The current market continues to experience an impressive level of transactions. When purchasing a business, it is important that taxpayers consider involving their tax advisors early in the process. Peco Foods, Inc & Subsidiaries. v. Commissioner, T.C. Memo. 2012-18 (January 17, 2012) is a prime example of why. In this case, had Peco Foods, Inc & Subsidiaries (the taxpayer) either conducted a cost segregation study prior to the two transactions or excluded certain terms from the purchase agreements, they could have taken advantage of over $5 million in additional depreciation expense over a five-year period.
When a business is purchased, the parties to the transaction agree on the terms and execute an asset purchase agreement or similar document (purchase agreement). Included in the purchase agreement could be a purchase price allocation (PPA). The purchase agreement, along with the PPA, is generally a binding legal contract that outlines the terms of the transaction. The PPA allocates the purchase price to different classes of assets: cash, inventory, goodwill, a class including real and personal property, etc. The resulting allocation guides how any purchased depreciable or amortizable property will have its cost recovered. For example, if $1,000 of the purchase price was allocated to the class which includes goodwill, then $1,000 should be amortized as goodwill using a 15-year life for tax purposes. While on the surface this appears straightforward, complications can arise when depreciable real and personal property is involved. In Peco, for example, the taxpayer had specified an allocation of the purchase price to a “processing plant building” and “real property: improvements.” Ultimately, specifying the real property nature of these assets precluded the taxpayer from taking advantage of the results of a cost segregation study performed following the transactions that sought to reallocate an additional portion of the purchase prices to something other than real property.
Cost segregation studies help to separately identify component assets being constructed or purchased, and therefore allow taxpayers to take advantage of accelerated depreciation afforded to assets with shorter lives. Following the transactions, Peco conducted a cost segregation study and then filed a Form 3115 to catch up on depreciation that had been previously missed by allocating the purchase prices strictly to the assets outlined in the PPAs. This took the total number of assets being depreciated from 29 to more than 1,000. More importantly, it decreased the purchase prices allocated to the 39-year real property buildings and shifted the value to personal property improvements and equipment which were eligible to be depreciated over a shorter life. However, it was this shifting of character that the IRS, and ultimately the Court, denied. While a cost segregation study can provide basis for allocating a purchase price even after the transaction is complete, the Court held that the specificity of the PPAs in Peco precluded the cost segregation from changing the allocations after the fact.
There were two hurdles that the taxpayer had to pass in order to uphold their argument for reallocating the purchase prices. The first hurdle can be found in IRC §1060(a)(2): “If in connection with an applicable asset acquisition, the transferee and transferor agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate.” Therefore, because all parties in Peco agreed to the PPAs, the Commissioner would have to deem the allocation “not appropriate” to allow for the cost segregation study to override the otherwise binding PPAs. Considering the PPAs were deemed appropriate, the second hurdle was the only remaining hope for the taxpayer’s argument.
The second hurdle rested on what is colloquially referred to as the “Danielson Rule.” Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967) concludes, “A party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.” Therefore, the taxpayer had to prove that the agreements were unenforceable due to these types of factors. The crux of the taxpayer’s argument was ambiguity in the wording of the agreements themselves. Essentially, the argument was that the PPAs delineated between general classes and not between the real or personal character of assets. However, as discussed previously, the Court found that by including “building” and “real property” in the descriptions of the PPAs, there was no ambiguity as to the intent of the allocations. The taxpayer and the sellers had agreed to allocate the stated purchase prices to section 1250 real property assets. Had the taxpayer included simply “processing plant” instead of “processing plant building,” there may have been a different outcome.
Outside of the terms refining the purchase price allocations to section 1250 property, there was also a statement included in the executed purchase agreements saying that the PPAs were applicable “for all purposes (including financial accounting and tax purposes).” This even further strengthened the Commissioner’s case. Considering the agreements specifically identified the terms within the PPAs as applicable for tax purposes, it became even harder for the taxpayer to argue that they could be considered unenforceable and later altered.
There can be time pressure when conducting a transaction. However, Peco is a prime example of why taking time to carefully draft a purchase agreement is crucial. Wording truly matters. Cost segregation studies certainly have the potential for tax savings, but these benefits could be negated by including a single word in the PPA. While purchase agreements and PPAs should include the necessary level of detail to appropriately allocate the consideration based upon the intent of both parties, taxpayers should avoid being too specific unnecessarily. If involved early prior to finalizing the agreement, tax advisors can help to avoid the issues the taxpayer in Peco faced. Further, if cost segregation studies are completed prior to the transaction being finalized, the results can be incorporated into the agreement itself.
How FORVIS Can Help
As noted above, involving your trusted tax advisors early in your purchase process can help save you money in the long run when it comes to the depreciation of property. FORVIS’ experienced advisors are here for you every step of the way in your business purchases.