Tax Court Rules on Change of Accounting Method

February 29, 2012

The Tax Court has ruled that a company could not modify the purchase price allocations it had agreed to in connection with two asset acquisitions.

In the case of Peco Foods Inc., et al. v. Commissioner (TC Memo 2012-18, Jan. 17, 2012), Peco Foods acquired two poultry processing plants: The Sebastopol plant in 1995 and the Canton plant in 1998. Both acquisitions were considered applicable asset acquisitions under Internal Revenue Code Section 1060.

In connection with both acquisitions, an appraiser was hired to value the purchased assets, and both the buyer and the seller agreed to purchase price allocation schedules attached to their respective tax returns.

In particular, both contracts contained words to the effect that both the buyer and the seller agreed to allocate the purchase price among assets “for all purposes (including financial accounting and tax purposes)” in accordance with the original allocation schedule.

Sometime during 1999, Peco Foods engaged another company to perform a cost segregation study. As a result of that study, Peco Foods recharacterized certain assets that it originally had treated as real property to tangible personal property.

To reflect this change, Peco Foods filed for a change in accounting method effective with its 1998 return. The company began depreciating the recharacterized assets over shorter lives, using accelerated depreciation methods.

The IRS refused to accept Peco Food’s accounting method change, arguing that the company was bound by the terms of the original purchase price allocation schedules it had filed with its returns first reporting the asset acquisitions.

Peco Foods argued that a subsequent cost segregation study does not change the terms of the original purchase price allocation. It only changes whether an asset – or a component of an asset – is considered real property or tangible personal property for tax depreciation purposes.

The Tax Court disagreed. According to the court, “The Omnibus Budget Reconciliation Act of 1990 … amended section 1060(a) to provide that where the parties to an applicable asset acquisition agree in writing as to the allocation of any amount of consideration, or as to the fair market value of any of the assets transferred, that agreement is “binding” on the transferee and the transferor unless the commissioner determines that the allocation (or fair market value) is not appropriate.”

As a result, Peco Foods was bound by its original determination of real vs. tangible personal property, depreciable cost and applicable depreciation method. Consistent with the reasoning in this case, for a cost-segregation study to be effective for an applicable asset acquisition described in IRC Section 1060(a), the study would have to be conducted before the asset acquisition takes place and reflected in the purchase price allocation schedules initially agreed to by the parties.

The court observed that if it allowed Peco Foods to reflect the cost segregation study in its depreciation calculations, it may be creating an inconsistency with how the seller reported the gain or loss on the sale of the assets. This is a type of inconsistency that Congress attempted to eliminate when it enacted IRC section 1060.