Final regulations issued on carryovers of accounting methods in section 381(a) transactions
TAX ALERT |
Tax-free transactions are usually accomplished for strategic business reasons without careful attention being given to tax accounting method issues. However, after certain corporate liquidations or reorganizations, the rules of section 381 must be evaluated to determine the combined entity's overall accounting methods, each accounting method for individual items, as well as methods for identifying goods and for valuing goods treated as inventory. Specifically, under section 381(a), where a corporation acquires the assets of another corporation, the acquiring corporation generally takes into account and succeeds to certain of the distributor/transferor's attributes, such as accounting methods.
Transactions subject to section 381(a) include section 332 liquidations and transfers to which section 361 applies, but only if the transfer is in connection with a reorganization described in section 368(a)(1)(A), (C), (D), (E) or (G). Section 381(c)(4) provides the rules for determining accounting methods in general (e.g., overall method (i.e., cash or accrual), special methods (e.g., percentage of completion)); section 381(c)(5) provides the rules for determining inventory methods; and section 381(c)(6) provides the rules for determining depreciation methods.
In November 2007, proposed regulations were issued in an attempt to clarify and simplify the existing regulations under section 381 for the carryover of inventory methods and most non-inventory accounting methods.1 On July 29, 2011, such regulations were slightly modified and published as final (see T.D. 9534), effective for section 381(a) transactions that occur after Aug. 30, 2011.
In general, in situations where the acquiring corporation and distributor/transferor use the same methods prior to the section 381(a) transaction, such accounting methods will carry over, unless IRS consent is requested to use a different method(s).
In situations where the acquiring and distributor/transferor use different methods of accounting with respect to an item and the entities are integrated in a section 381(a) transaction, it is necessary to determine if the acquiring corporation or distributor/transferor must change its method of accounting to the principal method (e.g., the principal method must be adopted by the acquiring corporation). Under the proposed regulations, the principal method tests were made at the entity level (i.e., the entity with the greater total adjusted asset bases and gross receipts for the most recent 12-month period had the principal overall method). However, under the final regulations and consistent with the general accounting method rules under section 446(d), the principal method tests are made at the trade or business level for the trades or businesses that will be integrated after the date of the section 381(a) transaction (i.e., rather than comparing attributes at the entire entity level). As was previously the case, the final regulations do not require a Form 3115 to be filed to change to the principal method. Also as before, the final regulations do not provide audit protection for changes to the principal method. In addition, any section 481(a) adjustment that is required as a result of a change to a principal method must be recognized by the acquiring corporation beginning with the tax year that includes the date of the section 381(a) transaction in a manner consistent with the voluntary method change rules, and should be determined as of the beginning of the day immediately following the date of the section 381(a) transaction. For example:
Calendar year Acquiring (one trade or business) and Transferor (one trade or business) merge in a section 381(a) transaction on June 30, 2011, and will be operated as an integrated business following the merger. Prior to the merger, Acquiring accounted for warranty expenses by properly applying section 461, while Transferor deducted an estimate of warranty expenses each year. Acquiring has the greater amount of warranty liabilities, and thus has the principal method. Transferor must change to Acquiring's method of accruing warranty liabilities after the merger. No Form 3115 is required, and Acquiring will generally recognize the section 481(a) adjustment resulting from the change (or appropriate part thereof), calculated as of July 1, 2011, beginning with its tax year ending Dec. 31, 2011. However, Transferor will not obtain audit protection for the use of its prior impermissible method.
The final regulations clarify that the intent of the acquiring corporation to integrate the trades or businesses is relevant in determining whether the principal method tests should be applied, even if integration does not occur until after the tax year of the section 381(a) transaction.
If after applying the principal method analysis it is determined that the principal method is an impermissible method, the acquiring corporation must file a Form 3115 to change to use a permissible method pursuant to the applicable IRS consent procedures2, along with a special label at the top. With respect to an advance consent method change request, the due date would be the later of (a) the last day of the year of change, or (b) the earlier of the day that is 180 days after the section 381(a) transaction or the day on which the acquiring corporation files its tax return for the year of the section 381(a) transaction. This rule provides consistency with the due date for voluntary advance consent method change requests, while providing additional time to file a request when the section 381(a) transaction occurs near the end of the acquiring corporation's tax year.
Alternatively, if the distributor/transferor's trade or business will be maintained separately from that of the acquiring corporation, each separate trade or business will continue to use the methods of accounting used prior to the transaction, provided the methods are permissible. For example:
Acquiring and Transferor merge in a section 381(a) transaction, and will be operated as separate trades or businesses following the merger. Prior to the merger, Acquiring accounted for warranty expenses by properly applying section 461, while Transferor deducted an estimate of warranty expenses each year. Because Transferor's method of deducting estimated warranty expenses will carryover after the merger, it must file a Form 3115 to change to use a permissible method under section 461.
The final regulations also clarify that if changes within LIFO after a section 381(a) transaction are implemented on a cut-off basis (i.e., no section 481(a) adjustment), the cost of beginning inventories for the year of change do not need to be recomputed. In addition, consistent with section 472(d), the final regulations provide that any restorations to cost of any previous write-downs to market are required to be taken into account by the acquiring corporation ratably over three tax years beginning with the tax year of the section 381(a) transaction (i.e., in situations where the acquiring corporation uses LIFO for a tax year that includes a section 381(a) transaction and immediately prior to the transaction the distributor/transferor did not use LIFO, adjustments are required to be made to restore to cost any inventories previously written down to market).
The final regulations recently issued under section 381(a) provide favorable rules for the carryover of accounting methods after certain tax-free transactions. A corporation contemplating a merger or acquisition, check-the-box transaction, Q-sub election, liquidation, etc., should take time, as part of careful transaction planning, to review these new rules and ensure to position itself to change, retain, or adopt the most favorable accounting methods post-transaction.
1 The separate rules governing the carryover of depreciation methods (see Treas. Reg. section 1.381(c)(6)-1) were outside the scope of the proposed regulations.
2 See Rev. Proc. 2011-14 (automatic consent procedures) and Rev. Proc. 97-27 (advance consent procedures).