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The lesson to be learned from the Peco Foods case is that a taxpayer, having agreed in writing to certain purchase price allocations, cannot unilaterally change its original allocations to achieve a better tax result.

Peco Foods Revisited: Binding Purchase Price Allocation Rules

  • 12/3/2013

Peco Foods Revisited: Binding Purchase Price Allocation Rules

The recent Peco Foods case ruling illustrates the importance of contractual arrangements in transactions where business assets are sold (or are deemed sold in an IRC Section 338 stock transaction). Since this ruling transpired, we are still seeing confusion in this area. Here's what the case is all about. 

Allocating the purchase price

When business assets are sold, the parties often negotiate and allocate the purchase price among the various assets. Generally, the buyer wants a significant portion of the purchase price allocated to depreciable assets in order to claim depreciation deductions over a shorter period of time (usually three to seven years depending upon asset type). The seller, on the other hand, may want the purchase price allocated primarily to intangible assets such as company goodwill, which generally results in a lower tax obligation. Because of these competing interests, the IRS generally respects the negotiated purchase price allocations of the parties if they follow the special asset allocation rules set forth in Section 1060.

Section 1060 prescribes special allocation rules for determining a transferee's basis and a transferor's gain or loss in an asset acquisition. Under Section 1060(c), an applicable asset acquisition is any transfer of assets that constitutes a trade or business when the purchaser's basis in the assets is determined to be wholly referenced to the consideration paid for them. If the parties to an applicable asset acquisition agree in writing to allocate any part of the purchase price to the acquired assets, or to the fair market value of any of the transferred assets, Section 1060(a) says the agreement is binding unless the IRS determines that the allocation or fair market value is not appropriate.

However, if the parties do not agree in writing to allocate any part of the purchase price to the acquired assets, then the residual method of Section 338(b)(5) and Section 1.338-6(b) determines the buyer's basis in, and the seller's gain or loss from, each of the transferred assets. Under this method the acquired assets are categorized among seven different asset classes (cash and cash equivalents, actively traded personal property, debt instruments, inventory, other assets not in the foregoing classes, intangibles, goodwill, and going concern value) and the purchase price is allocated to the asset classes according to the priority established by the regulations.

Typically a problem may arise after the transaction when the parties either forget or choose to disregard their contractual allocations, subsequently conduct an audit, and assign values to the acquired assets based on generally accepted accounting principles (GAAP), and report tax consequences using the newly determined values rather than the previously agreed-upon contractual allocations. The case of Peco Foods illustrates such a situation.

The Peco Foods case

Peco Foods, the parent corporation, through two of its subsidiaries, acquired the assets of two poultry processing plants for about $38 million during the 1990s. Each agreement allocated the purchase price of the assets among the two subsidiaries and further allocated the price among various assets in accordance with allocation schedules in the contractual agreements. Following the acquisitions, Peco arranged for a cost segregation analysis of the two plants, further subdividing certain acquired assets into subcomponents. The analysis determined that subdividing these assets would entitle Peco to additional depreciation expense of about $5.26 million. Accordingly, Peco filed a request for a change in accounting method and claimed depreciation on its tax returns in accordance with the cost segregation analysis.

The IRS challenged the purchase price reallocation and the court agreed that, under Section 1060(a), Peco was bound by the written allocation schedules that were agreed upon by the transaction parties. The court further found no ambiguity in the original allocations that would warrant further subdividing the assets into subcomponents as contended in the cost segregation study. The tax court disallowed the accounting method change and required Peco to claim depreciation in accordance with the original allocation schedules.

As noted by the court, this conclusion prevents the IRS from being disadvantaged if the parties treat the same transaction inconsistently. Moreover, even if there was no possibility of inconsistent tax treatment, the court reasoned that "binding Peco to the original ... allocation schedule[s] prevents it from realizing a better tax consequence than the one it bargained for." The appeals court agreed with the Tax Court and the IRS.

The lesson to be learned from the Peco Foods case is that a taxpayer, having agreed in writing to certain purchase price allocations, cannot unilaterally change its original allocations to achieve a better tax result. This is in accordance with Section 1060(a), which clearly states that taxpayers will be bound by their allocations of the purchase price or as to the fair market value of any of the transferred assets, unless the IRS determines that the allocation or fair market value is not appropriate. Because there was no such determination by the IRS in the Peco Foods case, the taxpayer was bound by its original allocations.

Therefore, before finalizing a transfer of business assets, ask your tax advisor to review the relevant sale documents, including any agreed upon purchase price allocations and determinations of the assets' fair market values.