Allocation of the Purchase Price in Sales Transactions.

• Author: Glazier, Scott L.
• Position: Tax Law

As a transactional lawyer for over 30 years, I have encountered many tax and nontax issues that while extremely important to my client, the client may have no idea how these issues may affect them from a liability or tax standpoint. Thus, many of these issues are left to the experienced counsel to be an advocate for his client's position even when the client is unaware of the various issues being debated. Some of these issues include topics, such as survival periods of representations and warranties, indemnification issues, including "baskets" and "caps," knowledge qualifiers and nuances surrounding restrictive covenants. While "best practices" dictate that you send a comprehensive letter to your client explaining the multitude of legal and tax points you have negotiated on their behalf so that if a post-closing issue should arise, the attorney has "covered" himself, in practice, deals do not stand by while you write "CYA" letters. Further, clients are loathe to pay for such things, especially on Main Street deals and smaller middle-market deals. (1)

Many of the issues identified above are hot topics with counsel for the other party and end up being some of the most negotiated issues in a transaction. However, there is another significant tax issue that I have found gets little attention in many transactions and ends up being one of the last items to be completed; that issue being the allocation of the purchase price in transactions in which such an allocation is required pursuant to [section]1060 of the Internal Revenue Code of 1986, as amended (code). Accordingly, this article explains the what, when, why, and how of purchase price allocations so that you will be aware of these issues and perhaps be a better advocate for your client, even though they may not recognize your valuable contributions (unless you point it out to them). Finally, we will look at the impact of the recently passed Tax Cuts and Jobs Act of 2018 (TCJA).

The What

Pursuant to the Tax Reform Act of 1986, a new code [section]1060 was adopted that altered the face of a typical asset purchase transaction. The asset purchase was, and remains, a popular vehicle for a business purchase, at least for nonpublicly traded company transactions and Main Street deals. Purchasers of businesses tend to favor asset acquisitions over stock purchases or mergers for liability reasons (i.e., the purchaser does not want to be responsible for the liabilities, known and unknown, of the acquired business). Another benefit of the asset purchase is that the purchaser receives a new tax basis (or "step-up") for the assets being purchased based on the purchase price. (2) Under the prior tax regime, although the purchaser receives a step-up in basis, with some exceptions, only the tangible assets could be depreciated or amortized, thereby generating a current tax benefit. The goodwill and going concern value were not amortizable. One exception to this rule was that noncompetition agreements entered into by the selling business or its owner(s) were amortizable over the term of the agreement. (3) Also, if a taxpayer could show that a specific intangible asset had a useful life that could be determined with reasonable accuracy, the taxpayer would be permitted to amortize that asset. (4) This paradigm led to exaggerated values being assigned to the seller's tangible assets (which could be depreciated over relatively short periods of time), and also inflated values being allocated to the seller's restrictive covenants, which were amortizable over the restricted period. In many transactions, the seller's goodwill, including such valuable assets as client lists, licenses, franchises and permits, workforce, intellectual property, and going concern were allocated relatively small amounts.

Furthermore, except for depreciation recapture, the seller was generally indifferent to the proposed allocations and, thus, the purchaser generally got his way in such transactions. As a result, these allocations were frequently challenged by the IRS and resulted in frequent and costly litigation. (5) The adoption of code [section]197 pursuant to the Omnibus Budget Reconciliation Act of 1993 sought a compromise to this issue by permitting intangible assets acquired in certain transactions to be amortized for tax purposes by the purchaser over a 15-year period. (6) Noncompetition agreements also fell into this category of intangibles and, thus, in applicable transactions, noncompetes must also be amortized over 15 years despite their shorter legal duration. Now, some 25 years later, the basic tenants of [section][section]1060 and 197 have been accepted in the M&A community as providing a reasonable tax benefit to the purchaser and, generally, certainty to the transaction, without fear of litigation with the IRS over the required allocations.

The When

Section 1060 of the code requires that in an "applicable asset acquisition," the purchaser's basis in the acquired assets and the seller's consideration with respect to the acquisition must be allocated among the assets pursuant to the "residual method." (7) An applicable asset acquisition (AAA) is...