The Peco Case: Are You Giving Enough Attention to Details in Purchase Price Allocations?
A recent Tax Court decision emphasizes the importance of planning and proper attention to detail when drafting purchase price agreements and commissioning cost segregation studies.
Earlier this year, the Tax Court determined that a taxpayer, Peco Foods, Inc. and Subsidiaries (Peco) could not modify agreed-upon purchase price allocations by subsequently reallocating and subdividing acquired assets into various subcomponents for tax depreciation purposes.
Peco acquired two poultry processing plants in the mid-1990s through two separate asset acquisitions. Both purchase agreements noted the stated allocation of the purchase price among the acquired assets would be “for all purposes (including financial accounting and tax purposes)” and both parties agreed to the allocation. In both agreements, the purchase price was allocated to real property and machinery and equipment, among other assets. Additionally, the agreement generally defined real property to include leaseholds and sub-leaseholds as well as any improvements, fixtures and fittings attached to the building. Equipment was generally defined within the agreement as tangible personal property such as machinery, equipment, computer hardware and software, furniture, automobiles, trucks, tractors, trailers, tools, jigs and dies. A few notable assets on the allocation schedule included a processing plant building, real property (specifically land and improvements), and machinery and equipment.
In its tax returns for the acquisition years, Peco depreciated the real property, including the processing plant building, as 39-year property. Several years later, Peco performed cost segregation studies for the acquired assets that resulted in reclassification of various real property assets into tangible personal property as either 7-year or 15-year depreciable property. Peco filed a Form 3115, Application for Change in Accounting Method, and subsequently filed tax returns that included favorable adjustments to reduce income tax liabilities due to the changes to depreciation.
In 2008, IRS issued a notice of deficiency attributable to the accounting method change, corrected depreciation adjustments for the real property and reduction to NOLs.
Tax Court Rulings
The purchase agreement was subject to Internal Revenue Code Sec. 1060, which specifies allocation rules in determining the basis and gain or loss in an asset acquisition, and provides that, if the parties agree in writing as to the allocation of any consideration, or as to the fair market value of any of the assets, such agreement shall be binding on the parties. The allocation can be set aside only if IRS determines the allocation is inappropriate or the taxpayer can prove there was a mistake, undue influence, fraud, duress, etc., in the purchase agreement. The Tax Court determined that none of these grounds for setting aside the agreement was present and Peco was therefore bound by the agreed to allocations. Notably, IRS did not dispute the correctness of the allocations in the purchase agreements or the results of the cost segregation study. IRS challenged only the applicability of the post-agreement cost segregation reclassifications due to the binding nature of IRC Sec. 1060.
Among its arguments, Peco maintained that the purchase agreements were not enforceable because the definitions within the agreements of “Processing Plant Building” and “Real Property: Improvements” were ambiguous. The Tax Court determined they were not. With respect to one of the purchase agreements, the Tax Court noted that the allocation of almost twice as much of the purchase price to “machinery, equipment, and furniture” as to the “Processing Plant Building” proved Peco’s intent to allocate the purchase price conclusively among the specific component assets. With respect to the other purchase agreement, the Tax Court noted that the decision to allocate the purchase price among various separate assets showed that Peco was aware of the existence of subcomponent assets but chose not to allocate additional purchase price to them. Additionally, the Tax Court noted in one circumstance that an appraisal was dated before the date of the agreement, suggesting that Peco could have adopted a more detailed allocation schedule but did not. The Tax Court also suggested that the timeline of events implied Peco believed in this ambiguity only after it understood it could receive a tax benefit by cost segregating the building into subcomponent assets.
The Tax Court concluded that Peco was bound by the allocations within the agreements and with IRS’ adjustments.
This case points out a significant trap for the unwary that can be avoided. One key observation is if the parties want to agree to a written purchase price agreement, they should carefully review the wording, definitions, and allocations of such agreements. Use of broad language such as “[the allocation] will be used for all purposes (including financial accounting and tax purposes)” needs to be considered carefully, as well as specific definitions within the agreement (e.g., “processing plant” instead of “processing plant building”) to ensure desired results are achieved. Additionally, consideration should be given to performing a cost segregation study early in the process or draft the agreement in such a fashion that a subsequent cost segregation and allocation is binding on both parties.
It should be noted that an agreement of the parties on purchase price allocation is not required for tax purposes. If the parties choose not to agree, the residual method of allocation provided in regulations would be used and subsequent cost segregation studies may be beneficial to this allocation.