Most owners negotiate the purchase price for weeks. Then they sign a purchase agreement with an allocation schedule buried near the back, and give it about four minutes of attention.
That schedule can be worth more than the last $50,000 of price you fought for.
Here’s the setup. In an asset sale (which is how the vast majority of small business deals are structured), the buyer isn’t purchasing “a business” in the eyes of the IRS. They’re purchasing a pile of individual assets: equipment, inventory, customer lists, a trade name, goodwill. The total price has to be divided among those assets, and each category is taxed differently for the seller. Both sides report the split to the IRS on Form 8594, and the two forms are supposed to match.
Most owners have never heard of it until their CPA mentions it in March.
Why the same $1.2 million can produce two different tax bills
Let’s take a hypothetical. Say an owner sells a service business for $1,200,000 in an asset sale. The assets break down roughly like this: $150,000 in trucks and equipment (all of it fully depreciated on the books), $50,000 in inventory and supplies, and the remaining $1,000,000 is goodwill, meaning the value of the customers, the reputation, and the fact that the phones ring.
The rule of thumb is simple. Goodwill is generally taxed to the seller at long-term capital gains rates, which top out at 20% federally (see the IRS’s capital gains overview). Equipment that’s been depreciated is a different story. Any gain up to what the seller previously deducted gets “recaptured” and taxed as ordinary income, which can run as high as 37%. Inventory is ordinary income too.
So on the surface, the seller wants as much of that $1.2 million as possible sitting in goodwill.
The buyer wants the opposite.
A buyer deducts what they pay for equipment quickly, sometimes in year one depending on the depreciation rules in effect. Goodwill has to be amortized over 15 years, no exceptions. So the buyer would love to see $350,000 allocated to equipment rather than $150,000. Faster write-offs, lower tax bills in the early years when cash is tightest.
Here’s where it gets expensive. Move $200,000 from goodwill into equipment, and the seller has just converted $200,000 of capital gain into ordinary income. At a 17-point spread between 37% and 20%, that’s roughly $34,000 in extra federal tax, before state tax and before the 3.8% net investment income tax that may or may not apply depending on the seller’s involvement in the business.
Same price, same buyer, same closing date. $34,000 apart.
The buyer isn’t being sneaky, and the seller can’t ignore it
This isn’t a trick buyers play. It’s a real tension in the deal, and any competent buyer’s CPA will push the allocation toward faster-depreciating assets because that’s their job. The IRS requires both parties to allocate using the residual method across seven asset classes, starting with cash and working down to goodwill last. Everything gets assigned fair market value in order, and goodwill is whatever’s left over.
The problem is that “fair market value” for a used truck or a set of commercial cleaning machines is a number reasonable people can disagree on by 30% or more. That gray area is where the negotiation lives.
A few things to watch for:
Equipment values with no support. If the buyer’s draft allocates $350,000 to equipment that an appraiser would put at $180,000, the buyer is leaning on a number nobody has verified. Ask for the basis, or get a quick equipment appraisal. A few hundred dollars for an appraisal against a five-figure tax swing is a trade worth making.
The non-compete. If the purchase agreement assigns a dollar amount to the non-compete, that amount is ordinary income to the seller, full stop. Buyers sometimes like putting value there. Sellers usually shouldn’t agree to anything beyond a modest, defensible figure.
Consulting or transition payments. Same issue. Money labeled as payment for post-closing services is compensation, not purchase price, and gets taxed that way (and you’ll owe self-employment tax on it, which stings).
Allocation that’s changed after the LOI. Some buyers don’t raise allocation until the purchase agreement draft shows up, when the seller is three months in, has legal fees on the meter, and has mentally spent the money. This is a close cousin of the retrade. If the allocation matters to you (it does), get it on the table when the LOI is signed.
What to do before the schedule shows up
Your CPA needs to see the allocation before you agree to it, not after. That sounds obvious, and it still gets skipped constantly, because the CPA who did the owner’s taxes for fifteen years isn’t usually looped in on the deal until the closing is a week away.
Run the numbers early. Have your tax advisor model two or three allocation scenarios against the same purchase price so you know what a $100,000 swing in either direction costs you after tax. Then you’ll know which fights are worth having and which ones aren’t.
Put the principle in the LOI: that allocation will follow the residual method and that any equipment values will be supported by an independent appraisal or documented book values. That one sentence takes pressure off the negotiation later.
And whatever you land on, make sure it’s consistent. The IRS gets Form 8594 from both sides. When the buyer’s form and the seller’s form disagree, that’s the kind of thing that generates letters.
The purchase price gets the attention, but the allocation decides what you actually keep from it.
If you’re thinking about a sale and curious what your business is worth, or what it would net after the deal is structured, reach out to The Turn Business Advisors. We can walk through the numbers before you’re anywhere near a purchase agreement.
This article is general information, not tax advice. Talk to your CPA about your specific situation.