By: Floyd C. Clem, CPA.
The revenue reconciliation act of 1993 changed significant aspects of tax law that can considerably alter the results of dealership buy/sell transactions. Every dealer considering purchasing or selling a store should be familiar with the impact of these new law changes.
Ordinary Income vs. Capital Gain
From 1986 through 1992 the tax rates applied to these types of income were the same or very close to the same. As a result, once price was agreed on, there was little conflict of interest between buyer and seller as to how the total price was allocated to specific assets and/or related agreements. The buyer wished to assign the price paid to assets or agreements that he could write off as fast as possible in order to obtain the greatest tax benefit. Since the tax paid by the seller was essentially the same, regardless of allocation, there was a spirit of cooperation in the allocation of price during this period.
The tax rate changes, effective January 1, 1993, have again established a large differential between tax paid on capital gain income versus tax gained on ordinary income. The new maximum federal rate applied to ordinary income is now 39.6%. Capital gains continue to be taxed at a maximum of 28%. The selling dealer will now pay 11.6% more in tax rate on the portions of the buy/sell agreement that are allocated to ordinary income items. This rate difference equates to paying approximately 41 % more in actual tax at ordinary rates instead of capital gain rates.
Obviously the selling dealer should attempt to allocate as much of the price as possible to the sale of assets that will result in the recognition of capital gain income.
Intangible Assets (New Code Sec. 197)
The 1993 tax act provides a new classification of assets referred to as “amortizable Section 197 intangibles.” The acquisition of qualified assets under this new code section will allow the buyer to amortize (write off) the cost of the asset ratably over a 15-year period beginning in the month in which it is acquired.
To qualify as an amortizable Section 197 intangible, the acquisition date had to be after August 10th, 1993 or as an alternative, at the specific election of the taxpayer, the Code Section may be applied to assets acquired after July 25, 1991. The definition of Section 197 intangibles includes the following types of assets that will most often impact a dealership buy/sell agreement:
1. Goodwill and going concern value.
2. Customer-based intangibles.
3. Franchise value.
4. Information base and workforce in place.
In addition to the above, Section 197 intangibles will include a covenant not to compete if acquired in connection with the acquisition of a business.
Planning Consideration
Although there are many issues to be considered, the major components of a typical dealership buy/sell agreement that will be affected by the issues discussed above are the allocation of price to consulting contracts and covenants not to compete.
To the extent a selling dealer agrees to perform future services for the buyer under a consulting contract, he will incur ordinary tax on income generated for personal service. The buyer will obtain current tax deductions for payments made to the seller under the consulting contract. If a selling dealer is actually going to provide ongoing services after the consummation of the buy/ sell agreement, a proper value should be assigned to those services. However, if substantial services are not going to be provided, or if it is unclear as to the nature and extent of the services to be provided, I suggest that little or no allocation be made to a consulting agreement.
In lieu of such an allocation, the agreed purchase price, in excess of hard assets acquired, would then be allocated to goodwill, going concern value, franchise value or other qualified intangible assets.
The sale of this type of intangible asset will be treated as a disposition of a depreciable asset and will generally be afforded capital gain treatment if the asset had been held for more than one year. The seller will then obtain a net tax rate benefit of 11.6% of the gain on the price reallocated to qualified tangibles due to the transfer of ordinary income to capital gain income. The buyer will be required to capitalize the price paid for these assets and amortize the price over 15 years. Although this is not as immediate a tax benefit as might have been enjoyed for the payment of consulting services, the tax treatment is assured and the risk of Internal Revenue Service attack on allocations and valuations is substantially lessened. The new law clearly sets forth the allowable tax write-offs methods.
In the event that it is desirable to still allocate large amounts of money to consulting contracts, the seller, and especially the buyer, should continue to be aware that the Internal Revenue Service requires that proper valuation be established to support the amount so allocated. An arbitrary agreement between non-related buyers and sellers is not sufficient. It will be necessary to actually establish the value of the services that are to be performed and adequate records must be maintained to support the actual performance of such services.
The other typical allocation of price contained in buy/sell agreements has been to a covenant not to compete. Prior to the 1993 tax act, the sale of a covenant not to compete would generally result in ordinary income to the seller and the seller would amortize the cost over the number of years that the covenant was to cover.
Under the 1993 tax act, a covenant not to compete acquired in connection with the acquisition of a business will be considered a Code Section 197 intangible asset. As such the buyer will be required to amortize the cost of such a covenant over a 15-year period.
The actual length of the covenant is immaterial to the tax treatment for the buyer. The seller will be treated as having sold a depreciable asset and, again, if held for more than one year, generally will obtain capital gain treatment.
It is important to remember that this is all new law, and, as such, is subject to interpretation and to future Internal Revenue Service Rules and Regulations. There are numerous exceptions to the various aspects of Code Section 197 intangible assets. Each buy/sell agreement is unique to itself, and each must be analyzed to determine the impact of the 1993 tax act. In order for both the buyer and the seller to understand the impact of these changes on their respective positions, I strongly recommend that you consult carefully with both your lawyers and your CPA before entering into an agreement.
I believe there are very positive opportunities under the new law to improve the results of buy/sell agreements to both buyer and seller. If properly used, the new rules will eliminate many of the allocation problems that can cause I.R.S. attacks. Each party to the agreement will be able to be more secure in the results from a taxation position.
(Mr. Clem is a Covina-based CPA who focuses his practice on service to the automobile industry. His phone number is 818-858-5100.)
This article was written in 1993.