At a Glance
Business combinations, in which an acquiring entity obtains control of another business (or multiple businesses), can yield revenue, eliminate competition, and allow companies to tap into previously inaccessible consumer markets.
However, after an acquisition merger, the combined business faces new and unique accounting challenges for income taxes under ASC 740. Knowing the possible tax effects of carryforwards and other income tax uncertainties is essential, as mistakes in this area can impact your shareholders and company.
Before engaging in a business combination, consider how ASC 740 compliance may affect your accounting for income taxes as a result of an acquisition and the impact on your financial statements going forward.
How ASC 740 Applies to Business Combinations
Business combinations present complicated issues when accounting for income taxes.
ASC 740 regulates how companies recognize the effects of income taxes on their financial statements under U.S. Generally Accepted Accounting Principles (GAAP).
What Business Acquisitions are Taxable?
Generally speaking, under accounting standards, business combinations that involve the direct acquisition of another entity’s assets (asset acquisition) are taxable, and combinations that involve acquiring its stock (share acquisition) are not. The term taxable in this context relates to whether a tax is imposed on the acquired entity as a result of the sale of its business.
Taxable asset acquisitions may result in tax-deductible goodwill for the acquirer at a rate equal to the amount paid for the company above the value of its net assets. Goodwill is typically calculated as the amount paid for the company over the fair value of its net assets, including other identifiable intangibles and deferred tax accounts.
In an asset acquisition, any tax attributes of the target business do not move to the acquiring company. These tax attributes include NOLs (net operating losses) and tax credit carryovers. The fair value of your acquired net assets is recorded for GAAP and IRS tax purposes. However, there can be differences between tax and GAAP in determining the fair value or allocating value between these liabilities and assets. The differences between the tax and book bases require you to record deferred taxes for your assets and liabilities.
Additional deferred tax consequences may arise due to the acquired business’ footprint on state, federal, and foreign tax filings. Companies record subsequent changes in deferred taxes to current operations, not to purchase accounting.
What Business Acquisitions are Nontaxable?
In most nontaxable business combinations, the acquiring company purchases the target company’s stock. Nontaxable stock acquisitions do not produce goodwill that is tax-deductible.
In a stock acquisition, the acquired company usually retains tax attributes like tax credit carryovers and NOLs. The acquiring entity should document any applicable deferred taxes for these assets. However, under Section 382, the company may be limited or barred from using tax attributes from before the acquisition date to offset taxable income acquired after the merger.
A company may sometimes be allowed to elect to treat a stock acquisition as an asset acquisition. If a company makes such an election, its purchase accounting and related deferred taxes should reflect the fair value tax basis based on that election and be accounted for as a taxable business combination.
Deferred Tax Assets and Liabilities and Goodwill in a Business Combination
Goodwill, an intangible asset associated with business combinations, refers to the leftover value of a company’s acquired net assets. This includes any deferred tax liabilities (DTLs) and deferred tax assets (DTAs).
To calculate the impact of tax assets and liabilities on goodwill, companies must consider:
- Uncertain tax positions. Before a company can calculate goodwill, it must record and evaluate any uncertain or acquired tax positions that exceed the recognition threshold by the acquisition date.
- Valuation allowances. The company must also assess the need for valuation allowances (VAs) against any deferred tax assets acquired as of the acquisition date. Recording VAs will generally increase goodwill. However, if a company changes its judgment about needing a VA against its deferred tax assets, increases or decreases must be recorded within continuing operations under income tax expense.
ASC 740 Accounting with Windes
ASC 740 inaccuracies and noncompliance are a leading cause of many businesses’ financial restatements and material weaknesses. Failure to comply with ASC 740 guidelines can damage your company’s reputation.
Windes’ expert tax accountants can help address tax reporting issues that may result from business combinations. Our experienced tax professionals have specialized technical knowledge across multiple industries and will work to ensure that your income tax reporting is accurate and ASC 740 compliant.
Let our team of experts help you navigate this complicated but critical process. Connect with us today.