M. Vance Saunders, CPA, Director, Andrew A. LoPresti, CPA, Associate, Spencer P. Cavalier, CFA, ASA, Managing Director & Principal, Thomas E. Kelso, Managing Director & Principal, Head of Downstream Energy & Retail Group

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Introduction
In corporate M&A transactions, a buyer and seller always have competing interests. The seller’s goal is to maximize after tax proceeds, while the buyer strives to maximize its expected return on investment. In the last Capital Markets Perspective©, we focused on how a seller’s corporate legal structure could impact after tax proceeds from a company sale or divestiture of assets. In this issue, we address another critical element of corporate M&A transactions: the allocation of purchase price to the various classes of assets in an asset sale transaction for a pass-through entity (e.g. S corporation, LLC, etc.). While the purchase price determines the amount of money that changes hands between the parties, the allocation of the purchase price among asset classes has a significant impact on the after tax proceeds retained by the seller as well as the future after tax cash flows received by the buyer.

Allocation of Value to the Different Classes of Assets
Variations in IRS rules across asset classes regarding depreciation and tax rates on gains at the time of a sale are important factors in incentivizing both a buyer’s and seller’s purchase price allocation. Buyers prefer to allocate more value to assets with shorter depreciable lives in order to increase the value of their future tax shield, while sellers prefer to allocate value in a manner that reduces depreciation recapture in order to minimize ordinary tax liability and maximize capital gain treatment.

Land is not a depreciable asset, therefore any gain or loss on the sale of land is always a capital gain or loss to the seller, and there is no future tax shield for the buyer associated with land value. In most industries, commercial buildings and depreciable improvements (Section 1250 property) are required to be depreciated on a straight-line basis over a period of 39 years; however, the IRS has granted an exception for retail motor fuels outlets [1] to be depreciated over a period of 15 years. Equipment (Section 1245 property) has the shortest depreciable life of any asset class and is depreciated over a period of three to seven years. The vast majority of convenience store equipment, including fuel equipment, canopies [2], computer equipment, and inside store equipment, can be depreciated over five years. In addition to the short recovery periods for buildings and equipment, these assets also qualify for accelerated depreciation methods, such as MACRS (Modified Accelerated Cost Recovery System) that allow for more of the tax benefits to be realized in the earlier years of an investment rather than equally over the life of the asset [3]. Goodwill and other Section 197 intangible assets that are acquired are amortized on a straight-line basis over 15 years, providing a tax shield for the buyer, albeit over a longer period. Goodwill and Section 197 intangibles that are created, rather than acquired, are not amortized for tax purposes by the entity that created them.

As discussed in our previous issue of Capital Markets Perspective©, when a pass-through entity sells its assets, a portion of any gain will be subject to depreciation recapture up to the amount of depreciation previously taken on the assets, and the remaining gain in excess of the original cost of the assets will be recognized as a capital gain and taxed at an individual’s capital gains rates [4]. Depending on the type of asset that had previously been depreciated, different tax rates may apply to the recapture amount. Depreciation recapture on equipment is taxed at ordinary income tax rates, and the capital gain is taxed at capital gains rates. For depreciable real property, depreciation recapture is comprised of any excess of accelerated depreciation over the straight line method and is taxed at ordinary income rates. Any remaining gain on real property up to the amount of depreciation previously taken (un-recaptured Section 1250 gain) is taxed at a maximum rate of 25%, and any gain in excess of original cost is taxed at individual capital gains rates. Any gain on non-depreciable assets, such as land, is treated as a capital gain and, therefore, receives more favorable tax treatment. For goodwill and other intangible assets, the taxation of the gain depends on whether the seller had basis in, and had been amortizing, the assets prior to the sale. For intangible assets that have been amortized, the portion of the gain up to the amount of previous amortization would be subject to recapture at ordinary income tax rates, and the remaining gain would be taxed at capital gains rates. However, for most sellers in the downstream petroleum industry, the intangible asset value has been created internally and not previously recognized on the balance sheet, and the value allocated to most intangibles will be a capital gain asset when sold. One exception is a non-compete agreement, which will be taxed at ordinary income rates to the seller.

In general, a seller would prefer to allocate a larger share of the purchase price to non-depreciable assets and goodwill to take advantage of favorable capital gain tax rates, while a buyer would prefer to allocate value to depreciable assets, with a preference on assets that depreciate faster, such as equipment, in order to increase the value of its future depreciation tax shield. The buyer’s preference for a higher allocation to equipment is in direct contrast to the seller’s preferred allocation to capital gain assets. This inherent conflict in the goals of each party should not be overlooked in a transaction.

Exhibit 1, on the following page, illustrates how different purchase price allocations for an asset sale of an S corporation could result in an approximate $1.25 million difference in after tax proceeds to the seller.

[1] Applies to assets placed in service after August 20, 1996. Property qualifies as a retail motor fuels outlet if: 1) 50% or more of its gross revenues are generated from petroleum sales; or 2) 50% or more of its floor space is devoted to petroleum marketing sales; or 3) it is a motor fuels outlet of 1,400 square feet or less.

[2] The supporting concrete footings used to anchor the canopies are classified as land improvements and may be depreciated over 15 to 20 years depending on the depreciation system used.

[3] Under certain circumstances, a buyer may be able to expense a portion of the value of equipment and retail improvement property in the year of acquisition under the Section 179 deduction; however, this will only apply in smaller transactions and is beyond the scope of this publication.

[4] This issue focuses on corporate transactions for pass-through entities such as S corporations, partnerships, and limited liability companies. Please keep in mind that for C corporations, all gains are taxed at the same ordinary corporate income tax rate regardless of the nature of the gain.

Allocation B, which has a greater allocation of the total $50 million purchase price to assets with accumulated depreciation, creates a significantly larger tax liability to the seller. The largest contributing component of the additional tax liability under Allocation B stems from the approximately $12.5 million of additional value that is subjected to depreciation recapture at less favorable, ordinary income tax rates. However, from the buyer’s perspective, allocating more value to assets that are either not depreciable or otherwise have a longer depreciable life, significantly reduces its future tax shield. Exhibit 2 examines the future tax consequences to the buyer under both allocations. Assuming that the buyer is subject to a 39.6% tax rate on ordinary income, Allocation B results in roughly $2.8 million of additional value in future tax savings.

In a stock transaction, where a buyer is purchasing the equity of a seller’s company, a purchase price allocation is not necessary because the buyer assumes the seller’s tax basis in the assets and there is simply a change in stock ownership. The future tax shield related to depreciation does not change as there is no step-up in basis in the assets. However, the parties may agree to treat a stock sale as an asset sale for tax purposes by making a Section 338(h)(10) election. If this election is made, the buyer’s basis is stepped-up to fair market value based on the allocation of purchase price to the assets, and taxes are levied on the seller’s gains consistent with an asset sale and, therefore, making the election is no more efficient from the seller’s tax perspective than an asset sale would be.

Allocation Requirements in an Asset Sale Transaction
An allocation of the purchase price must be made to establish the purchaser’s basis in the acquired assets and to calculate the seller’s gain or loss on a transaction. The IRS does not require a buyer and seller to agree on the allocation of purchase price. However, if the parties do not agree on the allocation, each party must be prepared to defend their allocation to the IRS, as it may be subject to additional scrutiny and challenge. When the parties agree on allocation in the asset purchase agreement or other documented allocation agreement, the IRS holds the allocation to be binding on the parties and will not challenge the allocation unless it determines that the allocation is inappropriate. A challenge to an agreed upon allocation is extremely unlikely to occur because the agreement between buyer and seller is an arm’s length agreement negotiated by parties with competing interests and therefore should represent market value for the assets. When the parties do not agree on the allocation of purchase price, the IRS is alerted to this fact when reviewing the Form 8594, as discussed below, and the accompanying tax return filings of both entities. Ultimately, the seller will usually bear a disproportionate level of risk since a reallocation by the IRS will likely reduce after tax proceeds to the seller. Depending on the risk tolerance of our clients, we might recommend that the parties try to agree to an allocation of purchase price among the various asset types in sufficient detail to support their basis or gains calculations to avoid the costs and potential penalties or reallocation associated with an IRS challenge. This allocation should go beyond the Form 8594 requirements to include a detailed allocation of purchase price between land, buildings and improvements, equipment, identifiable intangible assets, and goodwill.

Reporting Requirements
With limited exceptions, both a buyer and seller are required to include a Form 8594 with their income tax return for the year in which a transfer of a group of assets that constitute a trade or business occurs and when the buyer’s basis in the acquired assets is determined solely by the purchase price of the assets. The IRS defines a group of assets as a trade or business “if goodwill or going concern could be under any circumstances attached to such assets”. Filers of the Form 8594 are required to allocate the purchase price among the following seven asset classes:

According to Section 1060 of the IRS tax code, the residual method should be used when allocating a purchase price among the various asset classes. Value should be first assigned to Class I assets at their actual value and then assigned to identifiable assets in Classes II – VI based on their proportionate fair market values. Any remaining value is allocated to goodwill. As noted above, when the parties contractually agree to the allocation, such allocation is binding and supersedes the residual method. Allocation between fixed asset (Class V) and intangibles classes (Classes VI and VII) are most material to purchase price allocation negotiations of transactions in the downstream petroleum industry. Most working capital items (Classes I – IV) in downstream petroleum transactions are typically excluded assets, as outlined by the asset purchase agreement, with the exception of inventory, which is typically sold at cost at closing and is accounted for separately from the other assets. Dealer promissory notes or accounts receivables are commonly included as Class III assets when contract dealer accounts are sold. Any value that is allocated to dealer supply contracts would be considered a Class VI asset.

Form 8594 also requires identification of both parties to a transaction including entity name and Federal Tax ID number as well as the total transaction value. Form 8594 also asks if the buyer and seller agreed to an allocation in the sales contract and if the allocation provided in Form 8594 matches the allocation agreed to by the parties.

If the answer to either of these questions is no, the IRS is immediately alerted to the fact that there was no agreement on allocation between the parties and that they should review the allocations documented in each party’s tax return.

As mentioned above, the asset classes used for Form 8594 do not provide enough information for establishing a buyer’s basis or calculating a seller’s gain with respect to the fixed assets included in Class V (i.e., land, buildings and improvements, and equipment). Such allocation is made in the tax return filings of each entity, which may be reviewed by the IRS, especially if indicated on Form 8594 that the parties did not agree to an allocation. As previously mentioned, if the parties do not agree on an allocation, the parties should be prepared to present compelling evidence to the IRS that their allocations represent market value for the assets. Some of the more active consolidators in the downstream petroleum industry have moved to outsource their purchase price allocation to independent accounting firms to diminish the risk of any potential liability resulting from an IRS audit. These buyers are often unwilling to negotiate away from the independent accounting firm’s allocation and are willing to allow the seller to file an allocation different from their own, but sellers should be prepared to provide evidence equally as compelling as that of an independent accounting firm (appraiser) to support their allocation.

A typical allocation of purchase price between the various asset classes will vary from company to company depending on their asset mix and operating structure. Retail convenience store companies are much more likely to have a larger allocation of depreciable assets while the majority of a fuel distributorship’s value could be associated with identifiable intangible assets (supply contracts) and goodwill. Exhibit 3 illustrates how a purchase price allocation can differ between a retail focused marketer with a large fixed asset base compared with a wholesaler that primarily has supply contracts (dealer or commercial accounts) with minimal equipment at dealer sites.

Miscellaneous Issues

Non-compete Agreements
Non-compete agreements are common in corporate M&A transactions to protect the buyer’s investment since the seller often possesses information that could allow it to cause material damage to the transferred business if the seller were to compete with such business post-closing. Non-compete agreements are exceptionally important to buyers who are purchasing fuel supply businesses so that the seller is prohibited from leveraging past relationships to pick off previous customers as the transferred supply contracts expire. As with other Section 197 assets, non-compete agreements are amortized by the buyer over 15 years regardless of the term of the non-compete agreement. The allocation of purchase price to the non-compete agreement in downstream petroleum transactions is typically a very small part of the overall purchase price, and this value is always taxed at ordinary income rates for the seller.

1031 Exchanges
The allocation of purchase price among the various classes of assets is particularly important when a seller desires to defer all or a portion of the gain on real property (or equipment) in a like-kind exchange pursuant to Section 1031. In the case of a business with multiple real properties, such as a convenience store chain, it’s important to have the purchase price allocations on a site level basis with the allocation broken out between real property, equipment, and goodwill for each site as only the real property portion is typically considered like-kind in an exchange for other income producing real estate outside of the convenience store industry. A seller considering deferring part of their gain via 1031 exchange should give special consideration for the inclusion of the purchase price allocation in the asset purchase agreement.

Transactions with Multiple Sellers
It is common in the downstream petroleum and convenience store industries for the real estate to be owned in separate LLCs (or other pass-through entities) outside of the operating entity(s). Often, the shareholders will be different between the operating company(s) and the various real estate entities. In these instances, the allocation of the total purchase price is even more critical as there may be competing interests among the shareholders as well as different tax strategies for each entity. The best way to avoid future disputes, internally or with the IRS, is to document a detailed allocation in the asset purchase agreement.

Conclusion
When buying or selling a company, the allocation of the purchase price to the various classes of assets for income tax purposes has material consequences for both the buyer and the seller. The parties should consult their tax advisors and investment bankers to achieve the best possible allocation, keeping in mind that the allocation, as with the purchase price, is just one element of the overall transaction and the value derived by each party. The optimal solution for each party may not be achieved due to the compromise required to complete a complex transaction and allocation should not stop a good deal from being successfully concluded. If, however, the parties elect not to agree on an allocation, it is extremely important for each party to be able to defend their allocation in the event the IRS challenges the allocation put forth by either party.

Disclaimer

The contents of this publication are presented for informational purposes only. While Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”) believe the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non-infringement. Matrix assumes no responsibility for errors or omissions in this publication or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.

Matrix’s Downstream Energy and Retail Group is recognized as the national leader in providing transactional
advisory services to companies in the downstream energy and multi-site retail sectors.

 

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