Purchase Price Allocation (PPA): A Simple Guide for Business Sellers

The net takeaway (read this first)

In most business sales, the large majority of the purchase price ends up as goodwill, which is taxed at the 20% federal long-term capital gains rate (plus the 3.8% NIIT for most sellers, and whatever your state charges on top). Other categories — inventory, equipment, accounts receivable, non-competes — can be taxed differently, and some are taxed as ordinary income at much higher rates. But because goodwill is usually the biggest line in the allocation, the headline number most sellers should plan around is roughly 20% federal + state. The rest of this article walks through the other classes so you know where the exceptions are and where to push back during negotiations.

What is PPA?

If this is your first time selling a business, here is the key idea: your tax bill is not based on the headline sale price alone. It is based on how that price is split across different asset “buckets” (called classes) on a tax form called IRS Form 8594.

That split is called purchase price allocation (PPA), and it is one of the most important — and most overlooked — negotiations in any asset sale. Two deals at the same headline price can produce very different net proceeds depending on how the allocation lands.

In an asset sale, the buyer and seller agree on a total price (say, $5,000,000). Under IRC Section 1060, that total must be allocated across seven IRS-defined asset classes. Both sides then file Form 8594 with their tax returns reporting the same allocation. If buyer and seller report different numbers, both become audit targets, so the allocation is negotiated and locked into the purchase agreement before closing.

The IRS requires the residual method: you fill Classes I–VI first at fair market value, and whatever is left over drops into Class VII (goodwill). That is why goodwill is often described as “the plug.”

The seven classes — and how each is taxed to the seller

This is the part most first-time sellers never see explained clearly. Here is what each class is, and what happens to the seller’s tax bill when value is parked there.

Class I — Cash and demand deposits
Checking accounts, savings, cash on hand. Cash for cash — no gain, no tax impact. In most small-business deals the seller keeps the cash and Class I is zero.

Class II — Actively traded securities
Publicly traded stocks, bonds, CDs, foreign currency. Rare in Main Street M&A. Taxed at the seller’s basis vs. fair market value (usually capital gain).

Class III — Accounts receivable and debt instruments
A/R, notes receivable, mortgages held by the business. Taxed as ordinary income to the seller, because the seller would have collected that revenue and paid ordinary tax on it anyway. Many small-business sellers keep A/R and pay it off themselves rather than transfer it, which makes this class zero.

Class IV — Inventory
Stock-in-trade and product held for sale. Taxed as ordinary income (it is essentially a sale of inventory). Sellers cannot avoid this — if you have inventory, it goes here at cost or fair market value.

Class V — Tangible property (FF&E, equipment, vehicles, real estate)
Machinery, trucks, furniture, computers, leasehold improvements, and any owned real estate. This is where depreciation recapture bites. The math:

Gain up to the amount of depreciation you already took is recaptured as ordinary income under Section 1245 (equipment) or Section 1250 (real estate, capped at 25%).
Any gain above the original cost basis is long-term capital gain.

In plain English: if you bought a $100,000 truck, depreciated it to $0, and now allocate $40,000 to it, the full $40,000 is ordinary income — not capital gain. This is the single biggest tax surprise for sellers who have aggressively depreciated equipment.

Class VI — Intangibles other than goodwill (Section 197 intangibles)
Customer lists, supplier contracts, trade names, trademarks, patents, licenses, software, workforce-in-place, and covenants not to compete. Most of these are capital gain to the seller — but with two big exceptions:

Covenant not to compete: ordinary income to the seller (the IRS treats it as payment for a service — agreeing not to compete — rather than the sale of an asset).
Self-created intangibles like patents created in the business: also ordinary income under recent rules.

The buyer, meanwhile, amortizes everything in Class VI straight-line over 15 years regardless of category.

Class VII — Goodwill and going-concern value
The “plug.” Everything left after Classes I–VI is here. For sellers, this is the friendliest class: it is generally taxed at long-term capital gains rates. For C-corp sellers it is more complicated (the corporation pays tax, then the shareholder pays again on the distribution), which is one of the main reasons S-corps and LLCs sell more cleanly than C-corps.

The actual federal tax rates at stake

The reason allocation matters so much is the spread between two very different rate structures:

Ordinary income rates (Classes III, IV, parts of V, and non-competes in VI):
Federal brackets run from 10% to 37%. Most business sellers in the middle of a transaction land in the top two brackets (32% or 37% federal) because the sale itself pushes their taxable income up that year. Add state tax (0% to ~13%) and you can be looking at a combined rate north of 45% on every dollar parked in an ordinary-income bucket.

Long-term capital gains rates (most of Classes V, VI, and all of VII):
0% / 15% / 20% federal depending on income. Most business sellers land at 20%. On top of that, the 3.8% Net Investment Income Tax (NIIT) usually applies, so the real federal rate is closer to 23.8%.

The takeaway: every dollar moved out of an ordinary-income class and into a capital-gain class can save the seller roughly 15–20 cents in federal tax. On a $1M shift, that is $150,000–$200,000 of real money.

The buyer wants the opposite of what you want

This is why PPA is a negotiation, not a math exercise. The buyer’s incentives are flipped:

Buyers want value in Classes IV and V (inventory and equipment) because they get to deduct or depreciate it fast — inventory comes off as it sells, equipment over 5–7 years (or 100% in year one with bonus depreciation in some years).
Buyers are neutral-to-favorable on Class VI intangibles, including covenants not to compete, because everything in Class VI amortizes over 15 years — the same period as goodwill.
Buyers are least excited about Class VII goodwill on a cash-flow basis (also 15-year amortization, but it is the residual, so they cannot accelerate it).

The seller wants the mirror image: minimize Classes III, IV, and the recapture portion of V; maximize Class VII goodwill. The non-compete is the classic flashpoint — buyers often push to allocate $50K–$250K to a covenant because it protects them legally and they get the same 15-year write-off, but every dollar there is ordinary income to the seller.

Worked example: how allocation moves real dollars

Same $5,000,000 asset sale, two different allocations. Assume a seller in the top federal bracket (37% ordinary / 23.8% capital gains including NIIT), zero state tax for simplicity, and that all equipment is fully depreciated.

Allocation A — buyer-friendly:

Inventory: $500,000 (ordinary) → $185,000 tax
Equipment: $1,500,000 (all recapture, ordinary) → $555,000 tax
Non-compete: $250,000 (ordinary) → $92,500 tax
Goodwill: $2,750,000 (cap gain) → $654,500 tax
Total federal tax: $1,487,000

Allocation B — seller-friendly:

Inventory: $500,000 (ordinary) → $185,000 tax
Equipment: $750,000 (all recapture, ordinary) → $277,500 tax
Non-compete: $25,000 (ordinary) → $9,250 tax
Goodwill: $3,725,000 (cap gain) → $886,550 tax
Total federal tax: $1,358,300

Same deal price. Roughly $129,000 difference in federal tax to the seller — purely from how the line items were drawn. The numbers have to be defensible (you cannot allocate $750K to equipment that is obviously worth $1.5M), but within reasonable ranges there is meaningful room to negotiate.

Where PPA actually gets negotiated

The allocation should be a deal point, not an afterthought. In practice:

LOI stage: the better letters of intent already specify either the allocation or the methodology. Vague LOIs cost sellers money later.
Asset purchase agreement: the final allocation is locked into a schedule (often Schedule 2.x) of the APA. Once signed, neither side can deviate on Form 8594.
Form 8594: filed by both buyer and seller with the return for the year of sale. Inconsistent filings are an instant red flag for the IRS.

Practical advice for first-time sellers

You do not need to memorize Sections 1060, 1245, or 197. You do need to:

Get your CPA involved before the LOI is signed, not after. The allocation conversation should happen while you still have leverage.
Ask your broker to model the after-tax proceeds under at least two allocation scenarios before you counter-offer on price. A higher price with a worse allocation can net less than a lower price with a better one.
Watch the non-compete number. Buyers will often try to slip $100K+ into a covenant. If you do not need that big a number to protect the deal, push back.
Know your depreciation position. If you have been aggressively writing off equipment for years, expect the recapture conversation early.
Confirm consistency. Make sure the allocation in the APA matches what both sides actually file on Form 8594.

Bottom line

Purchase price allocation is not accounting trivia. It is the single line item that decides how much of the sale price you actually keep. The headline number gets the headlines; the allocation decides the wire.

Lean on your broker, CPA, and M&A attorney. You do not need to know this cold — you just need to know it exists, ask the right questions before the LOI is signed, and never treat the Form 8594 schedule as a formality.

Educational only; not tax or legal advice. Tax rates and rules referenced are federal and current as of writing. Always consult your CPA and M&A attorney for transaction-specific guidance.