Bowtie, Inc., is an S corporation that makes, sells and services machines used in manufacturing metal products. It generates its revenues by selling its machines and then servicing and maintaining the machines under separate service contracts with its customers. Bowtie's assets consist of:  

an inventory of its machines;  
its rights under its service contracts (which are assignable and have oneyear terms with provision for automatic renewal each year unless either side notifies the other of its election not to renew);  
patents to designs and processes related to its machines that were developed by its employees;  
software used in its business that was developed by its employees;  
its customer list;  
$100,000 of accounts receivable;  
the land and building where it maintains its principal office; and the furniture and equipment in its office.
 

Bowtie is owned 50% by Founder, who's 67, and 50% by Founder's daughter ("Daughter"), who's 35. Although Bowtie's products and technologies were developed by Bowtie's employees, Founder is well known in the industry and has been primarily responsible for maintaining Bowtie's relationships with its clients. Founder has been turning the reins over to Daughter gradually, and she has proven to be very capable. Founder is ready to retire, however, and Founder and Daughter believe that the time has come to sell the business.

 

Bowtie has asked Buyco, a C corporation, whether Buyco might be interested in purchasing Founder's and Daughter's stock in Bowtie. Buyco initially told Founder that it would be interested in purchasing only Bowtie's patents and software, but after some negotiation, Buyco has agreed to purchase Bowtie in its entirety on the following terms and conditions:  

 

Buyco will pay $10 million for Bowtie's assets;
In addition, Buyco will pay Founder and Daughter $500,000 each for their agreements not to compete with Buyco for a period of 5 years after the acquisition;  
In addition, Buyco will employ Daughter for 2 years after the acquisition, paying her $250,000 per year; and
In addition, Buyco will pay Founder $250,000 per year for 2 years in "consulting fees" in exchange for Founder's obligation to spend not more than 2 hours per week on the phone with Buyco personnel.
 

Founder and Daughter know that, in an asset purchase, they must allocate the purchase price among the assets purchased and sold. (see footnote 1) They have no idea, however, how much any particular asset is worth. In fact, they believe that separate sales of Bowtie's assets listed above would generate an aggregate price far below the amount to be paid by Buyco for the entire business.

 

Questions:

 

1. Why do you think Buyco wants to structure the transaction as a purchase of Bowtie's assets from Bowtie rather than as a purchase of the outstanding stock in Bowtie from Founder and Daughter?

 

2. What might Buyco's order of preference be in allocating maximum value to the various purchased assets? In other words, in allocating the purchase price among the purchased assets, which of the assets might Buyco want to value at the high ends of their possible valuation ranges? Which of the assets might Buyco want to value at the low ends of their possible valuation ranges?

 

3. What if Buyco is owned entirely by Founder's son?

 

4. How will the salary to Daughter and the consulting fees to Founder be treated?

 

5. If Buyco had been successful in its efforts to purchase only Bowtie's patents and software, how would those assets have been amortizable by Buyco?

 

6. What if, shortly after the closing, Buyco sells one of the patents it purchased from Bowtie at a price that is less than the amount of purchase price allocated to the patent in the Bowtie transaction?

 

Footnote 1: Regulations under Code Sections 1060 and 338 provide for the division of the assets into 7 classes. The first 2 classes consist of cash, cash equivalents, actively traded personal property, certificates of deposit and foreign currency. The third class consists of accounts receivable, mortgages and credit card receivables arising in the ordinary course of business. The fourth class consists of inventory or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business. The fifth class consists of all assets not in any of the other classes (such as machinery, equipment and real estate). The sixth class consists of Section 197 intangibles other than goodwill and going concern value. The seventh class consists of goodwill and going concern value. In general, purchase price is allocated sequentially by class to the extent of the FMV of the assets of the class. Even given Sections 1060 and 338, there is often some negotiability to allocating purchase price.