Residual Method to Allocate Business Purchase Price to Goodwill
The residual method to allocate a business purchase price to goodwill is often used to determine specific metrics for buyers and sellers when a business entity changes hands.
When a taxpayer sells a trade or business for a lump sum, and the character of the business is such that goodwill or going concern value could be attached to the assets that make up the business, the seller and purchaser who don’t otherwise have a binding written agreement as to how the purchase price is to be allocated among the assets must use a residual allocation method.
The result of this method is to determine the purchaser’s bases in the acquired assets and the seller’s gain or loss, capital or ordinary, on the assets sold. The allocation is reported on Form 8594, Asset Acquisition Statement (applicable to both buyer and seller).
The residual method requires that all assets of an acquired business be divided into seven classes:
Class I: Cash and cash equivalents.
Class II: Certificates of deposit, U.S. government securities, readily marketable securities, foreign currency.
Class III: Assets the taxpayer marks to market at least annually for tax purposes, including accounts receivable.
Class IV: Stock in trade or other property that would be included in inventory if on hand at the close of the tax year, property held primarily for sale to customers.
Class V: All assets other than Class I, II, III, IV, VI and VII assets (generally including furniture and fixtures, buildings, land, vehicles, and equipment, which constitute all or part of a trade or business).
Class VI: Code Sec. 197 intangibles, except goodwill and going concern value.
Class VII: Assets in the nature of goodwill and going concern value.
The purchase price (reduced by Class I amounts) is allocated successively to the assets in Classes II through VI based on their fair market value. The excess (residual) of the purchase price over the values of Class I through VI assets is goodwill and going concern value.
“ Example - Purchase of Goodwill - Gary bought a business from Ginny for $400,000. The following Class II, III and V assets were included as part of the purchase price: equipment, furniture, land, building, marketable securities, and accounts receivable. These assets had a value of $350,000. Also included in Gary’s acquisition are goodwill and a customer list claimed to be worth $26,000. The customer list is a Class VI asset, leaving the residual amount of $24,000 to be goodwill as a Class VII asset. Although both the customer list and goodwill are Sec. 197 assets amortizable over 15 years, they are classed separately for the asset acquisition computation on Form 8594Example – Insurance Agent Termination Payments - There was no sale or exchange where assets used by an insurance agent in the conduct of his business, including a computer, customer lists, and books and records, were returned to the insurance company. The assets weren't the agents to sell because his agreement with the insurance company specified that the assets were the insurance company's property. And while the agent developed goodwill during his tenure (the sale of which would generally produce capital gain), the goodwill, too, belonged to the company and wasn't the agents to sell. So, termination payments received by the agent were ordinary income. (Baker, Warren L. Jr. v. Com., (2003, CA7)). ”
- Insurance Agent Termination Payments