Mr. A entered into an agreement to purchase the assets of CC Corp. (CC). Mr. A assigned the purchase rights to a corporation (WCM) of which he was the sole shareholder. WCM consummated the agreement in November 1999.
WCM paid acquisition-related legal fees of $116,293 to CC’s counsel. Most if not all of these fees (group A fees) were for drafting loan documents and leases related to a seller-financing arrangement for the assets purchased. WCM also paid fees of $2,958 and $9,564 (group B fees) primarily for document review and other services related to inventory financing. Finally, WCM paid fees of $9,550 (group C fees) related to the overall acquisition and physical inventory.
The U.S. Tax Court, in West Covina Motors, Inc. v. Commissioner of Internal Revenue, T.C. Memo. 2009-291, found that the group B fees were attributable to inventory financing and that $6,675 of the group C fees was for services related to physical inventory. These fees, therefore, were allowable as cost of goods sold and thus became deductible business expenses.
The remaining fees, however, were not specifically related to inventory but were capital expenditures related to the acquisition. The Internal Revenue Service argued that these fees had to be allocated in accordance with the fair-market-value limitations of Section 1060 of the Internal Revenue Code. The IRS further maintained that all the fees had to be allocated to so-called class V intangible assets. The agency, therefore, contended that the fees had to be amortized ratably over 15 years, beginning with the month of purchase, under Section 197.
By contrast, WCM argued that Section 1060 did not apply to the allocation of legal fees. The Tax Court concurred with this view.
An Applicable Asset Acquisition
The purchase, the court found, constituted an applicable asset acquisition. An applicable asset acquisition is defined as any transfer of assets constituting a trade or business in which the transferee’s basis is determined wholly by reference to the consideration paid. Generally, a written agreement as to the allocation of the consideration is binding in such an acquisition.
However, when the parties do not allocate the consideration, the residual method of allocation may apply. Under the residual method, a taxpayer generally allocates the consideration to the acquired assets to the extent of their fair-market value, in descending order of priority, by class. Consideration is first reduced by the amount of class I assets (cash and cash items). Any remaining consideration is then allocated to the remaining assets in proportion to the assets’ fair-market value. The amount of consideration allocated to an asset may not exceed the fair-market value of that asset on the purchase date.
In the instant case, there were no class I, class II, or class IV assets transferred. Therefore, the entire purchase price had to be allocated between class III and class V assets. The parties stipulated that $8,808,675 of the purchase price was properly allocated to class III assets and $3,500,000 was properly allocated to goodwill. The issue to be decided was whether the legal fees had to be allocated under Section 1060.