Pub. 2 2020 Issue 5

J U L Y / A U G U S T 2 0 2 0 24 nebraska cpas DON’T BE “FLOORED” BY PURCHASE ACCOUNTING STRUGGLES BY JAMES P. SWANICK, CPA, AND MICHAEL J. TIGHE, CPA No twomerger and acquisition (M&A) deals are alike. Each is unique, opening the door to new challenges and uncharted territory for those tasked with determining the tax treatment of the transaction. One challenge that often gives practitioners headaches is how to handle assumed liabilities in an asset acquisition. When a buyer purchases the assets of a target company in a taxable transaction (or purchases the stock of a target company with an IRC Section 338(h)(10) election), the purchase consideration will typically include assumed liabilities, such as accrued expenses and certain reserves. For financial reporting purposes under FASB ASC 805, assumed liabilities are generally included in the total purchase consideration if the liability existed prior to the transaction and will lead to an increased value in book goodwill on the opening balance sheet. However, for income tax purposes, certain liabilities may not be includible as purchase considerations, and therefore are not included in the tax basis of the acquired assets until economic performance occurs under the “all-events test” of Section 461(h). When this test is met, no tax deduction is claimed; instead, the basis of the acquired assets is increased—often increasing tax goodwill under the residual method. Inmany cases, this triggering event occurs in a subsequent tax period, well after the transaction has closed. To avoid taking both a deduction and a basis increasewhen the liability is ultimately satisfied, taxpayers often establish a “floor” against the assumed liability. challenges and uncharted territory for those tasked with determining the tax treatment of the transaction. One challenge that often gives practitioners headaches is how to handle assumed liabilities in an asset acquisition. When a buyer purchases the assets of a target company in a taxable transaction (or purchases the stock of a target company with an IRC Section 338(h)(10) election), the purchase consideration will typically include assumed liabilities, such as accrued expenses and certain reserves. For financial reporting purposes under FASB ASC 805, assumed liabilities are generally included in the total purchase consideration if the liability existed prior to the transaction and will lead to an increased value in book goodwill on the opening balance sheet. However, for income tax purposes, certain liabilities may not be includible as purchase considerations, and therefore are not included in the tax basis of the acquired assets until economic performance occurs under the “all-events test” of Section 461(h). When this test is met, no tax deduction is claimed; instead, the basis of the acquired assets is increased—often increasing tax goodwill under the residual method. In many cases, this triggering event occurs in a subsequent tax period, well after the transaction has closed. To avoid taking both a deduction and a basis increase when the liability is ultimately satisfied, taxpayers often establish a “floor” against the assumed liability. Example On June 30, 2017, ABC Corp. acquired the assets of Target Corp. in an applicable asset acquisition, as defined in Section 1060, in exchange for $8 million in cash and the assumption of liabilities of $2 million. The $2 milli n liability relates solely to a warranty reserve recorded by Target on its past sales, which remain covered under the assumed warranty policy. The reserve did not meet the “all-events test” of Section 461(h), as it was neither fixed nor determinable and economic performance had not yet occurred. As a result, no tax basis was assigned to the reserve on the opening balance sheet. The warranty reserve on ABC’s year-end balance sheet (which consisted of liabilities acquired from Target Corp. as well as new liabilities recorded post-acquisition) is reflected in the chart below: Opening Balance Sheet 6/30/2017 12/31/2017 12/31/2018 12/31/2019 Warranty Reserve – ABC $0 $750,000 $900,000 $1,000,000 Warranty Reserve – Target $2,000,000 $2,000,000 $1,500,000 $0 Total Warranty Reserve $2,000,000 $2,750,000 $2,400,000 $1,000,000 Floor Amount ($2,000,000) ($2,000,000) ($1,500,000) $0 M-1 Adjustment $0 $750,000 $150,000 $100,000 Opening Balance Sheet 6/30/2017 12/31/2017 12/31/2018 12/31/2019 Goodwill – Books $10,000,000 $10,000,000 $10,000,000 $10,000,000 Goodwill – Tax $8,000,000 $8,000,000 $8,500,000 $10,000,000 Example On June 30, 2017, ABC Corp. acquired the assets of Target Corp. in an applicable asset acquisition, as defined in Section 1060, in exchange for $8million in cash and the assumption of liabilities of $2 million. The $2 million liability relates solely to a warranty reserve recorded by Target on its past sales, which remain covered under the ssume warr nty policy. The reserve did not meet the “all-events test” of Section 461(h), as it was neither fix d nor determinable and economic performance had not yet occurred. As a result, no tax basis was assigned to the reserve on the opening balance sheet. The warranty reserve on ABC’s year-end balance sheet (which consisted of liabilities acquired from Target Corp. as well as new liabilities recorded post-acqu sition) i reflected in the ch t below: As of December 31, 2019, the full amount of the original warranty reserve ($2 million) related to Target Corp.’s liability has been paid out in full. Analysis For book purposes, a total of $10 million ($8 million cash plus $2 million assumed liability) was allocated to the newly acquired assets with any residual consideration being allocated to book goodwill. In addition, the warranty reserve was recorded as a liability on the opening balance sheet. For tax purposes, only $8 million was allocated to the newly acquired assets since there was zero tax basis in the warranty reserve, initially resulting in a lower amount of tax-deductible goodwill compared to book goodwill. In addition, a $2 million “floor” against the reserve is tracked