Tax Savings and Deal Economics
It is a basic tax principle that the more (or the sooner) a seller pays in taxes on the sale of its business, the less will be the economic benefit the seller realizes from the sale. Similarly, the fewer the tax savings that the buyer realizes from the acquisition of the business, the less will be the economic benefit the buyer realizes from the acquisition.[i]
Allocation of Purchase Price
In most cases, these “truths” are first considered in determining the form of the transaction – a purchase and sale of assets or of stock. They become prominent again in the context of allocating the consideration[ii] actually, or deemed to have been,[iii] paid and received for the actual or deemed purchase and sale of the assets comprising the business.
For example, an allocation of consideration to the goodwill of the business will generate capital gain for the seller, and will be recoverable by the buyer over a 15-year amortization period; an allocation to tangible personal property used in the business may generate ordinary income for the seller (in the form of depreciation recapture),[iv] though it will be recovered by the buyer through depreciation over a relatively shorter period.[v]
There is another element in every purchase and sale of a business, however, that needs to be considered in determining the tax consequences of the transaction, but that is often overlooked until after the transaction has been completed and the parties are preparing the tax returns on which the transaction and its tax consequences are to be reported.
Transaction Costs
I am referring to the tax treatment of the various costs that are paid or incurred by the buyer and the seller in investigating the acquisition or disposition of a business, in conducting the associated due diligence, in preparing the necessary purchase and sale agreements and related documents, and in completing the transaction.
The seller and purchaser each adjusts the amount allocated to an individual asset to take into account the specific identifiable costs incurred in transferring that asset in connection with the applicable asset acquisition (for example, real estate transfer costs). Costs so allocated increase, or decrease, as appropriate, the total consideration that is allocated under the residual method. No adjustment is made to the amount allocated to an individual asset for general costs associated with the applicable asset acquisition as a whole or with groups of assets included therein (such as non-specific appraisal fees or accounting fees). These latter amounts are taken into account only indirectly through their effect on the total consideration to be allocated.[vi]
Where these costs may be deducted, they generate an immediate tax benefit for the party that incurred them by offsetting the party’s operating income, thereby reducing the economic cost of the transaction for that party.
Where the costs must be capitalized (i.e., added to the basis of the acquired property), they may reduce the amount of capital gain realized by, and taxable to, the seller on the sale; in the case of the buyer, these costs may be recovered over the applicable recovery periods for the assets acquired – depending upon how the costs are allocated – thereby making the deal potentially more expensive.
In a recent decision,[vii] the U.S. Tax Court considered an unusual argument by a taxpayer that certain costs incurred by the buyer in connection with its purchase of a service business should be characterized as cost of goods sold (“COGS”) – to be recovered in relatively short order – instead of being capitalized, and recovered over 15 years, as goodwill.[viii]
The Facts
Taxpayers were shareholders of Corp, which was treated as an S corporation for federal income tax purposes.[ix] Corp reported a loss on its federal income tax return.[x] The loss was in turn reported by Corp’s shareholders, including Taxpayers,[xi] on their individual federal income tax returns.[xii]
The reported loss stemmed from transactions related to a bankruptcy proceeding involving LLC,[xiii] a company that was wholly owned by a related company (“Partnership”),[xiv] in which three of Corp’s shareholders, including Taxpayers, were members. Two of LLC’s vendors (“Vendor-1” and “Vendor-2”; each a “Vendor”, and together the “Vendors”) had submitted significant claims as unsecured creditors in LLC’s bankruptcy.[xv]
The plan of reorganization submitted by LLC proposed the sale of substantially all of LLC’s assets (including the assignment of its contracts with the two Vendors) either to Buyer LLC – which was wholly owned by Corp[xvi] – or to the highest bidder.
Buyer LLC was the successful bidder. LLC and Buyer LLC executed an Asset Purchase Agreement (“APA”) which provided for Buyer LLC’s purchase of substantially all of LLC’s assets in exchange for the consideration described below (the “APA Payments”), subject to bankruptcy court approval of the reorganization plan. The APA also provided for LLC’s assignment of some or all of its contracts, including its contracts with Vendor-1 and Vendor-2 (the “Assigned Contracts”), to Buyer LLC.
Pursuant to the terms of the APA, as approved by the bankruptcy court,[xvii] Buyer LLC purchased substantially all of LLC’s assets in exchange for a payment of approximately $1.66 million in cash to LLC (comprising a $1.63 million Cash Purchase Price and approximately $30,000 for unsecured creditor claims allowed in the bankruptcy case, not including those of the Vendors). Buyer LLC also paid $1.60 million to Vendor-1 pursuant to a stipulated order of the court.[xviii] It also assumed certain of LLC’s liabilities (the “Assumed Liabilities”). The bankruptcy court’s order also stated that except for the Assumed Liabilities Buyer LLC would not be liable for any liability or obligation of LLC arising under or related to the Acquired Assets. Pursuant to another stipulated order of the court, LLC applied approximately $1.562 million of the cash it received from the sale of its assets toward its liability to Vendor-2.[xix]
Tax Returns
Corp reported as COGS the $1.60 million payment Buyer LLC made to Vendor-1 (the Vendor-1 Cure) and $1.562 million (roughly equal to the Vendor-2 Cure) of Corp’s $1.66 million payment to LLC;[xx] a total of $3.162 million.
Overall, Corp reported a loss of approximately $7.79 million, stemming from the transactions described above.
The shareholders of Corp, including Taxpayers, each received a Schedule K-1 from Corp[xxi] reporting their pro rata shares of Corp’s losses.[xxii]
Taxpayers reported their pro rata shares of Corp’s loss on their respective Forms 1040.[xxiii]
IRS Exam
The IRS examined Corp’s tax return and disallowed the reported increase to its COGS. The IRS determined that these payments should have been capitalized rather than reported as part of COGS.
The IRS then examined Taxpayers’ individual tax returns for that year.
Accordingly, it issued Notices of Deficiency[xxiv] to Taxpayers, who had reported their pro rata shares of Corp’s loss on their respective individual tax returns.
The IRS disallowed Taxpayers’ respective shares of the portion of Corp’s reported loss attributable to the inclusion of $3.162 million of the APA Payments in COGS and determined adjustments for each Taxpayer’s tax liability flowing from the partial loss disallowances.
Taxpayers petitioned the U.S. Tax Court.
Tax Court
The issue before the Court was whether $3.162 million of the APA Payments were a COGS, a deductible business expense, or a capitalizable asset.
COGS
Because the IRS disallowed the exclusions of the APA Payments at issue in on the basis that they were not COGS, the Court began by discussing the difference between the exclusion of COGS from gross receipts and the deduction of business expenses, particularly as it relates to service providers.
The Court explained that COGS is not a deduction but rather a subtraction from gross receipts in determining a taxpayer’s gross income. “For example, in a manufacturing or merchandising business, “gross income” means the total sales, less COGS, plus any income from investments and from incidental or outside operations or sources.[xxv]
Ordinary and Necessary Expenses
In contrast, the Court continued, the Code[xxvi] allows a deduction from gross income for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
According to the Court, service providers may incur deductible business expenses in providing their services, but they are not manufacturing an item with cost of goods incurred in producing the item. Where a business is engaged primarily in providing services, rather than manufacturing a material product or merchandising such a product, the business gross receipts will constitute gross income without any reduction for COGS.
Capital Expenditure
Although the Code allows a deduction for ordinary and necessary business expenses, it generally forbids a deduction for “[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.”[xxvii]
The Court explained that the principal tax consequence of classifying the payment of a cost as a deductible expense or as a capital expenditure concerns the timing of the taxpayer’s recovery of the cost. According to the Court, while business expenses are currently deductible, a capital expenditure usually is amortized or depreciated over the life of the relevant asset, the goal being to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes.[xxviii]
There is a priority given to capitalization, the Court continued, because income tax deductions are a matter of legislative grace, with taxpayers bearing the burden of proving entitlement to claimed deductions.[xxix]
In general, a business-related expenditure for which a deduction is denied or forbidden by the Code may be added to the basis of the property to which it is related (i.e., capitalized), and depreciated or amortized in future tax years.
The Court stated that an expenditure is required to be capitalized “when it (1) [c]reates or enhances a separate and distinct asset, (2) produces a significant future benefit, or (3) is incurred ‘in connection with’ the acquisition of a capital asset.”
Acquisition-Related Expenditure
The phrase “in connection with” in the third situation (above), the Court continued, means that the expenditure was directly related to the acquisition of an asset. An acquisition-related expenditure is a capital expenditure when its origin “is in the process of acquisition itself.”
Accordingly, the Court stated it would apply a “process of acquisition test,” under which it would consider not simply whether an expenditure was somehow related to an asset acquisition, but rather whether the expenditure was directly related to that acquisition.
Thus, expenditures that a buyer must capitalize into an acquired asset’s basis are not limited to the price paid to the seller but also include, for example, legal, brokerage, accounting, appraisal, and other ancillary expenses directly related to the asset’s acquisition.[xxx] They also include liabilities assumed, the Court added.
The Court stated that the payment of an obligation of a preceding owner of property by the person acquiring such property, whether or not such obligation was fixed, contingent, or even known at the time such property was acquired, is not an ordinary and necessary business expense. Rather, when such obligation is paid it is a capital expenditure, which becomes part of the cost basis of the acquired property. Such is the result irrespective of what would have been the tax character of the payment to the prior owner.[xxxi]
Taxpayers conceded that Corp was a service provider; still, they
maintained that $3.162 million of the APA Payments were COGS because they were inextricably linked to Corp’s trade or business and represented payments for “previously purchased services” without explaining how such costs were incurred in producing goods or selling an item held for sale.
Alternatively, Taxpayers asserted that the APA Payments at issue were ordinary and necessary business expenses. They maintained that the Buyer LLC paid or incurred a total of almost $5.44 million (including assumed liabilities) under the terms of the APA but that only $2.276 million of this amount was consideration for LLC’s assets. Taxpayers maintained further that the remaining $3.162 million (the sum of the Vendor Cures) was paid in settlement of Buyer LLC’s potential liability to the Vendors.[xxxii]
“The Danielson Rule”
The IRS relied on both the “Danielson rule” and the “strong proof rule” to hold Taxpayers to the tax consequences of the agreements that were signed in connection with LLC’s bankruptcy. The IRS stressed the increased administrative burden that would have resulted from allowing taxpayers to escape the form of their self-structured transactions whenever they could save tax by so doing.
The IRS likewise presented an assortment of additional arguments. The agency contended that a buyer’s intent and motivation in acquiring assets are irrelevant when determining whether the expenses related to the acquisition are capitalizable or deductible.For example, the cost of acquiring certain intangibles — such as a customer list, goodwill, or going-concern value — is specifically required to be capitalized.[xxxiii] The IRS further argued that any liabilities assumed by Buyer LLC in connection with the acquisition of LLC’s assets had to be capitalized.[xxxiv]
Addressing COGS first, it was clear, the Court stated, that Corp was in the business of providing services to customers, and not in the business of creating or selling any material products. Thus, COGS, which is linked to manufacturing or merchandising products, was not applicable in services industries. The Court refused to give Corp a reduction in gross income for COGS.
Next, the Court addressed the form of the transaction, explaining that when a taxpayer signs a contract unambiguously specifying the consideration for a purchase, the taxpayer generally is bound by that specification for tax purposes, absent extraordinary circumstances.[xxxv]
The Court stated further that, according to the strong proof rule, “[W]hen the parties to a transaction . . . have specifically set out the covenants in the contract and have there given them an assigned value, strong proof must be adduced by them in order to overcome that declaration.”[xxxvi]
In general, taxpayers are bound by the form of the transaction that they chose.
Taxpayers argued that neither the Danielson rule nor the strong proof rule applied to the APA because, according to them, the APA did not unambiguously allocate the Purchase Price among the various elements of LLC’s consideration.
Although the Court agreed there are limits to the Danielson and strong proof rules, in cases where there is some ambiguity in the allocations of payments under contract,[xxxvii] it found there was no ambiguity in the case before it. Taxpayers made much of the fact that no allocation of the purchase price was made to the liability release for Corp, yet that liability was primarily LLC’s.
Taxpayers did not provide proof that the APA was the result of mistake, undue influence, fraud, or duress which would allow the Court to ignore those provisions of the APA stating that the payments at issue were for acquisition of LLC’s assets.
Thus, the Court determined that Taxpayers did not prove that the APA was unenforceable. Moreover, the allocation was not ambiguous and was thoroughly vetted by the bankruptcy court and other creditors.
Finally, the Court posited that even if it were to accept some ambiguity in the purchase price allocation, it would still be compelled to accept the IRS’s argument that Corp was required to capitalize the full amount of the APA Payments because of those payments’ relationship to resolving LLC’s liabilities and acquiring LLC’s assets. If Taxpayers were correct, the Court continued, that a payment by Buyer LLC to resolve Corp’s potential liabilities to the Vendors might give rise to a current deduction under the Code, that payment primarily resolved LLC’s liabilities to the Vendors and was directly related to Buyer LLC’s acquisition of LLC’s assets.[xxxviii]
Therefore, Corp was required to capitalize the entirety of the APA Payments.
The Court emphasized that the Vendor-1 Cure and the Vendor-2 Cure were negotiated between LLC and each Vendor, respectively, in settlement of their disputes over the services agreement. The record was clear, the Court stated, that the portions of the APA Payments that funded the Cures were allocable to the resolution of LLC’s liabilities under the agreements, even if they were also allocable to the resolution of the Corp’s potential liabilities (which were wholly derivative of LLC’s liabilities).
Thus, the Court concluded that all components of the APA Payments were directly related to the acquisition of LLC’s assets. In particular, payment of the Cures was either an explicit or de facto condition of Buyer LLC’s acquisition of LLC’s assets. Finally, the amended tax return reporting by LLC made clear that the $3.162 million payment was for the sale of goodwill, correspondingly an asset acquisition requiring capitalization by the acquiring entity.
Therefore, the payments Buyer LLC made to resolve LLC’s liabilities to the Vendors were capitalizable,[xxxix] and Corp was not entitled to reduce its taxable income by $3.162 million of the APA Payments by treating it as COGS.
Takeaway
It is important for taxpayers that are contemplating the acquisition or disposition of a business that they do not overlook the tax benefits that may be realized from the expenses they incur in connection with such acquisition or disposition.
Although the discussion above focused on costs that had to be capitalized by the buyer, it behooves the parties to a purchase and sale transaction to familiarize themselves with the regulatory[xl] treatment of so-called non-facilitative, facilitative, inherently facilitative, and success-based costs for tax purposes.
Armed with this knowledge, an acquiring or selling taxpayer will be in a better position to gauge the true costs of certain expenditures, and should therefore be in a better position to negotiate the economics of a transaction.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] For purposes of this post, we’re assuming a taxable acquisition (no possibility for a tax-deferred rollover of any assets for equity in the acquirer), and basis step-up for the assets in the hands of the acquirer.
[ii] The consideration is equal to the sum of the amount paid or payable to the seller (which may consist of cash, other property (including a limited equity interest in the acquiring entity), and an installment obligation issued by the acquirer) plus the amount of any debt or other liabilities of the seller that are assumed, or taken subject to, by the acquirer.
[iii] See the elections under IRC Sec. 338(h)(10) and Sec. 336(e) pursuant to which the purchase and sale of stock is instead treated as a purchase and sale of corporate assets that is followed by the liquidation of the seller corporation.
[iv] IRC Sec. 1245. What’s more, the gain attributable to such recapture does not qualify for installment method reporting. IRC Sec. 453(i)(1)(A).
[v] It may even qualify for bonus depreciation – i.e., immediate expensing and deduction. IRC Sec. 168(k).
[vi] Reg. Sec. 1.1060-1(c)(3).
[vii] Temnorod v. Commissioner, United States Tax Court.
[viii] I’d wager that many of you have encountered closely held service businesses that somehow report cost of goods sold on their federal income tax return even when no physical product is sold or is directly used in providing the service. I’d also wager that, in most cases, you haven’t gotten a satisfactory explanation for such treatment.
I place these expenses in the same category as the line on a return for “other expenses (attach statement),” where the explanatory statement is hardly a model of clarity. It’s where certain expenses go to hide. Bush league.
[ix] IRC Sec. 1361.
[x] IRS Form 1120S, U.S. Income Tax Return for an S Corporation.
[xi] IRC Sec. 1366.
[xii] Forms 1040, U.S. Individual Income Tax Return.
[xiii] LLC voluntarily filed for chapter 11 bankruptcy protection in the U.S. Bankruptcy Court.
[xiv] LLC was disregarded as an entity separate from its owner (Partnership) for tax purposes. Reg. Sec. 301.7701-3(b)(1)(ii).
[xv] Approximately $24 million in the aggregate.
[xvi] Buyer LLC was disregarded as an entity separate from Corp for tax purposes.
[xvii] The bankruptcy court issued “Findings of Fact, Conclusions of Law, and Order” confirming LLC’s Chapter 11 Plan. The bankruptcy court found, among other things, that Buyer LLC’s offer for LLC’s assets “is the highest and best offer” and that the consideration specified in the APA “is fair and reasonable and constitutes full, adequate consideration and reasonably equivalent value for the Acquired Assets.”
[xviii] The Vendor-1 stipulated order specified, among other things, that the purchaser of LLC’s assets “shall pay to [Vendor-1] . . . the cash amount set forth in a separate agreement between [Buyer LLC] and [Vendor-1] of even date herewith.” The order also required that upon payment of the [Vendor-1] Cure, [Vendor-1] would release LLC from all preexisting claims under the contracts.
[xix] The Vendor-2 stipulated order required funding of $1.562 million as follows: cash payment of $912,004 and release of a Prepetition Escrow ($150,000) and a Post Petition Escrow ($500,000).
[xx] Because Buyer LLC was a disregarded entity for tax purposes, all of its the assets, liabilities, and items of income, deduction, and credit were treated as assets, liabilities, and items of income, deduction, and credit of its sole member, Corp.
[xxi] “Shareholder’s Share of Income, Deductions, Credits, etc.”
[xxii] IRC Sec. 1366.
[xxiii] IRC Sec. 1366(a)(1) (directing S corporation shareholders to take into account their pro rata shares of, among other items, the corporation’s loss for the tax year).
Buyer LLC subsequently amended its tax return explaining that “the return has been amended to properly classify proceeds from the sale of goodwill of $3.162 million inadvertently recorded as gross receipts.” A corresponding amendment was not made to Corp’s return. Taxpayers amended their returns to reflect the Buyer LLC, amendment. Taxpayers claimed net operating loss carrybacks of their respective shares of Corp’s reported loss. The other Corp shareholders still had positive gross income for the taxable year after taking into account their respective shares of Corp’s reported loss.
[xxiv] IRC Sec. 6212.
[xxv] Treas. Reg. §1.61-3(a).
[xxvi] IRC Sec. 162.
[xxvii] IRC Sec. 263(a).
[xxviii] Citing INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992).
[xxix] IRC Sec. 161 provides that in computing taxable income, “there shall be allowed as deductions the items specified in this [part VI of subchapter B of chapter 1 of subtitle A of the Code, which includes section 162], subject to the exceptions provided in part IX (sec. 261 and following . . . [which includes section 263]).” At the same time, IRC Sec. 261 provides that “[i]n computing taxable income no deduction shall in any case be allowed in respect of the items specified in this [part IX of subchapter B of chapter 1 of subtitle A of the Code].” The Courts have interpreted these two “priority-ordering directive[s]” to mean that “an expenditure incurred in acquiring capital assets must be capitalized even when the expenditure otherwise might be deemed deductible under Part VI.” The notion that deductions are exceptions to the norm of capitalization finds support in various aspects of the Code. Deductions are specifically enumerated and thus are subject to disallowance in favor of capitalization.”
[xxx] As stated by the Court: “The requirement that costs be capitalized extends beyond the price payable to the seller to include any costs incurred by the buyer in connection with the purchase, such as appraisals of the property or the costs of meeting any conditions of the sale.”
[xxxi] If the payment of the liability would have been deductible by the seller, the seller’s deduction should be preserved notwithstanding the buyer’s assumption of the liability and its treatment as consideration for the acquisition of the seller’s assets. After all, the seller accepted a lower cash purchase price, thereby having in effect paid the liability. So, purchase price to the seller, deduction by the seller, capital expenditure by the buyer.
[xxxii] Taxpayers’ theory was that, absent the chapter 11 plan and the related bankruptcy settlements, the two Vendors likely would have pursued Buyer LLC for satisfaction of their claims under the agreements with LLC. Under this theory, the $3.162 million was paid to forestall the Vendors from either suing to hold Buyer LLC directly liable for LLC’s alleged debts or seeking to convert LLC’s chapter 11 bankruptcy to a chapter 7 proceeding.
According to Taxpayers, this $3.162 million portion of the APA Payments need not be capitalized into Buyer LLC’s (i.e., Corp’s) basis in LLC’s assets, since that amount was paid to resolve Corp’s potential liabilities to the Vendors, not to purchase assets. Taxpayers asserted that such expenses were deductible as ordinary and necessary business expenses.
The IRS countered by pointing out that, according to the APA, “the purchase price for the Business and the Acquired Assets shall be the aggregate of” the Cash Purchase Price, the Assumed Liabilities (including the Cures), and the Buyer LLC’s waiver of its unsecured claims against LLC.
[xxxiii] Reg. Sec. 1.263(a)-4(c).
[xxxiv] Finally, the IRS alluded to a discrepancy between (1) the purchase price allocation in Corp’s and LLC’s federal tax returns (which did not report all of the APA Payments on Form 8594, Asset Acquisition Statement Under Section 1060) and (2) the reporting in Corp’s financial statements (which reported slightly higher acquired asset values and liabilities assumed than the amounts reported on the tax returns).
[xxxv] This is commonly referred to as the “Danielson rule,” which states as follows: “[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.” Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967).
[xxxvi] Some courts employ this rule instead of Danielson. The Court explained the rule as follows: “[W]here one alleges that an allocation is actually other than that contained in a contract, that party must prove it beyond a mere preponderance of the evidence — he must present ‘strong proof’ that that allocation [he proposes] is correct based on the intent of the parties and the economic realities.”
[xxxvii] “The Danielson rule can only be meaningfully applied in those cases where a specific amount has been mutually allocated to the covenant as expressed in the contract.” Likewise, the strong proof rule is “inapplicable when the relevant allocation terms of the contract were ambiguous; instead, the taxpayers needed to prove their preferred interpretations by only a preponderance of the evidence.”
[xxxviii] The Court stated that. absent other considerations, those payments had to be capitalized. Moreover, according to the Court, if a payment falls under both a deduction provision and a capitalization provision, the capitalization provision prevails. IRC Sec. 161 and Sec. 261.
[xxxix] “The payment of an obligation of a preceding owner of property by the person acquiring such property . . . is a capital expenditure which becomes part of the cost basis of the acquired property.”
[xl] Reg. Sec. 1.263(a)-5.