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The purchase of a going concern: planning for intangibles.

The Purchase of a Going Concern

Generally, when an ongoing business is purchased for a lump-sum amount, the assets include both tangible assets such as machinery and equipment and intangible assets such as subscription lists, customer lists and possibly goodwill. Often intangible assets have a fair market value, and the purchaser will pay a premium to acquire them. In many cases, the parties to the purchase/sale contract will negotiate a separate non-competition covenant. A covenant not to compete is a contract whereby the seller of a business agrees not to compete with the business sold for a specified period of time.

According to Treasury Regulations, under Internal Revenue Code Section 167 an intangible asset can be amortized if (1) the asset has a limited useful life and (2) the limited useful life is determinable with reasonable accuracy. Amortization of goodwill is specifically denied by Reg. 1.167(a)(3) because its useful life is not separately determinable from the business that is acquired. On the other hand, the courts have consistently held that amounts allocated on an arms' length basis to a non-competition covenant are amortizable by the payor as ordinary deductions and are ordinary income to the recipient.

Prior to the Tax Reform Act of 1986 (TRA '86) and the elimination of the long-term capital gain deduction, the seller preferred to allocate as much as possible of the price received to goodwill, a capital asset. Conversely, the purchaser did not want to acquire goodwill, as its cost could only be recaptured if the entire business is later sold or liquidated. With the elimination of the tax preference for capital gains, the impetus of the seller to prefer goodwill and the purchaser to avoid it has been neutralized. The Revenue Reconciliation Act of 1990 (RRA) once again created a capital gains preference, albeit much smaller than pre-1987, as the top individual rate is now 31%, whereby long-term capital gains are subject to a maximum 28% rate.

This article will examine the IRC required allocation format when a trade or business is acquired and offer planning strategies for possible tax savings as well as review the tighter reporting requirements as a result of the new law. As the tax ramifications to the seller vary little regardless of how allocations are made, the focus here will be on the purchaser.

Allocation of

Consideration Among

Assets Transferred

Internal Revenue Code Section 1060(a), Special Allocation Rules for Certain Asset Acquisitions, states that the consideration paid for the purchase of a trade or business shall be allocated to the assets in the same manners as amounts allocated under Section 338(b)(5) (where an election is made by a corporation to treat the acquisition of a controlling amount of stock of another corporation as the acquisition of assets). The transferor (seller) and the transferee (purchaser) must allocate the consideration received or paid in the transaction among the assets transferred in accordance with their respective fair market values. Among other items, Section 1060(b) requires both the transferor and transferee to inform the secretary as to the amount of the consideration which is allocated to goodwill or going concern value.

Treasury Regulation 1.1060.1T, Special Allocation Rules for Certain Asset Acquisitions, requires the seller and purchaser to allocate the consideration for the assets transferred using the residual method. This method divides the assets into four different classes: Class I: Cash, demand deposits

and similar accounts in depository

institutions and other

similar items designated by

the IRS. Class II: Certificates of deposit,

U.S. government securities,

readily marketable securities

[Reg. 1.351-1(c)(3)], foreign

currency and other similar

items designated by the IRS. Class III: All assets other than

Class I, II and IV. This includes

both intangible and

tangible assets without regard

to whether they are depreciable,

depletable or amortizable. Class IV: Intangible assets in the

nature of goodwill and going

concern value.

The total consideration is first reduced by the total fair market value amount of Class I assets transferred. Next, the remaining consideration is reduced in proportion to the fair market values of Class II assets on the purchase date. Class III assets are assigned their fair market values, and the balance of the total consideration is assigned to Class IV assets. The amount of consideration allocated to an asset (other than Class IV assets) shall not exceed the fair market value of that asset on the purchase date (date on which applicable asset acquisition occurs).

An express allocation agreement is now generally required and is usually included as part of the acquisition contract. Additionally, both parties must file Form 8594, Asset Acquisition Statement Under Section 1060, with their tax returns for the year of sale.

Example: Assume T sells to X a group of assets on January 1, 1991, which constitutes a trade or business. T pays X $5,000 in cash and assumes $2,000 in liabilities. Thus the total consideration is $7,000. Assets acquired are as follows:
Asset Fair Market
Class Asset Value
 I Cash $ 500
 II Portfolio of
 marketable sec. $600
 III Furniture and
 fixtures $ 700
 Building 1,300
 Land 900
 Equipment 300
 receivable 100
 Total Class III $3300

The amount assigned to each class of assets by purchaser and seller on Form 8594 is as follows: Class I: $500. Residual of ($7000

less 500) $6500 to remaining

classes of assets. Class II: $600. Residual of ($6500

less 600) $5900 to remaining

classes of assets. Class III: Since the remaining

amount of consideration

exceeds the sum of the fair

market value of Class III assets,

the amount assigned to

each Class III asset is its fair

market value, for a total of

$3,300. The amount assigned

to Class IV assets (goodwill

and going concern value) is

the residual ($5,900 less

3,300) $2,600. Class IV: $2,600.

Because it is often difficult to determine the fair market value of the individual assets, the parties have a significant amount of discretion in making the allocation. This discretion can be an important element in the negotiating process between the seller and buyer. Of course, the IRS may challenge (and has challenged) the taxpayers' agreed-upon allocation - all the more reason to have not only the substance but the form of the agreement in such shape as to be able to withstand such a challenge.

Recent Cases

In Newark Morning Ledger Co. v. the US of America (754 F. Supp. 176 (DC, NJ) April 3, 1990) the district court held that the acquisition of an existing paying subscriber group as part of an ongoing newspaper business warranted tax deductions for depreciation of the value of the subscribers as assets separate and apart from goodwill.

Important factual determinations of the court included: 1. The acquired subscriber group

had a limited life due to death,

relocation, changing life

styles, dissatisfaction with the

product and for various other

reasons. 2. The fact that new subscribers

replaced those lost from the

acquired asset group is not

relevant to the issue of a limited

life. 3. The fact that the expenses

that were incurred to maintain

the subscriber group are

deductible does not mandate

that the asset itself is not

depreciable. 4. The taxpayer had relied on

valid statistical analysis to

determine the projected useful

life of the subscriber group. 5. The taxpayer directly valued

the subscriber group by finding

the net present value of

its income flow. Two expert

witnesses at the trial supported

the taxpayer's valuation

method. 6. Using the residual approach

explained above, the taxpayer

had allocated some of the

acquisition cost of the going

business to goodwill.

In Irving H. Brain, Jr. and Kathleen B. Brain v. Commissioner (T.C. Memo 1990-35, Dec. 46,338(M) January 22, 1990) the Tax Court upheld the sale of a corporate business where only 11% of the total amount paid was allocated to the corporate stock and 89% was allocated to deductible consulting fees and a covenant not to compete. Prior to the RRA of 1990, the information reporting rules of Section 1060 did not apply to an acquisition of a trade or business which was structured as a stock acquisition if the transferee did not elect under Section 338 to treat the stock purchase as an asset acquisition.

Important factual determinations included: 1. In the context of a dispute

over an allocation to a covenant

not to compete, the Tax

Court has consistently held

that taxpayers must show that

the covenant was intended as

part of the agreement and that

the covenant has independent

economic significance as

a separately bargained-for

element of the agreement. 2. Both parties to the agreement

were identical in their treatment

of the amounts paid and

received under the contract.

the Court noting that the recipients

did so contrary to

their own tax position. 3. The payees met their obligation

under the contract by

not engaging in any form of

competition with the new

owners (in fact they moved to

New Hampshire from Florida

shortly after the transfer

and returned to Florida three

or four times a year to consult

with the new owners). 4. The Court did not consider it

important that the fees for

consulting services and the

covenant were to be paid even

after the death of the original

payees under the contract.

Revenue Reconciliation

Act of 1990

The courts have applied different standards in determining whether a party to the purchase of a trade or business can assert an allocation of the purchase price that is inconsistent with the allocation contained in a written agreement. The Third Circuit held that a different position could be taken only if court admissible proof existed as to mistake, undue influence, fraud or duress in the original purchase price allocation [Commissioner v. Danielson 378 F.2d 771, 775 (CA-3)]. The RRA of 1990 amends Section 1060(a) so that a written agreement regarding the allocation of consideration to the assets in an applicable asset acquisition is binding on both parties, unless the allocation can be refuted under the standards found in the Danielson case.

Where a person holds at least 10% of the value of an business (as in the Brain case above) and both sell an interest in the business and either enter into an employment contract, a covenant not to compete or other agreement with the purchaser, both parties must report the details of the sale and the other agreement(s) to the IRS.

Planning Strategies

The following planning strategies should help avoid allocation problems with the Internal Revenue Service: 1. Determine your goals with

respect to allocation. 2. Identify the assets for which

the allocation should be

minimized. 3. Be sure that the "hard assets"

are not undervalued. 4. If a premium is paid, search

for amortizable intangibles

which may or may not have

been booked by the seller.

Examples include a favorable

leasehold interest or other

contract, customer list, licenses

or permits. 5. Avoid the use of the term

"going concern" value as a

specifically identified intangible

as the courts have generally

agreed with the IRS

that "going concern" and

"goodwill" refer to the same

thing. 6. Covenants not to compete and

similar allocations (such as

amounts to be paid for consulting

services) should be

agreed upon before the overall

purchase price is determined.

In other words, a

covenant is not part of the

four step allocation of IRC

Section 1060. 7. Be sure that both you as the

buyer and the seller properly

document the allocation

negotiations. 8. Be sure that both you and the

seller timely file Form 8594

and that the information

thereon is consistent with the

acquisition agreement.

Jerry G. King, PhD, CPA, is a professor of accounting at the University of Southern Mississippi. He earned his PhD from the University of Mississippi and has written numerous articles in the area of taxation and financial accounting. He is also a practicing certified public accountant.

Paul D. Torres, PhD, CPA, is professor of accounting at the University of Southern Mississippi. He has been the recipient of several awards for excellence in teaching and participates actively in professional development courses.
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Article Details
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Author:King, Jerry G.; Torres, Paul D.
Publication:The National Public Accountant
Date:Mar 1, 1991
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