What are the rules for determining the allocation of consideration received in an applicable asset acquisition?

The allocation of consideration in an applicable asset acquisition is governed by Internal Revenue Code (IRC) § 1060 and the related Treasury Regulations. The rules are designed to ensure that both the seller and purchaser allocate the total consideration among the assets transferred in a manner that reflects their fair market values, using a specific ordering known as the "residual method." Below is a comprehensive explanation of the rules, including relevant legal details, definitions, and procedures:

1. Definition of Applicable Asset Acquisition

An "applicable asset acquisition" is defined as any transfer (direct or indirect) of assets that:

Constitute a trade or business, and
The transferee’s basis in such assets is determined wholly by reference to the consideration paid for such assets [1], [2].

A group of assets constitutes a trade or business if goodwill or going concern value could attach to such assets, or if the use of such assets would constitute an active trade or business under IRC § 355 [2], [4].

2. General Rule for Allocation

IRC § 1060(a):

The consideration received for the assets must be allocated among the assets acquired in the same manner as amounts are allocated to assets under IRC § 338(b)(5) [1].

Reg. § 1.1060-1(a)(1):

Both seller and purchaser must allocate the consideration using the "residual method" as described in Regs. §§ 1.338-6 and 1.338-7 [2].

3. The Residual Method: Asset Classes and Order of Allocation

The residual method divides assets into seven classes, and consideration is allocated in the following order [2], [4], [7], [6]:

Class I: Cash and general deposit accounts (other than certain certificates of deposit).
Class II: Actively traded personal property (e.g., U.S. government securities, publicly traded stock, certificates of deposit, foreign currency).
Class III: Assets marked to market at least annually for federal tax purposes and certain debt instruments (e.g., accounts receivable).
Class IV: Stock in trade or inventory held primarily for sale to customers in the ordinary course of business.
Class V: All assets not included in Classes I, II, III, IV, VI, or VII (e.g., land, buildings, equipment).
Class VI: All IRC § 197 intangibles except goodwill and going concern value (e.g., workforce in place, customer-based intangibles, covenants not to compete).
Class VII: Goodwill and going concern value.

3. Allocation Process:

Consideration is first reduced by the amount of Class I assets transferred.
The remaining consideration is allocated to Class II assets (pro rata, up to their fair market value), then to Class III, IV, V, and VI assets in that order, each up to their fair market value.
Any remaining consideration is allocated to Class VII assets (goodwill and going concern value) [2], [4], [7], [6].

Within each class: Allocation is made among the assets in proportion to their fair market values on the purchase date [4].

4. Determining Consideration

Seller’s consideration: The amount realized from selling the assets under IRC § 1001(b).
Purchaser’s consideration: The cost of purchasing the assets that is properly taken into account in basis [2], [7].

Consideration includes cash, the fair market value of other property received, and liabilities assumed by the purchaser to the extent they are taken into account for federal tax purposes [6].

5. Special Rules and Adjustments

Written Agreements: If the parties agree in writing as to the allocation or fair market value of any asset, such agreement is binding unless the IRS determines it is not appropriate [1], [2].
Subsequent Adjustments: If there is a later increase or decrease in consideration (e.g., due to a purchase price adjustment), the change is allocated among the assets as if it had occurred on the acquisition date [4], [7].
Reporting Requirements: Both seller and purchaser must file Form 8594, Asset Acquisition Statement, with their tax returns for the year of the acquisition, reporting the allocation and any subsequent adjustments [1], [2], [4].

6. Valuation of Inventory

For inventory (Class IV assets), fair market value must be determined. The IRS provides three safe harbor methods:

Replacement Cost Method
Comparative Sales Method
Income Method

The chosen method should reflect what a willing buyer and seller would agree upon, considering the size and nature of the inventory and relevant costs and risks [5].

7. Exceptions and Special Situations

Like-Kind Exchanges: If IRC § 1031 applies to a portion of the assets, those assets are excluded from the allocation rules of § 1060. Only the non-like-kind assets are subject to allocation [1], [2], [4].
Partnership Interests: The purchase of a partnership interest that is treated as a purchase of partnership assets (e.g., under Rev. Rul. 99-6) is subject to § 1060, and the purchaser must file Form 8594 [4], [3].

8. Examples

Example from Reg. § 1.1060-1(d): If a seller transfers assets with various classes and the consideration includes both cash and assumed liabilities, the allocation follows the residual method, with each class receiving consideration up to its fair market value, and any excess going to goodwill [7].

9. Penalties

Failure to file the required Form 8594 or to properly report the allocation may result in penalties under IRC §§ 6721–6724 [1], [4].

In summary:

In an applicable asset acquisition, the total consideration is allocated among the assets transferred using the residual method, in a specific order of asset classes, up to each asset’s fair market value, with any remaining amount allocated to goodwill and going concern value. Both parties must report the allocation on Form 8594, and any subsequent adjustments to consideration must be similarly allocated and reported. Special rules apply for inventory valuation, like-kind exchanges, and partnership interest purchases [1], [2], [4], [7], [5], [3].

Cited sources

[1] Statute § 1060. Special allocation rules for certain asset acquisitions

[2] Regulation § 1.1060-1. Special allocation rules for certain asset acquisitions.

[3] Admin Rev. Rul. 99-6

[4] Admin Instructions for Form 8594 (11/2021

[5] Admin Rev. Proc. 2003-51

[6] Admin PLR 200546036

[7] Admin PLR 200443003