Allocation Rules for Asset Transactions

 
In an asset sale transaction, the allocation of the aggregate purchase price among the target’s assets is of great importance for both the buyer and seller, and often leads to renewed negotiations after an initial deal has been struck.

The seller prefers to allocate as much of the price as possible to long-term capital gain items and as little as possible to ordinary income items. The buyer, on the other hand, prefers to allocate as much as possible to inventory or items recoverable by depreciation or amortization, and as little as possible to non-depreciable assets or assets with long lives for depreciation and amortization such as goodwill.

The following is intended to acquaint you with the basic income tax rules regarding the allocation of the purchase price for a company’s assets.

Two statutory provisions greatly reduce the parties’ flexibility in allocating the purchase price: the asset allocation rules of §1060 and the rules for amortization of intangibles under §197.

Section 1060
Section 1060 prescribes the so-called “residual method” for the allocation of purchase price in a taxable asset acquisition. Under that method, the amount of the purchase price (including assumed liabilities) is allocated in accordance with the following priorities:

1. First – To cash, demand deposits and similar assets in an amount equal to their fair market value.
2. Second – To certificates of deposit, U.S. government securities, readily marketable securities, foreign currency and similar assets, in like manner.
3. Third – To assets, consisting of all assets, tangible and intangible, other than the first two discussed, in like manner.
4. Fourth – The balance to intangible assets in the nature of goodwill and goingconcern value.

In item (3) above, is where accounts receivable, inventory, machinery and equipment are allocated. Item (4), the residual, is where this methodology gets its name.

Form 8594 must be filed by each party to the transaction with its tax return for the year of sale, and it’s typically a good idea to have this agreed upon and completed along with the asset purchase agreement. Discrepancies between the buyer and seller tax reporting will surely lead to post-closing problems.

Section 197
Under §197, an amortization deduction is allowed for the capitalized cost of certain types of intangibles, including goodwill, going concern value, workforce in place, books and records, customer lists, licenses, permits, franchises and trademarks. A §197 intangible must be amortized over a 15-year period.

COVENANTS NOT TO COMPETE AND CONSULTING AGREEMENTS
Purchasers of corporate assets or stock frequently attempt to allocate a portion of the consideration for the sale of the business to covenants not to compete, consulting agreements, or similar compensatory arrangements.

The purchasers’ motivation is often to convert a payment for nondepreciable stock (in a stock deal) or for assets depreciable over a long recovery period (in an asset deal) into a currently deductible payment. The seller may resist this allocation since those payments constitute ordinary income rather than capital gain.

Section 197 requires that non-competition payments be capitalized and amortized over a 15 year term. This period is considerably longer than the term of most non-compete agreements.

To the extent that payments for consulting services are reasonable in amount, they are deductible over the life of the agreement. If such payments are unreasonable in amount, they will be recharacterized as (i) part of the purchase price of the acquired stock (in a stock deal) or (ii) part of the purchase price of the acquired assets (in an assets deal). In the latter case, the amount so recharacterized may be allocated to depreciable or nondepreciable assets, including goodwill and covenants not to compete.

FWIW - Spring/Summer 2006

FWIW is intended to inform readers of developments in the field of valuation. The articles written may, or may not, reflect the opinion of the authors. Please note, any advice contained in this publication was not intended, or written, to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This publication is distributed with the understanding that the publisher and distributor are not providing legal, accounting or other professional advice and assume no liability whatsoever in conjunction with the information contained within this publication.