Tax Research Memo free essay sample

Inez Butler is the sole shareholder of Pelican, Inc. , which owns car dealerships. Pelican purchases the assets of a Chevrolet dealership. The purchase price of $12 million is allocated to the purchased assets based on the fair market values. This includes $3. 5 million that is allocated to goodwill. In addition to the price of $12 million, Pelican incurred legal fees of $250,000 associated with the purchase. According to an itemized invoice provided by the attorney, 80% of the legal fees relate to the acquisition of inventory. Consequently, Pelican assigned $200,000 of the legal fees to inventory with the balance being capitalized as goodwill. The expectation is that 60% of the $200,000 will become part of cost of goods sold in the current year with the remaining 40% doing so in the following year. The IRS has concluded that  § 1060 limits the amount that may be assigned to the fair market value of the inventory. Therefore, the $200,000 of legal fees cannot be added to the basis of the inventory. Instead, it must be included in goodwill under the residual method. The issues that are presented are: Can legal fees related to the acquisition of inventory be considered as a basis of the inventory? Are the legal fees classified as goodwill? Rules: Section 1060 states for purposes of determining both, the transferees 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 acquired in such acquisition in the same manner as amounts are allocated to assets under section 338(b)(5) . The transferee and transferor 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 both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate. IRS Publication 551 states when you purchase a trade or business, you generally purchase all assets used in the business operations, such as land, buildings, and machinery. Allocate the price among the various assets, including any section 197 intangibles. If you buy multiple assets for a lump sum, you and the seller may agree to a specific allocation of the purchase price among the assets in the sales contract. If this allocation is based on the value of each asset and you and the seller have adverse tax interests, the allocation generally will be accepted. West Covina Motors, Inc. v. Commissioner states considering new evidence including itemized attorney billing statements, determined that legal fees solely owned accrual-method auto dealership paid to various firms in connection with 1999 acquisition of another dealership were attributable in part to inventory financing and physical inventory of vehicle inventory, and as such were allowable as COGS and deductible 40% and 60% in [pg. 2141] subject years, respectively. As to remaining fees/acquisition-related amortizable capital expenditures, Court determined that portion paid to 1 firm related to overall acquisition; that other amounts paid to sellers counsel were in furtherance of seller-financing arrangement and related only to assets purchased under purchase agreement; that entire purchase price was allocable between class III and class V assets; and, rejecting IRSs Code Sec. 1060 argument, that fees should be allocated proportionately to assets with which they were associated and in accord with parties stipulations. Legal fees incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures and are to be added to the basis of the capital asset with respect to which they are incurred. Analysis According to Section 1060, â€Å"the transferee and transferor 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 both the transferee and transferor unless the Secretary determines that such allocation (or fair market value) is not appropriate†, which in the case of Pelican Inc. , Pelican Inc. purchased the assets that were based on the fair market values of the assets from the transferor, therefore there is no need to determine the transferee’s basis. With this being said the Section 1060 does not apply to Pelican Inc. because they have stipulated the cost for the assets. In West Covina Motors, Inc. v. Commissioner, the Tax Court found that the legal fees associated with the purchase of a dealership â€Å"are treated as capital expenditures and are to be â€Å"added to the basis of the capital asset with respect to which they are incurred†. This is a similar case that relates to Pelican Inc. Pelican Inc. attained legal fees in the preparation of the acquisition of a dealership. For Pelican Inc. to be able to purchase the dealership, they had to attain an attorney to draw up the paperwork. Since the legal fees are allowable, they can be included in the cost of goods sold. Conclusion Pelican Inc. will be able to include the legal fees in the basis of the inventory and will not be subject to IRS Section 1060 limitations. The balance of $50,000 in legal fees will be capitalized as goodwill. As long as Pelican Inc. is able to keep proper record keeping, they should be able to prove to the IRS that the legal fees are included in the cost of goods sold.