Purchase price allocation and inventory: valuing Class IV at fair market value
Short answer
Inventory is a Class IV asset in a purchase price allocation, so it is allocated its fair market value on the purchase date before equipment, intangibles and goodwill. Fair market value is usually not the seller's cost. IRS Rev. Proc. 2003-51 describes three methods: replacement cost for raw materials and goods bought for resale, comparative sales for finished goods (selling price less disposal costs and a fair profit), and an income method. Obsolete stock is worth less than cost.
Inventory is the easiest asset to count and one of the easiest to get wrong in an allocation. The common mistake is to take the seller's cost from the balance sheet and call it done. For tax, the allocation needs fair market value on the purchase date, and the IRS has published guidance on what that means for inventory. This page covers where inventory sits, how its fair value is worked out, a worked example, and what it means for each side. It isn't tax advice.
Where inventory sits
The Form 8594 instructions define Class IV as stock in trade, other property that would properly be included in inventory if on hand at the close of the tax year, and property held primarily for sale to customers in the ordinary course of business. Under the residual method, Class IV is allocated after cash (Class I), actively traded property and CDs (Class II) and receivables (Class III), and before equipment and real estate (Class V), intangibles (Class VI) and goodwill (Class VII). Each item gets no more than its fair market value.
Two practical consequences. First, inventory is almost always fully allocated, because there's usually plenty of price left when the residual method reaches Class IV. Second, if you understate inventory, the difference doesn't disappear; it falls through to goodwill, which the buyer recovers over 15 years instead of within months.
What "fair market value" means for inventory
Rev. Proc. 2003-51 sets out guidelines for determining the fair market value of inventory acquired when a business's assets are bought for a lump sum, or in a stock purchase with a Section 338 election. It frames the question as what a willing buyer would pay and a willing seller would accept, with a fair division of the profit on the inventory between them, recognizing that the quantity bought may be larger than normal. It describes three methods:
| Method | Best for (per Rev. Proc. 2003-51) | How it works |
|---|---|---|
| Replacement cost | Readily replaceable inventory in a wholesale or retail business; raw materials. Generally not for a manufacturer's work in process or finished goods | Current replacement cost as a base, plus the costs of acquiring and accumulating the same quantity (purchasing, handling, transport, storage), adjusted for factors such as obsolescence or a well-balanced stock |
| Comparative sales | Finished goods expected to be sold to customers in the ordinary course | Expected selling price, less the time to dispose of it, all disposal costs (discounts, commissions, freight) and a profit commensurate with the investment and risk |
| Income method | Finished goods in a going business | Uses the acquired company's historical data to work out what the finished goods must cover: costs of disposition plus a return during the disposal period |
Work in process, the revenue procedure says, is based on the same factors as finished goods, reduced by the expected costs of completion including a reasonable profit allowance for the buyer's completion and selling effort.
Worked example
Illustration, not a real deal
Say you're buying the assets of a hardware and garden store. The seller's books show finished goods at a cost of $180,000 and $12,000 of slow-moving seasonal stock at cost. Following the comparative sales approach for the regular stock:
- Expected selling price to customers in the normal course: $300,000.
- Less costs of disposal (staff time, discounts and markdowns, card fees, delivery): $45,000.
- Less a holding cost for the money tied up while the stock sells through: $5,000.
- Less a profit allowance for the buyer's selling effort and risk: $40,000.
- Fair market value: $300,000 − $45,000 − $5,000 − $40,000 = $210,000.
The slow-moving stock gets a separate look. If it can realistically only be cleared at a deep discount, its fair value might be, say, $3,000 rather than its $12,000 cost. Rev. Proc. 2003-51 recognizes that inventory containing obsolete merchandise may be worth less than replacement cost.
Class IV total: $210,000 + $3,000 = $213,000, compared with $192,000 on the seller's books. That $21,000 difference comes out of what would otherwise have gone to goodwill.
Every number above is an estimate that needs support. The selling price should reflect what the stock actually sells for, not list price; disposal costs should come from the store's own history; the profit split should be reasoned, not assumed. That's what an examiner will look at.
What it means for each side
| Higher inventory value | Lower inventory value | |
|---|---|---|
| Buyer | More basis recovered through cost of goods sold as stock sells; lower reported margins on that stock | More in goodwill, recovered over 15 years; higher reported margins on the first sell-through |
| Seller | More ordinary income (inventory gain is ordinary) | Less ordinary income; more in goodwill, often capital gain for an individual seller |
The tension is real, which is why both sides benefit from a documented method rather than a negotiated number. The general buyer-versus-seller picture is in purchase price allocation tax considerations.
Practical points at closing
- Count on the closing date. A count taken days earlier needs a roll-forward for sales and receipts. Agree who counts and who observes.
- Separate the categories. Saleable stock, slow-moving, damaged and obsolete items, consigned goods (which the seller doesn't own) and supplies used in operations.
- Supplies aren't always inventory. Cleaning chemicals a janitorial company uses on jobs aren't held for sale to customers. Whether they're Class IV depends on how they're held; ask your adviser.
- Tie it to the price mechanism. If the agreement has an inventory or working-capital true-up, the final count drives it. A true-up paid in a later tax year means a supplemental Form 8594.
- Keep the support. Count sheets, pricing data and the method used, in the deal file.
Mistakes that show up later
- Using the seller's book cost for finished goods, which usually understates fair value and pushes value into goodwill.
- Carrying obsolete or damaged stock at full cost, which overstates Class IV and gives the buyer basis in things that won't sell.
- Counting consigned goods the seller doesn't own.
- Forgetting that the buyer's first months of margins will look thin if inventory was stepped up, which can confuse anyone comparing post-closing results with the seller's history.
- Leaving the inventory method undocumented, so nobody can explain the number two years later.
Inventory and the SBA loan file
On an SBA 7(a) acquisition loan, the lender takes a lien on inventory, and under SOP 50 10 8.1 inventory counts toward collateral at only 10% of its value. A generous inventory allocation doesn't help collateral coverage. Inventory does matter to the lender's view of working capital, especially in retail and distribution businesses, and some deals include working capital financing or an SBA-backed line alongside the acquisition loan; see SBA working capital loans. How buyers set an inventory target in the purchase agreement is covered on our sister site under working capital peg.
For the full class order and more worked numbers, see the purchase price allocation guide and purchase price allocation examples. Guidance checked against Rev. Proc. 2003-51 and the Form 8594 instructions as of October 2026; confirm with your tax adviser.
Common questions
Can we just use the seller's book value for inventory?
Book value is a starting point, not fair market value. Finished goods often have a fair value above cost because some of the selling profit belongs to the seller, and obsolete items are worth less than cost. Rev. Proc. 2003-51 explains the adjustments.
Why would a buyer want more allocated to inventory?
Inventory is recovered through cost of goods sold as it's sold, usually within months, which is the fastest recovery of any class after cash and receivables. The seller generally reports gain on inventory as ordinary income.
What if the closing count is different from the estimate?
Use the count on the purchase date. If the price changes because of a working-capital or inventory true-up, the increase or decrease is allocated under the Form 8594 rules, with a supplemental statement if it falls in a later tax year.
Does the inventory allocation affect an SBA loan?
The lender takes a lien on inventory and, for SBA collateral purposes, counts it at a 10% value. The allocation doesn't change that, but the inventory count often feeds the lender's working-capital analysis.
Related guides
Sources
This guide explains rules and practice in plain English. It isn't legal, tax or credit advice, and SBA and IRS rules change. Check the current SOP, regulations and your lender's requirements before you rely on anything here. Examples with made-up businesses are illustrations, not real deals.