A founder I represented through an asset sale last spring told me, two weeks before closing, that the buyer had sent over a draft Section 1060 allocation and that his accountant was “fine with the numbers.” I asked him to send me the schedule. He sent it. I read it. I called him back and told him his accountant had just agreed to convert about $1.2 million of his proceeds from capital gain to ordinary income.
He had not understood that was what the allocation did. Most founders do not. The Section 1060 allocation looks like a tax-form chore — an IRS schedule that goes into a tax return, prepared by an accountant after closing. It is not. It is a negotiation that happens at signing, and it decides how much of the purchase price is taxed at the seller’s capital-gain rate and how much is taxed at the seller’s ordinary-income rate. The arithmetic is unforgiving and the buyer’s interests do not point the same direction as the seller’s.
I want to lay out the mechanic, name where the tension actually lives, and walk through the drafting choices founders should make at signing — not at filing.
What Section 1060 actually does
An asset sale, for tax purposes, is treated as a sale of each individual asset of the business rather than as a sale of a single equity interest. Section 1060 of the Internal Revenue Code requires the buyer and the seller to allocate the total purchase price among the assets being acquired, using a defined seven-class methodology that runs from cash at the top through Class VII goodwill at the bottom. Both parties file IRS Form 8594 reporting the allocation. The allocations are supposed to match, and the IRS uses the matching as an enforcement hook.
The allocation has tax consequences on both sides. The buyer’s allocation establishes the buyer’s tax basis in each acquired asset, which determines the buyer’s depreciation and amortization schedule going forward. The seller’s allocation determines the character of each dollar of gain — capital or ordinary — by reference to the asset that gain is attributable to. Class V tangible personal property and Class IV inventory are usually ordinary on the seller side. Class VI intangibles and Class VII goodwill are typically capital. Accounts receivable have their own treatment depending on the seller’s accounting method.
The headline tension is straightforward to state. The buyer wants more allocation to fast-amortizing or depreciable assets — equipment, inventory, customer lists with shorter useful lives — because those generate near-term tax deductions. The seller wants more allocation to Class VII goodwill, because goodwill gain is capital gain and is taxed at materially lower rates than ordinary income.
The arithmetic on a typical deal is enough to focus the mind. A founder selling a profitable services business for $20 million might be looking at $15 million of goodwill if the allocation is favorable. At a long-term capital gains rate of 23.8 percent including the net investment income tax, that is $3.57 million of federal tax. If the buyer pushes $5 million of that goodwill into a Class V allocation for “equipment and machinery” — at the seller’s ordinary rate of 37 percent plus 3.8 percent net investment income tax, the same $5 million is taxed at 40.8 percent — the swing is roughly $850,000 of additional tax to the seller. On a deal where the founder cleared $14 million pre-tax, that is a six-percent reduction in proceeds that nobody at the deal table called out by name.
Where the buyer wants the money to land
The buyer’s motivation is the mirror image of the seller’s. The buyer is paying ordinary cash today and wants the largest possible tax deduction in the early years post-closing. Goodwill amortizes over fifteen years under Section 197. Class V equipment depreciates over five or seven years. Inventory is fully expensed when sold — usually within the first year. A buyer who can shift allocation from Class VII goodwill into Class IV inventory or Class V equipment pulls forward the deduction by years, which has present-value benefits that are real.
The buyer’s tax structuring also runs into the cost-segregation question. A buyer who acquires real estate or improvements as part of the asset purchase will often run a cost-segregation study to push as much value as possible into shorter-lived asset categories. That study, when done right, is a legitimate engineering exercise that breaks out building components — electrical, mechanical, finishes — into shorter recovery periods. It is also a methodology that, if the seller is not paying attention, can show up as a Section 1060 allocation that has effectively shifted purchase-price allocation away from goodwill into depreciable property without the seller pricing the impact.
The buyer also faces the Section 197 anti-churning rules in transactions where the seller and the buyer have any common ownership — but in arm’s-length third-party deals, the buyer is largely free to negotiate aggressively on the allocation side, and the seller’s protection is the deal documents.
The drafting move is to lock the allocation in the agreement
The simplest seller protection is to negotiate the Section 1060 allocation as part of the merger agreement — or asset purchase agreement, more typically — and to attach a binding allocation schedule that both parties agree to file. The clause should require both parties to file Form 8594 consistently with the agreed allocation, and should prohibit either party from taking an inconsistent tax position without the other’s consent.
The phrasing matters. “Allocate the purchase price in accordance with Section 1060 and the regulations thereunder” is meaningless protection — it just restates the statute, which the parties are obligated to do anyway. “Allocate the purchase price in accordance with the schedule attached as Exhibit Y” is meaningful protection, because it forces the negotiation into the schedule, which is where the dollars actually move.
A seller who signs a merger agreement with an open or “to-be-determined” allocation — sometimes phrased as “the parties shall negotiate in good faith to agree on the allocation within sixty days of closing” — is signing a seller-unfavorable provision. Once the closing has happened and the money has moved, the seller’s leverage to push back on a buyer-favorable allocation is essentially zero. The buyer can run out the sixty-day clock, file a buyer-favorable Form 8594, and put the seller in a position where the IRS sees mismatched filings and the seller is the one explaining the inconsistency. The drafting move is to refuse the “to-be-determined” framing and to require a binding schedule attached at signing.
The character question is more important than the headline price
Founders who model their after-tax proceeds based on a blended capital-gain rate are often modeling wrong. The blend assumes a favorable allocation. The allocation is negotiated. If the allocation is negotiated badly — or, more commonly, if the allocation is negotiated invisibly by an accountant who is treating it as a tax-form question rather than a price question — the blended rate the founder modeled is materially lower than the actual rate the founder will pay.
The character distinction is also one of the few places in deal economics where the buyer’s and seller’s incentives are not just different but actually opposed. A purchase price negotiation has both parties agreeing on a single number, and the negotiation is over the size of the number. A character negotiation has both parties working from the same purchase-price number but allocating it differently — and the buyer’s allocation save is the seller’s allocation cost, dollar for dollar in present value, with no offsetting trade.
The same dynamic shows up — in a different register — in PE-led deals where the founder rolls over equity into the buyer entity. The private equity stockholders’ agreement framing tends to focus founders on the rollover side and downplay the cash-side allocation that determines the tax on the cash portion of the consideration. Founders selling to PE buyers should be at least as attentive to the Section 1060 allocation on the cash portion as they are to the rollover terms.
What the buyer’s “tax cap” usually leaves out
Some buyers offer a Section 1060 allocation negotiation that comes with a stated “tax cap” — a notional limit on how much of the allocation the buyer will push toward depreciable or short-lived categories. The cap reads like a seller protection. It is sometimes a real one, and it is sometimes a number that has been engineered around.
The thing to look for is whether the cap operates on Section 1060 categories or on present-value tax benefit. A cap that limits the dollar amount allocated to Class V equipment can be circumvented by shifting allocation into Class IV inventory or into intangibles with shorter useful lives than goodwill. A cap that limits the present-value tax benefit to the buyer is much harder to circumvent — but it is also much harder to draft and almost never proposed by buyers.
The honest read is that most “tax cap” provisions are buyer-side defenses against future seller second-guessing rather than seller-side allocation protections. A seller who wants real protection should not rely on the cap; the seller should negotiate the underlying allocation directly.
What founders should do before signing
The practical guidance is short. In any asset sale, the Section 1060 allocation should be negotiated, attached to the agreement as a binding schedule, and modeled by the founder’s tax advisor in dollars of after-tax proceeds rather than in percentages of the purchase price. The founder should know, before signing, how many dollars of the purchase price are being allocated to goodwill, how many to depreciable assets, how many to inventory, and what the seller’s after-tax proceeds look like under each scenario.
The allocation negotiation also belongs in the same conversation as the deal-structure question — whether the deal is an asset sale at all versus a stock sale with a Section 338(h)(10) or Section 336(e) election, or an F-reorganization on the front end that creates an asset sale at the deemed level. The structure choice and the allocation choice work together, and the founder who treats them as separate questions tends to leave money on each side.
The final point is that the allocation is a contract question, not a compliance question. The accountant’s job is to file the form. The lawyer’s job is to negotiate the schedule. A founder who lets the accountant negotiate the allocation as a filing matter is usually getting buyer-favorable terms. A founder who negotiates the schedule before signing — knowing what the dollars look like after tax — is getting what was actually agreed at the deal table.
If you are negotiating an asset sale or a stock sale with an asset-sale election, reviewing a draft Section 1060 allocation, or trying to understand what your after-tax proceeds actually look like under a proposed schedule, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
