Category: Sales & Exchanges Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Issue 2. If so, by what means can Law Firm A recover the cost so allocated? Answers 2. The basis of the cases ultimately won by Law Firm A should be recovered under the sale or other disposition provisions of Section 1001. The basis of cases ultimately lost or dropped should be recovered as a loss under Section 165. Discussion The principle set forth above was later codified by IRC Section 1060 which provides that the purchase price of a going business must be allocated as between certain specified categories of assets based on relative fair market value; and further, the amount so allocated to each category of assets must be allocated within that category based on the relative fair market value of the assets in the category. IRC Section 1060 referring to IRC Section 338(b)(5) and Regulation Section 1.338(b)-2T. I am at a loss to see why these general principles should not apply here. Assuming that the law firm work in progress has a demonstrable value, that value must become a factor in determining the allocation of purchase price among all the assets acquired in the purchase. In effect, I think the purchaser not only is permitted but is required to consider the value of work in progress and make an appropriate allocation thereto. I assume that you are fully aware of what it means to allocate purchase price based on relative fair market value. I assume you are also aware of the principle of residual value allocations as required by Section 1060. If you have any questions, don't hesitate to call. Once purchase price (i.e., tax basis) is allocated to the work in progress, the question of how to recover that basis becomes relevant. This work in progress is in effect an asset which has not yet matured into a bona fide account receivable. Based on my understanding of how contingent fee attorneys operate, some of these cases in progress will ultimately mature into an amount due the law firm as a result of a settlement or judgment in the case. Other cases in the "inventory" will ultimately prove worthless because the case was lost or dropped. First, it seems clear to me that the provisions of Section 197, amortization of intangibles, do not apply to an asset of this type; accordingly, I do not feel concerned that the taxpayer in this case might be forced to recover the cost of the purchased work in progress over the 15-year period required by Section 197. Section 197 expressly applies only to a) goodwill; b) going concern value; c) workforce in place, business books and records, operating systems or other information bases such as customer lists; c) patents, copyrights, secret formulae or processes; d) customer-based intangibles; e) supplier-based intangibles; and f) other similar items. With respect to cases in which Law Firm A ultimately collects, it seems clear that Section 1001 applies, at least to the extent of the allocated basis. Section 1001 provides as follows: "The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis of the property provided in Section 1011 for determining gain..." The issue here is not whether the amount realized is taxable but rather whether the taxpayer can offset his basis against the amount so realized. Clearly in this matter, collections against the purchased rights to the contingent fee case inventory do not constitute a sale of the rights. However, there is no definition for the statutory language "or other disposition" used in Section 1001, and it is fairly clear that this is intended as a catch-all provision. Regulation Section 1.1001-1(c) provides in part as follows. Even though property is not sold or otherwise disposed of, gain is realized if the sum of all the amounts received which are required by section 1016 and other applicable provisions of subtitle A of the Code to be applied against the basis of the property exceeds such basis. This regulation section clarifies in my mind that even though collections against the purchased rights to the contingent fee case inventory do not constitute a sale or disposition of the right in the ordinary sense of those terms, the basis of the purchased rights should be offset against the collections under Section 1001. With respect to cases in which Law Firm A ultimately collects nothing, i.e., cases which are lost or dropped or dismissed, I feel that the basis allocated to these items should be written off as an ordinary loss under Section 165. Here, there is not even a hint of a sale or exchange or other disposition of the rights. Simply, these are business assets that have proved worthless by operation of the contractual restrictions placed upon them when they were entered into, i.e., the contingent fee arrangement. This is a classic case for the application of Section 165, and in my view represents the conceptual reason why Section 165 is necessary in the first instance, that is to allow taxpayers to recover the basis of assets that have become worthless in a transaction that does not represent a sale, exchange, or other disposition of the asset. |
