Question

Andrew purchased Maple Manufacturing Company on March 17 of the current year for a lump-sum price of $3.5 million. The value of the assets was as follows:

	Carrying	Fair Market
	Amount	Value
Inventory	$ 100,000	$ 100,000
Cash	500,000	500,000
Equipment	1,650,000	1,750,000
Building	400,000	750,000
Land	100,000	150,000
Covenant not to compete	0	175,000
Goodwill	0	75,000

Andrew assumed no liabilities. What is his basis in the covenant not to compete?

Answer 1

$1,75,000
Under Sec. 1060, both the buyer and the seller involved in a transfer of assets that amount to a trade or business must allocate the purchase price among the assets using the residual method. The residual method requires the purchase price to be allocated first to cash; then to near-cash items, such as CDs, government securities, and other marketable securities; then to other tangible and intangible assets, such as equipment, buildings, land, accounts receivable, and covenants not to compete. The allocation of the purchase price may not exceed the FMV for each of these categories. Then any residual purchase price is allocated to intangible assets, such as goodwill and going concern value.
In this case, Andrew's purchase price of $3.5 million is in excess of the FMV of all the assets listed ($3,425,000). Therefore, the purchase price is allocated to each asset listed based on its FMV, and the remaining $75,000 is allocated to goodwill or going concern value. The covenant not to compete will have a basis equal to its FMV of $175,000.

Section 1060 also provides that the transferor and the transferee may agree in writing as to the allocation of consideration or as to the FMV of any assets. This agreement is binding on the transferor and the transferee unless it is determined inappropriate by the IRS.