Are Taxpayers Bound by Purchase Price Allocations?

Editor: Kevin D. Anderson, CPA, J.D.

Tax Accounting

A recent Tax Court memorandum opinion (Peco Foods, Inc., T.C. Memo. 2012-18) highlights the importance of preacquisition planning with respect to agreed-upon purchase price allocations in asset acquisition agreements under Sec. 1060.

Facts

In Peco Foods, the Tax Court determined that the common parent of an affiliated group of taxpayers electing to file a consolidated tax return was bound by the agreed-upon purchase price allocation for two poultry processing plants it acquired in Sec. 1060 applicable asset acquisition transactions in the 1990s.

The first asset purchase agreement occurred in 1995, when the taxpayer acquired business assets for approximately $27 million. Both parties agreed to allocate the purchase price among 26 groups of assets “for all purposes (including financial accounting and tax purposes).”

The asset groups included a processing plant building, a wastewater treatment plant, other real property, and machinery and equipment. Peco identified more than 750 assets in connection with the acquisition and categorized the assets for tax reporting purposes in accordance with the original classifications, as determined by an outside appraisal.

The second acquisition occurred in 1998, for $10.5 million. The asset purchase agreement included three broad groups of assets among which the purchase price was allocated: land; improvements; and machinery, equipment, furniture, and fixtures. Peco categorized and appraised more than 300 assets for tax reporting purposes in accordance with the three original classifications, as determined by the outside appraisal.

In 1999, Peco engaged a firm to provide a cost-segregation study for both acquisitions. The study separated the assets into subcategories based on the appraisals and provided for an additional accelerated depreciation expense totaling more than $5 million for tax years 1998 through 2002.

Peco filed its 1998 tax return with Form 3115, Application for Change in Accounting Method, to which it attached a schedule reflecting the cost-segregation study’s adjustments to real property assets originally classified with a 39-year class life, reclassifying them as tangible personal property with a 7-year or 15-year life. This automatic method change resulted in a negative Sec. 481(a) adjustment of approximately $2.1 million for additional depreciation that the taxpayer believed should have been accelerated in earlier years. The taxpayer also included the accelerated depreciation adjustment in its returns for the subsequent three years.

The IRS issued a notice of deficiency for three years including 1998 and 2001, based on its disallowance of the Sec. 481(a) adjustment for the acceleration of depreciation as well as the reclassification of real property to tangible personal property.

Law and Analysis

The IRS cited both Sec. 1060 and the Danielson rule (Danielson, 378 F.2d 771 (3d Cir. 1967)) in support of its position. Sec. 1060(a) provides that

[i]f in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate.

Under the Danielson rule, taxpayers are bound by their written agreements with another party unless they can prove the agreement can be legally altered or is unenforceable because of mistake, fraud, duress, undue influence, or similar cause.

Conclusion

The taxpayer disagreed with the IRS and argued it had a right to reclassify the property because Sec. 1060 required that it use the residual method of Sec. 338(b)(5) in classifying the property acquired and the Danielson rule did not apply. The Tax Court held for the IRS.

The Tax Court found that, under Sec. 1060, the residual method applies only where there is not a written allocation of the purchase price. Because there was a written allocation in this case, the residual method did not apply. The Tax Court further found the Danielson rule applied because the taxpayer, in seeking to reallocate the purchase price to assets not listed in the original agreement, was challenging the form of the transaction, not its tax consequences. Looking at the taxpayer’s allocations of the purchase price in the original agreement, it found the allocation schedules in the agreement were clear and unambiguous, and therefore, under the Danielson rule, they were binding on the taxpayer.

This decision serves as a reminder that it is important to consider all future tax aspects of an applicable asset acquisition before finalizing an asset acquisition agreement. These considerations should include any asset allocation of the purchase price and the possibility of any future cost-segregation study.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.