In a transaction consummated by parties who are unrelated and on an equal footing, one often assumes that the terms of the transaction should represent the fair market value of the property being exchanged. Even the tax law appears to follow the same assumption that “” After all, the fair market value of a property is generally established in an arm’s length transaction setting.
However, from time to time, even in an arm’s length transaction setting, we hear that someone “got a really good deal.” In particular, there have been acquisitions of business entities and the assets of business entities in which the total purchase price (including assumed liabilities) is less than the fair market value of each asset that came with the acquisition. In this blog, we will explore selected accounting and tax consequences of such acquisitions and certain traps for the unwary.
Under the generally accepted accounting principles in the United States of America (GAAP), when there is a business combination, the acquired entity’s book basis in the assets and liabilities steps up or down to fair market value. A business combination generally occurs when a person acquires control of a business. The process, under which the book basis of the acquired business is adjusted to fair market value, is often referred to as “purchase accounting.”
While a detailed explanation of purchase accounting is beyond the scope of this article, the fair market value of the assets as well as purchase price determine the opening balance sheet arising from purchase accounting. For example, a buyer pays $50 for a business entity with fair market value of assets of $100, and assumes the entity’s liabilities of $50. It is apparent that the opening balance sheet would be $100 of assets and $100 of liabilities and equity ($50 in liabilities and $50 in investment capital).
But what happens if the purchase price was $30? If the buyer is certain that the fair market value of the assets is $100 and the liabilities are $50, other than the fact that the buyer had a good deal, the balance sheet would not reconcile. As a result, the acquired company is required to book a negative goodwill of $20, but such negative goodwill will immediately run through the income statement as a gain on the acquisition date. Thus, the acquired entity would have assets of $100, liabilities of $50, and equity of $50. The $50 of equity consists of $30 investment capital and retained earnings of $20. In other words, GAAP requires the buyer to immediately recognize the benefit of the bargain purchase.
The way in which a business combination is treated for tax purposes is often different than under GAAP. In an acquisition of stock in a corporation, the inside basis of the acquired corporation’s assets does not change. On the other hand, in an acquisition of assets or an acquisition of at least 80 percent of a corporation with an election under IRC section 336 or 338 (both types of transactions will be referred to as “Asset Acquisition” for purposes of this article), the basis of the acquired assets steps up or down to fair market value. In an acquisition of a partnership interest, there are circumstances under which the inside basis of the assets steps up or down.
In the context of an Asset Acquisition, the buyer and seller should allocate the purchase price in accordance with seven classes of assets under the Internal Revenue Code and the Treasury Regulations: Class I through Class VII. Here is a brief description of each class (note that this is not an exhaustive list of all assets within these classes and there may be certain exceptions):
- Class I: Cash and general deposit accounts
- Class II: Actively traded personal property, certificates of deposit, and foreign currency
- Class III: A/R and assets that are marked to market at least annually for tax purposes
- Class IV: Inventory
- Class V: All assets other than Class I through IV or VI through VII
- Class VI: Section 197 intangibles except goodwill and going concern value
- Class VII: Goodwill and going concern value
The buyer and seller allocate the purchase price in proportion to the fair market values of assets within each class in the order of Class I through Class VII. Since one has to fully exhaust the fair market values of assets in a class before moving on to the subsequent class, it is possible that there is nothing allocated to a certain class although there are certain valuable assets in such class.
For example, the buyer acquires and assumes all of the assets and liabilities of a business, which has the following assets and liabilities on its balance sheet, and let us assume that the FMV of the accounts receivable, inventory and PP&E are equal to their net book value:
If the buyer pays $900 and assumes all of the liabilities, the buyer’s purchase price for tax purposes should be $1,200 because the assumed liabilities become part of the purchase price (for purposes of this analysis, transaction costs are assumed zero). As such, the buyer’s purchase price allocation for tax purposes will exactly match the fair market value.
What happens if the seller agrees to sell the company for $500? While one may think no prudent seller should sell this company for $500, there can be circumstances that may necessitate such a sale price. Perhaps, the seller may think it is not worth spending resources to “haggle” a higher price or the seller requires immediate liquidity. Whatever the reason may be, in this fact pattern, the purchase price is less than the sum of the fair market value of each asset.
For tax purposes, the allocation should be done in the following manner.
|Class I: Cash||$0|
|Class II: A/R||$100|
|Class IV: Inventory||$500|
|Class V: PP&E||$200|
|Total Tax Basis||$800|
As a result, the buyer will have less tax basis in PP&E than book basis, and thus will have less tax depreciation from the acquired PP&E.
What if the cash consideration was $100, making the total consideration $400? Then, the buyer has a tax basis in inventory of $300 while the fair market value is $500. This means that as inventory is sold, the buyer should generally recognize income due to a lack of basis. The buyer will have additional taxable income over book income due to the difference between book basis and tax basis.
One may think that the buyer can use the last-in-first-out (LIFO) basis of accounting to defer the gain on the inventory. The idea is that the buyer is trying to recover the costs of production incurred after the acquisition to defer the “built-in” gain on the acquired inventory.
However, the IRS position is that the taxpayer should treat the acquired inventory in a bargain purchase separately.
To the extent the bargain element is not substantial, there may be an opportunity to use the LIFO method of accounting to defer the recognition of such bargain element. This application should be carefully reviewed and analyzed on a case-by-case basis.
In a bargain purchase situation, GAAP requires the buyer to recognize the bargain element as income immediately. For tax purposes, depending on the allocation of the purchase price, the buyer may recognize that income over several years, or in some cases, in the year of acquisition. Depending on the facts and circumstances of a transaction, it may be possible to delay the recognition of that income for tax purposes.
Satpal Nagpal also contributed to this article.
Reg. section 1.170A-1(c)(2)
An acquisition of all of the outstanding interests in a partnership is treated as an asset purchase for U.S. tax purposes. Even an acquisition of a portion of the outstanding interests in a partnership, an election under Section 754 can effectively step up or down the acquirer’s share of the partnership’s bases in its assets.
IRS Industry Specialization Program Coordinated Issue Paper on Dollar-Value Last-In, First-Out Bargain Purchaser Inventory (Sept. 9, 2005); and TAM 9328002.
In UFE, Inc. v. Comm’r, the Tax Court held that the taxpayer does not have to remove the acquired finished goods in a bargain purchase from its ongoing inventory. 92. T.C. 1314, 1323 (1989); in Hamilton Industries, Inc. v. Comm’r, the Tax Court held that the acquired inventory should be separately treated from the taxpayer’s ongoing inventory.
Hamilton Industries, Inc., 97 T.C. 120, Kohler Co. v. United States, 34 Fed. Cl. 379 (Ct. C. 1995), aff’d, 124 F.3d 1451 (Fed. Cir. 1997)
Hamilton Indus., Inc. v. Comm’r, 97 TC 120 at 138 (1991).
In a nonrecognition transaction, inventory is deemed acquired in a bargain purchase if it was acquired less than or equal to 50 percent of the replacement cost under Reg. section 1.472-8(h).