United States

IRS addresses treatment of deferred revenue in stock acquisition

TAX ALERT  | 

In CCA 201619009, the IRS addressed a question regarding the tax year in which advance payments deferred under Rev. Proc. 2004-34 must be recognized into income following the acquisition of the taxpayer’s stock by an unrelated taxpayer and the subsequent Generally Accepted Accounting Principles (GAAP) write down of the deferred revenue liability.

The accrual basis calendar year taxpayer in question received an advance payment and under its method of accounting, deferred recognizing into income the payment following Rev. Proc. 2004-34. Within the same calendar year, the parent company of a consolidated group purchased all of taxpayer’s stock, and taxpayer joined the consolidated group. The consolidated group also files a calendar year return. As a result, the acquisition caused taxpayer to recognize two short period returns: (1) taxpayer’s final short period return, and (2) taxpayer’s initial short period return as a member of the consolidated group.

In accordance with the purchase accounting rules under GAAP, the parent company substantially wrote down the deferred revenue liability to fair market value in taxpayer’s financial statements. As a result, taxpayer will never recognize a portion of the advance payment in its financial statements.

In its memorandum, the IRS addressed two aspects of taxpayer’s fact pattern:

1.     Must taxpayer still recognize the deferred revenue following the write down for GAAP?

2.     If so, when must taxpayer recognize the deferred revenue in income for tax?

The IRS described the fundamental aspects of gross income under section 61(a) and explained that Rev. Proc. 2004-34 permits the deferral of advance payments in certain circumstances but does not authorize the elimination of income.

Rev. Proc. 2004-34 permits taxpayers who have an applicable financial statement to defer income recognition for certain advance payments received in one tax year to the following tax year, but only to the extent the advance payment is deferred in the taxpayer’s applicable financial statements. In the CCA, the IRS concluded that taxpayer received the advance payment in its final short period tax year and, following Rev. Proc. 2004-34, must recognize the remaining deferred revenue in income no later than its initial short period tax year as part of the consolidated group, regardless of the treatment in taxpayer’s financial statements.

This CCA highlights a potential hazard when acquiring taxpayers write down the value of an advance payment liability and therefore, do not include the full amount into income for financial statement purposes. The taxpayer will still need to recognize the total payment for federal tax purposes. During the due diligence process, taxpayers should work closely with their advisors to determine if the target company has any advance payments that the acquiring company would recognize on the succeeding tax return and, if so, reflect such amounts in the acquisition price.

 


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