M&A friendly procedures for accounting method changes issued
TAX ALERT |
New accounting method procedures help alleviate risks, minimize unintended tax results, and simplify negotiations in M&A transactions.
The IRS recently issued two revenue procedures, Rev. Procs. 2015-13 and 2015-14, that provide numerous updates and modifications to the procedures relating to accounting method changes. One significant change may be of great interest in the merger and acquisition (M&A) arena. Specifically, when a taxpayer makes an accounting method change in the same year as an eligible transaction (e.g., a stock acquisition or reorganization under section 368), it may now elect to accelerate an unfavorable section 481(a) adjustment into the year of the method change. Generally, unfavorable adjustments are taken into income over four years, and until now, the only time an unfavorable adjustment could be accelerated was in the case of an asset sale subject to section 1060 where the trade or business ceased and new methods were established. However, this new election now provides parties to eligible transactions the ability to accelerate the income.
Eligible transactions include corporate stock acquisitions and other eligible transactions, including tax-deferred asset acquisitions to which section 381(a) applies (i.e., certain reorganizations pursuant to section 368(a)(1)) and transactions involving partnership interests that do not cause a technical or actual termination of the partnership.
Often, when parties undertake an M&A transaction, the acquirer seeks to clean up any bad accounting methods of the target. As a result, the target often files accounting method changes before the transaction or in the year of the transaction. However, the previous requirement to spread any associated unfavorable adjustment over four years meant the acquirer assumed the target’s tax liabilities related to the bad method. This new ability to accelerate the unfavorable adjustment now allows the parties in an eligible transaction to not only agree to clean up impermissible accounting methods prior to the transaction, but to also have the target bear the full tax burden on a pre-transaction tax return. This allows for a clean break with respect to these tax liabilities in a “my watch/your watch” type arrangement where the seller is responsible for all taxes arising out of pre-transaction activity and the buyer is responsible for all taxes arising out of post-transaction activity.
This acceleration election is only available for accounting method changes made in the year of an eligible transaction, or where the transaction takes place before the due date of the prior year’s tax return. Thus, parties are not allowed to accelerate prior unfavorable section 481 adjustments. For example, assume a calendar-year corporate target made two accounting method changes that resulted in unfavorable adjustments, with the first change occurring in 2013 and the second in 2014. In February 2015, the corporation is acquired in a stock transaction. In this case, the total section 481(a) adjustment from the 2014 accounting method change would be eligible for acceleration into the 2014 tax year because the transaction took place prior to the due date of the 2014 tax return. However, the remaining section 481(a) adjustment related to the 2013 change would be recognized in the 2014-2016 tax years under the general four-year requirement.
In addition to the ability to clean up methods prior to an acquisition and make a clean break from the tax liability related to such changes, there are a few other potential opportunities and benefits worth discussing.
First, this acceleration election may provide an opportunity to alleviate negative tax consequences related to net operating loss utilization. Many of the eligible transactions are transactions that will give rise to a change in ownership under section 382. In such cases, the recognition of a pre-transaction section 481 adjustment in post-section 382 ownership change years would generally result in a recognized built-in gain, which would increase the annual section 382 limitation. However, if the corporation is a net unrealized built-in loss corporation, the recognition of the section 481 adjustment will not increase the annual section 382 limitation. In such a case, income inclusion resulting in a tax liability may occur in a post-transaction tax period as a result of the section 481 adjustment, without a corresponding increase in the annual section 382 limitation that would normally result from the recognition of a built-in gain. An election under the new procedures to accelerate the section 481 adjustment into the pre-transaction year should alleviate this issue.
The new election may also assist in minimizing earnings and profits (E&P) in the consolidated return context. Absent the election, when a corporation joins a new consolidated group and includes an unfavorable section 481(a) adjustment in post-transaction income, this inclusion not only increases taxable income for the group, but also creates a positive adjustment to E&P. However, use of the election to accelerate recognition of the unfavorable section 481(a) adjustment would instead create pre-affiliation E&P. Thus, absent a section 381 transaction, that E&P would remain pre-affiliation E&P and not become E&P of the acquiring consolidated group.
Finally, in the case of a partnership with an exiting partner and a method change in the same year, the election allows the partnership to accelerate the section 481(a) adjustment into the pre-transaction period, thereby protecting any new post-transaction partners from the pre-transaction section 481 adjustment.
These newly issued accounting method procedures provide significantly more flexibility to parties in an M&A transaction than had previously existed. Further, they serve as a reminder that careful tax due diligence and planning is critical for identifying opportunities and in mitigating unintended tax consequences.