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February 23, 2012
Taxpayer Bound by Allocation Agreements

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By Robert Willens

Robert Willens is the president of Robert Willens LLC, New York, and an adjunct professor of finance at Columbia University Graduate School of Business.

Robert Willens When, in an applicable asset acquisition, there is a written agreement regarding the allocation of the consideration paid and received in the transaction, the parties to that agreement are bound to use the allocations set forth in the agreement. The IRS can freely disregard or set aside the written allocations, whereas a party to the written agreement can deviate only from the particulars of the agreement by adhering to the strict standards of the Danielson rule.

Peco (P) and the members of its affiliated group were engaged in the business of poultry processing. P acquired a poultry processing plant in Sebastopol, Miss. P also acquired a poultry processing plant in Canton, Miss.

The Sebastopol acquisition was effected through an asset purchase agreement dated December 29, 1995. Included in the Sebastopol agreement was a schedule that allocated the purchase price of the acquired assets between Peco Foods of Mississippi Inc. and Limited Liability Co. as the purchasing subsidiaries. In particular, P and GA (the seller) agreed to allocate the $27.15 million purchase price among 26 assets "for all purposes (including financial accounting and tax purposes)."

The Canton acquisition was memorialized in an asset purchase agreement dated May 12, 1998. P and MD (the seller) agreed to allocate the $10.5 million purchase price among three assets "for all purposes (including financial accounting and tax purposes)."

P belatedly commissioned Moore Stephens Frost PLC (MSF) to perform a segregated cost analysis of the Sebastopol and Canton plants. The analysis subdivided the assets acquired into subcomponents. Beginning on the 1998 income tax return, P depreciated some assets acquired in the Sebastopol acquisition and in the Canton acquisition over seven-year or 15-year class lives with a double declining or 150 percent depreciation method. Before that, those assets had been depreciated over a 39-year period using a straight-line depreciation method. The IRS disallowed the accelerated depreciation deductions, and the Tax Court upheld that determination.1

Section 1060 prescribes special allocation rules for determining a transferee's basis and a transferor's gain or loss in an applicable asset acquisition, which is any transfer of assets that constitutes a trade or business and for which the purchaser's basis is determined wholly by reference to the consideration paid for them.2

When the parties to an applicable asset acquisition agree in writing as to the allocation of any amount of consideration, or as to the fair market value of any of the assets transferred, the agreement is binding on the transferee and transferor unless the commissioner determines that the allocation (or value) is not appropriate. The House report accompanying the enactment of the rule stated that the:

    written agreement . . . will be binding . . . unless the parties are able to refute the allocation or value under the standards set forth in the Danielson case. In Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), the court ruled that a taxpayer can challenge the tax consequences of a written agreement as construed by the Commissioner only by adducing proof which in an action between the parties . . . would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.3

The IRS asserted that section 1060 and the Danielson rule barred P from modifying the purchase price allocations in a manner inconsistent with the original allocation schedules. P contended that neither prohibited it from classifying property acquired in the acquisitions as section 1250 or section 1245 property. According to P, section 1060 and its legislative history are silent regarding whether a taxpayer may classify property as section 1250 or section 1245 property and require only that the purchase price be allocated under the residual method. The court disagreed.

When the parties to an applicable asset acquisition agree in writing as to the allocation of the consideration, the agreement shall be binding unless the commissioner determines that the allocation is inappropriate. When the parties do not agree in writing, the residual method applies. Congress's use of the phrase "shall be binding" indicates that the written agreement supersedes the residual method of allocation.4

For example, in West Covina Motors Inc. v. Commissioner,5 the petitioner (WC), paid to Norman Hoffman; Chrysler Financial; Cooksey, Howard, Martin, & Toolen; and Rogers, Clem, & Co. (RC) legal fees related to its acquisition of another company's vehicle inventory.

WC did not properly substantiate the legal fees it claimed were associated entirely with inventory. The court found that the legal fees paid to Chrysler and Cooksey were attributable to inventory financing and that part of the money paid to RC was for services related to physical vehicle inventory. It held that those fees were allowable as cost of goods sold.

The Service argued that the legal fees paid to Hoffman and the balance paid to RC had to be allocated in accordance with the FMV limitations of section 1060 (the remaining legal fees were capital expenditures related to the C acquisition). It argued that all the legal fees had to be allocated under section 1060 to Class V intangible assets, goodwill, and going concern value, and therefore had to be amortized ratably over 15 years, beginning with the month of purchase, under section 197.

WC did not dispute that the purchase constituted an applicable asset acquisition under section 1060, but argued that the section did not apply to the allocation of the legal fees. When the parties do not allocate the consideration entirely, the residual method of allocation may apply. Under that method, a party generally allocates the consideration to the acquired assets in descending order of priority by class under the residual allocation method. Consideration is first reduced by the amount of Class I assets. Any remaining consideration is then allocated to the residual classes in proportion to their FMV. Accordingly, the amount of consideration allocated to non-Class V assets must not exceed the FMV on the purchase date.6

The court found that there were no class I, II, or IV assets transferred and had to decide whether the legal fees must be allocated under section 1060. The IRS cited no authority requiring legal fees to be allocated under the FMV limitations of section 1060 when the parties have stipulated the cost of each asset. The court noted that the section is meant to prevent abuse when there is no agreement between the parties concerning how much of the purchase price is allocable to which class of assets. Here, the parties had stipulated the cost of each asset; therefore, section 1060 did not apply.

The court held that the legal fees should be allocated proportionately to the assets with which they are associated. The legal fees allocated to fixed assets were amortizable over seven years, those allocated to goodwill were amortized over 15 years, and those allocated to inventory were allowable as cost of goods sold in 1999 and 2000.

In East Ford Inc. v. Commissioner,7 petitioner EF owned a Ford dealership in Jackson, Miss. On September 25, 1985, Action Leasing and Rental Inc. merged into EF. Less than one year later, EF decided to sell Action's truck-leasing and rental business.

On October 14, 1986, EF and Thomas Truck Lease Inc. executed a sales agreement. The tangible assets included 65 trucks and trailers. The sales agreement did not contain an allocation of the purchase price to any of the assets transferred. EF and Thomas later filed timely income tax returns but reported conflicting allocations of the purchase price; Thomas allocated the entire purchase price (in this pre-section 197 case) to the trucks and trailers and nothing to goodwill.

Clearly, Thomas's purchase constituted an applicable asset acquisition. To determine the amount realized from, and the basis in, each of the transferred assets in that type of acquisition, section 1060 mandates the use of the residual method in section 338(b)(5).

There were no class I or II assets transferred. The $1.3 million Thomas paid for Action's truck-leasing business had to be allocated to the Class III assets to the extent of their FMVs, with any excess applying to goodwill.

The court concluded that "the best evidence in the record" regarding the FMV of the trucks transferred was in the Truck Blue Book. The parties agreed that Blue Book wholesale values should be used to value a bulk purchase of used trucks. Thomas, unlike EF, increased each truck's wholesale value by any add-ons and made the 8 percent regional adjustment listed in the Blue Book for trucks sold in Mississippi.

The court concluded that under the residual method, a reasonable value for Action's trucks was $1.28 million. Moreover, under that method, the excess purchase price over the portion allocated to the Class III assets should have been allocated entirely to goodwill.

Here, P entered into two written agreements allocating the purchase price of the Sebastopol plant and the Canton plant among the acquired assets. Those allocations bind P unless the Service determines that the allocation is inappropriate or the agreement is unenforceable under traditional contract formation defenses.8 The IRS did not dispute the propriety of the allocations.

P argued that the Sebastopol agreement was unenforceable because the term "processing plant building" (the original allocation schedule allocated $3,802,550 to an asset so described) was ambiguous. As P saw it, the term did not reflect the intention of it and GA to include in the term assets that qualify as section 1245 property. The court disagreed with P.

The court believed that P and GA would have simply used the term "processing plant," rather than "processing plant building," had they intended to include in the term assets that are not part of a building. The court believed that by including the term "building" to describe the assets acquired, P and GA intended to allocate to a structure and not to the assets contained therein. Moreover, P acknowledged that it perceived the need to alter the depreciation method of the processing plant building following its consultation with MSF. The chronology of events suggested that P believed the term "processing plant building" was ambiguous only after it perceived a benefit that could be realized by subdividing the building into component assets. Thus, it is reasonable to conclude that there was not an ambiguity concerning the asset described as the processing plant building. Because P alleged no other defect in the Sebastopol agreement that rendered it unenforceable, the court gave effect to the agreement for tax purposes, as P agreed to be bound. A similar analysis applied to the Canton acquisition.

Nor was the IRS unreasonable in determining that assets described in the Canton agreement as "real property: improvements" were nonresidential real property depreciable over 39 years, according to the court. The Canton agreement defined the term "real property" to include "improvements, fixtures, and fittings thereon." The court thought it was reasonable to conclude that assets described as "real property: improvements" were better viewed as nonresidential real property than as tangible personal property. It therefore sustained the Service's determination that the asset was section 1250 property depreciated using a straight-line method over a recovery period of 39 years.

The original allocation schedules bind P, and therefore it may not subdivide assets in a manner at odds with those schedules. The case certainly points out the benefits of component depreciation and depicts the difficulties a taxpayer can encounter in attempting to set aside an agreement it entered into freely. It is virtually impossible to disavow such an agreement in light of the inflexibility of the Danielson rule, which the IRS adheres to and the courts have embraced almost universally.


1 See Peco Foods Inc. v. Commissioner, T.C. Memo. 2012-18, Doc 2012-941, 2012 TNT 11-16.

2 See section 1060(c).

3 H. Rept. 101-881, at 351 (1990).

4 See FSA 0479 (1993). X Corp. acquired the assets of the Y division of Z Corp. The acquired assets included accounts receivable, inventory, fixed assets, patents and trademarks, a covenant not to compete, and miscellaneous assets.

Paragraph B of the purchase agreement stated that the purchase price was to be allocated to the acquired assets as scheduled and provided that neither party would take a position with any taxing authority that was inconsistent with the allocation. X indicated that it intended to redefine the asset designated as goodwill as amortizable customer lists and file claims for refund. The IRS concluded that such a redefinition was impermissible.

For many years, the Service maintained that some intangible assets, such as covenants not to compete and patents or trademarks, had an ascertainable and limited useful life and were therefore amortizable, and that other intangible assets were so interrelated with the "expectancy of continued patronage" that they could not be said to have an ascertainable and limited useful life and were per se non-amortizable. "Since the nature of goodwill is the . . . expectancy of continued patronage . . . the term goodwill for tax purposes encompasses a wide spectrum of intangibles which are associated with favorable customer patronage . . . goodwill is not a depreciable asset since it is self-regenerating and its benefits extend over a substantial period of time which cannot be estimated with reasonable accuracy." See Houston Chronicle Publishing Co. v. United States, 481 F.2d 1240 (5th Cir. 1973).

Most of the litigation (before the enactment of section 197, which requires the cost of most acquired intangible assets, including goodwill and going concern value, to be amortized ratably over a 15-year period beginning with the month in which the intangible assets are acquired) between the Service and taxpayers did not dispute that goodwill was not amortizable, but rather disputed whether various types of intangibles were part of goodwill. To minimize the flood of litigation, the IRS began asserting, what is often called "the Danielson rule," that if the buyer and seller of assets agreed to values that were to be assigned to specific assets during an acquisition negotiation, the commissioner had the right to bind the parties to their values unless proof was adduced that would be admissible in an action between the buyer and seller to show that the agreement was unenforceable because of mistake, undue influence, fraud, or duress. Thus, unless the commissioner deemed the values assigned unreasonable, they would not be challenged.

In 1986 section 1060 was added to the code to require that in an applicable asset acquisition, buyers and sellers make an allocation of the consideration among the assets acquired and disposed of, respectively. In 1990 the section was amended to codify the Danielson rule and bind a buyer and seller to any asset allocation agreement made unless the commissioner determined that the asset allocation was not appropriate. The House report explained that Congress deemed it "appropriate to bind the parties . . . to any written agreement they reach regarding the allocation of the consideration to, or fair market value of, any of the specific assets . . . transferred." H. Rept. 101-881, at 351 (1990).

The Service concluded that the above supported its prohibiting X from altering the values assigned to specific assets in the purchase agreement. Neither the Danielson rule nor its codification suggests that the interests of the buyer and seller must be antithetical for the agreed allocation to be binding. Both the Danielson rule and the 1990 amendment to the code stress that absent fraud and the like, the government is entitled to rely on the written agreement of the parties to an acquisition regarding how the purchase price for the assets should be allocated.

5 T.C. Memo. 2009-291, Doc 2009-27624, 2009 TNT 240-19.

6 See reg. section 1.338-6(b).

7 T.C. Memo. 1994-261, Doc 94-5491, 94 TNT 110-16.

8 See reg. section 1.1060-1(c)(4).


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