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LBO: Allocation of Purchase Price

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


A taxable sale of assets is treated for tax purposes as, in effect, a sale of each individual asset or group of assets, requiring that the consideration paid be allocated across the assets being sold for purposes of calculating the character of the income and the basis of the assets in Newco's hands.[1] Prior to the Tax Reform Act of 1986, negotiations[2] on the issue of allocation were spirited—sellers obviously preferred weighting the capital assets heavily while buyers preferred to expense the price currently wherever possible and/or to allocate value to asset categories which promised rapid recovery of the price paid, i.e., inventory and depreciable assets with short useful lives.

The "residual" method of allocation is now the method required for allocating the purchase price (calculated as the price paid plus liabilities assumed and transaction costs absorbed) across the assets purchased; this method controls both the character of the income or loss to the Target and the Host's basis in the assets acquired.[3] The calculation requires an order of allocation that starts with cash and cash equivalents, and then various other classes of assets, ending with "going concern" value, a.k.a. goodwill.[4]

Perhaps the most frequently encountered choice for achieving maximum purchase price deductibility has been, over the years, the allocation of "reasonable" amounts to consulting/noncompetition compensation (lump sum over time) with the principal selling shareholders, the allocated amounts being deductible as paid (as compensation) over fifteen years under § 197 (for noncompetition agreements). Of course, deductibility of such amounts typically means ordinary income for the recipient.

Under § 197, most acquired intangible assets are amortized over a fifteen year life. Included are the obvious, such as goodwill and going concern value. Also covered, however, and less obvious, are covenants not to compete. Consequently, a covenant paid out and enforceable over three years is no longer amortized over three years but rather over a fifteen year period.

Affiliated Groups

Analysis of the law governing taxation of members of affiliated groups is beyond the scope of this treatise. The Regulations under § 1502 of the Code, which constitute the law on point,[5] extend for over 200 pages in the standard CCH compendium, approximately 270 words to a page. The underlying premise of the § 1502 Regulations is that the group constitutes, in essence, a unitary economic enterprise.

In the LBO context, the deferred gain and loss provisions are the most significant: the Target is often a member of an affiliated group and/or the common parent, and the Host is often a parent as well. The rules pertaining to deferred gain and loss are, therefore worth summarizing at this point. Thus, three affiliated group concepts are important and a discussion of the same should provide background on the tax treatment of affiliated groups.

The primary concern is the qualification for filing a consolidated federal income tax return. Section 1504(a) defines an "affiliated group" as a chain (or cluster) of corporations (and only corporations) connected to a common parent. The parent must own stock in at least one subsidiary constituting 80% of the voting power and 80% of the total value of the outstanding stock of the subsidiary. Once this requirement is satisfied, all other subsidiaries, 80% of the voting power and value of which are owned by members of the group, are included in the affiliated group. In analyzing the voting and value tests, "plain vanilla" preferred stock-nonvoting, nonconvertible, and nonparticipating-is excluded from consideration.

Under § 1504(b), certain corporations such as investment companies, foreign and tax-exempt corporations and other exotica, are not eligible to file consolidated returns. Moreover, once an election to file a consolidated return is made by a group, all members which qualify and are within the group (or subsequently join the group) must join the filing.[6]

The deferred intercompany transaction provisions are the second cornerstone of the consolidated return rules. These rules further the above stated premise of the § 1502 Regulations that the members of an affiliated group are to be treated as a single entity. Accordingly, the rules provide for deferring gain or loss when property is transferred between members of a consolidated group until (1) either the transferor or the transferee leaves the affiliated group or (2) the transferred property leaves the group.[7] When an exit event occurs, that is, when the property is disposed of outside the group or the group member involved (the Target) leaves the group, then the government plays "catch up" and a tax is involved.[8] Thus, if the Target had in the past sold to another member of its affiliated group noninventory property at a gain, then a purchase of the Target's stock triggers the deferred gain (and thus, a tax) to the seller.[9] However, deferred intercompany gain may not be triggered but transferred over to the new group if the Target was the common parent of the old group; technically the old group has ceased to exist, thus triggering gain, but an exception to the triggering rule may obtain,[10] assuming all the members of the old group become members of the new group and the new group files a consolidated return for the first tax year after the acquisition. If deferred intercompany gain occasions a tax to the group which the Target is leaving, it appears that the selling group can step up its basis in the stock of Target it is selling to equal the deferred intercompany gain on which there is a tax.[11]

The third important set of rules are the Investment Adjustment Account rules. Thus, parent corporations adjust their basis in the stock of subsidiaries in accordance with the profits or losses at the subsidiary level; otherwise, gain or loss would be double counted. Under existing Regulations, profits and losses are generally based on an earnings and profits calculation rather than a taxable income calculation. The calculations are not the same, and Proposed Regulations chart the convention to be based on taxable income. Most specifically, certain conventions (e.g., accelerated depreciation) reduce taxable income but are not available to reduce earnings and profits. This anomaly was viewed as a "quirk" in the Regulations and was the focus of litigation in which the Service tried to disavow the application of its own Regulations because it provided a form of a double deduction[12] generated by a taxpayer using accelerated depreciation to generate tax deductions but not earnings and profits reductions. The taxpayer then sold the subsidiary and recognized a reduced gain because the stock basis had not been adjusted to fully reflect the use of accelerated depreciation for tax purposes. The Tax Court told the Service that, in order to disavow its own Regulations, it must repeal or supersede the same. The "quirk" was removed in 1987 by the enactment of § 1503(c). Henceforth, notwithstanding the language in the consolidated return Regulations, upon the sale of a subsidiary the stock basis must be calculated, with respect to the investment adjustment account, so as to eliminate effectively the differences between the calculations of earnings and profits versus taxable income. The new Regulations implement this rule, basing adjustments on modified taxable income.

If basis is adjusted downward below zero, the parent must track the excess downward adjustment in an excess loss account (ELA);[13] if the parent has an ELA with respect to the Target subsidiary, the ELA must be taken into income when the Target stock is sold—a variation on the familiar theme that negative basis in an asset (the result of tax-deductible losses) equitably must produce a gain when the asset is disposed of without penalty. The ELA is not recaptured if a § 338(h)(10) election is made.[14] Moreover, the ELA carries over if Target is the common parent of the group in which the ELA exists.[15]

There is an interesting risk to the Host if the Target was a member of a consolidated group—the Target may remain jointly responsible for taxes incurred by the group for years in which the Target was a member. The seller is usually liable to the Host in such event by virtue of the agreement of sale but the seller may be insolvent when push comes to shove.[16] Moreover, if a tax allocation agreement exists among members of the selling group, including the Target, such allocations should be settled prior to the reorganization because payments between the parties after the Target has been separated from the group may be taxable.[17] Tax refunds attributable to the Target's losses while a member of the selling group will revert to the common parent of the selling group unless the acquirers bargain for those losses in the agreement.[18]


[1] Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945); see Rev. Rul. 55-79, 1955-1 C.B. 370 (general rule for allocation is fair market value).

[2] Because there is less tension between the parties, the Service is not as respectful as it once was of agreements allocating basis. Presumably, the courts will follow suit. Compare, Major v. Commissioner, 76 T.C. 239 (1981) (strong proof required to overturn negotiated allocations). If the parties agree as to a particular allocation scenario, the danger is that the parties will be bound but the Service will not, i.e. "heads I win, tails you lose." Thus, as part of the 1990 Tax Act, Congress included a provision specifically stating that a written agreement allocating consideration is binding on both the transferee and the transferor unless the Secretary of the Treasury determines that the allocation is not appropriate. "Revenue Reconciliation Act of 1990: Law and Explanation" (CCH) ¶ 1205. To assist the Service in spotting aggressive positions, the § 1060 reporting requirements were extended to apply to any transaction in which a 10% owner transfers an interest in the Target and, in connection with the transfer, enters into an employment contract, covenant not to compete, royalty or lease agreement, or any other agreement with the transferee. (It might be noted, parenthetically, that § 1060 should apply to any agreement the transferor enters into with the Target as well as with the Host.)

[3] Section 1060(a) refers to the method set out in § 338(b)(5), regulations under which is set out a residual valuation methodology. See Treas. Reg. § 1.338-6(b).

[4] See Treas. Reg.§ 1.338-6(b).

[5] Section 1502 is nothing more than a "blank check" grant of authority to the Treasury to promulgate Regulations. See generally, Peel, Consolidated Tax Returns (1984).

[6] See: § 1501; Treas. Reg. § 1. 1502-2(b)(1); Treas. Reg. § 1.1502-75(a)(1). The election must include the ultimate parent corporation. See Rev. Rul. 56-559, 1956-2 C.B. 595. The election is binding until terminated, and termination generally requires good cause. Treas. Reg. § 1.1502-75(a)(2).

[7] Treas. Reg. §§ 1.1502-13 and 1.1502-13T.

[8] See id..

[9] Id., § 1.1502-13(f)(2)(iii). The Regulations confirm the "single entity" approach to a consolidated group, id. at § 1.1502-13(b), and address the character and timing of deferred gain.

[10} Id., § 1.1502-13(f)(2). The exception applies to an acquisition by the Host of the Target's stock or an acquisition of assets in an A- or C-type § 368(a) reorganization, i.e., the type of transaction in which tax attributes carry over generally.

[11] This results from the application of the consolidated return regulations which require the deferred gain to be recognized immediately before the Target leaves the group. The seller's basis in its Target stock, which is increased for income of the Target, is so adjusted as a result of Target recognizing the deferred gain immediately before it leaves the group. Treas. Reg. § 1.1502-33(a); Id., § 1.1502-32; see CCH Tax Transactions ¶ 210. Under the loss disallowance rules, the step-up will not occur, generally, if the deferred intercompany gain is in turn traceable back to built-in gain which the Target enjoyed at the time the old group acquired it. Treas. Reg. § 1.1502-20.

[12] See Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985).

[13] Treas. Reg. § 1.1502-14.

[14] Rev. Rul. 89-98, 1989-2 C.B. 219.

[15] Treas. Reg. § 1.1502-19(g)(1).

[16] See: id., § 1.338-4T(l)(1); id., § 1.338(h)(10)-4T(e)(8)(ii); id., § 1.1502-6(a). Liability can be avoided if the acquiring corporation buys the Target's assets instead of its stock. See Faber & Offer, "Strategies in Representing Buyers," in 1 Tax Strategies 219, 255 (1991).

[17] Dynamics Corp. of America v. United States, 392 F.2d 241 (Ct. Cl. 1968).

[18] Faber & Offer, "Strategies in Representing Buyers," in 1 Tax Strategies 219, 260 (1991).


Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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