Proposed IRS Regulation Reduces Cost Allocation Flexibility in Mergers & Acquisitions
The IRS and Treasury Department have released proposed regulations that could change which tax year taxpayers recognize income and expense items during a merger or acquisition.
Parties involved in an acquisition often negotiate which day items such as success-based fees and termination payments occur, allowing one party to benefit from the deduction. While the proposed regulations don’t currently change the law, they will remove the ability to negotiate certain tax deductions if finalized.
Under current regulations, a C corporation joins or leaves a consolidated group at the end of the day. The ownership change ends the acquired corporation’s tax year, and income and deductions occurring before the end of the day the corporation joins the group are included on the acquired corporation’s last tax return before joining the group. The next-day rule is an exception allowing taxpayers to allocate items occurring after the acquisition to the next day, even if the item occurs before the end of the acquisition date. This lets the acquirer include the item on the first tax return after the acquired company joins the consolidated group and claim a deduction for termination payments and success-based fees related to the acquisition.
The proposed regulations modify the next-day rule to only apply to extraordinary items, e.g., change-in-control payments and the sale of unwanted assets. However, if an item becomes fixed and determinable before or at the same time as the transaction closing, it doesn’t qualify for the next-day rule, meaning taxpayers must allocate the item to the acquired company’s final return before joining the group. Because change-in-control payments and success-based fees occur at the deal closing, the acquired company would recognize these payments on its final return.
The proposed regulations also create a previous-day rule that clarifies the treatment of certain transaction costs for S corporations. To avoid the need to file a one-day tax return, S corps join a consolidated group at the beginning of the day. Currently, S corps recognize items such as success-based fees and termination payments on their first consolidated return after acquisition, as the liability becomes fixed and determinable with the acquisition closing. The proposed regulations attempt to fix the inconsistent treatment between C corps and S corps by requiring S corps to allocate items occurring before or at the same time as the transaction to the acquired company’s last return before joining the group.
If the IRS finalizes the proposed rules without modification, taxpayers will lose flexibility in allocating transaction costs. While the proposed rules don’t change the current treatment of transaction costs for mergers and acquisitions, there’s no published timeline for when the IRS will finalize the regulations. Those planning a merger or acquisition should consult their tax advisor to determine the potential impact on the transaction if the IRS finalizes the regulations prior to transaction close.
If you have questions regarding the proposed regulations or how they might affect your current or upcoming merger or acquisition, contact your BKD advisor.