New Election Provides Flexibility and Opportunities for Tax Accounting Methods in M&A Transactions

The New Rules

Tax risk related to a target company’s methods of accounting is often identified by the buyer either as part of the due diligence process or subsequent to a transaction. Even when a change in method of accounting is filed with IRS in a period prior to the transaction, at least a portion of the tax cost is borne by the acquirer due to the mandatory four-year spread period for unfavorable adjustments. Complicated indemnity provisions or adjustments to purchase price were often necessary to shift the tax burden from the buyer to the seller. IRS recently published new accounting method rules that allow the seller to elect to accelerate an unfavorable adjustment resulting from a change in method of accounting into the preacquistion tax year. In addition to simplifying the transaction, the election also opens a new planning opportunity for target companies with net operating losses (NOLs) that will be limited following the transaction. The target can make unfavorable accounting method changes (including changes from a proper method to another proper method) and accelerate the unfavorable adjustments into the preacquistion tax year, where they can be offset by NOLs and create additional tax basis. This new election is a welcome change for private equity funds and other taxpayers who engage in frequent transactions.

Specifically, Revenue Procedure 2015-13 provides that the target in an "eligible acquisition transaction” can elect to accelerate all unfavorable adjustments into the tax year of the change, rather than spread the adjustments over four taxable years. Generally, an eligible acquisition transaction means:

An acquisition of stock ownership in a corporation or CFC that either results in the acquisition of control of target by acquirer, or causes the target’s taxable year to end,
An acquisition of the target’s assets in certain tax-free reorganizations or liquidations, or
An acquisition of an ownership interest in target that does not cause a technical termination of the partnership.

The eligible acquisition transaction has to occur either in the tax year of the accounting method change or in the subsequent tax year before the due date (including any extension) for filing the target’s federal income tax return for the year of change.

The Takeaway

A robust accounting methods review is necessary to ensure that the buyer identifies the potential tax risks of the target in any due diligence process. These new elections provide flexibility and opportunities with respect to such transactions.