United States: Insights and Frequently Overlooked Items Arising From Purchase Price Allocations in an Asset Purchase

Many more acquisitions of businesses occur in the form of asset purchases, as opposed to stock purchases. This structure presents many opportunities and pitfalls when it comes time to allocate the purchase price for the assets over the various types of assets acquired in the acquisition. This article focuses on some of the often overlooked allocation opportunities and the hidden tax liabilities that are important to understand when a deal is being negotiated and priced. Many times, if these issues are not addressed prior to closing, the opportunities are lost.

Many corporate buyers prefer purchasing the assets (as opposed to stock) of a corporation for several reasons, including the sense that the buyer may have more control over which of the target’s assets it acquires directly and the ability to exclude pre-acquisition liabilities that may attach to the corporate entity. Another important reason for engaging in an asset purchase is for the income tax benefits that may arise from obtaining a cost basis and the associated increased depreciation and amortization for years going forward. Unlike buyers, corporate sellers may generally prefer stock sales so that they can be relieved of certain liabilities associated with the unwanted line of business (including those not readily identifiable or valued at the time of the transaction) and incur only one level of tax at the shareholder level. Section 338 of the Code provides some relief to reconcile these divergent motivations by allowing taxpayers that enter into a stock sale to file an election to treat a stock sale transaction as an asset sale for tax purposes.

Section 338 provides several choices for buyers and sellers in determining how they want to be taxed in a purchase situation. For example, a basic Section 338(a) election is made by the buyer only and results in stock sale treatment to the seller. The buyer will be responsible for any income tax due as a result of the "deemed sale" of all of "old target’s" assets to "new target." The buyer will then receive a step-up in the tax basis of the target company’s assets. For domestic purchases, this is not a favored approach because of the tax cost on the transaction date.

A more typical use of Section 338, is the Section 338(h)(10) election. This election is made jointly by both the buyer and the seller and can only be applied to a target corporation that is either an "S" corporation for federal income tax purposes, or a target corporation whose stock is held by a controlling (80%) shareholder. If a Section 338(h)(10) election is made, the target corporation is treated as having sold all of its assets at the close of the acquisition date at fair market value in a single transaction, and a new target corporation is deemed to purchase all the assets on the day after the acquisition date. Once the buyer and seller agree to file the election, the seller will recognize the gain or loss on target’s assets on its consolidated income tax return with no recognition of the gain or loss on the sale of the target stock. If the target is a member of a consolidated group of corporations which has net operating losses, tax credits, and other tax benefits available for use, the gain on the deemed asset sale may be partially or totally offset by these available tax attributes because the deemed sale is treated as occurring while the target corporation is still owned by the selling parent corporation.

To qualify for the election, the corporate acquirer must purchase at least 80% (based on vote and value) of the target stock within a "12 month acquisition period." The buyer and seller must both sign Form 8023 agreeing to the election and the allocation of the purchase price. The form must be filed no later that the fifteenth day of the ninth month, beginning after the month in which the acquisition date occurs. This is very important because these election deadlines do not normally coincide with a normal tax return due date, and as a result can be easily overlooked.

The mechanics involved in treating a stock sale as a deemed asset acquisition or just an outright purchase of the desired assets, are generally identical. The buyer’s basis in the assets acquired is equal to its aggregate cost of purchasing such assets including any liabilities assumed as part of the transaction. The allocation of purchase price among the acquired assets for purposes of determining the assets’ new tax basis in the hands of the buyer is accomplished by allocating the aggregate purchase price in proportion to their relative fair market values. This allocation is made in accordance with the seven-class residual allocation method. For Section 338(h)(10) elections, the buyer and the seller must each report the allocation on Form 8883 (or Form 8594 in the case of an actual asset sale) which is filed with the federal income tax return in the year that the purchase is taken into account.

Although the mechanics of the election seem pretty straightforward, many nuisances are frequently overlooked and if planned for, could create tax benefits or minimize tax surprises. While many of these positions are highly factual and require a thorough analysis, we have provided a short list of some of the more interesting items: Non-Traditional Assets; Contingent Liabilities (including Employee Benefits); Treatment of Deferred Revenue, Possible Termination of a Partnership; Opportunities to Elect New Accounting Methods, and Potential Estimated Tax Payment Relief.

• Intercompany obligations that are not extinguished – When a business is sold through an asset purchase it is possible for intercompany items to still exist among the members of the group of purchased companies. A portion of the purchase price may need to be allocated to these types of Class V assets. In the context of a bargain sale (one where the value of the tangible assets are greater than the purchase price), this could create low tax basis receivables that could result in gain being recognized when and if, these receivables are repaid.

• Allocation to an overfunded defined benefit plan after the purchase – If one of the assets acquired as part of the purchase of a business is a defined benefit plan, and that plan is overfunded, a portion of the purchase price might be properly allocable to the overfunded portion of the plan as a Class V asset. A buyer may be able to recover the basis of this asset equal to the amount by which the overfunded portion of the pension plan has been reduced by the amount of the annual pension expense accrued.

• Current deduction for certain contingent claims instead of capitalizing them as part of the purchase price - Certain contingent liabilities that are included in the purchase price for financial accounting purposes may not actually be considered assumed liabilities under the tax laws, but are rather liabilities that arise out of the transaction and could lead to current deductions or allocations to the underlying assets.

• Deferred revenue related to the assumption of pre-existing contracts - Assumption of a seller’s deferred revenue that arises from pre-existing contracts can have tax implications to the seller and to the buyer. Sellers will generally have to recognize additional gain and receive an offsetting deduction since the buyer assumed the liability. The theory behind this result is that the seller, by transferring the obligation to the purchaser, forgoes receipt of consideration for the assumption of the liability. Because this gain may be characterized as capital and the deduction as ordinary, the corporate seller is tax neutral unless it has any unused capital loss carryfowards that can be utilized. With respect to the buyer’s tax impact, a buyer will generally recognize revenue and deduct expenses to perform the services as required, under the terms of the assumed pre-paid contracts, without receiving any cash. Buyers negotiating the purchase price of a business with a significant amount of pre-paid items should consider any significant future tax liability that will arise once goods or services are delivered following the acquisition and these pre-paid amounts are converted into revenue.

• Vacation pay accrual - The Internal Revenue Code permits a corporate deduction for deferred compensation (such as vacation pay) in the year it is actually paid, unless it is paid within two and half months from the close of the relevant tax year. An issue arises when a vacation pay accrual is assumed by a buyer as part of an asset purchase and paid by the buyer at closing. Generally, a buyer is not entitled to a deduction for the cost of paying the seller’s vacation pay obligation that is assumed in an asset acquisition because the liability assumed is added to the basis of the acquired assets (it is considered to be a cost of acquiring the assets). Since the rule requires the vacation accrual to be paid in order to receive a deduction, the seller may want to consider establishing some type of escrow arrangement in lieu of a cash payment at closing that will allow the buyer to pay the expense in future years, thus potentially preserving the deduction.

• Real estate transfer and other asset specific costs - In the context of an asset acquisition, certain liabilities must be taken into account directly with respect to a particular asset rather than being allocated over the entire transaction. For example, real estate transfer costs or security interest perfection costs should be taken into account directly. Thus, if the seller is required to pay a transfer tax on the conveyance of real estate, and the buyer pays this tax, the seller must determine its gain or loss on the sale of this real estate by taking into account the transfer tax. Correspondingly, if the buyer pays the tax, it increases the buyer’s tax basis in the real estate asset.

• Termination of partnership status - If a corporation owns fifty percent or more of a partnership and a Section 338(h)(10) election is made in connection with the purchase of that corporation, the IRS has previously taken the position that the partnership is terminated. If the termination occurs, the newly formed partnership would retain its employer identification number and might be able to make new elections regarding its accounting methods and other matters without the consent of the IRS.

• Ability to adopt new methods for the purchased business - A corporate buyer that makes a Section 338(h)(10) election can often adopt a new taxable year and methods of accounting without obtaining IRS approval. However, new target keeps the same employer identification number and, thus, may not have to start the wage base over for FICA and FUTA purposes.

• Certain relief from estimated tax payments - For estimated tax purposes, a corporation is required to make quarterly estimated income tax installment payments. Unless certain elections are made, a corporation generally must make an installment payment equal to 25% of the required annual payment. Section 6655 imposes a penalty on corporations that do not satisfy this requirement. Section 338(h)(13) saves the day by stating that Section 6655 will not be taken into account for sales in which a Section 338 election is made. Thus, sellers may have a position that the gain from a deemed asset sale should not be taken into account for estimated tax purposes but can pay the tax, if any, on the due date for their tax return.

In preparing this article, we have highlighted certain positions that have been taken by other taxpayers facing these issues. These determinations are highly fact driven and therefore, no assurance can be made that a similar result will apply under a particular taxpayer’s facts. For your reference we have listed some of the more significant authorities that we draw from to prepare this article:

• IRC §§ 404(a)(11) & 1012,
• Treas. Reg. §§ 1.338-1(b)(1)(ii);1.338-6(b)(2)(iii)(A); 1.1060(c)(3); & 1.1060-1T(c)(1),

• 1998 FSA Lexis 372 (1998); TAM 9721002 (1997); & TAM 9734003 (1997), and

• James M. Pierce Corp. v. Comm, (326 F2d 67 (1964).

Some of the finer details involved with an asset purchase or deemed asset purchase can have a major tax impact on both buyers and sellers with regard to the timing and amount of tax liability that will arise out of the transaction. As a result, both parties should consider these opportunities prior to the close of the transaction. n

Copyright 2004 Gardner Carton & Douglas

This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.