Accounting for Transaction Costs and Earn-outs in M&A

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1 Accounting for Transaction Costs and Earn-outs in M&A Daniel Lundenberg, Grant Thornton LLP (Canada) and Brice Bostian, Ernst & Young This Note provides an overview of certain key financial accounting (book) and US federal income tax (tax) considerations when accounting for M&A transactions. This is just one example of the many online resources Practical Law Company offers. To access this resource and others, visit practicallaw.com. This Note provides an overview of certain key financial accounting (book) and US federal income tax (tax) considerations when accounting for business combinations. A business combination generally is a transaction or an event in which an acquiror obtains control of one or more businesses, including the acquisition of: All of the outstanding stock of one company by another company. All of the assets of a division or line of business of one company from another company. This Note discusses the general book and tax treatment of: Transaction costs. Contingent consideration (specifically, earn-outs). For more information about earn-outs, see Practice Note, Earnouts ( and Standard Clause, Purchase Agreement: Earn-out with EBITDA Targets ( BOOK AND TAX ACCOUNTING FOR TRANSACTION COSTS Both buyers and sellers incur various costs in connection with a business combination. These costs can include: Professional fees (for example, legal, accounting and investment banking fees). Regulatory and filing fees. Transaction financing fees. There can be a significant difference between book and tax when accounting for these transaction costs. In fact, there can be a divergence of desired results between the accountants and tax lawyers: For tax purposes, transaction costs are currently deductible or capitalized to the basis of the acquired stock or assets, or both. For book purposes, different rules apply for expensing or capitalizing depending on the type of transaction cost. Often, tax lawyers want current deductibility for transaction costs because this generates a current tax deduction that can be used to offset taxable income. However, accountants often want longterm capitalization of the same expenses (instead of a current book expense) because a current book expense can result in an immediate negative impact to the earnings per share charge. Book Tax versus Cash Tax The tax treatment of transaction costs and the book treatment under FAS Statement 141(R) (FAS 141(R)) can be different and can have a meaningful effect on taxpayers depending on whether they focus on: Book tax, which is the company s financial accounting that affects earnings per share and effective tax rate. Cash tax, which is the total of actual cash that is owed to various jurisdictions that affects after-tax cash flows. Generally, large publicly traded companies tend to focus on book tax because earnings per share figures are meaningfully impacted by this figure. However, portfolio companies owned by private equity funds often focus on the company s cash tax because this figure impacts the after-tax cash flows. The areas of a particular company s focus do not always fit into these broad categories. Accounting and tax advisors must consider the business and other objectives of their particular client when considering how best to balance the book tax and cash tax effect of business combinations. Tax Treatment of Transaction Costs For tax purposes, transaction costs generally are allocated to: Costs that are deductible (see IRC 162 & 165; Deductible Costs required to be capitalized (see IRC 263; Capitalized Deductible Costs The tax rules specify that certain business costs can be deducted currently. For example, IRC Section 162 allows a current deduction for ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. These include ordinary and necessary expenses taxpayers incur Learn more about Practical Law Company practicallaw.com

2 Accounting for Transaction Costs and Earn-outs in M&A to improve and expand their existing business as part of the active conduct of their trade or business. In addition, IRC Section 165 permits a deduction for losses sustained during the taxable year that are not reimbursed by insurance or otherwise. When a taxpayer considers transactions for a specific business purpose, it often incurs legal, accounting and investment banking costs to analyze various options. Although only one of these options is ultimately accepted, the facts and circumstances surrounding these costs must be analyzed to determine if a portion of these costs are: Allocable to the rejected option or options so properly characterized as a currently deductible IRC Section 165 loss. Allocable to the pursued option so required to be capitalized into the basis of the acquired stock or assets (see Capitalized Capitalized Costs Costs that would otherwise be deductible are not currently deductible if considered a capital expenditure. Generally, a capital expenditure is a cost that yields future benefits to the taxpayer s business (see IRC 263). Costs incurred by an acquiring taxpayer while investigating or otherwise pursuing a transaction may be required to be capitalized under IRC Section 263. This means the costs are not currently deductible. Instead, these costs are added to the basis of the acquired stock or assets and recovered over several tax years (generally, the depreciable or amortizable life of the underlying property). The tax rules generally require taxpayers to capitalize amounts paid in the process of investigating or otherwise pursuing each of the following transactions (regardless of whether the transaction is carried out in a single step or a series of steps that are part of a single plan): An acquisition of assets that constitute a trade or business. An acquisition of an ownership interest in a business entity. An acquisition of an ownership interest in the taxpayer. A restructuring, recapitalization or reorganization of the capital structure of a business entity. Whether an amount is paid in the process of investigating or otherwise pursuing the transaction depends on all of the facts and circumstances of the transaction. For example, in auction scenarios when a company has multiple bidders, much of the transaction costs of bidders before the selection of the winning bidder (known as the bright-line date) generally can be currently deducted, rather capitalized. Costs incurred before the brightline date generally are not considered inherently facilitative for purposes of investigating or otherwise pursuing a transaction and are currently deductible. While certain costs incurred in investigating or otherwise pursuing a transaction may be required to be capitalized even if the transaction never occurs, a taxpayer may able to currently deduct the capitalized costs as a loss under IRC Section 165 when the transaction is abandoned (see Deductible In addition, certain capitalized costs can be recovered through depreciation or amortization deductions. Depending on the investment and business objectives of the particular taxpayer, the time value of money benefit of the tax deduction may be significantly (or completely) diminished if required to be capitalized and recovered over several years. For example, private equity investors typically purchase companies with a five-year investment horizon. If a deduction for transaction costs is unavailable within that investment horizon, the investor may never receive the cash benefit from it. However, the private equity investor may seek to recover some of the tax benefit through commercial means in their negotiations on exit (for example, as an increase in the sales price for future tax benefits that a buyer can expect to receive). Special Rules for Success-based M&A Fees The issue of how to treat success-based fees paid in connection with an M&A transaction has been the subject of controversy between the IRS and taxpayers. In 2011, the IRS issued Revenue Procedure , which provides a safe harbor election for companies to currently deduct success-based fees paid in connection with specified business acquisitions (including mergers, asset purchases and acquisitions of majority interests in target companies). Success-based fees are contingent on the closing of an acquisition or merger and often include investment banker fees. Under the Revenue Procedure, a company can elect to deduct 70% of a success-based fee related to a particular transaction and must capitalize the remaining 30%. By contrast, existing treasury regulations generally require a company to capitalize successbased fees unless it maintains adequate documentation (such as time records) to support a deduction for the portion of the fee allocable to activities that do not facilitate the acquisition (for example, bankers fees for investigating a transaction prior to the date the company decided to proceed with the acquisition). Under the new safe harbor election, a company does not need to maintain this documentation to deduct 70% of the success-based fees. Book Treatment of Transaction Costs For book purposes, transaction costs are categorized as: Direct costs (costs for services of lawyers, investment bankers, accountants and others). Indirect costs (certain recurring internal costs, for example, the cost of maintaining a corporate development or planning department). Financing costs (costs to issue debt or equity instruments used to effectuate the transaction). For book purposes, transaction costs are not part of the fair value of the exchange between the buyer and seller for the acquired business. As a result, direct and indirect transaction costs are 2

3 not accounted for as part of the consideration paid. This means that these costs do not generate goodwill and are otherwise not considered part of the basis of the acquired stock or assets. Instead, direct and indirect transaction costs are accounted for separately as transactions in which the buyer makes payments in exchange for the services received. Therefore, direct and indirect transaction costs are charged as a book expense in the period that the related services are received. However, financing costs are treated differently. Debt issuance costs generally are deferred and amortized over the term of the related debt. The costs of registering and issuing equity securities are generally treated as a reduction of the proceeds from the securities issued. This means that the issuer is treated as issuing an amount less than the face amount of securities sold. Deferred Tax Assets Although the financial accounting rules require that direct and indirect transaction costs be charged to a book expense in the period the related services are rendered, these costs may not be immediately deductible for tax purposes. Further, because these costs are incurred before closing the transaction, the tax treatment of these costs may be unknown when the costs are incurred. For example, the costs may be currently deductible for tax purposes if the transaction is never consummated, but may be required to be capitalized and included in the tax basis of the acquired stock or assets if the transaction is completed. One approach to accounting for the tax effects of transaction costs is to assess the tax consequences based on the circumstances that exist on the date the costs are incurred, without assuming the business combination will ultimately occur. This approach is consistent with the book principle that these costs are accounted for separately from the business combination. Therefore, if the transaction cost will result in a future tax deduction should the business combination not occur, the acquiror reports a deferred tax asset for book purposes when the related cost is charged to book expense. However, if the transaction costs will result in a tax benefit only if the business combination is consummated, a deferred tax asset for book purposes should not be recognized. In general, deferred tax assets are recorded amounts for book purposes that result in a lower cash tax than book tax expense in a future period. One common example of a deferred tax asset is a company s net operating loss carryforward (NOL carryforward). For tax purposes, if a company reports a net loss on its tax return and can carryforward that loss to offset its future taxable income, the company may be able to record a deferred tax asset for book purposes. This deferred tax asset represents the tax effected value of the future tax deduction for the NOL carryforward (meaning, the amount of the NOL carryforward multiplied by the effective tax rate). If a deferred tax asset for book purposes is reported for transaction costs, once the business combination is completed, the acquiror must assess whether the deferred tax asset continues to exist or whether it must be written off for book purposes. If the transaction is a taxable business combination, the transaction costs that are capitalized for tax purposes are generally included in the basis of the acquired stock or assets (for example, an inclusion in tax deductible goodwill) and could result in a deferred tax liability to the extent that it is deducted for tax but not book purposes. If the transaction is a non-taxable stock acquisition (for example, a stock for stock type B reorganization), the transaction costs that are capitalized for tax purposes do not result in a deferred tax asset or liability because no future tax deduction is reasonably expected. Although a reduced gain on a future sale may be expected, these generally are not recorded as temporary book or tax differences that would create a deferred tax asset or liability. For more information about tax-free reorganizations, see Practice Note, Tax-Free Reorganizations: Acquisitive Reorganizations ( BOOK AND TAX ACCOUNTING FOR EARN-OUTS In a perfect world, the exact value of assets and the finite liabilities associated with those assets could be readily determined and deals would be negotiated on these terms. Unfortunately, this is rarely the case, and parties often disagree on both asset values and the liabilities associated with business enterprises in their negotiations. As a result, most mergers and acquisitions have some contingent aspect associated with them, either in the form of contingent consideration (for example, earn-outs) or contingent liabilities (for example, environmental liabilities). When buyers and sellers disagree on the value of a business enterprise, one common method of negotiating the difference is to agree to an earn-out which can be paid out in one or more future payments. These future payments can be contingent on future earnings or cash-flow targets for the company (for example, different EBITDA targets). The following discussion highlights some of the common book and tax treatments and considerations for earn-outs. For more information about earn-outs, see Practice Note, Earnouts ( and Standard Clause, Purchase Agreement: Earn-out with EBITDA Targets ( Tax Treatment of Earn-outs Earn-outs can create some interesting tax considerations and consequences for both the buyer and the seller. Buyer From a buyer s perspective, the main tax issue with an earn-out is its basis in the acquired stock or assets. In general, the buyer does not receive basis in the acquired stock or assets until the amount of any contingent consideration is fixed and determined. Under IRC Section 1012, a taxpayer s basis in purchased property generally is the cost of that property. If a cost is not fixed or cannot be determined, that cost may not be properly includable in a taxpayer s basis for the property until fixed or determined. 3

4 Accounting for Transaction Costs and Earn-outs in M&A Seller From a seller s perspective, the main tax issues with an earn-out are: The characterization of the earn-out payment: as deferred purchase price; or as a payment of compensation income. The timing of gain recognition on any payments of deferred purchase price. The tax characterization of an earn-out payment as deferred purchase price or as compensation income is important to the seller because: Payments of deferred purchase price are generally taxable as capital gains. Long-term capital gain of a non-corporate seller currently is taxed at a preferential rate (maximum rate of 15%, see IRC 1(h)(1)). Payments of compensation income are taxed at ordinary income rates, which can be as high as 35%, and are subject to employment taxes (for example, Social Security and Medicare taxes). If the seller is not performing services for the buyer or the target company after an acquisition, the earn-out generally is treated as a payment of deferred purchase price that is potentially taxable at the lower capital gain rates. On the other hand, the earn-out payments may be treated as compensation income if the seller provides services for the buyer or the target company after the acquisition or, in certain cases, provides a non-compete. Earn-out payments that are characterized as compensation generally are deductible by the buyer. The installment sale rules under IRC Section 453 also must be considered when there is an earn-out. The timing of income recognition by a seller depends on whether the gain is reported under the installment method. Under the installment method, gain recognition is deferred until earn-out payments are made (see IRC 453). If the consideration that a seller receives in a transaction spans at least past the taxable year the transaction closes, the default rule is that the installment sale provisions of IRC Section 453 generally apply to the transaction. If a transaction meets the requirements for an installment sale, the installment method must be used unless the seller formally elects not to have it apply (see IRC 453(d)). If the installment method applies, the seller s recognition of gain on the earn-out payments is tax deferred. The seller recognizes gain as earn-out payments are made based on the amount realized in that year and the basis allocated to that year. However, special basis recovery rules that apply to earn-out payments reported under the installment method operate as a trap for the unwary and may improperly accelerate the recognition of gain by the seller (see Box, Trap for the Unwary: Basis Recovery Rules under the Installment Method). If a seller elects not to apply the installment method, the seller recognizes a gain equal to the amount realized on the sale and its basis in the stock. The amount realized includes the fair market value of the right to receive the future earn-out payments. Electing out of the installment sale rules can have unintended Trap for the Unwary: Basis Recovery Rules under the Installment Method Special basis recovery rules that apply to earn-out payments reported under the installment method operate as a trap for the unwary and may improperly accelerate the recognition of gain by the seller. These special tax rules for basis recovery depend on whether there is: A cap on the earn-out. If there is a cap on the earnout, the tax rules assume that the total capped selling price is the selling price. This rule may have the effect of deferring (or back-loading) basis recovery and improperly accelerating gain recognition, particularly if the potential amount of earn-out payments is high and the likelihood of receiving the full payment is low. A fixed term for the earn-out. If the earn-out is not subject to a cap but has a fixed term, the seller recovers its basis ratably over the fixed term. This rule benefits the seller if earn-out payments are smaller in earlier years and larger in later years. Neither. If there is neither a cap nor a fixed term, the seller generally recovers its basis ratably over 15 years. tax consequences for the taxpayer. For example, if a taxpayer elects out of the installment sale rules, the true-up to the amount of gain or loss reported in year one is either capital or ordinary in character. One characterization of transaction is that the character of the income or loss on the true-up follows that of the original transaction, which means that it could be capital in character (see Arrowsmith v. Comm r, 344 U.S. 6 (1952)). Another characterization is that the transaction is closed as a result of the election out of the installment sale rules. Based on this characterization, the character of the income or loss on the trueup could be ordinary rather than capital. Taxpayers do not have definitive guidance on the tax treatment of true-up payments. Because the tax characterization is dependent on the particular facts and circumstances of a given situation, taxpayers often have strong arguments supporting either characterization. While a corporate entity may not be as concerned about the character of the income because there currently is no difference between the corporate ordinary income rates and the capital gain rates, corporations can be affected by the character of a loss to the extent that they do not have (and do not expect to have) capital gains against which to use a capital loss. Therefore, in a capital loss scenario, a corporation may recognize a deferred tax asset for the capital losses, only to set up a full valuation allowance (meaning, a full reduction to the book asset) because the corporation cannot reasonably expect to use it. For more information about the installment method in stock acquisitions, see Practice Note, Stock Acquisitions: Tax Overview ( 4

5 Book Treatment of Earn-outs Under FAS 141(R), buyers are required to record potential earnout payments at fair value on the date of acquisition and then re-measure their fair value periodically until all potential payments are made. Any annual changes in the fair value of the earn-outs are recorded as a gain or loss on the buyer s income statement. The estimated fair value of earn-out payments must reflect the present value of the future payments and the probability of these payments being paid out based on factors within the acquisition agreement. Accuracy of the estimated fair value is important for the buyer because differences between the estimated fair value and the amounts paid are reflected as a gain or loss on the buyer s income statement. Inaccurate estimates can cause the buyer s earnings to seem volatile. In addition, an overestimation creates larger goodwill on the buyer s balance sheet than is supported by the financial performance of the target company. As a result, the buyer may need to record a goodwill-impairment charge if the earn-out is not actually paid out. Practical Law Company provides practical legal know-how for law firms, law departments and law schools. Our online resources help lawyers practice efficiently, get up to speed quickly and spend more time on the work that matters most. This resource is just one example of the many resources Practical Law Company offers. Discover for yourself what the world s leading law firms and law departments use to enhance their practices. To request a complimentary trial of Practical Law Company s online services, visit practicallaw.com or call To reduce the uncertainty and accounting issues presented by FAS 141(R), buyers may try to shorten the earn-out period to make estimating fair value easier. In some cases, buyers may try to avoid an earn-out arrangement altogether. FAS 141(R) does not apply to earn-out payments that are characterized as compensation rather than as part of the purchase price. This can happen when the earn-out arrangement is structured as compensation for services, use of property or a profit-sharing arrangement. There are many different factors that can lead to this characterization. One of the more common factors is when the earnout payments are made contingent on the continued employment of the seller. In this case, buyers account for compensation earn-outs as expenses in the periods in which they are paid. Compensation earn-outs can have adverse tax consequences for the seller (see Tax Treatment of Earn-outs: Seller) Use of PLC websites and services is subject to the Terms of Use ( and Privacy Policy (