Mergers & Acquisitions: Allocation of Purchase Price Disagreements

In M&A transactions—particularly asset sales—how the purchase price is allocated among various asset classes can have significant tax consequences. While it may seem like a formality after the headline price is agreed upon, the allocation of purchase price is often a second-round negotiation that involves the seller’s M&A advisor, accountant, and legal counsel. If mismanaged, this issue can derail deals or lead to long-term tax liabilities for both parties.

The IRS requires both buyers and sellers to report the allocation of the purchase price on Form 8594. Disagreements on how to divide that value—especially between goodwill, tangible assets, and service agreements—are common and often reflect the diverging tax objectives of buyers and sellers.

Why Allocation of Purchase Price Matters

From a seller’s perspective, maximizing allocation to long-term capital gains items—like goodwill—can minimize tax liability. On the other hand, buyers typically prefer allocating purchase price to assets with faster tax deductibility, such as consulting agreements or equipment that can be depreciated quickly.

These competing interests can create tension. In software and tech M&A, where most of the value lies in intangible assets, the risk of allocation disputes is especially pronounced. For example:

• Sellers want as much value as possible allocated to Class VII goodwill (taxed at favorable capital gains rates).
• Buyers may seek to allocate more value to Class VI intangibles or to consulting and non-compete agreements, which are deductible over shorter periods.

If an agreement cannot be reached, there is no legal requirement that the parties file Form 8594 with identical numbers. However, inconsistent allocations may raise red flags with the IRS. Both parties must be able to support their positions with a defensible fair market value assessment.

What Happens If the Parties Don’t Agree?

In some cases, the parties agree to disagree and report separate allocations. While this is technically permissible, it can increase the risk of IRS scrutiny. If there is a written agreement on how to allocate the purchase price, both parties must adhere to it when filing their taxes. Inconsistencies in such cases are likely to draw attention and potentially trigger audits or penalties.

In sectors like software, where tangible assets are minimal, the majority of value often falls into goodwill. However, buyers may push to allocate a portion of the value to non-compete clauses or post-close consulting, which they can amortize over shorter periods. If the valuation gap is significant and cannot be reconciled, it may be strategically advisable to proceed without a mutual allocation agreement—as long as both parties can defend their positions.

IRS-Defined Asset Classes

For asset sales occurring after March 15, 2001, the IRS requires allocation across the following classes, in order of priority:

Class I Assets:

• Cash and general deposit accounts (e.g., checking, savings)

Class II Assets:

• Certificates of deposit
• U.S. government securities
• Foreign currency
• Publicly traded securities

Class III Assets:

• Accounts receivable and debt instruments
• Assets marked to market for tax purposes

Class IV Assets:

• Inventory or property held for sale in the ordinary course of business

Class V Assets:

• Tangible property not included in Classes I–IV, VI, or VII (e.g., furniture, equipment, real estate)

Class VI Assets:

• Section 197 intangibles other than goodwill or going concern value (e.g., trademarks, customer lists)

Class VII Assets:

• Goodwill: The intangible value linked to brand reputation, ongoing customer relationships, and ability to generate future business
• Going Concern Value: The value of a business as a functioning operation, apart from its identifiable assets

Per IRS rules, any asset fitting into more than one category must be reported in the lowest-numbered applicable class. This hierarchy is important in ensuring consistent, legally compliant filings.

Strategic Considerations for Buyers and Sellers

To avoid late-stage surprises and failed deals, advisors should raise the topic of allocation early in the negotiation process. Consider the following:

• Work with your tax advisor and M&A advisor to model different allocation scenarios and their respective tax outcomes.
• Prepare a defensible fair market valuation for major asset categories—especially intangible assets like goodwill and IP.
• If an allocation agreement is reached, include it in the purchase agreement to reduce ambiguity and risk.

Firms like iMerge help software and tech clients navigate these negotiations with precision—ensuring alignment between legal documentation, financial modeling, and IRS compliance.

Conclusion

Allocation of purchase price is a critical—but often underappreciated—aspect of M&A tax planning. For software companies, where value is concentrated in intangible assets, thoughtful allocation can protect against tax inefficiencies and disputes. By understanding IRS rules and engaging experienced advisors, both buyers and sellers can structure deals that optimize financial outcomes and withstand regulatory scrutiny.

If you’re preparing for strategic discussions with buyers or investors, contact iMerge for a confidential M&A consultation tailored to your company’s goals.