The Residual Method

Once you and the buyer agree on a price for all the assets of your business, the amount must then be allocated to each asset included in the sale in a specific order. The method used to allocate the sales price is called the residual method.

The residual method must be used for any transfer of a group of assets that constitutes a trade or business and for which the buyer's basis is determined only by the amount paid for the assets.

The buyer and seller may enter into a written agreement as to the allocation of the sales price or the fair market value of any of the assets.

This agreement is binding on both parties unless the IRS determines the amounts are not appropriate.

How the Residual Method Works

The assets included in the sale of your business must be segregated into asset classes on Form 8594. There are seven classes of assets.

IRS Form 8594 instructions lists the following seven classes of assets:

  • Class I assets:
    • Cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit held in bank,s, savings and loan associations, and other depository institutions.
  • Class II assets:
    • Actively traded personal property within the meaning of the section 1092(d)(1) and Regulations section 1.1092(d)-1 (determined without regard to section 1092(d)(3)).
    • Class II assets also include, certificates of deposit and foreign currency even if they are not actively traded personal property.
      • Note that Class II assets DO NOT include stock of the seller's affiliates, whether or not actively traded, other than actively traded stock described in section 1504(a)(4).
    • Examples of Class II assets include U.S. government securities and publicly traded stock.
  • Class III assets:
    • Assets that the taxpayer marks-to-market at least annually for federal income tax purposes and debt instruments (including accounts receivable). However, Class III assets DO NOT include:
      • Debt instruments issued by persons related at the beginning of the day following the acquisition date to the target under section 267(b) or 707;
      • Contingent debt instruments subject to Regulations sections 1.1275-4 and 1.483-4 or section 988, unless the instrument is subject to the non-contingent bond method of Regulations section 1.1275-4(b) or is described in Regulations section 1.988-2(b)(2)(i)(B)(2); and
      • Debt instruments convertible into the stock of the issuer or other property..
  • Class IV assets:
    • This is stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year (i.e. office supplies), or
    • property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.
  • Class V assets:
    • Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets.
    • Examples of Class V assets include, furniture and fixtures, equipment, buildings, land, and vehicles, which constitute all or part of a trade or business..
  • Class VI assets:
    • Class VI assets are all section 197 intangibles, EXCEPT goodwill and going concern value.
    • Section 197 intangibles include:
      • Workforce in place
      • Business boos and records, operating systems, or any other information base, process, design, pattern, know-how, formula, or similar item
      • Any customer-based intangible
      • Any supplier-based intangible
      • Any license, permit, or other right granted by a governmental unit.
      • Any covenant not to compete entered into in connection with the acquisition of an interest in a trade or business
      • Any franchise, trademark, or trade name. (See the list below for items that are NOT considered section 197 intangibles)
  • Class VII assets:
    • Goodwill and going concern value (whether or not the goodwill or going concern vale qualifies as a section 197 intangible).

Section 197 Intangibles Does Not Include Any of the Following:

  • An interest in a corporation, partnership, trust, or estate
  • Interests under certain financial contracts
  • Interests in land
  • Certain computer software
  • Certain separately acquired interests in films, sound recordings, video tapes, boos, or other similar property
  • Interest under leases of tangible property
  • Certain separately acquired rights to receive tangible property or services
  • Certain separately acquired interests in patents or copyrights
  • Interest under indebtedness
  • Professional sports franchises acquired before October 23, 2004
  • Certain transaction costs (see section 197(e) for more information)

Form 8594

On Form 8594, for each asset class:

  • Enter the total fair market value of all assets included in that particular class in one column.
  • Then, enter the allocation of the total sales price for each asset class in the adjacent column.

The amount allocated to an asset, other than a Class VII asset, cannot exceed its fair market value on the purchase date.

Allocation Order of the Total Sales Price Paid Using the Residual Method:

  1. Start by first reducing the total sales price by Class I assets, (if any).
  2. Then, allocate the remaining sales price to:
    • Class II assets, then
    • Class III assets, then
    • Class IV assets, and so on, in ascending order.

Class VI assets:

Class VI assets include section 197 intangibles. However, goodwill and going concern value are excluded from Class VI; they are Class VII assets.

Example of the Residual Method:

  • You sold your business.
  • The selling price was $30,000.
  • No cash or deposit accounts or similar accounts were sold.
  • Included in the sale was equipment and furniture, sold at a fair market value of $20,000.
  • The only other asset was inventory, sold at a fair market value of $7,000.

Result:

  • Of the $30,000:
    • $20,000 is allocated to equipment and furniture (Class V), $7,000 to inventory (Class IV), and
    • $3,000 to goodwill (Class VII).

File your personal and small business taxes (Schedule C)