Issue 35-2013 — If you are acquiring assets, make sure you really believe — and are willing to live with — the purchase price allocation agreed to and reflected in your purchase agreement. In other words, if you think you can do a more detailed review and adjust this allocation later, think again! In a recent decision (Peco Foods Inc. v. Commissioner, No. 12-12169 (11th Cir. July 2, 2013)), the U.S. Court of Appeals for the Eleventh Circuit upheld a Tax Court decision that a taxpayer could not retroactively modify a purchase price allocation by changing the descriptions in its allocation agreements related to the asset purchases of two plants. Specifically, Peco (the taxpayer) could not use the results from a cost segregation study to accelerate deductions in a manner that was inconsistent with the original contractually agreed to purchase price allocation. 

Background

Under IRC Section 1060, an applicable asset acquisition is any transfer of assets constituting a trade or business in which the transferee's basis is determined wholly by reference to the consideration paid for the assets. In general, if a transferor and a transferee enter into a written agreement allocating the consideration or determining the fair market value of any asset in an applicable asset acquisition, that agreement is binding, unless either the IRS determines that the allocation or value is not appropriate or the parties are able to reject the allocation of value under the Danielson standards (Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967)) — i.e., showing of fraud, duress, mistake. 

The Peco Case

In the mid-late 1990s, Peco Foods Inc. acquired two poultry processing plants in Mississippi (Sebastopol in 1995 and Canton in 1998). For each acquisition, Peco entered into asset purchase agreements with allocation schedules allocating the purchase price among various assets. In 1999, Peco hired an outside advisor to perform a cost segregation study of the Sebastopol and Canton plants. The study subdivided the assets acquired by Peco into subcomponents based on appraisals of the plants. The study showed that, while not changing the IRC Section 1060 classification, the company could break the assets down further and claim additional depreciation deductions for the period of 1998-2002 by claiming shorter depreciation lives for certain components of the asset groupings. 

Specifically, for the 1997 tax year, Peco depreciated nonresidential real property (i.e., the Sebastopol processing plant building) via straight-line over 39 years. After the cost segregation study, Peco filed its 1998 federal income tax return and submitted an Application for Change in Accounting Method to reclassify certain component parts of the processing plant building as tangible personal property (therefore subject to shorter recovery period and a faster depreciation method). For the Canton plant, Peco also subdivided the asset labeled “real property: improvements” into subcomponents and claimed accelerated depreciation for certain subcomponents on its 1998 return. In addition, Peco claimed an IRC Section 481(a) adjustment related to the accounting method change to accelerate depreciation on the assets it believed it should have depreciated more rapidly in the prior tax years. 

The IRS assessed income tax deficiencies for Peco's 1997, 1998 and 2001 tax years, indicating that Peco was not entitled to the IRC Section 481(a) adjustment, as it was not entitled to an accounting method change to reclassify real property assets to tangible personal property, therefore subject to faster depreciation. The IRS argued that IRC Section 1060 and the rule in Danielson prevented Peco from modifying the purchase price allocations of the Sebastopol and Canton plants in a manner inconsistent with the original allocation schedules. While Peco argued that the Danielson rule only applied to prohibit the taxpayer from changing the form of the transaction (not the underlying detail), the Tax Court and Appeals Court both concluded that Danielson precluded the taxpayer from making any change from the agreed-upon allocation agreement.

The Tax Court rejected Peco's assertion that the agreements were unenforceable under state law because the terms “processing plant building” and “real property: improvements” were ambiguous. The Court further rejected the assertion that the parties intended to include in those terms specialized mechanical systems and other assets that would qualify as IRC Section 1245 property. The Court concluded that the terms were not ambiguous, and the fact that purchase price was allocated separately among various assets was evidence that Peco knew about the subcomponent assets but intentionally did not allocate purchase price to those assets. 

Alvarez & Marsal Taxand Says:

The Peco decisions seem to suggest that taxpayers purchasing assets should give careful consideration to the allocation they agree to in their purchase and sale agreement, as it appears that their allocation for IRC Section 1060 purposes will be respected and, in fact, enforced, despite later evidence that assets should be classified differently for depreciation purposes. The government does not want to be whipsawed by taxpayers agreeing to one allocation with the seller in the purchase agreement, then treating the acquired assets differently on their tax returns. 

There could be debate over, among other things, how much purchase price is allocated to shorter- versus longer-lived assets, as well as assets that are potentially nondepreciable (e.g., land). It also should be noted that it is apparently not just the allocation but the language that should be carefully reviewed in order to allow for as much flexibility as possible. For example, it may be better to use even broader terminology in the purchase agreement than that used in the Peco case, so taxpayers are not held to the plain meaning of the terms they choose for their asset descriptions. On the other hand, taxpayers should carefully consider the use of words such as “building,” where the implication could be that items more appropriately segregated are treated as included in the structure of the building. In addition, careful consideration should be given to the completion of Form 8594, reflecting the allocation. Where possible, taxpayers may wish to undertake additional analysis up front to ensure that they achieve the most favorable results. For example, depending on the type of assets involved, a cost segregation study might be worthwhile (e.g., real property intensive purchases). The issue will most certainly be one of timing, however, as most deals do not have open-ended timeframes that allow for labor-intensive studies to be undertaken. A practical hybrid approach may be warranted whereby some level of analysis is undertaken — short of a full study but greater than a cursory review. In any event, the moral of the story is to make sure you are comfortable with your allocations as you will likely be forced to live with them — at least in the Eleventh Circuit.