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.
The IRS, the court noted, cited no authority requiring legal fees to be allocated under the fair-market-value limitations of Section 1060 when the parties have stipulated the cost of each asset, as was the case here. Moreover, the court could locate no such authority. The court observed that Section 1060 is meant to prevent abuse when there is no agreement between the parties concerning how much of the purchase price is allocated to which category of assets.
The IRS equated the term “consideration” in Section 1060 to basis. Legal fees incurred in the acquisition of a capital asset are added to the basis of the capital asset with respect to which the fees are incurred. The agency, therefore, argued that WCM’s basis, including fees, had to be allocated under the fair-market-value limitations of Section 1060.
But the Tax Court disagreed. Here, the parties had stipulated the cost of each asset, and accordingly, in the court’s view, Section 1060 did not apply.
The court concluded that “the legal fees should be allocated proportionately to the assets with which they are associated.” The legal fees allocated to fixed assets were amortizable over seven years and the legal fees allocated to inventory were allowable as cost of goods sold. Only the legal fees allocable to goodwill had to be recovered under Section 197’s elongated (15-year) recovery period.1
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 This decision pertained to a transaction that predated the regulations issued under Section 1060. Those regulations, which affect applicable asset acquisitions occurring after March 15, 2001, provide that “in the case of an applicable asset acquisition, sellers and purchasers must allocate the consideration under the residual method” (see Regulation Section 1.1060-1(a)(1)). Moreover, the regulations provide that under the residual method the amount allocated to an asset cannot exceed the fair-market value of that asset at the beginning of the day after the acquisition date (see Regulation Section 1.338-6(c)(1)). In addition, the regulations provide that if, in connection with an applicable asset acquisition, the seller and purchaser agree in writing as to the allocation of any amount of consideration to, or as to the fair market value of, any of the assets, such agreement is binding on them (see Regulation Section 1.1060-1(c)(4)). This latter provision does not explicitly exempt the parties from the strictures of the residual method of allocation and, presumably, the amount so allocated pursuant to the written agreement to any such asset cannot exceed its fair market value. Further, the regulations expressly provide that no adjustment is made to the amount allocated to any individual asset for “general costs” associated with the applicable asset acquisition “as a whole” or with groups of assets included therein. These latter amounts, the regulations direct, are taken into account only indirectly through their effect on the total consideration to be allocated. Accordingly, given the specificity of the regulations, it is unclear that the court would have rendered a similar decision had the applicable asset acquisition under scrutiny occurred after the effective date of the regulations. We think it is highly unlikely that the court would have rendered such a similar decision.