Taxpayer couldn’t modify purchase price allocations after cost segregation study

The Tax Court has concluded that a taxpayer could not modify purchase price allocations that it agreed to in connection with two asset acquisitions.  The taxpayer made the modifications in an attempt to secure quicker depreciation deductions following a cost segregation analysis.  The Court concluded that IRS did not abuse its discretion in prohibiting the taxpayer from determining useful lives of assets in a manner that was inconsistent with the original allocation schedule.

Background.   Under Code Sec. 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.  Generally, in connection with an applicable asset acquisition, the parties to a written agreement concerning purchase price allocation are bound by the agreement, absent satisfaction of the Danielson rule.  Under the Danielson rule, a party may for tax purposes contradict an unambiguous contractual term only by offering proof that would be admissible in an action between the parties to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, or duress.

Code Sec. 1060, amended after Danielson, provides that if the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value (FMV) of any of the assets, the agreement is binding on both the transferee and transferor unless IRS determines that the allocation (or FMV) is not appropriate. But where the parties do not allocate the consideration entirely, the residual method of purchase price allocation may apply to determine both the purchaser’s basis in, and the seller’s gain or loss from, the transferred assets.

Code Sec. 446(b) authorizes IRS to compute taxable income under a method which, in its opinion, clearly reflects income. IRS’s determination of whether an accounting method clearly reflects income is entitled to “more than the usual presumption of correctness.” IRS’s interpretation under the “clear reflection standard” is given wide latitude that courts have been loathe to interfere with “unless clearly unlawful.” Before a court will disturb the IRS’s determination that an accounting method does not clearly reflect income, the taxpayer bears the burden of proving that IRS acted arbitrarily, capriciously, or without sound basis in fact.

A building and its structural components are classified as Code Sec. 1250 property (Code Sec. 1245(a)(3)(B)), and nonresidential real property is per se Code Sec. 1250 property. (Code Sec. 168(e)(2)(B)) Reg. § 1.1250-1(e)(3) defines real property to include the structural components of a building within the meaning of Code Sec. 1.1245-3(c), which in turn specifies that the terms “building” and “structural components” have the meanings assigned to those terms in Reg. § 1.48-1(e).

Facts. Peco Foods (Peco) acquired two poultry processing plants in the ’90s (Sebastopol and Canton plants). The Sebastopol acquisition was effected through, and the Canton acquisition was memorialized in, an asset purchase agreement that, in each case, included a schedule allocating the purchase price among various assets. Each agreement stated that Peco and the transferor agreed to allocate the purchase price among the assets “for all purposes (including financial accounting and tax purposes)” in accordance with the allocation schedule.

Subsequent to the purchases, in about ’99, the taxpayer hired a company to perform a cost segregation study of the Sebastopol and Canton plants. The study subdivided the assets acquired by Peco into subcomponents based on the Sebastopol appraisal and the Canton appraisal. The study determined that subdividing the acquired assets into various subcomponents entitled Peco to an additional depreciation deduction of $5,258,754 from ’98 through 2002.

On Peco’s ’97 U.S. corporate income tax returns for Sebastopol, Peco depreciated nonresidential real property (i.e., Processing Plant Building) via straight-line over 39 years. After the cost segregation study, Peco filed its ’98 U.S. corporate income tax returns and attached an Application For Change in Accounting Method with attachments indicating that it was reclassifying certain component parts of the Processing Plant Building as tangible personal property subject to a 7-year or 15- year recovery period and a double declining or 150% depreciation method. With regard to the Canton plant, Peco also subdivided the asset titled “Real Property: Improvements” into subcomponents and claimed accelerated depreciation for those subcomponents on its ’98 return. In addition, Peco claimed a Code Sec. 481(a) adjustment reflecting accelerated depreciation on the assets that it believed could have deducted via more rapid methods for the previous tax years. For the ’99 through 2001 tax years, Peco continued to depreciate reclassified or subdivided assets under accelerate depreciation methods.

IRS determined income tax deficiencies for Peco’s ’97, ’98 and 2001 tax years. The deficiencies arose, in part, from IRS’s conclusion that Peco was not entitled to Code Sec. 481(a) adjustment, and was not entitled to change its method of depreciation by reclassifying the real property assets as tangible personal property assets subject to accelerated depreciation.

Parties’ positions.  IRS asserted that Code Sec. 1060 and the Danielson rule each barred Peco from modifying the purchase price allocations of the Sebastopol and Canton plants in a manner inconsistent with the original Sebastopol and Canton allocation schedules.

Peco contended that Danielson and Code Sec. 1060 did not prohibit the taxpayer from classifying property as Code Sec. 1250 property (structural components of a building) or Code Sec. 1245 property (tangible personal property), and that Code Sec. 1060 required only that the purchase price be allocated under the residual method of Code Sec. 338(b)(5). Thus, Peco argued that it may redetermine the useful lives of assets received in the Sebastopol acquisition, and make an initial determination of the useful lives of assets received in the Canton acquisition.

Court sides with IRS.  The Tax Court rejected Peco’s attempt to elevate the residual method of Code Sec. 338(b)(5) over the written allocations. The Court stated that the written agreement superseded the residual method of purchase price allocation since the Sebastopol agreement and the Canton agreement were each enforceable. 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 and did not reflect the parties’ intent to include within the terms specialized mechanical systems and other assets that qualify as Code Sec. 1245 property. The Court concluded that the terms were unambiguous. It viewed Peco’s decision to allocate the purchase price separately among various assets as evidencing that Peco was aware of the existence of subcomponent assets, but chose not to allocate additional purchase price to them.

The Tax Court rejected Peco’s argument that neither Code Sec. 1060 nor the Danielson rule prohibited it from making an initial determination of the useful lives of assets acquired in the Canton acquisition inconsistent with the original Canton allocation schedule. It found that IRS was authorized under Code Sec. 446(b) to compute taxable income under a method which, in IRS’s opinion, clearly reflects income. The Court said it would not disturb IRS’s determination that an accounting method did not clearly reflect income, unless the taxpayer could prove that IRS acted arbitrarily, capriciously, or without sound basis in fact.

The Tax Court concluded that IRS did not abuse its discretion in prohibiting Peco from determining useful lives of assets in a manner that was inconsistent with the original Canton allocation schedule. The Canton agreement defined the term real property to include, in addition to other assets, “improvements, fixtures and fittings thereon.” In light of the Canton agreement and Reg. § 1.48-1(e), the Court found it reasonable to conclude that assets described as Real Property: Improvements were better viewed as nonresidential real property depreciable with a straight-line method over a period of 39 years, than tangible personal property.

Recommendation:  Taxpayers contemplating the purchase of the assets of a business should arrange for a cost segregation analysis before the purchase agreement is entered into.

 

Warmest regards,

Douglas Rutherford, CPA

 

© 2012 Douglas Rutherford, CPA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.  Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing.