Tax implications of FASs 141 and 142.

With the enactment of Sec. 197 in 1993, over 200 types of intangible assets claimed by taxpayers as separable from then-nondeductible goodwill (and therefore arguably amortizable for tax purposes) were rolled into 15-year tax goodwill.

In 2001, the Financial Accounting Standards Board (FASB) resurrected 30 categories of goodwill and intangibles for financial accounting purposes.

The FASB noted the difficulty in comparing the financial results of entities, because the entities used different methods of accounting for business combinations. The need for better information about intangible assets is growing, as those assets are an increasingly important economic resource for many entities and are an increasing proportion of the assets acquired in many business combinations.

Financial Accounting Statement (FAS) No. 141, Business Combinations, addresses financial accounting and reporting for business combinations and supercedes Accounting Principles Board (APB) Opinion 16 rules on purchase and pooling accounting. All business combinations within the scope of FAS 141 are to be accounted for using the purchase method.

FAS No. 142, Goodwill and Other Intangible Assets, addresses financial accounting and reporting for acquired goodwill and other intangibles and supercedes APB Opinion 17.

An understanding of the accounting treatment of acquisitions under FAS 141 and 142 and how those provisions compare to the corresponding tax accounting treatment under the Code is important.

Acquisitions Measured at FMV 

Like other exchange transactions, acquisitions are measured in general on the basis of the fair market values (FMVs) of the exchanged or acquired properties. For Federal income tax purposes, this same concept is found in Sec. 1001. Generally, the cost or amount realized in an exchange equals the cash received plus the FMV of the property received. If that value cannot be determined with reasonable accuracy, the amount received would be based on the value of the property given up.

Allocation of Cost to Individual Assets

General guidance for assigning amounts to assets acquired and liabilities assumed, except goodwill, is provided in FAS 141. Under FAS 141, acquired assets are placed into groups and the cost of those asset groups ascertained. The purchase price of an asset group must then be allocated among the assets within the group. For Federal income tax purposes, the same concept is applied in a taxable asset acquisition under Sec. 1060, which requires that the purchase price be allocated to seven categories under the residual method. The residual method requires the FMV of each group to be established and the purchase price to be allocated to the first six groups in a hierarchy up to the group's FMV. Any unallocated purchase price is allocated to the final group, goodwill/going concern value. The allocation is reported on Form 8594, Asset Acquisition Statement. The Service issued final regulations, effective March 16, 2001.

Accounting for the Assets

An asset's nature and not the manner of its acquisition determines an acquiring entity's subsequent accounting for the asset. For Federal income tax purposes, the manner of acquisition determines an acquiring entity's subsequent accounting for the asset. In a taxable asset acquisition, purchase price is allocated to assets under Sec. 1060 and individual assets are assigned a cost basis under Sec. 1012.

In a taxable stock acquisition, there is no revaluation of the assets, because they continue to be held by the acquired entity, unless the buyer elects under Sec. 338 to treat the taxable stock acquisition as an asset acquisition. In a tax-free asset or stock acquisition, there is a carryover basis in the assets acquired under Sec. 362.

Acquisition of a Business

A business combination occurs when an entity acquires net assets that constitute a business or equity interests of one or more other entities and obtains control over that entity or entities. Control is generally indicated by ownership by one company (directly or indirectly) of over 50% of the outstanding voting shares of another company For Federal income tax purposes, the same concept applies to applicable asset acquisitions under Sec. 1060(c). However, in a tax-free acquisition or a deemed sale under Sec. 338, control requires an 80% ownership level; generally, in a tax-free transaction, the control must be direct.

Joint Ventures Are Not Business Combinations

For purposes of FAS 141, the formation of a joint venture is not a business combination. For Federal income tax purposes, the formation of a joint venture generally is tax free under Sec. 721.

Types of Business Combinations

A business combination may include (1) one or more entities merging or becoming subsidiaries, (2) one entity transferring net assets or its owners transferring their equity interests or (3) all entities transferring net assets or the owners transferring their equity interests to a newly formed entity. For Federal income tax purposes, these transactions are described as types of tax-free reorganizations in Sec. 368, or may be structured as taxable transactions.

Identification of the Acquiring Entity

Application of the purchase method requires' the identification of the acquiring entity.

In a business combination effected solely through the distribution of cash or other assets or by incurring liabilities, the entity that makes such distributions is generally the acquiring entity. In a business combination effected through an exchange of equity interests, the entity that issues the equity interests is generally the acquiring entity. In a reverse acquisition, the acquired entity issues the equity interests. For Federal income tax purposes, the same concept is applied in Regs. Sec. 1.1502-75(d)(3).

Assumption of the Acquired's Name by Acquirer

In some business combinations, the combined entity assumes the name of the acquired entity. For Federal income tax purposes, the same concept is applied in Sec. 368(a)(1)(F).

Costs of the Business Combination

The cost of an entity acquired in a business combination includes the direct costs of the business combination, which include "out-of-pocket" or incremental costs directly related to a business combination (such as a finder's fee and fees paid to outside consultants for accounting, legal or engineering investigations or for appraisals). Internal costs associated with a business combination are expensed as incurred. For Federal income tax purposes, the Eighth Circuit concluded in Wells Fargo, 224 F3d 874 (8th Cir. 2000), that salaries were deductible ordinary expenses. In addition, costs related to unsuccessful negotiations also are expensed as incurred.

Indirect and general expenses related to business combinations are expensed as incurred. For Federal income tax purposes, transaction costs generally are discussed in Rev. Rul. 99-23 and categorized into the following components:

* Ordinary and necessary business expenses, currently deductible under Sec. 162;

* Abandonment of alternative transaction plans, currently deductible under Sec. 165;

* Exploratory and start-up costs, currently deductible (if the acquirer is already in the same business as the acquired entity) or amortizable under Sec. 195;

* Organization costs, amortizable under Sec. 248; and

* Capitalizable costs, includible in basis under Sec. 263.

Equity Registration and Issuance Costs

Costs of registering and issuing equity securities are recognized as a reduction in the securities' otherwise determinable FMV. For Federal income tax purposes, the same concept is applied in Rev. Rul. 69-330.

Contingent Consideration

A business combination agreement may provide for the issuance of additional shares of a security or the transfer of cash or other consideration contingent on future specified events or transactions.

Consideration issued or issuable at the expiration of the contingency period or held in escrow pending the outcome is disclosed but not recorded as a liability or shown as outstanding, unless the outcome of the contingency is determinable beyond a reasonable doubt. The contingent consideration usually should be recorded when the contingency is resolved and consideration is issued or becomes issuable.

In general, the issuance of additional securities or the distribution of other consideration on the resolution of contingencies based on earnings results in an additional element of cost of an acquired entity. In contrast, the issuance of additional securities or the distribution of other consideration at resolution of contingencies based on securities prices does not change the recorded cost of an acquired entity.

Amounts paid to an escrow agent representing interest and dividends on securities held in escrow are accounted for according to the accounting for the underlying securities.

For Federal income tax purposes, Rev. Proc. 84-42 provides guidance on contingent consideration.

A tax reduction resulting from imputed interest on contingently issuable shares reduces the FMV recorded for contingent consideration based on earnings, and increases additional capital recorded for contingent consideration based on security prices.

If the substance of the agreement for contingent consideration is to provide compensation for services, use of property or profit-sharing, the additional consideration given would be recognized as an expense of the appropriate periods. For Federal income tax purposes, this may be challenged as a disguised purchase price, as highlighted in Regs. Sec. 1.1060-1(c)(4).

Acquisition Date

The date of acquisition ordinarily is the date assets are received and other assets are given, liabilities are assumed or incurred or equity interests are issued.

For convenience, the parties may designate as the effective date the end of an accounting period between the dates a business combination is initiated and consummated.

For Federal income tax purposes, the closing date in a stock acquisition generally is the end of the day that control is obtained, pursuant to Regs. Sec. 1.1502-75(b)(ii)(A).

Goodwill Impairment

Under FAS 142, goodwill and intangible assets with indefinite useful lives will not be amortized, but rather will be tested at least annually for impairment. An impairment loss would be recognized if the carrying amount of an intangible asset is not recoverable and the carrying amount exceeds its FMV. Subsequent reversal of a previously recognized impairment loss is prohibited. Impairment charges recorded for financial reporting purposes will not be deductible for tax purposes. However, if the assets are acquired in a taxable transaction that qualifies as the acquisition of a trade or business, under Sec. 197 the acquired intangibles would be amortized over a 15-year period under Sec. 197.

Conclusion

An understanding of the financial accounting for goodwill and other intangibles is critical for tax advisers to properly adjust book income to taxable income when the financial accounting rules differ from those for tax purposes. For tax purposes, goodwill is created only in taxable asset acquisitions. For financial accounting purposes, goodwill will be recognized anytime a premium is paid in a business combination.

FROM MARK A. SELLNER, MANAGING PRINCIPAL--TAX SERVICES, LARSON, ALLEN, WEISHAIR & CO., LLP, MINNEAPOLIS, MN