Purchase Price Allocation: What the Seller Keeps: the facts

1. The sale of a business is the sale of each asset separately, and the price is allocated among seven classes by the residual method: cash, traded securities, receivables, inventory, everything else, section 197 intangibles other than goodwill, and finally goodwill and going concern value (§ 1060(a); Reg. §§ 1.1060-1(c), 1.338-6(b)).
2. Both the buyer and the seller report the allocation on Form 8594, and a written allocation agreed between them binds both unless the Service finds it unreasonable (§ 1060(a), (b)). The two forms are expected to match.
3. To the seller, inventory and a cash-basis seller's receivables are ordinary income; equipment is ordinary up to the depreciation taken and capital gain above it (§§ 1245, 1231); a building's straight-line depreciation is taxed at up to 25% and the rest is capital gain (§ 1(h)(1)(E), (h)(6)); goodwill is capital gain.
4. A covenant not to compete is ordinary income to the seller and is amortized by the buyer over 15 years, the same schedule as goodwill (§ 197(d)(1)(E), (f)(3)). So the buyer is indifferent between the two for its deductions, and the seller is not: that is the tension in the allocation.
5. Example: a $3,000,000 price with $1,200,000 of goodwill, $150,000 for a covenant, and $100,000 for consulting, at 37% ordinary and 20% on gains: $572,000 of federal tax, $2,428,000 kept, with 20% of the price taxed as ordinary income. Moving $100,000 from the covenant to goodwill saves $17,000.
6. Pay for a consulting or employment agreement is ordinary income and is also subject to payroll or self-employment tax, and it is deductible to the buyer as paid rather than over 15 years. It is compensation, not part of the Form 8594 allocation.

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