Purchase Price Allocation in M&A: Tax and GAAP Considerations

BY C. BRETT COOPER

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The following article was prepared by its author(s). The opinions expressed in the article are those of the author(s) and may not reflect the views or opinions of Vallit Advisors and its staff. Views and opinions are based on the specific facts and circumstances of each matter.

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C. Brett Cooper, CPA•ABV, ASA•BV/IA, BVAL, CRFAC is a Managing Director with Vallit Advisors, LLC. He has more than 30 years of experience as a business consultant and nearly 40 years of experience in the CPA profession. At Vallit Advisors, Brett leads the firm’s Valuation and Advisory services. He specializes in business appraisal and valuation, litigation support, transaction advisory, forensic accounting, and ESOPs. Brett is one of a select few individuals within the American Society of Appraisers who has earned the specialty credential of “ASA in Intangible Asset Valuation.”

Contact Mr. Cooper in Tampa, Florida, by calling 813-402-8840 or visiting www.vallitadvisors.com.

Vallit Viewpoints

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This article examines purchase price allocation in mergers and acquisitions, with emphasis on the differing requirements for income tax reporting and GAAP financial reporting. It contrasts the tax treatment of asset and equity transactions with the fair value measurement framework under FASB ASC 805 and ASC 350. Key valuation considerations include working capital, fixed assets, identifiable intangible assets, goodwill, and contingent consideration. The article underscores the need for transaction-specific analysis to support compliant, defensible business combination reporting.

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Introduction

Business combination accounting, commonly referred to as purchase price allocation (“PPA”), is a critical element of mergers and acquisitions (“M&A”) that directly affects both income tax reporting and U.S. Generally Accepted Accounting Principles (“GAAP”) financial reporting. Although the mechanics of a PPA may appear straightforward, the underlying valuation issues often require careful judgment because tax and financial reporting frameworks do not always produce the same result. Whether a transaction is structured as an equity transaction or an asset purchase transaction, the acquired business assets must be analyzed and recorded at their appropriate current value—fair market value (“FMV”) for tax purposes and fair value (“FV”) for GAAP purposes.

 

This article outlines the principal tax and financial reporting considerations that arise in a PPA, including the treatment of working capital, fixed assets, identifiable intangible assets, goodwill, and contingent consideration. It also highlights why the allocation process should be tailored to the facts of each transaction rather than approached as a mechanical compliance exercise. Upon completion of transactions involving a change in control, companies are required to complete business combination accounting for financial reporting purposes when the transaction constitutes the sale of a business, regardless of whether the transaction is structured as an asset deal or a stock deal. Sections 1060 and 338 of the Internal Revenue Code (“IRC”) provide procedures for completing PPAs for U.S. income tax reporting purposes. Section 754 of the IRC provides similar guidance for partnerships and limited liability companies that elect to be taxed as partnerships.

 

U.S. Income Tax Reporting

U.S. income tax regulations generally require a PPA only for transactions structured as asset deals, or as deemed asset sales when a transaction is structured as an equity deal and an election is made under IRC § 338(h)(10) or § 754. In a pure equity transaction in which neither election applies, the allocation of purchase price by the buyer is generally not required because the buyer acquires the equity interests rather than the underlying assets and typically retains the existing tax basis of those assets.

 

Current federal tax law requires the buyer and seller in an asset transaction or deemed asset transaction to complete Internal Revenue Service (“IRS”) Form 8594, which reports the values allocated to the different classes of assets purchased and sold.¹ Most asset purchase agreements we review require the buyer and seller to agree on the allocation of value among the asset classes. This language is typically included to promote consistency between the parties’ respective reporting positions. An allocation agreed to by the parties and memorialized in writing generally becomes binding under the IRC unless the IRS determines that the allocation is inappropriate.

 

The IRC requires the value allocated to each asset class to be stated at FMV. The asset classes that often receive the most attention are certain current assets, sometimes referred to as “hot assets,” which may cause income to be recognized as ordinary income in the year of sale, and fixed assets, or “hard assets,” for which ordinary income may be recognized in the year of sale due to depreciation recapture.

 

The asset classes that address acquired intangible assets, including goodwill, are generally treated as the residual amount after value is allocated to hot assets and hard assets. For income tax purposes, intangible assets, including goodwill, are generally amortizable over 15 years, regardless of the nature or estimated useful life of the individual intangible asset.²

 

In practice, we typically see a negotiated amount between the buyer and seller for hard assets. This asset class often receives significant attention because the seller may recognize ordinary income from depreciation recapture and therefore may prefer to limit the amount of purchase price allocated to this class. Conversely, the buyer may prefer to maximize the amount allocated to hard assets because the recovery period through depreciation is generally shorter than the 15-year amortization period for intangible assets, including goodwill. In certain circumstances, the buyer may also be able to claim accelerated depreciation in the year of purchase.

 

The value of hot assets is often readily determinable. In many cases, FMV is equal to the carrying value of the asset. Cash-basis accounting taxpayers may be required to report certain accrual-basis amounts, such as accounts receivable and accounts payable, as ordinary income items in the year of sale.

 

U.S. Financial Reporting

In the United States, guidance for business combination accounting is contained in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, Business Combinations (“FASB ASC 805” or “ASC 805”), and Topic 350, Intangibles—Goodwill and Other (“FASB ASC 350” or “ASC 350”). In 2014, FASB ASC 805 and FASB ASC 350 were amended to provide privately held companies with accounting alternatives intended to simplify the accounting and reporting process for PPAs. Under Accounting Standards Update (“ASU”) 2014-18 and ASU 2014-02, privately held companies may elect certain accounting alternatives related to the recognition and measurement of certain intangible assets (the “Intangibles Accounting Alternative”) and the amortization and impairment testing of goodwill (the “Goodwill Accounting Alternative”). This private-company guidance resulted from the efforts of the Private Company Council (“PCC”) and related FASB endorsements.³

 

Business combination accounting is required when a transaction or other event occurs in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as “true mergers” or “mergers of equals” are also business combinations. For purposes of determining whether this requirement applies, ASC 805 defines a business as “an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants.” Accordingly, an asset sale involving the transfer of a business must apply the provisions of ASC 805.⁴

 

The acquirer measures the identifiable assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date FVs. Similar to the income tax valuation exercise, hot assets, or net working capital assets, are valued and are often recorded at carrying value. Hard assets are also valued, as they are for income tax purposes. The principal difference arises with respect to acquired intangible assets and goodwill.

 

Intangible assets are valued separately if they are identifiable. An intangible asset is identifiable if it meets either of the following criteria:

• It is separable, that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability, regardless of whether the entity intends to do so.
• It arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.⁵

 

The accounting alternative discussed above allows certain customer-related assets and non-compete agreements that initially meet the criteria for identifiable intangible assets to be subsumed into goodwill. This accounting alternative is generally available only to privately held companies.

 

Income Tax vs. GAAP

The disparity between income tax PPAs and GAAP business combination accounting begins with the treatment of intangible assets and goodwill. For income tax purposes, separately identifiable intangible assets are generally not evaluated in the same manner because intangible assets, including goodwill, are grouped within the same broad category. For GAAP business combination accounting, identifiable intangible assets are identified, assigned a useful life when applicable, and valued separately from goodwill. Goodwill is then determined as a separate component of the allocation.

 

In addition to the separate recognition of identifiable intangible assets and goodwill in a GAAP PPA, contingent consideration, or earn-outs, may be treated differently for income tax reporting and GAAP purposes. Contingent consideration may take the form of cash, shares, or other consideration intended to address a key transaction risk. A transaction includes contingent consideration when the amount of consideration transferred depends on an uncertain condition, situation, or set of circumstances that future events will ultimately resolve. In certain cases, for income tax reporting purposes, the FMV of contingent consideration must be determined and added to the purchase price. Under GAAP, contingent consideration is included as part of the transaction price when the payment is part of the sale transaction rather than a compensation arrangement.

 

In practice, a well-supported PPA does more than satisfy a reporting requirement. It provides a defensible framework for aligning the economics of a transaction with the applicable tax and financial reporting standards. Because the treatment of asset classes, identifiable intangible assets, goodwill, and contingent consideration can differ significantly between income tax and GAAP reporting, each allocation should be developed with careful attention to the transaction structure, governing agreements, and available valuation evidence. The professionals at Vallit Advisors are experienced in navigating these considerations and advising as part of the M&A team to help address the tax and financial reporting issues associated with a transaction.

 

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References

¹ IRS, Instructions for Form 8594, Asset Acquisition Statement Under Section 1060.

² Internal Revenue Code § 197.

³ FASB ASC Topic 805; FASB ASC Topic 350; FASB ASU 2014-18; FASB ASU 2014-02.

⁴ FASB ASC 805, definition of a business and business combination guidance.

⁵ FASB ASC 805, identifiable intangible asset recognition criteria, including separability and contractual-legal criteria.