92 T.C. 1314 (1989), 38480-86, UFE, Inc. v. C.I.R.

Docket Nº:38480-86.
Citation:92 T.C. 1314
Opinion Judge:WILLIAMS, JUDGE:
Party Name:UFE, INC., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:David R. Brennan, for the petitioner. Gordon L. Gidlund, for the respondent.
Case Date:June 22, 1989
Court:United States Tax Court

Page 1314

92 T.C. 1314 (1989)

UFE, INC., Petitioners



No. 38480-86.

United States Tax Court

June 22, 1989

In an arm's-length agreement, newly formed P acquired substantially all of the assets of an ongoing division of K for $14 million. The purchased assets included raw materials, work in progress, finished inventory and accounts receivable. P elected to use the LIFO method of accounting. P and K agreed to allocate $50,000 of the purchase price to the cost of goodwill but did not discuss going concern value. P continued the business activity of the purchased division. After the sale, P obtained an appraisal of the purchased assets that showed a fair market value of $25 million.

Held: P correctly included the acquired finished inventory in a single LIFO pool with its subsequently manufactured inventory.

HELD FURTHER: under any of the three accepted methods of determining going concern value, P did not acquire going concern value.

HELD FURTHER: to the extent that the credit worthiness of P's customers was unimpeachable, the accounts receivable are cash equivalents, and the purchase price should be allocated to them to the extent of the face value.

David R. Brennan, for the petitioner.

Gordon L. Gidlund, for the respondent.


The Commissioner determined a deficiency in petitioner's Federal income tax for the taxable year ending March 31, 1981, in the amount of $651,084. By Amendment to Answer, respondent asserts that an additional unspecified deficiency is due for the same taxable year.

The issues we must decide are (1) whether petitioner correctly included in its LIFO inventory pool the finished inventory that was purchased simultaneously with all the assets of an ongoing manufacturing business purchased by petitioner, (2) whether petitioner acquired intangible going concern value, and (3) whether certain accounts receivable that petitioner purchased with the business were cash equivalents.


Some of the facts are stipulated and are so found.

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Petitioner is a corporation formed under the laws of Minnesota which maintained its principal office in Stillwater, Minnesota at the time of filing the petition herein. Petitioner was incorporated on February 25, 1980, by Orville D. Johnson (‘ Johnson‘ ), Robert W. Kaul (‘ Kaul‘ ) and Richard Heath (‘ Heath‘ ). On March 31, 1980, petitioner purchased substantially all of the assets of the thermoplastics division of Kroy Industries Incorporated (‘ Kroy ‘ ), a publicly held corporation formed under the laws of Minnesota. All the disputes in this case arise out of this purchase.

Prior to March 31, 1980, Kroy comprised two divisions: the thermoplastics division and the graphic arts division. The thermoplastics division, doing business under the name UFE (‘ UFE‘ ), was engaged in the manufacture and sale of precision engineered, close tolerance thermoplastic molds, called tools, and molded parts made from those tools to customers' specifications. The manufactured parts included gears, cams, connectors, or wheels related to the mechanical operation of equipment such as typewriters, office copiers, computers, telephones, cameras and automobiles. UFE made the tool to the exact specifications of the customer's order and injected plastic into the tool to make the parts. The customer purchased the tool after inspection and approval of the parts. UFE kept possession of the tool to fill subsequent orders and to secure payment for orders. The bulk of UFE's business consisted of sales to manufacturers in the automobile industry, and UFE was affected by business cycles of the automobile industry.

Kroy's other division, the graphics division (‘ Graphics‘ ), designed, manufactured and sold graphics products, principally lettering systems and supplies, but also electric drafting erasers, sharpeners for mechanical pencils, transfer film and other drafting supplies. Although Graphics commenced business operations in 1972, UFE supported it until it became profitable in 1977. Between 1977 and 1979 Graphics enjoyed rapid growth and success while UFE suffered from a decline in the automobile industry.

In 1979, Don Gustafson (‘ Gustafson‘ ), Kroy's controlling shareholder, chief executive officer and the chairman of the board of directors, decided that in order to continue to flourish and expand, Graphics would need a substantial

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infusion of cash. Furthermore, Gustafson wanted to retire a $5,000,000 debt. To raise the needed cash as well as to insulate Graphics from the cyclical nature of UFE's business, Gustafson decided that Kroy should sell UFE. After much discussion, some of which grew heated, the Kroy board of directors, which included persons who were not employed at Kroy, authorized Johnson and Kaul, then the President of UFE division and Vice President of Finance at Kroy, respectively, to solicit offers for the purchase of UFE. Gustafson pressed Johnson and Kaul to find a buyer quickly.

In attempting to sell UFE, Kroy never seriously contemplated a liquidation of individual assets. The board of directors was concerned for the welfare of the UFE employees and desired to sell the UFE business as a whole. Kroy received inquiries from two prospective purchasers. Kaul and Johnson arranged tours of the plants and explained UFE's lack of long-term contracts. The prospective purchasers made tentative offers in the approximate amounts of $7.5 million and $9 million but neither made a firm offer in writing. Marks, an investment banking firm, considered purchasing UFE through a leveraged buyout and inspected the plant and the books before deciding not to make an offer.

As Kaul negotiated to sell UFE, he began to consider an employee backed purchase. Kaul, Johnson, and Heath, who managed UFE, decided to offer to buy UFE. In addition to serving as president of the UFE division, Johnson was a member of Kroy's board of directors. Heath was director of marketing of UFE. Based on their understanding that an appropriate purchase price for UFE should equal five or six times the division's annual earnings, Kaul, Johnson and Heath made an offer of $11 million which they believed was fair and reasonable. By the time of sale, the purchase price had risen to $14,708,068.90 to reflect changes in then current accounts receivable, prepaid expenses and book value of inventory.

In conjunction with the sale, Kroy obtained a fairness opinion letter from Douglas E. Johnson, an officer in the finance department of Dain Bosworth, a venture capital investment firm. In including that the purchase price was

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fair, Douglas Johnson reviewed five publicly traded companies with comparable investment characteristics in similar businesses. He determined that the comparison companies were trading at price-to-earnings ratios between 5.8 and 6.8 while the purchase price offered for UFE of $14,708,068.90 reflected a price to earnings ratio between 6.9 and 7.7. In evaluating the fairness of the terms and the price, he did not consider the value of the individual assets that could be realized on liquidation. Dain Bosworth's fairness opinion letter was presented to the shareholders at a meeting in which they decided to accept the offer from Johnson, Kaul and Heath. A pro forma balance sheet which was also submitted to the shareholders prior to the meeting, indicated that the book value of the assets of UFE division was $13,290,000 at the time of sale.

During the negotiations with Kroy, Johnson, Kaul and Heath were represented by their own counsel. Kaul and Patrick J. Dirk (‘ Dirk‘ ), Kroy's president at the time of the sale, specifically negotiated over the acquisition of the name of the division for use by petitioner and agreed to allocate $50,000 of the purchase price to the purchase of goodwill. Kroy also agreed to transfer UFE's lists of suppliers of raw materials, as well as its long-standing customer structure. Furthermore, 300 to 500 members of UFE's skilled work force, the entire sales force and most of the management group were hired by petitioner. Although UFE's customer lists were transferred, petitioner did not succeed to any long-term sales contracts of Kroy's.

The offer was accepted and after incorporation, petitioner purchased substantially all of UFE's assets from Kroy in exchange for $14,708,068.90. Petitioner borrowed $10,000,000 from the Prudential Insurance Company to finance the purchase. Pursuant to the purchase agreement, Kaul, Johnson, Heath and petitioner transferred to Kroy 85,000 shares of their 133,423 shares of Kroy common stock.

In organizing the petitioner's books, Kaul, petitioner's new vice president of administration, requested an appraisal of the purchased assets from the accounting firm of Peat, Marwick, Mitchell & Co. Contrary to expectations, the appraisal report determined that the aggregate value of the

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purchased assets was $25,124,230.26 comprising the following asset values:

Asset Value
Accounts receivable $4,651,783.00
Raw materials 3,270,181.00
Work in progress 1,979,176.26
Finished inventory 1,890,693.00
Prepaid expenses 57,030.00
Land and Buildings 12,974,667.00
ENM note 250,000.00
Cash 700.00
Goodwill 50,000.00
Total 25,124,230.26
In preparing to enter the accounts receivable on the new corporate books, Earl R. Duckett (Duckett) evaluated the collectibility of each individual account. Duckett was petitioner's comptroller and had been employed at Kroy as comptroller for the UFE division. As comptroller of UFE, he had been responsible for collecting the accounts receivable, preparing the monthly accounts receivable reports and recommending action relating to UFE's bad debts. Duckett determined that the customers whose accounts receivable had been transferred to petitioner from Kroy were, on the whole, large and successful companies including International Business Machines,...

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