In an “applicable asset acquisition,” the sale of the assets of a business may be subject to certain allocation and reporting requirements for federal income tax purposes. It’s essential for the seller and purchaser to be aware of these requirements.
What’s an Applicable Asset Acquisition?
An “applicable asset acquisition” is any transfer of assets which constitute a trade or business and with respect to which the transferee’s basis in such assets is determined wholly by reference to the consideration paid for such assets.[1] A group of assets is a trade or business if its character is such that goodwill or going concern value could under any circumstances attach to those assets.[2]
Goodwill is the value of a trade or business attributable to the expectancy of continued customer patronage, which may be due to the name or reputation of a trade or business or any other factor.[3] Going concern value is the additional value that attaches to property because of its existence as an integral part of an ongoing business activity.[4] Going concern value includes the value attributable to the ability of a trade or business (or a part of a trade or business) to continue functioning or generating income without interruption notwithstanding a change in ownership.[5] It also includes the value that is attributable to the immediate use or availability of an acquired trade or business, such as the use of the revenues or net earnings that otherwise would not be received during any period if the acquired trade or business were not available or operational.[6]
The basis of an asset generally is its cost as adjusted for various items including depreciation or amortization.[7] Thus, when an asset is sold, its basis generally is the consideration paid for that asset.[8]
What Happens in an Applicable Asset Acquisition?
The consideration received in an applicable asset acquisition has to be allocated among the assets that that make up this acquisition for purposes of determining both the transferee’s basis in such assets and the gain or loss of the transferor with respect to such acquisition.[9] The method of this allocation is usually referred as the “residual method.”
Under the residual method, the assets that make up the applicable asset acquisition are assigned to the following classes:
- Class I assets—Cash and general deposit accounts other than certificates of deposit held in banks, savings and loan associations, and other depository institutions.[10]
- Class II assets—Actively traded personal property, including U.S. government securities and publicly traded stock, and certificates of deposit and foreign currency.[11]
- Class III assets—Assets that the taxpayer marks to market at least annually for federal income tax purposes and debt instruments (including accounts receivable).[12] Class III assets does not include debt instruments issued by related parties, certain contingent debt instruments, and debt instruments convertible into the stock of the issuer of other property.[13]
- Class IV assets—Stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.[14]
- Class V assets—All assets other than Class I, II, III, IV, VI, and VII assets.[15]
- Class VI assets—All section 197 intangibles except goodwill and going concern value.[16]
- Class VII assets—Goodwill and going concern value.[17]
Other than goodwill and going concern value, Section 197 intangibles for purposes of determining Class VI assets include:
- workforce in place including its composition and terms and conditions (contractual or otherwise) of its employment,
- business books and records, operating systems, or any other information base (including lists or other information with respect to current or prospective customers),
- any patent, copyright, formula, process, design, pattern, knowhow, format, or other similar item,
- any customer-based intangible,
- any supplier-based intangible, and
- any license, permit, or other right granted by a governmental unit or an agency or instrumentality thereof,
- any covenant not to compete (or other arrangement to the extent such arrangement has substantially the same effect as a covenant not to compete) entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof, and
- any franchise, trademark, or trade name.[18]
The consideration received in an applicable asset acquisition first gets reduced by the amount of Class I assets.[19] The remaining consideration is then allocated among the Class II assets, then among Class III assets, then among Class IV assets, then among Class V assets, then among Class VI assets according to the fair market value of the assets in each class at the time of acquisition. [20] Finally, anything left over gets allocated to Class VII assets.[21] If an asset in applicable asset acquisition is includible in more than one class, then it is included in that class with the lowest class number.[22] Thus, only the consideration remaining after allocations to all other tangible and intangible assets transferred as part of the applicable asset acquisition may be allocated to goodwill or going concern value.
If the transferor and transferee agree in writing as to the allocation of any amount of consideration to, or as to the fair market value of, any of the assets, such agreement is binding on them.[23] The parties to an applicable asset acquisition may dispute an allocation set forth in a written agreement only if they are able to show that the agreement is unenforceable because of mistake, undue influence, fraud, or duress.[24]
What are the Reporting Requirements for Applicable Asset Acquisitions?
Both the transferor and transferee are required to report information concerning the amount of consideration in an applicable asset acquisition and the allocation of that consideration among the assets transferred.[25] Both parties are required to file asset acquisition statements on Form 8594, “Asset Allocation Statement,” with their income tax returns or returns of income for the taxable year that includes the first date assets are sold pursuant to an applicable asset acquisition.[26]
Can the IRS Challenge the Parties Allocation of Consideration in an Applicable Asset Acquisition?
Short answer: Yes.
An allocation under an applicable asset acquisition is strictly scrutinized if the allocation does not have adverse tax consequences for the parties, because adverse tax interests deter allocations which lack economic reality.[27]
An example of where an allocation might be challenged is where amounts are allocated to goodwill versus covenants not to compete. Amounts allocated to goodwill or going concern value yield capital gain to the transferor.[28] On the other hand, amounts that a transferee pays to a transferor for a covenant not to compete results in ordinary income to the transferor.[29] Ordinary income currently is subject to federal income tax at marginal rates, with the top marginal rate currently being 37%.[30] Net capital gain may be subject to a reduced rate of federal income tax.[31] The adjusted basis of a section 197 intangible (which, again, includes covenants not to compete, goodwill, and going concern value) are required to be amortized ratably over a 15-year period beginning with the month that the intangible was acquired.[32]
Thus, from a purchaser’s perspective, any consideration (and therefore basis) attributable to goodwill or a covenant not to compete would be amortizable in the same manner as basis attributable to other section 197 intangibles.[33] But, the seller may be able to obtain a reduced rate of federal income tax if the amount is allocated to goodwill rather than a covenant not to compete.
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[1] 26 U.S.C. § 1060(c).
[2] 26 C.F.R. § 1.1060-1(b)(2)(i).
[3] Id. § 1.1060-1(b)(2)(i).
[4] Id.
[5] Id.
[6] Id.
[7] 26 U.S.C. §§ 1011, 1012, 1016.
[8] 26 U.S.C. § 1012.
[9] 26 U.S.C. § 1060(a).
[10] 26 C.F.R. § 1.338-6(b)(1).
[11] Id. § 1.338-6(b)(2)(ii).
[12] Id. § 1.338-6(b)(2)(iii).
[13] Id.
[14] Id. § 1.338-6(b)(2)(iv).
[15] Id. § 1.338-6(b)(2)(v).
[16] Id. § 1.338-6(b)(2)(vi).
[17] Id. § 1.338-6(b)(2)(vii).
[18] I.R.C. § 197(d)(1); Treas. Reg. § 1.338(b)(2)(vi).
[19] Id. § 1.338-6(b)(1).
[20] Id. § 1.338-6(b)(2)(i).
[21] Id. § 1.338-6(b)(2)(i).
[22] Id. § 1.338-6(b)(2)(i).
[23] 26 U.S.C. § 1060(a)(2); 26 C.F.R. § 1.1060-1(c)(4).
[24] 26 C.F.R. § 1.1060-1(c)(4).
[25] 26 C.F.R. § 1.1060-1(e)(1)(i).
[26] 26 C.F.R. § 1.1060-1(e)(1)(ii).
[27] Lorvic Holdings, Inc. v. Comm’r, T.C. Memo. 1998-281 (1998).
[28] See, e.g., Heritage Auto Center, Inc. v. Comm’r, T.C. Memo. 1996-21, 71 T.C.M. (CCH) 1839, 1844 (1996); Muskogee Radiological Group, Inc. v. Comm’r, TC Memo 1978-490.
[29] Ullman v. Comm’r, 264 F.2d 305 (2d Cir. 1959); Rev. Rul. 69-643.
[30] 26 U.S.C. § 1(j)(2).
[31] 26 U.S.C. § 1(h)(1).
[32] 26 U.S.C. § 197(a), (b) (c), (d)(1)(A), (B), (E).
[33] See Complex Media, Inv. v. Comm’r, T.C. Memo. 2012-14 n. 28 (2012).
