If you are considering a cost segregation study on a building you have recently purchased or are about to purchase, you should be aware of new guidance issued by the Tax Court. The Tax Court recently concluded that a taxpayer could not modify purchase price allocations that it agreed to in connection with an asset acquisition.
Typically an asset acquisition will document how the purchase price is to be allocated. Such documentation often does not segregate the building from the fixtures and other items. which could be depreciated over a shorter life. Without proper consideration of purchase price allocations, purchasers and sellers of the assets of a trade or business may find themselves forced into substantially unfavorable tax treatment. The following are considerations that should be taken into account before agreeing upon purchase price allocations.
Why is the purchase price allocation important to the purchaser?
The IRS treats the depreciation of real property and personal property differently. Real property is required to be depreciated over 39 years using straight line depreciation methods. Personal property is depreciated over a shorter life (typically 5 – 15 years) and is eligible for an accelerated depreciation method known as MACRS, whereby greater depreciation is allowed in the earlier lives of the asset. The IRS determines the eligibility of these accelerated methods of depreciation based on the class of asset.
In addition, to the extent the purchase price was allocated to personal property, the taxpayer could be eligible for Section 179 or bonus depreciation, which could potentially result in the taxpayer’s ability to deduct the entire cost of such property in the year of acquisition.
With the new Tax Court conclusion, it is important for the purchaser to identify assets acquired during the transaction to establish the proper class of assets purchased. Under the new Tax Court conclusion, the purchaser will not be able to change the asset classification documented in the purchase agreement. If 100% of the purchase price was allocated to a building for instance, the purchaser would be stuck depreciating the cost over 39 years with no opportunity for accelerated depreciation deductions.
In the past, a taxpayer could purchase a building and not specifically identify the classes of assets included in the building purchase. Once the purchase was finalized, the taxpayer would then hire a specialist to perform a cost segregation study so fixtures and other items included in the building could be depreciated over a shorter life using accelerated depreciation methods.
Why is the purchase price allocation important to the seller?
The seller must identify and pay tax on gains and losses associated with the sale of their business on an individual asset basis. As different asset classes receive different tax treatment upon sale, the seller may find certain purchase price allocations to be more beneficial than others.
For example, typically the gain on sale of machinery and equipment used in an S Corporation or Partnership is taxed at a favorable capital gain rate of 15%, to the extent the gain exceeds depreciation previously taken on the assets. However, if the seller had previously disposed of machinery and equipment at a loss during the five years prior to the sale, the seller may be prevented from utilizing this favorable 15% rate. Instead, the seller would be forced to recognize a gain on the sale at their ordinary income tax rate, typically higher than 15%, to the extent losses were previously recognized. As such, the seller may be inclined to allocate more of the purchase price to non machinery and equipment assets.
How would the IRS know the purchase price allocation?
When selling a trade or business, purchasers and sellers must typically each file a statement with the Internal Revenue Service (“IRS”), under its prescribed guidance, identifying the business being sold, its respective purchase price, and the allocation of the purchase price among the business’s assets. Assets must be allocated among seven class categories as follows: (i) cash and general deposit accounts, (ii) actively traded personal property, (iii) market-to-market assets, (iv) stock in trade, (v) all assets except those identified in other classes, (vi) other intangibles except goodwill, (vii) goodwill.
Purchasers and sellers may use either:
- a residual method to allocate the assets sold, providing limited control over the allocation, or
- they may agree upon the allocation in writing during the sale, providing increased control over the allocation
Considering disagreeing statements, while allowed, provide undue cause for the IRS to examine the transaction, it is most often in the parties’ best interests to agree upon asset allocations at the time of sale.
How can a purchaser and seller arrive at a favorable purchase price allocation?
Before entering into an agreement, purchasers and sellers should consider engaging appraisers to determine the fair market value of assets being transferred in order to assist in a fair allocation of the purchase price. If buildings are involved, the parties may consider hiring specialists to perform a cost segregation analysis to help identify and assign fair market values to individual assets. In addition to assisting in favorable allocations of the purchase price, these studies will also help substantiate any asset allocations in the event of an IRS examination.
If the parties are not willing to provide for a cost segregation analysis, they should consider agreeing upon only aggregate classifications required to be reported to the IRS. Even though purchasers and sellers must each prepare detailed working papers allocating the purchase price on an individual asset basis for all assets transferred, agreeing upon only aggregate prices will allow the parties to modify sub classifications of the categories after the sale should they see fit.
