI: Section 197 intangibles other than goodwill and going concern value, such as customer lists, workforce in place, franchises, trademarks, trade names, and covenants not to compete.
Class VII: Goodwill and going concern value.

How the Residual Method Fills the Classes

The total consideration flows through the classes in order. It first fills Class I up to the face value of the cash and deposit accounts, then Class II up to fair market value, and continues through Classes III, IV, V, and VI in sequence. No class receives more than the combined fair market value of its assets.² Section 1060 borrows this framework from Section 338(b)(5), the same rules that govern deemed asset sales.³

Fair market value here means what a willing buyer and willing seller would agree to at arm’s length, with neither under pressure to close. Whatever remains after Class VI is filled becomes Class VII goodwill. Class VII has no ceiling, so in most small and mid-market deals a significant portion of the price lands there.

Assumed liabilities count as consideration. If you pay $3 million in cash and take on $1 million of the seller’s debts, the total being allocated across the seven classes is $4 million, not $3 million.⁴ Leaving assumed liabilities out understates the total price and throws off every class below.

Why the Allocation Matters

The classes carry different tax treatment on both sides of the deal, and the parties’ interests point in opposite directions.

Seller Side

The seller calculates gain or loss asset by asset, using the difference between the allocated price and the seller’s adjusted basis.⁵ Character depends on the class.

Gain on inventory (Class IV) is ordinary income at the seller’s regular rate.
Gain on depreciable equipment and property (Class V) is ordinary income to the extent of prior depreciation deductions under the Section 1245 recapture rules; any gain above the recapture amount is generally Section 1231 gain eligible for long-term capital gains treatment.⁶
Amounts allocated to covenants not to compete (Class VI) are ordinary income.
Gain on goodwill (Class VII) is generally long-term capital gain if the business was held more than a year.

Sellers therefore push for larger allocations to goodwill and smaller allocations to inventory, equipment, and noncompete agreements. Every dollar shifted out of Class VII into Class IV or the recapture portion of Class V costs the spread between capital gains and ordinary income rates.

Buyer Side

The buyer’s concern is how fast each dollar becomes a deduction.

Inventory in Class IV is deducted as cost of goods sold when the inventory sells.
Equipment and fixtures in Class V are depreciated under MACRS over recovery periods that run from 5 to 39 years depending on the property, with bonus depreciation or Section 179 potentially accelerating the write-off.
Section 197 intangibles in Classes VI and VII, including goodwill, are amortized ratably over 15 years starting in the month of acquisition.⁷

Buyers want more allocated to short-lived assets. A dollar in 5-year equipment recovers three times faster than the same dollar in 15-year goodwill, and a dollar in inventory can be deducted within months. That pull runs directly against the seller’s preference for goodwill, which is why the allocation clause is often one of the more contested provisions in the purchase agreement.

Written Allocation Agreements Are Binding

If the buyer and seller agree in writing to specific allocations or fair market values for any of the assets, that agreement binds both parties for tax purposes.¹ Neither side can file a return using different numbers because they later found a better position.

The only escape is an IRS determination that the agreed allocation is not appropriate, which generally happens when the numbers stray so far from fair market value that they look like manipulation. Absent that, the written agreement controls, which makes the allocation clause one of the most tax-significant terms in the entire deal.

Filing Form 8594

Both parties file Form 8594, the Asset Acquisition Statement Under Section 1060, by attaching it to their federal income tax return for the year of the sale.² The form calls for each party’s name and taxpayer identification number, the date of sale, and the total consideration, and it asks whether the parties signed a written allocation agreement. The sum of allocations across the seven classes must equal the total consideration.

Because both sides file, the IRS has a built-in cross-check. If the buyer reports $2 million of goodwill and the seller reports $800,000, the mismatch is likely to draw attention.

Post-Closing Adjustments

Earn-outs, holdbacks, and other price changes after closing shift the amount allocated to one or more assets. When that happens, the affected party files a supplemental Form 8594, completing Parts I and III and attaching it to the return for the year the adjustment occurs.² The supplemental filing has to explain the reason for the change and reference the tax year and form number of the original.

An adjustment in the same tax year as the sale is treated as if it happened on the purchase date. An adjustment in a later year is reported in that year. Additional consideration flows through the same class hierarchy, filling Class I first and moving down, with each class capped at fair market value on the original purchase date. In practice, most increases end up adding to Class VII goodwill. A separate supplemental statement is required for each year an adjustment occurs.

Penalties for Getting It Wrong

Form 8594 is treated as an information return, so failing to file it or filing incorrect information triggers penalties under Section 6721.⁸ For returns due in 2026, the amounts step up with the delay:⁹

$60 per form if corrected within 30 days of the due date.
$130 per form if corrected after 30 days but on or before August 1.
$340 per form if corrected after August 1 or not corrected at all.
$680 per form for intentional disregard, with no annual cap.

Annual caps apply to each tier for non-intentional failures, and those caps are lower for small businesses with gross receipts of $5 million or less. The bigger risk is often not the per-form penalty but the audit that inconsistent buyer-seller allocations tend to invite, which can put every valuation decision in the deal under review.

1
Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions
2
Internal Revenue Service. Instructions for Form 8594 – Asset Acquisition Statement Under Section 1060
3
Office of the Law Revision Counsel. 26 USC 338 – Certain Stock Purchases Treated as Asset Acquisitions
4
eCFR. 26 CFR 1.1060-1 – Special Allocation Rules for Certain Asset Acquisitions
5
Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets
6
Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property
7
Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles
8
eCFR. 26 CFR 301.6721-1 – Failure to File Correct Information Returns
9
Internal Revenue Service. IRM 20.1.7 Information Return Penalties