Corporate Tax | Just Tax
Asset Acquisition Price Allocation (§§ 1060, 197)
This checklist guides tax practitioners through the allocation of purchase price in an applicable asset acquisition under § 1060 and the amortization of acquired intangibles under § 197. Use this checklist when analyzing any asset purchase that constitutes a trade or business acquisition, including stock purchases with deemed asset sales under § 338.
§ 1060(c) defines "applicable asset acquisition" as "any transfer (1) of assets which constitute a trade or business, and (2) with respect to which the basis of such assets in the hands of the transferee is determined wholly by reference to the consideration paid for such assets."
- The statutory definition requires both that transferred assets constitute a trade or business and that the transferee's basis is determined wholly by reference to purchase consideration (§ 1060(c))
- A transfer of a single asset does not trigger § 1060 unless that asset by itself constitutes a trade or business
- Basis determined wholly by reference to consideration paid excludes carryover basis transactions such as gifts (§ 1015) and certain reorganizations (§ 362)
- The trade-or-business standard under Treas. Reg. § 1.1060-1(b)(1) is broader than the § 162 trade or business test
- A group of assets constitutes a trade or business if its use would permit an individual to begin carrying on that trade or business
- The regulation also captures assets that constitute "a corner of a trade or business" even if not a complete freestanding operation
- Treas. Reg. § 1.1060-1(b)(2) provides a nonexclusive list of factors including goodwill, going concern value, customer lists, licenses, and other intangible assets
- Goodwill or going concern value is the most common indicator that assets constitute a trade or business
- Treas. Reg. § 1.1060-1(b)(2) treats the presence of goodwill or going concern value as generally sufficient
- Their absence does not automatically mean § 1060 does not apply if other intangible assets or operating assets are present in sufficient quantity
- Asymmetrical transfers may still constitute applicable asset acquisitions under Treas. Reg. § 1.1060-1(b)(4)
- A transfer is treated as an applicable asset acquisition even if the transferor retains some assets from the trade or business
- The transferee must still acquire a group of assets that constitutes a trade or business in its hands
- CAUTION. The transferor's retained assets are not relevant to whether the transferee acquired a trade or business
- The like-kind exchange exception under Treas. Reg. § 1.1060-1(b)(8) removes certain transactions from § 1060
- A transaction qualifying for nonrecognition under § 1031 does not constitute an applicable asset acquisition
- This exception applies even if the acquired assets would otherwise constitute a trade or business
- Transactions outside § 1060 include transfers subject to § 1041 (transfers between spouses) and transfers of partnership interests under § 743(b) (Treas. Reg. § 1.1060-1(b)(7))
- Stock acquisitions are not directly subject to § 1060 but may trigger parallel allocation rules through § 338
§ 1060(a) provides that "in the case of any applicable asset acquisition, for purposes of determining both (1) the transferee's basis in such assets, and (2) the gain or loss of the transferor with respect to such acquisition, the consideration received for such assets shall be allocated among such assets in the same manner as amounts are allocated to assets under § 338(b)(5)."
- The statutory mandate requires identical allocation methodology for both purchaser basis and seller gain/loss (§ 1060(a))
- Both parties must use the same allocation method preventing asymmetrical tax treatment
- The regulations under § 338(b)(5) are incorporated by reference into § 1060 through cross-reference to Treas. Reg. §§ 1.338-6 and 1.338-7
- Consideration for § 1060 purposes is defined under Treas. Reg. § 1.1060-1(c)(1)
- For the seller, consideration equals the amount realized under § 1001(b) including cash, FMV of property received, and liabilities assumed
- For the purchaser, consideration equals the cost properly taken into account in basis including cash paid, FMV of property transferred, and liabilities assumed
- The seller's amount realized and the purchaser's cost may differ (e.g., due to selling expenses or different valuation dates)
- The waterfall allocation proceeds sequentially through seven asset classes under Treas. Reg. § 1.338-6(b)
- Each class is filled to FMV before any amount moves to the next higher-numbered class
- The residual after Classes I through VI are filled goes to Class VII (goodwill and going concern value)
- This is why the method is called the "residual method"
- Substitution of terms between § 338 and § 1060 requires careful attention
- In § 338 the allocation uses ADSP (Adjusted Deemed Sales Price) for the old target and AGUB (Adjusted Grossed-Up Basis) for the new target
- In § 1060 "consideration" replaces both ADSP and AGUB as the allocable amount
- The mechanical waterfall rules otherwise operate identically
- Written allocation agreements under § 1060(a) and Treas. Reg. § 1.1060-1(c)(4) bind both parties
- The agreement must be executed before the due date of the seller's return for the transfer year
- Both parties must attach the agreement to their returns
- The Secretary may determine the allocation is "not appropriate" and may reallocate accordingly
- TRAP. An allocation agreement that deviates from FMV may be challenged by the IRS even if both parties consented
Treas. Reg. § 1.338-6(b)(2) defines the asset classes as follows. "Class I assets are cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit and other similar instruments. Class II assets are actively traded personal property within the meaning of § 1092(d)(1) and Treas. Reg. § 1.1092(d)-1, certificates of deposit, and foreign currency. Class III assets are assets that the taxpayer marks to market at least annually for Federal income tax purposes and debt instruments, and assets that are designated as Class III assets in accordance with paragraph (c)(2)(i) of this section (accounts receivable). Class IV assets are stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets. Class VI assets are all § 197 intangibles (as defined in § 197(d) other than goodwill and going concern value). Class VII assets are goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a § 197 intangible)."
- Class I (Cash and Deposit Accounts) receives first priority in allocation
- Includes checking accounts, savings accounts, and demand deposits
- Excludes certificates of deposit which fall in Class II
- Valued at face amount so no FMV adjustment is typically needed
- Class II (Actively Traded Property, CDs, Foreign Currency) includes readily marketable instruments
- Actively traded personal property is defined by reference to § 1092(d)(1) and Treas. Reg. § 1.1092(d)-1
- Valued at FMV using established market quotations
- Foreign currency is translated at the spot rate on the acquisition date
- Class III (Marked-to-Market Assets and Debt Instruments) includes financial assets carried at market
- Debt instruments not actively traded fall here rather than in Class II
- Accounts receivable are generally Class III assets and are valued at face amount less any appropriate reserve
- TRAP. A taxpayer cannot manipulate classification by voluntarily marking assets to market solely for purposes of the allocation
- Class IV (Inventory and Stock in Trade) captures all inventory-type assets
- Valued at FMV which may differ from the taxpayer's book inventory value
- For LIFO inventory, special valuation rules may apply under Treas. Reg. § 1.338-6(c)(3)
- Inventory step-up or step-down affects both purchaser basis and ordinary income to seller
- Class V (All Other Assets) is the catch-all category for tangible and intangible assets not in other classes
- Includes real property, furniture, fixtures, equipment, and non-§ 197 intangibles
- Tangible personal property is generally depreciable under § 168 (MACRS)
- Real property is depreciable under applicable recovery periods (§ 168(c))
- Non-§ 197 intangibles may be amortizable if they have an ascertainable useful life separate from goodwill
- Class VI (§ 197 Intangibles Except Goodwill and Going Concern Value) includes the enumerated intangibles under § 197(d)(1)(C)
- This class is amortizable over 15 years under § 197(a)
- Includes workforce in place, customer lists, know-how, licenses, covenants not to compete, and other statutory intangibles
- Allocation to this class cannot exceed FMV
- Class VII (Goodwill and Going Concern Value) is the residual class that absorbs any remaining consideration
- Only Class VII can receive an allocation in excess of FMV because it is the residual
- Goodwill and going concern value are treated as a single residual pool under Treas. Reg. § 1.338-6(b)(2)
- This is where most acquisition premium ultimately lands
- The FMV limitation under Treas. Reg. § 1.338-6(b)(1) restricts allocation to each asset's FMV
- No class (except Class VII) may receive an allocation exceeding the aggregate FMV of assets in that class
- If aggregate FMV of Class V assets is $2 million, the allocation to Class V cannot exceed $2 million regardless of how much consideration remains
- Excess consideration pushes up to the next class in the waterfall
- The lower-numbered class rule for ambiguous assets under Treas. Reg. § 1.338-6(b)(2) prevents double allocation
- Any asset that could fall in more than one class is placed in the lowest-numbered class for which it qualifies
- This rule minimizes the amount reaching Class VII by prioritizing earlier classes
- EXAMPLE. A marketable security held as inventory would be a Class II asset (not Class IV) because Class II has the lower number
Treas. Reg. § 1.197-2(b)(1) defines goodwill as "the value of a trade or business attributable to the expectancy of continued customer patronage. This expectancy may be due to the name or reputation of a trade or business or any other factor." Treas. Reg. § 1.197-2(b)(2) defines going concern value as "the additional value that attaches to property by reason of its existence as an integral part of an ongoing business activity. Going concern value includes the value attributable to the ability of a trade or business to continue functioning or generating income without interruption notwithstanding a change in ownership."
- Goodwill represents customer-facing intangible value attributable to patronage expectancy (§ 197(d)(1)(A))
- The statutory definition focuses on the source of value (customer patronage) rather than a particular measurement method
- Goodwill includes brand equity, business reputation, and established customer relationships at a general level
- It does not include identifiable intangibles such as specific customer lists or trademarks which are separately classified as Class VI assets
- Going concern value represents operational continuity value distinct from customer-facing goodwill (§ 197(d)(1)(B))
- Going concern value captures the value of an assembled business that can continue operating without interruption
- It includes the value of having workforce, systems, supplier relationships, and licenses in place
- The distinction between goodwill and going concern value is often blurred in practice because both are residual Class VII assets
- Both are Class VII residual assets under Treas. Reg. § 1.338-6(b)(2)
- They absorb whatever consideration remains after all other classes are filled to FMV
- In most acquisitions, Class VII receives the largest dollar allocation because earlier classes are limited to FMV
- Because both are treated as a single residual pool, practitioners rarely need to separate goodwill from going concern value for allocation purposes
- Pre-§ 197 treatment under Treas. Reg. § 1.167(a)-3 historically prohibited depreciation for goodwill
- Prior to § 197's enactment in 1993, goodwill was generally nonamortizable because it had no determinable useful life
- This created significant tax asymmetry because purchasers could not recover goodwill basis while sellers recognized capital gain
- § 197 was enacted to provide uniform 15-year amortization for acquired intangibles including goodwill
- Newark Morning Ledger Co. v. United States, 507 U.S. 546 (1993) established the two-prong test for amortizable intangibles outside § 197
- Prong one requires that the intangible have an ascertainable value separate and distinct from goodwill
- Prong two requires that the intangible have a limited useful life estimable with reasonable accuracy
- The Supreme Court rejected the per se rule that subscriber lists were nonamortizable goodwill
- Post-§ 197, this two-prong test primarily applies to intangibles excluded from § 197 coverage
- Interaction between § 197 and Newark Morning Ledger significantly changed the landscape for intangible amortization
- Customer lists that might have been amortizable under the two-prong test before 1993 are now § 197 intangibles amortizable over 15 years
- The residual method under § 1060 captures these intangibles in Class VI rather than Class VII
- CAUTION. Do not apply the Newark Morning Ledger test to assets clearly covered by § 197(d)(1)(C). Use the test only for assets outside statutory coverage
- Customer-based intangibles are defined under § 197(d)(1)(C)(iv) as "the composition of market, market share, and any other value resulting from the future provision of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with customers"
- This category captures the value inherent in having an established customer base
- It includes both contractual relationships (written agreements) and noncontractual relationships (repeat patronage)
- The statutory definition is broad and covers any value traceable to customer relationships
- Special rule for financial institutions under § 197(d)(2) treats deposit base as a customer-based intangible
- § 197(d)(2)(A) specifically includes deposit base and similar items in the definition of customer-based intangibles
- § 197(d)(2)(B) includes mortgage servicing rights as customer-based intangibles only if the rights are separately stripped and purchased
- This statutory override ensures that core banking intangibles receive 15-year amortization
- Information base under § 197(d)(1)(C)(ii) includes "business books and records, operating systems, or any other information base (including lists or other information with respect to current or prospective customers)"
- Customer lists, subscription lists, insurance expirations, and patient files all fall in this category
- The information base must be acquired as part of a trade or business acquisition to qualify as a § 197 intangible
- Lists developed internally by the acquirer are not § 197 intangibles
- Houston Chronicle Publishing Co. v. United States, 481 F.2d 1240 (5th Cir. 1973) rejected the per se rule that customer lists constitute goodwill
- The Fifth Circuit held that customer lists could have an ascertainable value separate from goodwill
- The case applied a facts-and-circumstances test to determine whether a specific customer list had separable value
- Post-§ 197, customer lists are statutorily defined as § 197 intangibles regardless of the pre-1993 case law outcome
- Golden State Towel & Linen Service v. United States, 373 F.2d 938 (Ct. Cl. 1967) established the "mass asset" rule
- The Court of Claims held that a group of intangibles (customer accounts) could be depreciated as a unit even if individual accounts were not separately valuable
- The mass asset rule allows amortization of a portfolio of customer relationships as a single asset
- This principle underlies modern treatment of customer-based intangibles under § 197
- Post-§ 197 treatment of customer lists removes much of the prior uncertainty
- Customer lists acquired in a trade or business acquisition are now unambiguously § 197 intangibles
- They fall in Class VI of the residual method waterfall
- They receive 15-year straight-line amortization beginning in the month of acquisition
- TRAP. A customer list purchased outside of a trade or business acquisition may not be a § 197 intangible and must be analyzed under Newark Morning Ledger
- Workforce in place under § 197(d)(1)(C)(i) includes "the composition of a workforce (including the terms and conditions (whether or not formalized and whether or not collectively bargained) of any employment relationship)"
- This captures the value of having an assembled and trained workforce with established employment terms
- It includes not only current employees but also the structure and conditions of employment
- Even informal employment arrangements can contribute to workforce-in-place value
- The value of specific employment contracts with key employees is separately includible in workforce in place
- Know-how, processes, patents, and copyrights under § 197(d)(1)(C)(iii) covers intellectual property and technical intangibles
- This includes patented and unpatented technology, formulas, processes, and technical knowledge
- Copyrights in computer software may fall here unless the software qualifies for the § 197(e)(3) off-the-shelf exception
- If a patent or copyright is separately amortizable under another provision (e.g., § 167(g) for patents), it may still be a § 197 intangible if acquired as part of a trade or business
- Supplier-based intangibles under § 197(d)(1)(C)(v) include "any relationship (contractual or otherwise) with a supplier of goods or services to a trade or business"
- This captures the value of favorable supply agreements, distribution relationships, and vendor networks
- Like customer-based intangibles, supplier relationships may be contractual or noncontractual
- A below-market supply contract may have FMV that reflects the favorable terms
- Licenses, permits, and governmental rights under § 197(d)(1)(C)(vi) include "a license, permit, or other right granted by a governmental unit"
- This covers FCC licenses, liquor licenses, environmental permits, and franchises granted by government entities
- Even if the license is not transferable under local law, it may still be a § 197 intangible if it has value in the acquisition context
- TRAP. Some governmental licenses have indefinite lives but are still amortizable over 15 years under § 197 because the statute overrides any useful life determination
- Franchises, trademarks, and trade names under § 197(d)(1)(C)(vii) and § 197(d)(1)(F) are separately addressed
- Trademarks and trade names are § 197 intangibles if acquired as part of a trade or business
- Franchises are covered whether granted by the franchisor or acquired from a franchisee
- Self-created trademarks are not § 197 intangibles but acquired trademarks are
- Books, records, and operating systems under § 197(d)(1)(C)(ii) (information base) and § 197(d)(1)(C)(viii) (operating systems)
- Includes accounting records, customer databases, inventory management systems, and other operational data
- Computer software that is part of an operating system may be treated as part of the § 197 intangible rather than separately
- CAUTION. Software that is readily available off-the-shelf may qualify for the § 197(e)(3) exception and 36-month amortization under § 167(f)
- Uniform 15-year amortization applies to all § 197 intangibles regardless of actual useful life (§ 197(a))
- Amortization is computed on a straight-line basis over 180 months
- The amortization period begins in the month the intangible is acquired
- No salvage value is taken into account
- This statutory convention overrides any actual determination of useful life
§ 197(d)(1)(E) includes in the definition of amortizable § 197 intangibles "any covenant not to compete (or arrangement having substantially the same effect) entered into in connection with the direct or indirect acquisition of an interest in a trade or business or a substantial portion thereof." § 197(f)(1)(B) provides that "a covenant not to compete described in subsection (d)(1)(E) shall be treated as disposed of only if the entire interest acquired in the trade or business described in subsection (d)(1)(E) is disposed of."
- The statutory definition captures any agreement that restricts competition and is entered into in connection with a business acquisition (§ 197(d)(1)(E))
- The covenant must be entered into in connection with the acquisition of an interest in a trade or business
- "Interest" includes both direct acquisitions of assets and indirect acquisitions through stock purchases
- "Substantially the same effect" language catches arrangements that function as covenants even if not labeled as such
- Always 15-year amortization applies regardless of the covenant's stated duration
- A 3-year covenant receives the same 15-year amortization as a 10-year covenant
- The statutory period overrides the contractual period because § 197 controls recovery method
- This can create significant timing differences between economic reality and tax amortization
- Special disposition rule under § 197(f)(1)(B) prevents loss recognition on covenant expiration
- A covenant is not treated as disposed of (and no loss is recognized) until the entire acquired interest in the trade or business is disposed of
- If a purchaser acquires a business and the seller covenants not to compete for 5 years, the purchaser cannot deduct the unamortized basis when the 5 years expire
- Instead, the purchaser continues amortizing the covenant over the full 15 years
- Frontier Chevrolet Co. v. Commissioner, 116 T.C. 23 (2001), aff'd, 329 F.3d 1061 (9th Cir. 2003) held that a stock redemption triggers § 197 covenant treatment
- The case involved a stock redemption that included a noncompete agreement
- The Tax Court and Ninth Circuit held that the redemption was an indirect acquisition of the dealership's trade or business
- The covenant therefore qualified as a § 197 intangible even though no assets were directly purchased
- Recovery Group v. Commissioner, 652 F.3d 122 (1st Cir. 2011) extended § 197 to minority interest acquisitions
- The First Circuit held that a 23% interest in a trade or business was "substantial" for purposes of § 197(d)(1)(E)
- This low threshold means most acquisitions involving any meaningful business interest will trigger § 197 covenant treatment
- TRAP. Even a small minority stock purchase that includes a noncompete may result in 15-year amortization and no loss on expiration
- The economic reality test from Schultz v. Commissioner, 294 F.2d 52 (9th Cir. 1961) remains relevant to covenant valuation
- The Ninth Circuit requires that a covenant have independent economic substance apart from the sale proceeds allocation
- A covenant that lacks economic reality (e.g., a seller with no ability or intention to compete) may be recharacterized
- Courts examine whether the parties bargained at arm's length and whether the payment reflects genuine restrictive value
- IRS reallocation risk is significant when covenants lack independent economic substance
- The Service may allocate covenant amounts to goodwill if the covenant appears to have no genuine economic function
- Factors suggesting reallocation include (1) the seller was retiring and had no competitive capability, (2) the covenant amount is disproportionate to the business value, (3) no arm's-length negotiation occurred
- CAUTION. A covenant from an 80-year-old seller with no competitive experience will likely be reallocated to goodwill upon examination
§ 197(f)(9)(A) provides that " subsection (a) shall not apply to any amortizable § 197 intangible if (i) such intangible was held by the taxpayer or any other person at any time on or after July 25, 1991, and before the date the taxpayer acquired such intangible (hereafter in this paragraph referred to as the 'transition period'), and (ii) the taxpayer acquired such intangible directly from a person who held such intangible at any time during the transition period and the acquisition is part of a transaction or series of related transactions in which the user of such intangible does not change."
- The core prohibition in § 197(f)(9)(A) denies amortization for certain goodwill, going concern value, and other transition-period intangibles
- The anti-churning rules apply only to intangibles not amortizable under prior law (primarily goodwill, going concern value, and self-created intangibles)
- Intangibles that were already amortizable before § 197 (e.g., patents with determinable lives) are not subject to anti-churning
- The transition period runs from July 25, 1991 through August 10, 1993
- Category (i) under § 197(f)(9)(A)(i) applies when the taxpayer or a related person held the intangible during the transition period
- If the acquiring taxpayer itself held goodwill in the target business between 1991 and 1993, that goodwill cannot be amortized
- This prevents a taxpayer from selling and reacquiring its own goodwill to create amortizable basis
- Category (ii) under § 197(f)(9)(A)(ii) applies when the intangible is acquired from a person who held it during the transition period and the user does not change
- This captures sales to related parties and sales where the same economic user controls the intangible
- The "user does not change" test looks to economic use rather than legal ownership
- Category (iii) under § 197(f)(9)(A)(iii) applies when the right to use the intangible is granted to a transition-period holder
- This prevents licensing structures from circumventing the anti-churning rules
- The grant of a license to a party that held the intangible during the transition period triggers the prohibition
- The statutory modification in § 197(f)(9)(C) substitutes "20 percent" for "50 percent" throughout § 267(b) and § 707(b)(1)
- This lower threshold captures many relationships that would not be related under the standard § 267 definition
- For example, two corporations with 25% common ownership are related persons under § 197(f)(9)(C) even though they are not related under § 267(b)
- Three independent tests determine related-person status
- § 267(b) at 20% ownership applies the familiar related-party rules at the reduced threshold
- § 707(b)(1) at 20% ownership applies to partnerships and partners
- § 41(f)(1) common control at 50% ownership applies a separate controlled group test
- If any test is satisfied, the parties are related for anti-churning purposes
- Timing is tested immediately before or immediately after the acquisition
- The relationship need not exist continuously through the transition period
- A related-party status that arises immediately after the acquisition is sufficient to trigger the rules
- This prevents post-acquisition restructuring from avoiding anti-churning
- De minimis rule under § 197(f)(9)(C)(iv) provides a limited exception
- Corporations related solely through § 267(f)(1)(A) (stock ownership) are exempt if no more than 10% of the stock is beneficially owned by the transferor
- This de minimis rule applies only to the corporate stock ownership test
- It does not apply to other § 267(b) relationships such as family members or controlled groups
- The gain recognition exception under § 197(f)(9)(B) allows amortization if the seller recognizes gain at the highest tax rate
- The seller must recognize gain on the transfer equal to the gain that would be recognized if all transferred intangibles were sold at FMV
- The gain must be taxed at the highest rate applicable to the seller under § 1 or § 11
- This exception effectively requires the seller to pay full tax on the intangible's value as a condition to the buyer's amortization
- The basis step-up exception under § 197(f)(9)(D) applies to property with basis under § 1014(a)
- Property acquired from a decedent with a stepped-up basis under § 1014(a) is not subject to anti-churning
- The stepped-up basis reflects the FMV at death and represents a genuine economic event
- This exception applies only to the extent of the § 1014 basis step-up
- Partnership special rule under § 197(f)(9)(E) makes anti-churning determinations at the partner level
- Each partner is tested separately for related-party status and transition-period holding
- A partnership may amortize an intangible even if one partner is related to the seller so long as that partner's share of basis does not exceed the gain recognized by the seller
- This rule prevents one related partner from tainting the entire partnership's amortization
- Anti-abuse rule under § 197(f)(9)(F) authorizes the Secretary to disregard transactions with a principal purpose of avoiding anti-churning
- The Secretary may treat a series of transactions as a single transaction
- Step transactions, circular cash flows, and intermediary entities may be collapsed
- TRAP. Using an unrelated intermediary to acquire and resell goodwill will likely be collapsed if the principal purpose is to avoid anti-churning
- § 338 deemed acquisitions under Treas. Reg. § 1.197-2(h)(8) treat new target as distinct from old target
- The new target resulting from a § 338 election is not treated as the same person as the old target
- Therefore the new target is not a transition-period holder of the old target's intangibles
- This facilitates amortization following a qualified stock purchase with a § 338 election
§ 1060(a) provides that "in the case of any applicable asset acquisition, for purposes of determining both the transferee's basis in such assets, and the gain or loss of the transferor with respect to such acquisition, the consideration received for such assets shall be allocated among such assets in the same manner as amounts are allocated to assets under § 338(b)(5)." Treas. Reg. § 1.1060-1(c)(4) authorizes written allocation agreements executed before the due date of the seller's return that are binding on both parties.
- Written allocation agreements under § 1060(a) and Treas. Reg. § 1.1060-1(c)(4) create mutual binding obligations
- The agreement must be in writing and executed by both purchaser and seller
- It must be executed on or before the due date (including extensions) of the seller's return for the taxable year of the transfer
- Both parties must attach a copy of the agreement to their respective returns for the year of transfer
- The agreement is binding on both parties for all Federal income tax purposes
- The Secretary's override authority under Treas. Reg. § 1.1060-1(c)(4) permits the IRS to reject inappropriate allocations
- The Secretary may determine that an allocation is "not appropriate" based on the FMV of assets
- This override applies when the agreed allocation has "no basis in fact or law"
- The standard for override is high and requires a clear departure from economic reality
- Commissioner v. Danielson, 378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967) established the binding nature of contractual allocations
- The Third Circuit held that taxpayers are generally bound by the express terms of a written agreement
- Taxpayers may challenge an allocation only through proof of fraud, duress, mutual mistake, or undue influence
- The burden of proving these exceptions is on the party challenging the agreement
- CAUTION. A taxpayer who signs an allocation agreement with unfavorable tax consequences will rarely succeed in overturning it
- The IRS is NOT bound by allocation agreements between the parties
- The Service may independently challenge any allocation regardless of whether both parties agreed
- The IRS may challenge an allocation that allocates excessive value to one asset class or that lacks economic substance
- Competing tax interests between buyer and seller may cause the IRS to adjust both returns
- Peco Foods, Inc. v. Commissioner, T.C. Memo 2012-18 held that cost segregation studies cannot override binding allocations
- The Tax Court rejected a taxpayer's attempt to use a post-acquisition cost segregation study to reallocate basis
- Where a written allocation agreement exists, the taxpayer is bound by its terms absent the Danielson exceptions
- Cost segregation studies are still valuable for assets within a Class V allocation but cannot reallocate between classes
- International Multifoods Corp. v. Commissioner, 108 T.C. 25 (1997) articulated the competing tax interests doctrine
- When buyer and seller have adverse tax interests in the allocation, courts are more likely to defer to the agreed allocation
- When buyer and seller have aligned interests (e.g., both seek to maximize basis in depreciable assets), courts scrutinize the allocation more closely
- CAUTION. Where buyer and seller both allocate excessive value to Class V or Class VI assets, the IRS will likely challenge the allocation as collusive
- § 338(b)(5) authorizes the Secretary to prescribe regulations for allocating ADSP and AGUB among target assets
- Treas. Reg. §§ 1.338-6 and 1.338-7 implement this authority
- The same residual method (seven asset classes) applies to § 338 deemed asset sales
- The cross-reference in § 1060(a) imports these regulations into applicable asset acquisitions
- ADSP (Adjusted Deemed Sales Price) formula for the old target under § 338(b)(1) and Treas. Reg. § 1.338-4
- ADSP equals the grossed-up amount realized on the sale to the purchasing corporation of the purchasing corporation's recently purchased target stock
- Plus the liabilities of the old target
- Less any reduction under § 338(b)(2) for excluded offsets
- ADSP is computed as of the close of the acquisition date and is redetermined as liabilities are satisfied or contingencies resolved
- AGUB (Adjusted Grossed-Up Basis) formula for the new target under § 338(b)(2) and Treas. Reg. § 1.338-5
- AGUB equals the purchasing corporation's basis in recently purchased target stock
- Plus the purchasing corporation's basis in nonrecently purchased target stock (if any)
- Plus the liabilities of the new target
- AGUB is allocated among the assets of the new target using the residual method
- Redetermination events under Treas. Reg. § 1.338-7(b) require reallocation when ADSP or AGUB changes
- Increases in ADSP or AGUB are allocated using the residual method in the same manner as the original allocation
- Decreases are applied in reverse order starting with Class VII
- This "first-in-last-out" approach for decreases prevents distortion of FMV-based allocations to earlier classes
- TRAP. A contingent liability that is ultimately satisfied for more than estimated will increase ADSP and require a supplemental allocation that may fall in Class VII
- § 338(h)(10) elections for subsidiaries create consistency between deemed and actual sales
- In a § 338(h)(10) election, the subsidiary is treated as selling all its assets to an unrelated person and then liquidating
- The selling consolidated group recognizes gain/loss on the deemed asset sale
- The purchasing corporation takes a stepped-up basis in the stock and the deemed asset sale produces the same result as a direct asset purchase
- Treas. Reg. § 1.338(h)(10)-1 provides special rules for allocating the deemed sale price
Treas. Reg. § 1.1060-1(c)(3) provides rules for allocating contingent and unidentified consideration. Treas. Reg. § 1.338-7(b) addresses redetermination of ADSP and AGUB and the allocation of increases and decreases.
- Specifically identifiable costs are included in the allocable consideration
- Direct acquisition costs such as legal fees, appraisal fees, and brokerage commissions are part of the purchaser's cost basis
- These costs increase total consideration and are allocated through the residual method waterfall
- Costs that are deductible as ordinary business expenses under § 162 or § 195 are not included in allocable basis
- TRAP. A purchaser cannot selectively capitalize only those costs that will land in Class VII. All capitalized costs flow through the waterfall
- General costs that are not specifically identifiable to the acquisition are generally deductible
- Internal overhead, general corporate legal expenses, and administrative costs are typically § 162 deductions
- The determination of whether a cost is acquisition-related is fact-intensive
- Rev. Rul. 73-580 provides guidance on distinguishing acquisition costs from general expenses
- Contingent consideration (earn-outs) increases total consideration when the contingency is resolved
- An earn-out payable based on post-closing performance increases the total purchase price when paid
- The increase is allocated using the residual method which typically means it falls in Class VI or Class VII
- Because contingent payments often relate to goodwill (future performance of the business), they frequently land in Class VII
- Reallocation mechanics under Treas. Reg. § 1.338-7(b) apply when consideration is redetermined
- An increase in total consideration is allocated by filling each class to FMV starting with Class I
- If Classes I through VI are already at FMV, the entire increase goes to Class VII
- This means most earn-out payments ultimately increase goodwill basis
- CAUTION. A purchaser may not want an earn-out allocation to increase nonamortizable goodwill. Consider structuring earn-outs as compensation under § 61(a)(1) instead
- Illinois Tool Works, Inc. v. Commissioner, 355 F.3d 997 (7th Cir. 2004) addressed contingent liability satisfaction
- The Seventh Circuit held that the satisfaction of a contingent liability assumed in an acquisition is capitalized as an additional acquisition cost
- Where the assumed liability exceeded the estimated amount, the excess was added to the basis of acquired assets
- This principle applies equally to § 1060 allocations. A liability ultimately paid for more than estimated increases allocable consideration
§ 197(f)(1)(A) provides that "no loss shall be recognized by the taxpayer on the disposition of an amortizable § 197 intangible if the taxpayer has any other amortizable § 197 intangible which was acquired in the same transaction (or a series of related transactions) and which the taxpayer continues to hold." § 197(f)(1)(B) provides the special rule for covenants not to compete quoted in Step 7.
- General loss disallowance under § 197(f)(1)(A) prevents selective loss recognition
- A taxpayer cannot recognize loss on the disposition of one § 197 intangible until all § 197 intangibles from the same acquisition are disposed of
- This prevents taxpayers from selling loss assets while retaining gain assets
- The rule applies to all § 197 intangibles from the same transaction or series of related transactions
- CAUTION. A taxpayer that acquires multiple businesses in a series of related transactions must dispose of all intangibles from all acquisitions before recognizing loss on any single intangible
- Covenant-specific rule under § 197(f)(1)(B) prevents loss on covenant expiration
- A covenant not to compete is treated as disposed of only when the entire acquired interest in the trade or business is disposed of
- The covenant's contractual expiration does not trigger disposition
- The purchaser continues to hold the covenant basis and continues amortizing over the 15-year period
- This is one of the harshest provisions in § 197 because the economic benefit expires while the tax basis continues
- Straight-line amortization over 180 months begins in the month of acquisition (§ 197(a))
- The monthly amortization deduction equals basis divided by 180
- A mid-month or mid-year convention does not apply. The first month of amortization is the full month of acquisition
- Amortization continues even after the intangible ceases to provide economic benefit
- Gain characterization under § 197(f)(3) treats gain as ordinary income to the extent of prior amortization
- When a § 197 intangible is sold at a gain, the gain is ordinary income up to the amount of amortization deductions previously allowed
- This recapture rule operates similarly to § 1245 recapture for depreciable personal property
- Gain in excess of prior amortization is § 1231 gain (or capital gain if the intangible is a capital asset)
- TRAP. The ordinary income recapture applies even if the intangible was held for more than one year. There is no long-term capital gain treatment for the amortization-recapture portion
- Form 8594 (Asset Acquisition Statement under § 1060) must be filed by both purchaser and seller
- Part I reports general information about the acquisition including date, total consideration, and business description
- Part II reports the allocation of consideration among the seven asset classes
- Part III is completed only if the allocation is subsequently redetermined
- Both parties must file Form 8594 with their income tax return for the taxable year in which the sale occurs
- Supplemental statements on Form 8594 are required when consideration increases or decreases
- An increase in consideration requires a supplemental Form 8594 reporting the additional allocation
- The supplemental form uses the same class allocation methodology as the original form
- Both parties must file the supplemental statement for the year in which the increase occurs
- A decrease in consideration is similarly reported on a supplemental statement
- Consistency between seller and purchaser is mandatory
- Both parties must report the same allocation. Discrepancies will likely trigger IRS correspondence
- If the parties execute a written allocation agreement under § 1060(a), the agreed allocation controls both returns
- If no agreement exists, each party uses its best estimate of FMV allocation but must ultimately reconcile
- Form 8883 (Asset Allocation Statement under § 338) applies to deemed asset sales from § 338 elections
- Form 8883 reports the AGUB or ADSP allocation among target asset classes
- New target and old target each file Form 8883
- Form 8883 is filed with the income tax return for the year of the qualified stock purchase
- Due dates and extensions follow the general return filing rules
- For a calendar-year taxpayer, Form 8594 is due April 15 of the following year (or the extended due date)
- For a fiscal-year taxpayer, Form 8594 is due with the fiscal-year return
- Late filing may trigger penalties under §§ 6721-6724 (see Step 14)
- CAUTION. A taxpayer that fails to file Form 8594 may still be subject to § 1060 allocation. The statutory obligation exists independent of the filing obligation
- Failure to file correct information returns under § 6721(a) imposes escalating penalties
- The penalty for each incorrect or missing information return is indexed annually. For returns required to be filed in 2027, the penalty is $340 per return (Rev. Proc. 2025-32)
- The penalty is $60 per return if corrected within 30 days of required filing date
- The penalty is $130 per return if corrected after 30 days but before August 1
- These penalty amounts are adjusted for inflation annually under § 6721(f)
- Intentional disregard under § 6721(e) increases penalties substantially
- If a failure is due to intentional disregard of the filing requirement, the penalty is the greater of $690 (indexed for 2026) or 10% of the aggregate amount of items required to be reported
- For Form 8594 purposes, the "aggregate amount" is the total consideration allocable to the acquisition
- Intentional disregard requires more than negligence. It requires a conscious decision not to file
- Separate penalty for each failure applies to both seller and purchaser
- The seller is penalized for failure to file Form 8594. The purchaser is separately penalized for the same failure
- Each year's failure to file a required supplemental statement is a separate penalty event
- Reasonable cause may excuse a failure under § 6724(a) if the taxpayer can show good faith and reasonable effort to comply
- Penalties are assessable under deficiency procedures and may be contested in Tax Court
- The taxpayer may raise reasonable cause defenses including reliance on professional advice
- Good faith reliance on a tax professional's determination that § 1060 does not apply may excuse non-filing
- TRAP. The reasonable cause defense fails if the taxpayer did not provide the professional with all relevant facts
- Off-the-shelf software exception under § 197(e)(3) removes certain software from § 197 treatment
- The software must be readily available for purchase by the general public
- It must be subject to a nonexclusive license
- It must not have been substantially modified
- Software meeting all three criteria is not a § 197 intangible and instead receives 36-month amortization under § 167(f)(1)(A)
- Substantial modification safe harbor under Treas. Reg. § 1.197-2(c)(4)(i) provides an objective threshold
- Modification is not substantial if the cost of all modifications does not exceed the greater of 25% of the price of the readily available unmodified version or $2,000
- Modification costs exceeding this threshold do not automatically make the modification substantial but create a rebuttable presumption
- The safe harbor applies on a per-license basis
- CAUTION. A taxpayer that pays $10,000 for software and then spends $3,000 on customization exceeds the 25% threshold ($2,500) and the $2,000 floor. The software may be treated as substantially modified and thus a § 197 intangible
- § 167(f)(1)(A) provides 36-month straight-line amortization for computer software excluded from § 197
- The amortization period is 36 months regardless of the software's actual useful life
- Amortization begins on the date the software is placed in service
- Software that does not meet the § 197(e)(3) exception but is not a § 197 intangible may be depreciated under § 168 as 5-year property
- Separately acquired films, sound recordings, and books under § 197(e)(4) are excluded from § 197
- These assets are amortized using income forecast or unit-of-production methods
- The exclusion applies only to assets that are separately acquired. Self-created assets are outside § 197 in any event
- A motion picture acquired as part of a film library in a trade or business acquisition may still be a § 197 intangible if not separately acquired
- Interests under leases and debt instruments under § 197(e)(5) are excluded from § 197
- A leasehold interest is amortized over the lease term under § 168
- A debt instrument is accounted for under the applicable OID, market discount, or premium rules
- Mortgage servicing rights are generally excluded from § 197(e)(5) and instead treated as customer-based intangibles under § 197(d)(2)(B)
- Other excluded intangibles include interests in corporations and partnerships (§ 197(e)(1)), interests in land (§ 197(e)(2)), and certain sports franchises (§ 197(e)(6))
- Stock in a target corporation is not a § 197 intangible. The asset purchase itself is the relevant transaction
- Sports franchises have special amortization rules under § 197(e)(6) and related regulations
- Contemporaneous written allocation agreement should be executed at closing or shortly thereafter
- The agreement should describe each asset class and the dollar amount allocated to each class
- It should reference the total consideration including any contingent payments
- It should be signed by authorized representatives of both purchaser and seller
- The agreement should state that it is executed pursuant to § 1060(a) and Treas. Reg. § 1.1060-1(c)(4)
- TRAP. An allocation agreement executed after the seller's return due date is not binding under the regulation even if both parties agree
- Independent appraisals or valuations provide the strongest support for challenged allocations
- A qualified appraisal from an independent third party establishes objective FMV evidence
- The appraisal should address each asset class and identify the valuation methodology
- Cost segregation studies for Class V assets support the allocation of tangible personal property
- A goodwill valuation from a business valuation expert supports the residual Class VII allocation
- Documentation of business purpose strengthens the economic substance of the allocation
- The acquisition file should include due diligence reports, board resolutions, and financing documents
- These documents demonstrate the business reasons for the acquisition and the assets acquired
- Where a covenant not to compete is involved, the file should document the seller's competitive capability and the arm's-length negotiation
- Retention of Form 8594 and supporting schedules is required for the applicable statute of limitations period
- § 6501(a) generally provides a three-year limitations period from the date of filing
- If a taxpayer omits more than 25% of gross income, the period extends to six years under § 6501(e)
- There is no statute of limitations for fraudulent returns under § 6501(c)(1)
- Supporting schedules should be retained even if not filed with the return
- Anti-churning documentation should establish unrelated-party status and transition-period timing
- The file should document the ownership structure of both parties immediately before and after the acquisition
- Where related-party status is unclear, a § 267(b) analysis at 20% ownership should be prepared
- Documentation should establish whether the intangible was held during the transition period (July 25, 1991 through August 10, 1993)
- Where the gain recognition exception is relied upon, the file should document the seller's recognized gain and applicable tax rate
- Covenant valuation documentation should demonstrate economic reality and arm's-length bargaining
- The file should include evidence of the seller's competitive capability (industry experience, customer relationships, technical knowledge)
- The negotiation history should show independent consideration of the covenant value
- The covenant amount should bear a reasonable relationship to the total purchase price
- CAUTION. A covenant allocation that exceeds 20% of total purchase price without strong justification faces significant reallocation risk
- The file should include any noncompete agreements that the seller entered into in prior transactions as evidence of customary practice