Tax Issues Arising
with IRC Section 338(h)(10) Acquisitions
By Joseph Unger
A number of important tax issues arise when a business is acquired through the purchase of stock where the acquirer makes a section 338(g) election or the acquirer and seller join in making a section 338(h)(10) election, as well as a simple purchase of assets. In a section 338(h)(10) election, the transaction is treated as an asset purchase for tax purposes. Ownership of the assets continues with the target corporation. The basis of the target corporation’s assets is adjusted to reflect the purchase price.
Allocation of Purchase Price
The purchase price paid by the acquirer must be allocated among the assets acquired. The allocation has significant tax consequences to both the seller, which often seeks to maximize capital gains, and the acquirer, which often seeks to maximize the present value of tax deductions.
The purchase price of the acquired assets consists of consideration paid, or the sum of the payments made, liabilities assumed, and acquisition costs. As described below, the residual method is to be used to allocate the purchase price among the assets acquired (Treasury Regulations section 1.1060-1).
Both the purchaser and seller are required to report the purchase price allocation to the IRS on Form 8594, Asset Acquisition Statement, which is filed by both parties for the year of purchase. An amended Form 8594 is filed if there has been a change of the purchase price in a subsequent year, such as the payment of additional consideration contingent upon performance.
Assets are categorized in a seven-class system:
The Exhibit shows examples. The second example illustrates that the residual method allocates amounts equal to fair value to each asset class except Class VII, goodwill, when the basis to be allocated is greater than the total fair value of specific tangible and intangible assets (other than goodwill). Any excess is allocated to goodwill.
Acquisition costs are added to the basis of assets acquired. The regulations appear to require that the allocations, including acquisition costs, to Class I–VI assets not be in excess of fair value. Any excess acquisition costs are allocated to Class VII, goodwill. This apparent requirement places such costs in a 15-year amortization class, longer than other classes, although reasonable acquisition costs should be taken into account in determining the fair value of Class I–VI assets and included as part of their basis.
Liabilities That Have Not Matured into a Deduction
Liabilities transferred to the purchaser are treated as consideration paid for the assets and are added to basis. Liabilities often exist that have not matured as of the purchase date.
A number of uncertainties surround the treatment of contingent liabilities in taxable asset acquisitions. Although various definitions are possible, generally a contingent liability does not satisfy all elements of the “all events” test, including economic performance.
In a taxable asset acquisition, the initial question is whether a contingent liability, as so defined, should be treated as a liability of the seller assumed by the buyer, or merely as a liability of the buyer that arose after the transaction. If a buyer successfully argues against the assumption of the liability as part of the acquisition (e.g., it incurred its own liability and not the seller’s), then the liability should be deductible or capitalized under the usual timing and capitalization rules. The seller would be unaffected.
The following are examples of liabilities that have not matured into deductions:
Cost of Obtaining Debt Financing
Costs allocable to obtaining debt financing for an asset acquisition (e.g., bank debt and subordinated debt) are generally amortizable over the life of the related debt obligation (Revenue Ruling 70-360; Revenue Ruling 70-359). Because bridge loans are normally an integral part of overall financing, those costs are capitalized as well.
Severance Payments to Terminate Seller’s Employees
The purchaser may decide to reduce the workforce of the acquired business, often making severance payments to terminated employees based on agreements entered into by the seller and assumed by the purchaser. There is a significant difference in the tax treatment of payments made to employees terminated before the purchase and those terminated after the purchase.
Revenue Ruling 94-77 provides that severance payments made when downsizing are generally deductible, even though a future benefit is obtained through lower payroll costs. In TAM 9721002, expanding on Revenue Ruling 94-77, the IRS permitted the deduction of severance costs incurred after an acquisition where the termination occurred two days after the acquisition and the purchaser terminated a group of senior executives and began a program to eliminate a number of salaried jobs. The terminated employees were entitled to severance benefits under agreements they had made with the target company. The IRS concluded that the severance payments were not considered an assumed liability (part of the purchase price), because the liability did not exist at the time of the acquisition. The liability arose only after the acquisition, even though the existence and the amount of the liability were based on the terminated employees’ service with the predecessor. The IRS determined that the severance payments were not made in connection with the acquisition.
Business expenses incurred prior to the beginning of business operations cannot be deducted (Richmond Television, 66-1 USTC para. 9754 7th Cir. 1980). The courts point toward the commencement of revenue-generating operations as the time of the beginning of business.
The doctrine applies only to expenses deductible under IRC section 162 and, consequently, does not apply to interest (IRC section 163), taxes (IRC section 164), or research and development (IRC section 174). Other provisions limiting deductions do apply, however, including the rules of IRC section 263A requiring capitalization of production costs, including certain interest and taxes.
While start-up expenditures are not deductible, they may be amortized over 60 months only if such an election is made. Investigatory costs and preliminary due diligence costs are treated as start-up costs, amortizable over 60 months, if the election is made. Due diligence costs incurred after a decision to purchase are treated as acquisition costs allocable to assets purchased.
Start-up costs are defined in IRC section 195(c)(1) as any amount:
There is a distinction between the tax treatment of costs incurred when the purchaser of a business is already engaged in that business and when it is not. When the purchaser is already engaged in the same business, investigatory and due-diligence costs with respect to an acquisition are considered deductible expansion costs. When the purchaser is not in the same business, such costs are considered start-up costs.
When the purchaser is not already in the same business, expenses may be considered to be investigatory costs only if incurred prior to the “final decision” to acquire the business (Senate Report of 1980). The court allowed the deduction of expansion costs (Briarcliff, 475 F. 2nd 775, 2nd Circ., 1973) and of expenditures incurred by the taxpayer to develop a new market for wholesale customers (which gave the taxpayer little more than an expectation of future sales).
The meaning of the term “final decision” is not clear. The IRS’ position in Revenue Ruling 99-23 is that the final decision occurs at the time when the taxpayer and seller are legally obligated to each other. Thus, expenses incurred in order to determine whether to enter a new business and which new business to enter are start-up expenditures under IRC section 195. Costs incurred attempting to acquire a specific business are capital expenditures rather than section 195 start-up costs.
Applying this general principle to a set of facts, the IRS concluded that the purchaser made a final decision to acquire the business when it instructed its law firm to prepare and submit a letter of intent. Costs for preliminary due diligence incurred prior to that time, including industry research and review of the target’s financial projections, were section 195 start-up costs. Costs for due diligence incurred after that time, including costs of reviewing the target’s internal documents, books, and records, were considered acquisition costs, to be capitalized and allocated among the assets purchased. If there is no letter of intent, but rather only negotiations, general investigation costs (including an investment banker’s review) would be start-up costs. Costs incurred to arrive at a price are capital acquisition costs rather than start-up expenses because they facilitated the acquisition.
Identifying start-up costs is important because such costs are amortizable only if an election and proper disclosure are made for the year in which the costs are incurred.
Often, a new entity is formed for purposes of an acquisition. As a newly formed entity, it is not considered to have engaged in business, even if a parent company has been so engaged. Thus, a significant amount of its costs are potentially start-up costs.
The treatment of inventory must be addressed at the time of an acquisition:
The lack of clarity in the rules governing the capitalization of costs incurred in connection with the acquisition of intangible assets has resulted in uncertainly and controversy. The U.S. Supreme Court decision in INDOPCO, Inc. [503 U.S. 709 (1992)] has led to a significant future benefit standard that the IRS uses to determine whether an expenditure is to be capitalized or expensed. The significant future benefit standard is subjective and unclear, because virtually all expenditures could provide a future benefit. Prior to INDOPCO, the standard for distinguishing a capital expenditure from an expense was whether the payment resulted in the creation or enhancement of a separate and distinct additional asset [Lincoln Savings & Loan Ass’n, 403 U.S. 345 (1971)].
In December 2002, the IRS issued proposed regulations providing a more objective approach than INDOPCO for determining which costs related to intangible assets are required to be capitalized. Final regulations effective after December 31, 2003, were issued in January 2004. The regulations contain the capitalization rules for amounts paid to acquire, create, or enhance intangible assets. They adopt a “separate and distinct intangible asset” standard, which supersedes the future benefit standard of INDOPCO.
In addition to consideration paid, the regulations require capitalization for amounts paid to “facilitate” a transaction involving the acquisition, creation, or enhancement of an intangible asset, as well as the restructuring or reorganization of an entity, including the acquisition of capital. An amount facilitates a transaction if it is incurred in the process of investigating or pursuing the transaction.
The regulations attempt to adopt a bright-line rule for the acquisition of a business (asset deal or stock deal). Amounts paid in the course of pursuing an acquisition of a business are capitalized only if the expenditure inherently facilitates the transaction, or if the expenditure facilitates steps taken after the earlier of the date of executing a letter of intent or similar communication or the date the board of directors approves the proposed transaction. The regulations identify expenditures that are inherently facilitative, which may be capitalized, even if incurred earlier in the process. Examples are amounts incurred in determining the value of the target company, drafting acquisition documents, or transferring property between the parties.
The “facilitate” standard of the regulations is more limited than the previous “but for” standard. The “but for” standard is relevant but not determinative. Costs such as integration expenses incurred after a merger or acquisition that might have been considered capital expenditures under previous standards are not considered to facilitate the transaction under the proposed regulations, and therefore are not required to be capitalized.
The determination of whether employee compensation must be capitalized in connection with the acquisition of an intangible asset has been controversial [Wells Fargo & Co. v. Comm’r, 224 F.3d 874 (8th Cir. 2000)]. The lower court rejected the taxpayer’s argument that amounts paid to employees for due diligence in connection with an acquisition were deductible. The court held that such costs must be capitalized because they were “sufficiently related to an event that produced a significant long-term benefit.” The Eighth Circuit reversed the Tax Court and held in favor of the taxpayer.
Under the regulations, employee compensation and overhead expenses are not considered expenditures that facilitate the acquisition or creation of an intangible asset. Compensation of employees may be deducted even if the employees work full time on the acquisition of intangible assets.
The regulations further provide that de minimis transaction costs (costs aggregating $5,000 or less per transaction) are not required to be capitalized.
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