When a physical therapy practice is sold as an asset purchase — the dominant structure used by PE-backed consolidators and strategic buyers — every dollar of the purchase price must be assigned to a specific asset category under Section 1060 of the Internal Revenue Code. That assignment determines whether you pay ordinary income tax rates of up to 37% or long-term capital gains rates of 20%. On a $5M transaction, an unfavorable allocation versus a seller-favorable one can cost $150,000 or more in additional federal tax — and with extreme allocation splits, the gap can be significantly larger. Understanding how this works — and negotiating it before you sign — is non-negotiable.
What Section 1060 Actually Requires
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The Residual Method Is Mandatory
Under IRC §1060, when a buyer acquires a trade or business in an applicable asset acquisition, both parties must allocate the purchase price (including assumed liabilities) across seven asset classes in a prescribed order. Neither party can ignore the allocation or adopt a different number on their own tax return. Both buyer and seller must report on IRS Form 8594 and their allocations must be consistent — or the IRS treats the inconsistency as an audit flag.
Section 1060 applies to any transfer of a group of assets that constitutes a trade or business — meaning the buyer could continue operating the business. In the physical therapy M&A market, virtually every transaction involving an operating clinic meets this test. The law was enacted specifically to prevent buyers and sellers from privately agreeing on allocations that maximize their respective tax positions at the government's expense.
The Seven Asset Classes: The Residual Waterfall
Purchase price is allocated in order from Class I through Class VII. Each class must be funded to its fair market value before any remainder flows to the next class. What remains after Classes I–VI is allocated to Class VII — goodwill and going concern value.
| Class |
Asset Type |
Typical PT Practice Examples |
Seller Tax Rate |
Buyer Treatment |
| Class I |
Cash & Cash Equivalents |
Bank accounts, petty cash — if transferred; in cash-free, debt-free deals, cash is retained by the seller and Class I allocation is typically zero |
Ordinary (up to 37%) if transferred |
No depreciation; face value |
| Class II |
Actively Traded Personal Property |
Certificates of deposit, government securities |
Ordinary / varies |
Mark-to-market basis |
| Class III |
Accounts Receivable & Debt Instruments |
Accounts receivable (if transferred), patient balances |
Ordinary (up to 37%) |
Amortized / collected |
| Class IV |
Inventory |
Medical supplies, DME inventory |
Ordinary (up to 37%) |
COGS upon sale |
| Class V |
All Other Tangible Property |
Treatment tables, therapeutic equipment, computers, leasehold improvements |
Ordinary if depreciated (§1245 recapture); LTCG on appreciation |
5–7 yr depreciation (MACRS); bonus depreciation eligible |
| Class VI |
Section 197 Intangibles (Non-Goodwill) |
Non-compete agreements, patient lists, referral source relationships, proprietary software, licenses |
Ordinary (up to 37%) for non-competes; may vary for others |
15-yr straight-line amortization |
| Class VII |
Goodwill & Going Concern Value |
Reputation, brand, assembled workforce, payer contracts, patient volume, market position |
Long-term capital gains (20% + 3.8% NIIT = 23.8%) |
15-yr straight-line amortization |
ExamplesBank accounts, petty cash — if transferred to buyer; in cash-free, debt-free deals, cash is retained by the seller and Class I is typically zero
Seller RateOrdinary (up to 37%) if transferred
BuyerNo depreciation; face value
ExamplesCertificates of deposit, government securities
Seller RateOrdinary / varies
BuyerMark-to-market basis
ExamplesAccounts receivable (if transferred), patient balances
Seller RateOrdinary (up to 37%)
BuyerAmortized / collected
ExamplesMedical supplies, DME inventory
Seller RateOrdinary (up to 37%)
BuyerCOGS upon sale
ExamplesTreatment tables, therapeutic equipment, computers, leasehold improvements
Seller RateOrdinary if depreciated (§1245 recapture); LTCG on appreciation
Buyer5–7 yr MACRS; bonus depreciation eligible
ExamplesNon-competes, patient lists, referral relationships, licenses
Seller RateOrdinary (up to 37%)
Buyer15-yr straight-line amortization
ExamplesBrand, assembled workforce, payer contracts, patient volume, market position
Seller RateLTCG (20% + 3.8% NIIT = 23.8%)
Buyer15-yr straight-line amortization
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Most PT Deals Are Cash-Free, Debt-Free — Which Changes Class I
In the predominant deal structure used by PE-backed and strategic buyers in PT M&A, the seller retains all cash at closing and the buyer pays enterprise value only. In these cash-free, debt-free transactions, Class I typically carries a zero allocation because no cash is being transferred. Similarly, accounts receivable (Class III) are often retained by the seller and collected post-close rather than transferred. See Section 08 for a full explanation of how CFDF structure interacts with the §1060 allocation.
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Section 1245 Recapture: The Hidden Trap in Class V
If your practice has depreciated equipment over its life (as virtually all practices do), the IRS "recaptures" those prior deductions and taxes them as ordinary income — even if you sell for a gain. Example: A $50,000 treatment table with an adjusted tax basis of $10,000 (reflecting depreciation claimed), sold for $30,000, generates $20,000 of §1245 ordinary income recapture. Only gain above the original $50,000 cost would qualify for capital gains treatment — and since $30,000 is well below original cost, there is zero capital gain here.
The Fundamental Conflict: Buyer vs. Seller Interests Are Opposite
Section 1060 creates a zero-sum negotiation embedded inside every asset purchase. What is tax-efficient for the buyer is often tax-costly for the seller — and vice versa. Understanding this conflict is the foundation of every allocation negotiation.
Seller's Preference
Maximize Goodwill (Class VII)
- Goodwill proceeds taxed at long-term capital gains rates (20% federal) — the lowest available rate
- Adding 3.8% Net Investment Income Tax (NIIT) for high earners, effective rate is ~23.8% federal
- Minimize allocation to non-competes and equipment, which trigger ordinary income
- Minimize accounts receivable transfer to avoid converting working capital into ordinary income
- Every $1M shifted from ordinary income to goodwill saves ~$130,000+ in federal tax at top rates
Buyer's Preference
Maximize Depreciable / Amortizable Assets
- Goodwill and §197 intangibles must be amortized over 15 years — a slow, long deduction
- Tangible equipment (Class V) qualifies for 5–7 year MACRS depreciation or 100% bonus depreciation in qualifying years
- Non-compete payments (Class VI) amortize over 15 years but create a deduction the seller pays ordinary income on
- Buyers often seek high equipment and non-compete allocations to accelerate their deductions
- PE-backed buyers may be less sensitive due to entity-level tax structures (flow-through vs. C-Corp)
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The Non-Compete Is Almost Always a Flashpoint
Buyers routinely push for large non-compete allocations because they get a 15-year amortization deduction. Sellers pay ordinary income rates — up to 37% — on every dollar assigned there. A $500,000 non-compete allocation costs a seller in the 37% bracket approximately $185,000 more in federal tax than if the same amount had been allocated to goodwill. This number alone justifies having a tax advisor at the negotiating table before term sheet execution.
IRS Form 8594: The Reporting Obligation Both Parties Must File
Both the buyer and the seller are required to attach IRS Form 8594 (Asset Acquisition Statement Under Section 1060) to their federal tax returns for the year the sale closes. The form reports the total consideration, the agreed-upon allocation across each asset class, and any supplemental statements for deferred payments or contingent consideration.
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Agreed Allocation Is Binding on Both Parties
If buyer and seller reach a written allocation agreement — typically embedded in the asset purchase agreement (APA) — both are bound to report that allocation on Form 8594. Deviation from an agreed allocation is treated as a misrepresentation and can trigger penalties.
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No Agreement? The IRS Doesn't Care
If the APA is silent on allocation, each party technically files their own Form 8594 using their own values — but inconsistent filings are a known IRS audit trigger. The IRS cross-matches the forms. Significant discrepancies invite examination of the entire transaction.
3
Subsequent Adjustments Must Be Reported
If the purchase price is adjusted post-closing — due to working capital true-ups, earnout payments, or other contractual consideration adjustments — a supplemental Form 8594 must be filed for the year in which the adjustment occurs, reallocating the additional consideration across the same asset classes. Note that indemnification payments are generally treated as separate income or expense items, not as §1060 purchase price adjustments.
4
Earnouts Create Complexity
Earnout payments received in future years must be allocated to the same asset classes as the original purchase price — they are not automatically treated as capital gain. The character of the income follows the asset class, not the timing of payment. If the APA assigns earnout proceeds to goodwill, they receive capital gains treatment. If to a non-compete, ordinary income.
Illustrative Example: $5M Practice Sale — Two Allocation Scenarios
Consider a PT practice owner selling for $5,000,000. The following comparison shows the impact of two different allocation structures on the seller's after-tax proceeds. All figures are illustrative and assume a seller in the top federal bracket.
Class I–IV
Inventory & Other
$300K
37%
Class V
Equipment
$700K
37%*
Class VI
Non-Compete
$1,000K
37%
Class VII
Goodwill
$3,000K
23.8%
Class I–IV
Inventory & Other
$300K
37%
Class V
Equipment
$300K
37%*
Class VI
Non-Compete
$200K
37%
Class VII
Goodwill
$4,200K
23.8%
📊 After-Tax Proceeds Comparison
The Difference Between Scenario A and Scenario B
Scenario A — Buyer-Favorable
Ordinary income (Classes I–VI)$2,000,000
Tax on ordinary @ 37%($740,000)
Capital gains (Class VII)$3,000,000
Tax on LTCG @ 23.8%($714,000)
Estimated federal tax($1,454,000)
Net after-tax proceeds$3,546,000
Scenario B — Seller-Favorable
Ordinary income (Classes I–VI)$800,000
Tax on ordinary @ 37%($296,000)
Capital gains (Class VII)$4,200,000
Tax on LTCG @ 23.8%($999,600)
Estimated federal tax($1,295,600)
Net after-tax proceeds$3,704,400
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$158,400 in Additional Proceeds — Same Purchase Price
On an identical $5,000,000 sale, a seller-favorable allocation generates approximately $158,000 more in after-tax proceeds than a buyer-favorable allocation. These are illustrative federal-only figures. State income taxes — many of which do not conform to federal capital gains treatment — can widen this gap further. The allocation is negotiated, not given. Sellers who accept a buyer's proposed APA without scrutinizing the allocation schedule are leaving money on the table.
Negotiation Strategies for Sellers
The allocation is not fixed by law — it is negotiated between the parties. Most buyers present a proposed allocation embedded in the APA that reflects their interests. Sellers who engage with this proactively — before signing a letter of intent — maintain far more leverage than those who address it at closing.
Before LOI
Establish Allocation Principles Early
- Request that allocation methodology be addressed in the LOI or term sheet, not left to the APA phase
- Understand the buyer's proposed non-compete amount — and push back on overvaluation
- Ask whether the buyer is a C-Corp PE platform or pass-through — their tax sensitivity differs significantly
- Have your CPA model the after-tax proceeds under the buyer's proposed allocation before you accept any offer
During APA Negotiation
Push Back on Specific Line Items
- Challenge equipment allocations that appear inflated — request the buyer's FMV support; allocations should reflect fair market value, not a number engineered to maximize their depreciation benefit
- Non-compete allocations should be proportionate to deal size and supportable by FMV analysis — scrutinize any allocation that appears sized to maximize the buyer's amortization deduction rather than reflect genuine restraint-of-trade value
- Ensure patient list and referral relationship allocations are analyzed — these are §197 intangibles (Class VI) taxed at ordinary rates
- If agreement cannot be reached, consider whether the purchase price should be grossed up to compensate for the adverse allocation
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You Cannot Have Two Different Allocations
A common misunderstanding: sellers sometimes believe they can simply report a different number than the buyer on their own tax return. This is incorrect and carries serious risk. While parties technically file separately when no written agreement exists, inconsistent Form 8594 filings are a known IRS cross-matching trigger. If examined, the IRS can challenge your allocation, impose penalties, and assess additional tax plus interest. Written agreements in the APA control. If the APA is silent, you may have more flexibility — but also more risk.
Asset Sale vs. Stock Sale: The Section 1060 Alternative
Section 1060 only applies to asset purchase transactions. If a buyer purchases the stock (or membership interests in an LLC) of the practice entity rather than its underlying assets, there is no §1060 allocation — the seller's gain on the stock or membership interests is generally taxed as long-term capital gain (assuming the requisite holding period), without any forced allocation across ordinary-income classes. This is why sellers generally prefer stock sales and buyers generally prefer asset purchases.
Asset Sale (§1060 Applies)
Buyer Preferred; Seller Disadvantaged
- Purchase price must be allocated across Classes I–VII
- Equipment and non-compete proceeds taxed as ordinary income
- Buyer gets stepped-up basis in all acquired assets
- Buyer can depreciate/amortize purchased assets from closing
- Most PE and strategic acquirers in PT strongly prefer asset structure
Stock Sale (§1060 Does Not Apply)
Seller Preferred; Buyer Disadvantaged
- Seller's gain — proceeds minus adjusted stock basis — is taxed as long-term capital gain, with no forced allocation to ordinary-income classes
- No §1245 recapture — prior depreciation does not trigger ordinary income
- Buyer inherits the entity's historical tax basis — no step-up in asset basis
- Buyer takes on entity's historical liabilities and contingencies
- Buyers typically price stock deals lower to compensate for lost depreciation benefit
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The §338(h)(10) Election: A Middle Ground
For S-corporations, buyers and sellers can jointly make a §338(h)(10) election, which treats a stock sale as a deemed asset sale for federal income tax purposes while remaining a stock sale for state law and liability purposes. The seller reports gain as if the S-Corp sold its underlying assets — meaning §1060 allocation applies — but because the S-Corp is a pass-through entity, there is only one level of tax (at the shareholder level), avoiding the double taxation that a C-Corp asset sale would trigger. The buyer receives a stepped-up basis in the deemed acquired assets, exactly as in an asset purchase. This election requires mutual agreement by both parties and is commonly negotiated by PE buyers acquiring S-Corp PT practices as a way to achieve asset-purchase economics without taking on the legal risks associated with an asset deal.
Cash-Free, Debt-Free Deals: What Happens to the Cash You Keep
The vast majority of PT practice acquisitions are structured on a cash-free, debt-free (CFDF) basis. This means the buyer pays the negotiated enterprise value for the operating business only — free of existing debt obligations — and the seller retains all cash held in the business at closing. Understanding how this interacts with §1060 is essential, because the two concepts operate independently and are frequently confused.
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The Cash You Retain Is Not Part of the §1060 Allocation
In a CFDF asset purchase, the cash sitting in your practice's bank accounts at closing is not transferred to the buyer and therefore never enters the §1060 purchase price allocation. The buyer is purchasing the operating assets of the business — equipment, intangibles, goodwill — not the cash. You simply keep the cash as your own money. The §1060 allocation applies only to the consideration the buyer actually pays you for the business assets.
Cash Retained by Seller
How It Works in an Asset Sale
- In an asset purchase, the practice entity itself is not sold — only the specified operating assets are. Cash held by the entity stays in the entity, which the seller continues to own post-closing
- After the asset sale closes, the seller winds down or dissolves the entity and distributes remaining cash and any retained assets to themselves
- For an S-Corp or LLC, that final distribution is tax-free to the extent of the owner's adjusted basis in the entity; any excess is capital gain
- The cash itself was already taxed when earned as ordinary business income — keeping it at the sale does not create a new tax event on the cash alone
Accounts Receivable — The Key Variable
Retained A/R vs. Transferred A/R
- In most CFDF structures, accounts receivable are retained by the seller and collected post-closing — they are not part of the asset sale and do not enter the §1060 allocation
- If A/R is transferred to the buyer, it becomes Class III and is taxed as ordinary income under §1060
- Retaining A/R is generally favorable to sellers — you collect face value over 30–90 days and the proceeds are treated as collection of previously recognized income, not a separate sale event
- Confirm explicitly in the APA which receivables are included in or excluded from the purchased assets
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The Working Capital Peg: Where CFDF and §1060 Do Intersect
CFDF deals almost always include a working capital target — a negotiated "peg" representing the level of net working capital (excluding cash and debt) the buyer expects to receive. If actual working capital at closing falls short of the target, the purchase price is reduced dollar-for-dollar; if it exceeds the target, the price increases. These post-closing adjustments are treated as adjustments to the §1060 purchase price and must be reported on a supplemental Form 8594 in the year the adjustment is finalized. The character of the adjustment follows the asset class to which it is allocated — typically goodwill for residual true-ups. Sellers should understand their working capital position well before closing to avoid surprise price reductions that arrive after they've already filed taxes on the full purchase price.
📋 Illustrative CFDF Deal Structure
How Cash, A/R, and §1060 Interact at Closing
What the Buyer Pays For
Enterprise value (negotiated)$5,000,000
Cash included in deal?No — stays with seller
A/R included in deal?No — retained, collected post-close
§1060 allocation base$5,000,000
What §1060 applies toOperating assets only
What the Seller Keeps
Cash in bank at closing$320,000
Accounts receivable (retained)~$180,000
Total retained outside deal~$500,000
Subject to §1060?No — not part of purchase price
Taxed separately?Cash: wind-down distribution; A/R: collection
Installment Sales & Earnouts: When Payments Arrive Over Time
Many PT acquisitions involve deferred payments — earnouts tied to future performance, seller notes, or other contingent consideration paid after closing. Under §453 of the Internal Revenue Code, sellers can in some cases report gain ratably as payments are received rather than all in the year of closing. However, the tax character of each installment payment is determined by the asset class to which it was allocated — not by when you receive it.
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Character Follows the Asset Class, Not the Payment Date
If a portion of the purchase price is allocated to goodwill (Class VII) and paid via a two-year earnout, each earnout payment received on that goodwill allocation retains long-term capital gains character. Conversely, if earnout proceeds are allocated to a non-compete (Class VI), they are taxed as ordinary income — in the year each payment is received. The allocation governs the tax rate; the installment method governs the timing.
2
Installment Reporting Is Not Available for All Asset Classes
§453 installment treatment is generally not available for §1245 recapture income (i.e., depreciation recapture on Class V equipment). Even if you elect installment reporting on the rest of the transaction, the recapture income from depreciated equipment is fully taxable in the year of sale — regardless of when you receive the cash. This can create a mismatch: you owe tax on recapture income in Year 1 even if the corresponding payment doesn't arrive until Year 2.
3
Contingent Consideration and "Open Transaction" Treatment
Where the total earnout amount cannot be determined at closing (e.g., payments depend on future EBITDA), special rules apply to determine how basis is recovered against each payment. Sellers with significant contingent consideration should confirm with their CPA whether the "closed transaction" (fixed price) or "open transaction" (contingent price) installment rules apply — they produce materially different timing of tax.
4
Interest Imputation on Seller Notes
If the APA includes a seller note without a stated interest rate (or below the applicable federal rate, "AFR"), the IRS will impute interest income under §483 or the original issue discount rules. Imputed interest is taxed as ordinary income, effectively converting a portion of what you negotiated as purchase price into interest income. Any seller note should carry an interest rate at or above the current AFR to avoid this issue.
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The APA Allocation Controls Earnout Character — Negotiate It That Way
Buyers will sometimes propose that earnout payments be allocated to working capital, performance milestones, or non-compete obligations rather than goodwill — language that converts future payments from capital gains to ordinary income. Review every earnout provision in the APA through a tax lens, not just a valuation lens. If earnout proceeds are economically tied to the ongoing value of the practice (i.e., they represent contingent goodwill payments), they should be structured and allocated as goodwill.
Seller's Pre-Closing Allocation Checklist
1
Engage a CPA With M&A Transaction Experience Before LOI
Your practice's annual accountant may not have deal-specific tax expertise. Engage an advisor experienced in healthcare M&A who can model after-tax proceeds under multiple allocation scenarios before you agree to any price.
2
Request the Buyer's Proposed Allocation at or Before LOI
Most buyers will not volunteer this information. Ask for their preliminary allocation schedule as a term sheet exhibit. If they resist, that itself is information worth having.
3
Get a Fixed Asset Schedule With Current Adjusted Tax Basis and FMV
You need to know the adjusted tax basis of every depreciable asset being transferred. §1245 recapture is calculated on the difference between the allocated sale price and the asset's adjusted tax basis — which reflects all depreciation actually claimed for tax purposes, not necessarily book depreciation. Know your numbers before negotiations.
4
Understand the Non-Compete Terms and Their Tax Cost
Before agreeing to any non-compete payment, calculate its after-tax cost at ordinary income rates and compare it to what you would net if that dollar amount were allocated to goodwill. Model the net cost explicitly.
5
Determine Whether a Stock Sale or §338(h)(10) Election Is Feasible
If your practice is organized as an S-Corp, a §338(h)(10) election may be available and worth serious consideration. Discuss with your advisor whether the buyer will entertain it and at what price adjustment.
6
Scrutinize Any Allocation to Patient Lists or Referral Relationships
These are §197 intangibles (Class VI) — they generate ordinary income for the seller. Buyers sometimes inflate these categories. Push back with support for why this value belongs in goodwill (Class VII) instead.
7
Confirm the APA Contains an Explicit, Agreed Allocation Schedule
Do not let the APA go to closing without a signed Exhibit specifying each class and dollar amount. An APA silent on allocation leaves you exposed — both to IRS scrutiny and to a buyer who files differently than you expect.
8
Plan for Estimated Tax Payments on Closing Proceeds
The sale will likely trigger a substantial federal (and state) tax liability due in the year of closing. Sellers who fail to set aside and remit estimated tax payments face underpayment penalties on top of their tax bill. Coordinate with your CPA on timing and withholding.
Legal & Tax Disclaimer
This whitepaper is published by Mihama Acquisitions for general informational and educational purposes only. It does not constitute legal, tax, accounting, or financial advice and should not be relied upon as such. The tax rates, rules, and code sections referenced herein are based on federal law in effect as of the date of publication and are subject to change by legislation, regulation, or administrative guidance at any time. State and local tax treatment may differ materially from the federal treatment described. Individual circumstances vary significantly; the after-tax outcomes illustrated in this document are hypothetical examples intended solely to demonstrate the potential magnitude of allocation decisions and do not represent a guarantee or prediction of actual results for any specific transaction. Nothing in this whitepaper creates an attorney-client, accountant-client, or advisor-client relationship between Mihama Acquisitions and any reader. Before entering into any transaction, you should consult with qualified legal counsel, a licensed CPA or tax advisor, and a financial advisor experienced in healthcare mergers and acquisitions regarding your specific facts and circumstances. Mihama Acquisitions is an investment banking and M&A advisory firm and is not a law firm or accounting firm.