The allocation schedule decides your tax rate, not the headline price

Your headline price decides how much money arrives. The allocation schedule decides how much you keep. In an asset sale, Section 1060 spreads the price across seven asset classes by the residual method, and each class carries its own tax character. Inventory, equipment recapture and covenants are ordinary income. Goodwill usually is not. Stated as of August 2026.

What is the Section 1060 residual method, and why does it set my tax rate?

The Section 1060 residual method is the mandatory formula for spreading your sale price across the assets you sold. It applies to any applicable asset acquisition, meaning a transfer of assets making up a trade or business where the buyer’s basis is what the buyer paid. It assigns dollars class by class, in order.

The mechanics are unforgiving. Consideration fills Class I first, then II, III, IV, V and VI, and whatever is left lands in Class VII. Within a class, dollars are spread in proportion to fair market values. No asset outside Class VII may be allocated more than its own fair market value.

That cap is the most useful rule you own. A buyer cannot move two million dollars onto equipment worth six hundred thousand. But it limits dollars, not argument: value is a question of fact, and the IRS may challenge either side’s number.

Law: 26 U.S.C. 1060; Treas. Reg. 1.1060-1(c); Treas. Reg. 1.338-6(a)(2), (b), (c)(1).

What are the seven asset classes, and where does my money change character?

The seven classes run from cash to goodwill, and your tax character changes as you move down the list. Cash produces no gain. Receivables and inventory produce ordinary income. Equipment produces recapture at ordinary rates up to prior depreciation. Section 197 intangibles are mixed. Goodwill is usually capital gain.

Law: Treas. Reg. 1.338-6(b); 26 U.S.C. 1221(a)(1), (a)(4); 1245; 1250; 1(h)(1)(E); 453(b)(2)(B), (i); 197(a), (d)(1)(E), (f)(7).

Inventory and recapture both create tax in the closing year, ahead of the note payments. A seller-financed deal with a fat equipment allocation can produce a tax bill larger than your closing cash.

Why does the buyer push value onto equipment and inventory?

The buyer is buying deductions, and speed is what the buyer is buying. Dollars allocated to inventory come back through cost of goods sold almost immediately. Dollars on qualifying equipment can be expensed up front. Dollars on goodwill, going-concern value and other Section 197 intangibles come back over fifteen years.

As of August 2026, 100 percent first-year bonus depreciation is available for qualifying property acquired and placed in service after January 19, 2025. Section 179 expensing rose to 2.5 million dollars with a 4 million dollar phaseout for tax years beginning after December 31, 2024, and both figures are indexed, so for tax years beginning in 2026 they are 2.56 million and 4.09 million. Buildings get none of it, and state conformity varies.

Law: 26 U.S.C. 168(k)(6) and 179(b), as amended by Public Law 119-21 (2025); Rev. Proc. 2025-32; 26 U.S.C. 197(a).

The buyer’s incentive is not malice. It is arithmetic. A dollar on the equipment schedule is worth more to the buyer today, and on your return it converts from capital gain to ordinary recapture.

Where is the buyer indifferent, and how do I use that?

The buyer is largely indifferent among goodwill, going-concern value and the covenant not to compete, because all three amortize over fifteen years under Section 197. Moving a dollar from the covenant to goodwill costs the buyer nothing in timing. It moves you from ordinary rates to capital rates. That fight you can win.

Section 197 lists goodwill and going-concern value, and separately lists a covenant not to compete entered into in connection with an acquisition of an interest in a trade or business. Same statute, same fifteen-year period. The buyer’s model does not change when the label does, provided both are amortizable in the buyer’s hands.

Fight hardest where the buyer loses nothing by agreeing. The covenant line is the clearest example on the schedule.

The indifference is not total. A buyer may want a visible covenant number to make the restriction look supported. Whether the covenant holds with a small number on it is state law, not tax law. Most states enforce a reasonable sale-of-business covenant, and California, which bars most employee noncompetes, excepts covenants tied to the sale of a business’s goodwill or ownership interest. Scope and duration decide it, not the allocation.

Law: 26 U.S.C. 197(d)(1)(A), (d)(1)(E), (f)(9); Cal. Bus. and Prof. Code 16601.

How does a consulting agreement differ from a covenant in my hands?

A covenant not to compete produces ordinary income. A consulting or employment agreement produces ordinary income plus employment tax. Consulting fees paid to you as a contractor carry self-employment tax. Wages carry payroll tax on both sides. Both are worse than goodwill, and consulting is usually the worse of the two.

Watch for the version dressed as generosity. The buyer keeps you on for a transition year and trims the price by the same total. You have converted capital gain into wage income and taken it in installments. Price the role separately, and keep it small.

If your buyer is using an SBA 7(a) loan, the lender’s rulebook narrows your options. Under SOP 50 10 8, effective June 1, 2025, a complete change of ownership requires that you not remain an officer, director, stockholder or employee, and any consulting or employment role is capped at 12 months from closing. A partial change, where you keep equity, is treated differently. Confirm which SOP version governs the loan.

Law: 26 U.S.C. 1401, 1402; 3101, 3111; SBA SOP 50 10 8 (effective June 1, 2025), change of ownership provisions.

Can I sell personal goodwill separately if my company is a C corporation?

Personal goodwill means the relationships, reputation and know-how that belong to you rather than your corporation. Where the target is a C corporation, an asset sale is taxed twice, at the company and again on the distribution to you. Consideration paid directly to you for genuine personal goodwill is taxed once, as capital gain.

That treatment is fact-driven, and the IRS contests it. In Martin Ice Cream, a shareholder’s relationships were held to be his own, because a corporation can distribute only assets it owns. In Bross Trucking, a memorandum opinion, the company held no corporate goodwill. The winning cases share a pattern: the business ran on relationships the corporation never captured.

The failures are equally consistent. In Howard, the owner had already signed an employment agreement and a noncompete with his own corporation, so the goodwill had been handed to the company years earlier and the separate sale failed. Howard is unpublished and persuasive only, but its reasoning is what sellers trip over.

Cases and law: Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998); Bross Trucking, Inc. v. Commissioner, T.C. Memo. 2014-107; Howard v. United States, 448 F. App’x 752 (9th Cir. 2011) (unpublished); 26 U.S.C. 336, 331.

So it must look like what it is: a separate personal goodwill purchase agreement, a supportable valuation prepared before signing, no earlier noncompete handing your relationships to the company, and matching reporting. If you converted from C to S, ask about the built-in gains tax, which runs five years from the first day of your first S corporation year.

Does the allocation in the purchase agreement actually bind anyone?

Section 1060 says that if buyer and seller agree in writing on the allocation of consideration, or on the fair market value of assets, that agreement binds both of them unless the Secretary determines the allocation is not appropriate. So the schedule binds the two of you. It does not bind the IRS.

Courts add a second lock, and which lock depends on where you would litigate. Under the Danielson rule, adopted in some circuits, you cannot walk away from clear contract terms absent mistake, fraud or duress. Elsewhere the Tax Court applies a strong proof standard, which demands far more than a change of heart.

Both sides report it. Buyer and seller each file Form 8594 with the return for the year the sale occurred, so the filings can be compared. Inconsistent numbers are an invitation.

Law: 26 U.S.C. 1060(a); Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967) (en banc); Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959), aff’g 29 T.C. 129 (1957); IRS Instructions for Form 8594 (rev. 11/2021).

How should the allocation be handled in the purchase agreement itself?

Put the allocation schedule in the asset purchase agreement as a signed exhibit with dollar figures by class. Do not agree to settle it 30 to 90 days after closing. After closing your leverage is gone and the buyer’s accountant is the only person still holding a pen. Deferral is how sellers lose.

• Signed exhibit at signing. Dollar amounts for Classes I through VII, not a methodology promise. Buyers at this size routinely propose a post-closing exhibit. That proposal is the negotiation.
• Who drafts first. If a schedule cannot be finished, name who delivers the first draft and when. The first draft is the anchor. It should be yours.
• A consistency covenant that bites. Both parties file Form 8594 consistent with the schedule and take no inconsistent position on any return or audit, excepting only a final determination.
• A deadlock rule you will use. Referral to an independent appraiser is standard in much larger deals, uncommon at this size, and binding only between you, never on the IRS. Finish the schedule before you sign.
• A reallocation rule. Say how a working capital adjustment, indemnity payment or earn-out is applied. The cleanest seller rule treats later payments as additional consideration under the residual method, routing them to Class VII.
• No new labels. No payment may be recharacterized as wages, consulting fees or covenant consideration without your written consent.

When consideration changes after the year of sale, the Form 8594 instructions require a supplemental statement in Part III, and decreases work down from the residual class through Classes VI, V, IV, III and II. Increases usually land in Class VII because the other classes’ value ceilings are fixed at the original allocation date. Three limits on that comfort: an earn-out tied to your continued employment can be recast as compensation whatever the schedule says, deferred payments carry imputed interest taxed as ordinary income, and contingent payments go on the installment method unless you elect out.

The earn-out clause and the allocation clause are one clause. Draft them apart and you will pay for the gap.

Law: Instructions for Form 8594, Part III (rev. 11/2021); Treas. Reg. 1.338-7; 26 U.S.C. 483, 1274, 453.

What should I do first, before the letter of intent is signed?

Start with facts, not arguments. You need three things before you negotiate: a fixed-asset schedule showing tax basis and accumulated depreciation asset by asset, your entity type and any C corporation history, and a written estimate of your after-tax proceeds under two different allocations of one price. That estimate is your leverage.

• Identify the recapture buried in the equipment schedule, and separate any real estate, because the rules and rates differ.
• Confirm your state’s treatment as of August 2026, including whether gain is sourced outside your home state.
• If you are a C corporation and the business runs on your relationships, raise personal goodwill before the letter of intent. Structure is set early.
• Ask whether the buyer is using SBA financing, since that dictates any post-closing role.
• Ask for the allocation exhibit as a closing deliverable in the letter of intent. One sentence there prevents a 90-day fight later.

Federal tax rules and the SBA’s procedures both move. Everything above is stated as of August 2026, and any allocation position should be confirmed against the versions in force when your deal signs.