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Tax Consultants Recommendations for Structuring Agreement

Able Corporation is a manufacturer of electrical lighting fixtures. Able is currently negotiating with Ralph Johnson, the owner of an unincorporated business, to acquire his retail electrical lighting sales business. Johnson's assets that are to be acquired include the following:

Assets Adjusted Basis FMV
Inventory of electrical fixtures $30,000 $50,000
Store Building 80,000 100,000
Land 40,000 100,000
Equip 7yr Recovery Period 30,000 50,000
Equip 5 yr Recovery Period 60,000 100,000
Total 240,000 400,000

Mr. Johnson indicates that a total purchase price of $1,000,000 in cash is warranted for the business because of its high profitability and strategic locations and Able has agreed that the business is worth $1,000,000. Despite the fact that both parties attribute the excess payment to be for goodwill, Able would prefer that the $600,000 excess amount be designated as a 5-year covenant not to compete so that he can amortize the excess over a 5-year period.
You are a tax consultant for Able who has been asked to make recommendations as to the structuring of the purchase agreement and the amounts to be assigned to individual assets. Prepare a client memo to reflect your recommendations.

Solution Preview

The covenant not to compete has several points to be made:
a. It should be separate from the total sales price. Able would buy assets for $1M - $600,000 = $400,000
b. The allocation must have a basis in economic reality in the event it is challenged
c. A covenant not to compete is a Sec 197 asset - intangible with a write-off period of 15 years to the seller
d. Payments under a covenant are ordinary income to the recipient

The buyer, Able, ...

Solution Summary

The solution examines a tax consultants recommendations for Able Corporation. A client memo is prepared to deliver the recommendations.