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...