Accounting for merger and acquisition (M&A) activity is a common challenge for tax compliance professionals. Since each transaction can result in unique tax issues, a one-size-fits-all approach rarely applies. When the transaction is complete, it is common for the M&A tax consultants to step back, and the engaged tax compliance adviser or industry tax director becomes responsible for correctly reflecting the income tax considerations of the M&A transaction in the tax returns.
This article discusses common U.S. federal income tax implications and challenges that the tax compliance team will have to address. Implications for state and local, foreign, and other federal taxes (i.e., franchise, sales, employment, and property tax) should also be reviewed but are not within the scope of this article.
UNDERSTANDING THE FORM OF ACQUISITION
The first step is to understand the form of the transaction by reviewing the merger/purchase agreement as well as the relevant transaction step plan or memorandum. It is important to review the legal entity organizational chart before and after the acquisition. There are two general taxable transaction forms—the stock deal and the asset deal.
Stock—basis carryover: A stock acquisition generally refers to the acquisition of the ownership interest in a C corporation (or S corporation). An acquirer will receive a tax basis in the stock acquired ("outside basis") equal to the consideration paid. However, the target's assets carry over at their historic tax basis ("carryover basis," or "inside basis"); the tax attributes (losses, credits, etc.) also carry forward but may be subject to certain limitations.
Asset—basis revaluation to fair value: An asset acquisition is the purchase of the assets of a business instead of the stock. The purchase of assets generally results in a step-up in the asset basis as the acquirer receives basis equal to the consideration paid and liabilities assumed. Certain ownership interest acquisitions can be treated as the purchase of assets. For example, the purchase of 100% of a partnership or disregarded entity (e.g., a limited liability company) will be treated as an asset purchase. The purchase of the stock of an S corporation or a subsidiary of a consolidated group can be treated as an asset purchase if a joint Sec. 338(h)(10) election is filed. The acquisition of stock of a corporation can be treated as an asset purchase if a Sec. 338(g) election is filed (at a tax cost to the acquirer).
OTHER ACQUISITION CONSIDERATIONS
If a transaction involves multiple target entities or changes in entity classifications, there could be a mix of carryover basis and asset step-up events and, potentially, taxable gain/loss events. A common consideration in M&A transactions is whether the transaction results in short-period tax filings to split the pre- and post-transaction periods.
For C corporation stock acquisitions, the tax year will generally terminate if the target is joining a new consolidated tax filing. Consolidation is elective by each subsidiary and is permitted if the acquirer is an eligible common parent. Often, the buyer will incorporate an eligible acquisition company to facilitate the purchase of the target and form the new consolidated group ("new group"). When a consolidated return will be filed after the acquisition, the target's separate-return tax year terminates at the end of the day that its status as a member of the group changes (see Regs. Sec. 1.1502-76).
If a short period applies, it is important to determine the due dates in each period. If the acquirer and target both have adopted a calendar year for federal income tax purposes, the due date of the pre-transaction short period could be extended until the due date of the acquirer's consolidated return (see Regs. Sec. 1.1502-76(c)).
For a straight asset purchase, buyer and seller tax years generally do not terminate. However, there are exceptions, including a deemed asset purchase. For example, the purchase of 100% of a partnership is a purchase of assets from a buyer's perspective while, at the same time, this purchase terminates the partnership on the acquisition date (see Rev. Rul. 99-6).
CALCULATION OF TAXABLE INCOME: COMMON CHALLENGES
Taxable income should be calculated for the pre- and post-transaction periods; if there are corresponding short tax periods, income should be split between the periods. There may be nonrecurring differences in GAAP versus tax-basis income (book-tax adjustments) resulting from the transaction. Additional analysis is necessary when the acquisition company's financial statements apply FASB Accounting Standards Codification (ASC) Topic 805, Business Combinations. Topic 805 will result in a reset of the target's balance sheet to fair value. Financial statements of an acquisition company may exclude the target's pre-transaction income statement or balance sheet leading up to the close, leaving a "blackout" period that is not reported. Additional diligence may be necessary to understand the blackout period events relevant to the transaction tax filings.
If there is a short pre-transaction tax period, generally, the target will "close the books" as of the transaction date to calculate income/loss; the income for the post-transaction period through the end of the year will be reported in the new consolidated return. An election to prorate income to each short period can be made under Regs. Sec. 1.1502-76(b)(2)(ii); however, extraordinary items are still required to be allocated to the proper period.
In a stock acquisition, the tax carryover asset basis will not be affected by the asset revaluation under Topic 805, creating a book-tax difference in the inside basis. For fixed assets and intangible assets, the carryover basis is simple to track if fixed-asset software is used. Similarly, net working capital items such as accounts receivable, inventory, or deferred revenue may be revalued for Topic 805 purposes, while the carryover basis continues to apply for tax; when such an asset or liability reverses, a book-tax adjustment is generally necessary. If these financial accounting balances are constantly turning over from new activity, it may be difficult to track reversal of the transaction date balances without close examination of general ledger activity.
Similarly, certain GAAP liabilities that were not incurred under the all-events test of Sec. 461 prior to the transaction were historically subject to mechanical book-tax adjustments (a trial balance "swing" in a bad debt, unpaid compensation, or a reserve). The nondeducted liabilities should be tracked forward post-transaction, to be deducted when the all-events test is met (see Sec. 461 and the associated regulations). Careful analysis of the activity in the swing accounts must be taken to ensure book-tax differences are properly computed, as Topic 805 adjustments may increase or decrease the account balances.
The target's transaction professional fees, equity compensation, and transaction bonuses or retention/severance should be reviewed to determine the federal income tax deductibility as well as the period of deductibility. Success-based professional fees will be 70% deductible if safe-harbor treatment is elected (see Rev. Proc. 2011-29). Equity compensation is tied to the amounts reported as U.S. employee/contractor compensation on Forms W-2, Wage and Tax Statement, and 1099-MISC, Miscellaneous Income. Determining which entity is the direct and proximate beneficiary of such expenses is an additional challenge in a multiple-target acquisition. Also, the acquisition company may incur buy-side transaction professional fees. It is also important to understand how transaction payouts were reflected for GAAP purposes to compute appropriate book-tax adjustments.
Accounting method considerations are also necessary if the target is on a cash basis or was using an impermissible method of accounting.
For an asset acquisition, the tax basis of the purchased assets will be revalued to fair market value (FMV) at amounts to be mutually agreed upon between the buyer and the seller (see Sec. 1060). The consideration (including liabilities assumed) is allocated first to the most liquid assets in accordance with the fair value and last to intangibles and goodwill (Classes VI and VII). The FMV allocation among assets typically is similar to the amounts determined for financial reporting purposes. The calculation of the acquirer's taxable income after the transaction should include the deductions and amortization attributable to the acquired basis. It is typical for Topic 805 and other valuations to apply to the target enterprise as a whole. When multiple targets are acquired, the allocation of the purchase price among the targets will be necessary.
In asset acquisitions, a portion of consideration may be tied to future performance of the acquired business that occurs outside the tax year of the deal (such as an earnout). The contingent purchase price element may be included in the Topic 805 basis at fair value but may nevertheless be excluded from tax basis until it becomes fixed (see Regs. Sec. 1.197-2(f)(2)). If the contingent purchase price is revalued to the GAAP income statement, a book-tax adjustment is necessary, as earnout settlements increase or decrease the tax purchase price.
As with the discussion above for stock acquisitions, careful analysis of the swing accounts must be taken to ensure a deduction is not taken for liabilities assumed.
KEY ELECTIONS AND TAX FORMS
An acquisition will typically result in additional tax forms and elections to be filed either with the tax return or separately with the IRS.
In a C corporation stock acquisition, if a consolidated return will be filed, the initial return will include a signed Form 1122, Authorization and Consent of Subsidiary Corporation to Be Included in a Consolidated Income Tax Return, the target subsidiary's consent to consolidation with the new group. If a consolidated return is not filed but the acquiring and target entities are part of a controlled group of corporations, Schedule O, Consent Plan and Apportionment Schedule for a Controlled Group, is required with each corporation's Form 1120, U.S. Corporation Income Tax Return, to apportion tax benefit items, such as tax bracket amounts.
If the target (or acquirer) is a foreign corporation or branch activity, information return requirements may include Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations; Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business; Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities; and Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation (see Secs. 6038, 6038A, and 6038B).
Form 8832, Entity Classification Election, is filed to change the U.S. federal income tax classification of a target or elect initial classification for a newly formed entity; this is a critical election in certain acquisition structures. In addition, a Sec. 382 statement, Sec. 351 statement, Rev. Proc. 2011-29 safe-harbor election, and Regs. Sec. 1.1502-76 statement are common elections/statements resulting from an acquisition.
In an asset acquisition, Form 8594, Asset Acquisition Statement Under Section 1060, is filed by the buyer and seller to report the Sec. 1060 allocation (discussed above). In the acquisition of the stock that is treated as an asset purchase, a Sec. 338 election is filed with the IRS using Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases; in addition, Form 8883, Asset Allocation Statement Under Section 338, is required to report the asset allocation.
CARRYOVER OF TAX ATTRIBUTES IN A STOCK DEAL
After a stock acquisition, the net operating losses and tax credits will generally remain with the target (and its new group), while Sec. 382 (and Sec. 383) imposes an annual limitation on the use of these attributes. The annual limitation is calculated as the adjusted long-term applicable federal rate multiplied by the value of the corporation on the change date. However, the target's business enterprise must continue for two years; otherwise, the Sec. 382 limitation is set to zero. Any unused Sec. 382 limitation will carry forward to increase the subsequent year's limitation (see Sec. 382(b)(2)). If the annual limitation is low because the change-date valuation is low, the unused attributes may expire before they can be used. Analysis of Sec. 382 requires consideration of a built-in gain (or loss) that existed before the change date. In addition, limitations from earlier ownership changes continue to apply to earlier losses if the first limitation is lower than the current limitation.
When a change of control occurs, it is also important to examine new debt issuances in connection with the deal. The debt agreements should be reviewed to determine that debt is the proper characterization (versus equity). It is also important to determine any debt's impact on the Sec. 382 limitation and to assess deductibility of interest and financing cost (and interaction with net operating losses) and retirement of old debt, as well as future compliance filing requirements, such as Forms 1099-INT, Interest Income, and 1099-OID, Original Issue Discount.
LEAVING NO STONE UNTURNED
For successful execution of post-M&A tax compliance, the tax compliance professional's communication with the company and its deal advisers will be critical to develop a clear understanding of the transaction's material tax implications as well as all required filings and their deadlines, so that no stone is left unturned.
About the authors
Justin N. Wilcox (firstname.lastname@example.org) is a tax manager and Lisa J. LaSaracina (email@example.com) is managing partner, Tax Services, both with Fiondella, Milone & LaSaracina LLP in Glastonbury, Conn.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
- Advanced Mergers, Acquisitions, and Sales of Closely-Held Businesses (#164261, online access; #GT-PSAS, group pricing)
- Corporate Financing and M&A Track (Modules 6—10) (#165329, online access; #GT-SMA-CFSF, group pricing)
- Financial and Strategic Implications of Mergers and Acquisitions (#165325, online access; #GT-SMA-CFSF4, group pricing)
- Introduction to Business Acquisitions: Tax Staff Essentials (#157784, online access; #GT-TSE.IBA, group pricing)
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