In any negotiation for the purchase of a business, the valuation of the various assets of the business is likely to be a contentious issue. Valuation is challenging, not only because the purchase price of the business is directly derived from the value of its assets, but also because getting it wrong can have potentially devastating tax consequences for the parties. More specifically, if the Service disagrees with the way that the assets of a business have been valued, it may reallocate the various values in the purchase price based on its interpretation of the economic realities of the transaction. Thus, parties engaging in the purchase of a business should be confident that their allocations can be supported by the facts. Tax professionals advise that the best way to protect against a reallocation action by the Service is to obtain a professional valuation of the business’s assets. A recent Tax Court case, however, casts some doubt on this conservative wisdom. The case shows that the parties to a business purchase transaction may have significantly more freedom to value a business’s assets than previously thought. In H&M, Inc. v. Commissioner, the Tax Court dismissed the Service’s contention that the parties to an asset purchase agreement had inaccurately valued the assets of the business in an effort to receive more advantageous tax treatment. National Insurance Agency (National) paid over $620,000 in the purchase of Harold Schmeets’s business, but the parties allocated only (and paid capital gain taxes on) a mere $20,000 of that amount to the value of the actual business. The remaining $600,000 was paid directly to Schmeets for his post-sale employment agreement with National, which the Tax Court found included a noncompete agreement and personal goodwill. Further inviting scrutiny from the Service, Schmeets failed to retain any records or a professional valuation substantiating these respective values. Despite the disproportionate allocation of purchase price value, as well as the taxpayer’s evidentiary lapses, the Tax Court concluded that the amounts the parties had allocated in the purchase price were grounded in economic reality.
This Note argues that the H&M, Inc. court came to the correct conclusion in upholding the parties’ purchase price allocations because the Service failed to produce convincing evidence supporting reallocation. However, the court’s failure to impose a higher evidentiary standard on the taxpayer encourages parties in future asset purchase transactions to choose allocations—particularly goodwill allocations—that are tax advantageous, rather than grounded in economic reality. This case also serves as a reminder to the Service that it must come prepared with rigorous expert evidence in order for the court to recharacterize purchase price allocations. Part II provides background about goodwill and the tax advantages of a purchase price allocation to personal goodwill. Part III describes the facts and holding of H&M, Inc. v. Commissioner. Part IV argues that the Tax Court’s failure to insist on more documentation from the taxpayer to support the values H&M, Inc. had assigned to its assets encourages C corporation taxpayers to be lax in keeping records and to exaggerate the value of personal goodwill for its tax benefits. Part IV also discusses the increased evidentiary burden this case places on the Service in its pursuit of purchase price reallocations.