The purchase or sale of a business, and the allocation of the price among its assets, have many tax ramifications. For the seller, the allocation of the purchase price determines the amount realized on the sale of each asset, either as capital gain or as ordinary income. Similarly, for the buyer, it determines the cost basis of each asset and the amount of allowable depreciation or amortization to expense every year, as well as gain or loss on subsequent disposition of the assets acquired.
A recent court case, Peco Foods v. Commissioner, highlights very important issues related to transactions involving asset allocations. Peco purchased two poultry processing plants through its subsidiaries in the mid 1990’s. This type of transaction required an asset breakdown according to Internal Revenue Code Section 1060 and the reporting to the IRS on Form 8594 Asset Acquisition Statement. Peco and the seller included elaborate and detailed schedules in the contract, showing how the purchase price would be allocated among individual assets and between the two subsidiaries. The contract also specified that the allocations were "for all purposes (including financial accounting and tax purposes)." The allocation included values for "Processing Plant Building," "Real Property Improvements," "Machinery and Equipment," and "Furniture, Fixtures and Equipment" among other items.
Towards the end of 1990’s Peco performed a cost segregation study that further subdivided the acquired assets and assigned different tax lives. The most significant changes related to the change in the treatment of assets originally described as “building” from realty to equipment. Apparently the original building included some equipment that was not separately allocated. The company requested a change in its accounting method and submitted amended returns that would have resulted in an additional depreciation expense in excess of $5 million.
The IRS objected, stating that the original asset allocation agreements were clear. Ultimately, matter ended up in the Tax Court. The Tax Court sided with the IRS by disallowing the cost segregation analysis, and determining that the original allocation agreements were unambiguous, enforceable, and complete in their coverage of all the assets at issue. Tax Court’s decision stated that when the allocation is made in a written agreement, the parties will be bound by it.
A cost segregation study should be made prior to finalizing an asset allocation agreement between the buyer and seller. By doing so, the correct allocations can be worked into the contract so both parties are in mutual agreement. Careful consideration must also be paid to the descriptions and definitions used when drafting the purchase documents.
If cost segregation cannot be performed before the transaction, it is recommended avoiding the use of the term "building" in the agreement and substituting the term "plant" if possible. The use of the word "Improvement" by itself could also be problematic as it may be considered part of a building. Furthermore, the agreement should carefully define "Machinery and Equipment" or "Furniture, Fixtures, and Equipment" by not describing these as "tangible personal property," in order to account for the different tax depreciation lives of such assets.
Should you or your business contemplate acquiring the assets of another company, we suggest that you contact your Marcum Tax Advisors to verify the allocations of purchase price within the agreement for an applicable asset acquisition and to ensure that the contract will permit a cost segregation study.