Vol. 6, No. 1, Pg. 42. Reworking the Numbers: Allocating Purchase Price after the Revenue Reconciliation Act of 1993.

South Carolina Lawyer

1994.

Vol. 6, No. 1, Pg. 42.

Reworking the Numbers: Allocating Purchase Price after the Revenue Reconciliation Act of 1993

42Reworking the Numbers: Allocating Purchase Price after the Revenue Reconciliation Act of 1993By Harley D. Ruff"The lesson is simple: a great deal of money effectively can be made or lost simply by being able to distinguish between ordinary income and capital gain and allocating accordingly. Given the new spread between the two, parties no longer can ignore the issue of characterization."

Many provisions of the Revenue Reconciliation Act of 1993 (the 1993 Act) affecting businesses are designed mainly to raise more revenue for the federal government. However, for taxpayers who are buying or selling business assets, the 1993 Act presents importantopportunities to control income tax burdens.

When purchased assets constitute a trade or business, both the buyer and seller must allocate the total purchase price among all assets acquired, under Internal Revenue Code (Code) § 1060. Both buyerand seller also must file IRS Form 8594 with their tax returns, detailing their allocations. As one might guess, the IRS can hold parties to agreed-upon allocations, but it also can attack allocations it determines to be inappropriate. See Code § 1060(a).

43 Before the 1993 Act

Under the Tax Reform Act of 1986, interests of buyers and sellers in allocating purchase price often did not conflict much. The principal tax issue inherent in purchase price allocations-characterization of income-vanished. Top rates for both capital gains and ordinary income were set at 28%, rendering most characterization issues pointless. Allocation negotiations became much less difficult. Parties typically assigned high values to inventories, accounts receivable, depreciable property, consulting fees and non-compete covenants; this valuation benefited the buyer by providing income deferral and deduction acceleration.

To help the seller, low values were assigned to assets subject to depreciation recapture that were being sold on the installment method, to avoid the immediate triggering of gain under Code § 453(i). The increase in the top ordinary income rate from 28% to 31% in 1990 caused some conflict between buyers and sellers to re-emerge, but the general pattern of allocations persisted.

Buyer-Seller Conflicts After the 1993 Act

The first impact of the 1993 Act on purchase price allocations is in its hallmark: huge increases in ordinary income rates. The stated top ordinary income rate was raised from 31% to 39.6%. But after one accounts for the Medicare tax on self-employed persons, the loss of deductions and phase-out of personal exemptions for high-income taxpayers and the loss of deductions for club dues and certain other business expenses, the true top ordinary income rate can exceed 45%.

Because partnerships and Subchapter S corporations are "flow-through" entities, these rates have similar effects on their interestholders. (For Subchapter C corporations, the stated top rate was raised to 35%; there is no difference between ordinary income and capital gain rates for these entities.)

Thus, the 1993 Act has restored to the Code a substantial capital gain preference that impacts on most commercial transactions. This preference is enhanced by the fact that South Carolina law allows a partial deduction of net capital gain recognized from the South Carolina taxable income of individuals, partnerships, S corporations, estates and trusts. See S.C. Code Ann. §12-7-437.

Because of all these factors, parties' interests in allocating purchase price are now often in direct conflict. Sellers should be more aggressive in seeking allocations to capital gain items to lower their tax burdens on sale. Buyers, meanwhile, should negotiate for allocations to ordinary income items to lower potential future ordinary income.

Consider the following example. X Corp., which is in the business of publishing and distributing books, wants to sell all its business assets. Principal among these are land, a building, equipment (all held for more than one year), inventory, accounts receivable and copyrights. X Corp. has an aggregate basis in these assets of $1 million and has amortized the building and equipment from $1.3 million to $400,000. Y agrees to purchase these assets for a total price of $2 million. If X and Y allocated to each item an amount equal to its basis in the hands of X, but allocated $1.4 million to the building and equipment, then X would recognize ordinary income of $900,000 (representing the depreciation recapture inherent in the building and equipment; see Code §§ 1245 and 1250) and capital gain of $100,000 (representing the excess of the amount realized over X's original basis; see Code § 1231). Assuming all of X's income is taxed at the top rate, Xwould have to pay federal income tax of $384,400.

However, assume that this allocation was varied so that only $400,000 was allocated to the building and equipment, and an extra $500,000 was allocated to both the land and the copyrights. X would now recognize a capital gain of $1 million, because the gain attributable to the land is covered by Code § 1231 and the copyrights are capital assets in the hands of X under Code § 1221. The federal income tax on this gain would amount to $280,000, a $104,400 decrease in tax owed as compared to the previous allocation.

The lesson is simple: a great deal of money effectively can be made or lost simply by being able to distinguish between ordinary income and capital gain and allocating accordingly. Given the new spread between the two, parties no longer can ignore the issue of characterization.

Amortization of Intangibles

The second major impact of the 1993 Act on purchase price allocations deals with the amortization of intangibles. Formerly, buyers did not want purchase price allocated to intangibles for fear the IRS would hold the intangibles to be indistinguishable from goodwill and thus nonamortizable. See Treas. Reg. § 1.167(a)-3. Because this issue did not affect sellers, allocations to such items frequently were kept to a bare minimum. The IRS often attacked these allocations, attempting to allocate a greater amount to goodwill and claiming that various intangibles the buyer claimed as amortizable were, in fact, not. This conflict was time-consuming for the IRS and led to considerable litigation that culminated in a major taxpayer victory in Newark Morning Ledger Co. v. United States, 113 S.Ct. 1670 (1993).

In Newark Morning Ledger, the taxpayer allocated $67.8 million to an

44 item labeled "paid subscribers" as part of its acquisition of a newspaper company. The taxpayer claimed depreciation deductions for this amount; the IRS disallowed the deductions because it found the concept of "paid subscribers" indistinguishable from goodwill. The United States Supreme Court, in a 5-4 opinion, ruled that because the item had an ascertainable value and a limited useful life, the duration of which could be ascertained with reasonable accuracy, the taxpayer was entitled to the depreciation deductions.

Code§197After its Newark Morning Ledger defeat, the IRS faced a backlog of about 8,000 cases carrying an aggregate price tag of about $13 billion. Knowing that Congress soon would be handling a major tax bill, the IRS lobbied for a solution to this problem. Congress responded by adding new Code § 197, which provides for amortization over 15 years on the straight-line method of "Section 197 intangibles" held in connection with the conduct of a trade, business or income-producing activity.

Code § 197 intangibles are broadly defined to include goodwill, going concern value, workforce intangibles, information-based intangibles, "know-how" intangibles, supplier-based intangibles, non-compete covenants, franchises, trademarks, trade names, customer-based intangibles, and licenses and permits granted by a governmental entity. Significant exclusions from this definition include self-created intangibles, certain computer software and certain other interests not acquired in an acquisition of assets constituting at least a substantial portion of a trade or business.

Code § 197 benefits taxpayers because payments for goodwill formerly were nondeductible in all cases. For many other items coveredin the section, payments were formerly nondeductible unless it could be shown that such items had a limited useful life that could be determined with reasonable accuracy. These admittedly ambiguous concepts are now irrelevant-which means that taxpayers and their advisors can be more confident in tax planning and return preparation. Also not to be overlooked, Code § 197 provides more items to which parties can allocate purchase price to their mutual advantage.

Noncompete Covenants

Code § 197 contains a trap on noncompete covenants, which were deductible over the life of the covenant before Code § 197. This arrangement worked well in South Carolina and other states where noncompete covenants are kept relatively short. (South Carolina lawyers are justifiably reluctant to draft noncompete covenants with restraint periods of over five years, because of the apparent safe harbor rule of Cafe Associates, Ltd. v. Gerngross, 305 S.C. 6, 406 S.E. 2d 162 (1994)

Code § 197 dictates a 15 year amortization period regardless of the life of the covenant. This is disturbing because the former rule truly carried out the tax accounting objective of deductibility over useful life. Code § 197 elevates a simple but strict rule over this objective.

Given all this, buyers should be more willing to have purchase price allocated to intangible items. Section 197 intangibles have a shorter recovery period than the periods for residential rental property (271/2 years), nonresidential real property (39 years) and most property with a class life of at least 25 years (20 years). This means that deductions can be claimed more quickly, albeit not in the accelerated fashion provided for in Code § 168. Sellers can benefit by allocations to intangibles,also, because payments for many intangibles will produce capital gain.

Allocations of large sums to noncompete covenants generally should end. Parties should instead allocate these sums to consulting fees or provide for liquidated damages, or both, in lieu of a bar on competition. (See J.W. Hunt v. Davis, 437 S.E.2d 557 (S.C. App. 1993), in which the Court of Appeals ruled that a liquidated damages provision was not a noncompete covenant, subject to strict scrutiny by the courts, but "nothing more than a term of an ordinary contract." Id. at 560.)

Under many consulting arrangements, amounts paid by a buyer will be immediately deductible under Code § 162 as business expenses. Although recognizing ordinary income, the seller will be no worse off than in the case of monies allocated for noncompete covenants. Such allocations should be kept reasonable, of course. A multi-million dollar "consulting fee" arrangement, for most closely-held businesses, surely would generate an IRS scrutiny. This is especially true in light of ominous language in the Conference Committee Report relating to the 1993 Act:

[A]n arrangement that requires the former owner ... to continue to perform services ... that benefit the trade or business is considered to have substantially the same effect as a covenant not to compete to the extent that the amount paid to the former owner under the arrangement exceeds the amount that represents reasonable compensation for services actually rendered.

A simple example illustrates the usefulness of allocating purchase price to intangibles. R deals in commercial real estate and holds for sale a large tract of land with a basis of $2 million; this land is R's sole holding. B, also a dealer in commercial real estate,

45wishes to acquire R's business for $5 million. If R and B were to allocate all $5 million of the purchase price to the land, then R would recognize $3 million of ordinary income, on which it would pay federal income tax of $1,188,000, assuming the top rate applied. (Ordinary income results because of the exception from capital gain treatment for otherwise qualifying property that is held by the taxpayer primarily for sale to customers in the ordinary course of trade or business. See Code § 1231(b)(1)(B).) B would own the land with a basis of $5 million and would not be entitled to any amortization. See Treas. Reg. § 1.167(a)-2.

However, if the parties allocated the total purchase price as follows:

2 million to the land,

$1.5 million to goodwill, $500,000 to governmental permits, $500,000 to a noncompete covenant and $500,000 to consulting fees,

the tax results would be much better for both R and B. R would recognize no gain for the land, $2 million capital gain from the goodwill and permits (both capital assets under Code § 1221) and $1 million in ordinary income from the noncompete covenant and consulting fees. This allocation translates into total federal income tax of $956,000, a $232,000 reduction in federal income tax liability from the previous allocation.

B would receive an immediate deduction of $500,000 for the consulting fees, assuming they were reasonable, and would have an amortizable basis in the goodwill, permits and noncompete covenant of $2.5 million, which could be claimed over the prescribed 15 year period.

To be sure, Code § 197 encourages extensive number crunching. Various factors-such as characterization, recovery period and deferred payments-can make this task time-consuming and challenging. But for those willing to devote time and thought, the tax savings can be substantial.

Amortization for Nonresidential Real Property

The final noteworthy change in the 1993 Act that affects purchase price allocations involves the amortization period for nonresidential real property. This period has been lengthened from 31X years to 39 years, effective for property placed in service on or after May 13, 1993.

"The 1993 Act is a wake-up call for taxpayers and counsel to take purchase price allocations seriously and to aggressively pursue their best interests."

The new period does not apply to property placed in service before January 1, 1994, however, if either (1) the taxpayer or a "qualified person" (generally anyone who assigns contract or property rights to the taxpayer, but only if the property is not first placed in service by the assignor) entered into a binding written contact to purchase or construct the property before May 13, 1993; or (2) construction of the property was begun by or for the taxpayer or a qualified person before May 13, 1993.

As a result, buyers should be more reluctant to allocate purchase price to nonresidential real property. Almost all other property to which purchase price can be allocated will have a much shorter recovery period. Where the seller is a dealer in nonresidential property, it will be to both parties' advantage to avoid allocations to this property, otherwise the seller will recognize ordinary income.

This change squeezes the commercial real estate industry and others who have benefited from large depreciation deductions just as they seem to be recovering from the recent plunge in real estate values. It can be seen as a trade-off for a 1993 Act provision that modifies the passive activity loss rules for certain real estate persons. See Code § 469(c)(7).

Conclusion

The 1993 Act is a wake-up call for taxpayers and counsel to take purchase price allocations seriously and to aggressively pursue their best interests. This approach probably will lead to a new wave of IRS crackdowns and attempted reallocations. Until this happens, however, the 1993 Act provides opportunities for savings and improvement of the ever-important bottom line.

Harley D. Ruff is an associate with Richardson, Plowden, Grier & Howser, P.A. in Columbia.