Chief Counsel Provides Guidance on Allocating Acquisition-Related Costs

By Bruce Feinstein, CPA, J.D., LL.M., and Adam Cupersmith, CPA, J.D., LL.M., ParenteBeard LLC, Philadelphia

Editor: Anthony S. Bakale, CPA, M. Tax.

Consolidated Returns

The IRS Office of Chief Counsel released Advice Memorandum 2012-010, which discusses how certain acquisition-related transaction costs should be allocated between short tax periods when a target corporation (the terms “target” or “subsidiary” are used interchangeably as the context requires) joins a consolidated group. The advice memorandum considers the following three deduction items: (1) The target’s nonqualified stock options and stock appreciation rights (SARs) vest on the date of a change in control; (2) the target’s financial advisory and investment banking fees incurred in connection with the acquisition become fixed and determinable on the date of a change in status; and (3) the target’s debt is retired at a premium after closing on the acquisition date. To aid understanding of the guidance in the advice memorandum, this item briefly summarizes some of the relevant rules that govern the tax years of subsidiaries that join or leave a consolidated group.

Tax Year of Consolidated Group Members

As a general matter, Regs. Sec. 1.1502-76(b)(1)(i) provides that a consolidated group’s tax return includes the common parent’s items of income, gain, deduction, loss, and credit for the entire consolidated return year. However, the group’s return includes a subsidiary member’s items only for the portion of the year during which it is a member of the group. The subsidiary member’s items that are not included in the group’s return must be included in a separate return (including the consolidated return of another group). Specific rules govern the allocation of such items to avoid their duplication or elimination.

End-of-the-day rule and exceptions: Under Regs. Sec. 1.1502-76(b)(1)(ii)(A)(1), if a target becomes or ceases to be a member of a consolidated group during a tax year, its status as a group member begins or ends at the end of the day on which the change occurs. The target’s tax year ends for all federal income tax purposes at the end of the change date. The regulations also require that appropriate adjustments be made, such as the restoration of intercompany transaction items or excess loss accounts.

Special rules apply when an S corporation becomes a member of a consolidated group. Under Regs. Sec. 1.1502-76(b)(1)(ii)(A)(2), except where the S corporation becomes a member through a qualified stock purchase with a Sec. 338(g) election in place, an S corporation becomes a member of the consolidated group at the beginning of the day that includes the acquisition, and its tax year ends for all federal income tax purposes at the end of the day preceding the acquisition. This rule prevents the acquired S corporation from having a one-day tax year for the date of acquisition for which it would be required to file a return.

Next-day rule: In certain situations, the regulations acknowledge, strict application of the end-of-the-day rule makes little sense. In such cases, the regulations prescribe a next-day rule. Regs. Sec. 1.1502-76(b)(1)(ii)(B) provides that if, on the day of a subsidiary’s change of status as a member of the group, a transaction occurs that is properly allocable to the portion of that day after the event resulting in the subsidiary’s change of status, then the subsidiary and all related persons (within the meaning of Sec. 267(b)) must treat the transaction as occurring at the beginning of the following day. The regulations provide some leeway when applying the next-day rule, provided that the treatment is reasonable and consistently applied by all affected persons. The following factors, among others, are considered when making such determinations: (1) whether the items are inconsistently allocated to maximize a seller’s Regs. Sec. 1.1502-32 consolidated investment stock basis; or (2), in cases where the transaction causes the subsidiary to affiliate or disaffiliate, whether the applicability of certain special consolidated tax return rules require that the tax consequences associated with the transaction be viewed as occurring while the subsidiary is still a member of the group.

For example, if a member transfers encumbered property to a nonmember target that results in the target’s becoming a member of the group, will Sec. 357(c) apply? If the next-day rule is applied, Regs. Sec. 1.1502-80(d) “turns off” Sec. 357(c), and the subsidiary’s consolidated Regs. Sec. 1.1502-32 investment basis is reduced to the extent of assumed liabilities, possibly resulting in a Regs. Sec. 1.1502-19 excess loss account. On the other hand, if a subsidiary is a member but becomes a nonmember as a result of a stock redemption using appreciated property, the subsidiary’s Sec. 311(b) gain is treated as occurring before the deconsolidation event.

Ratable-allocation election: Regs. Sec. 1.1502-76(b)(2)(ii) permits affected groups to make an election to allocate certain items between periods on a pro rata basis. However, so-called extraordinary items may not be ratably allocated. A detailed discussion of these rules is beyond the scope of this item; however, the ratable allocation rule and the ex traordinary item exception are briefly touched on below.

Advice Memorandum 2012-010

Advice Memorandum 2012-010 discusses how Regs. Sec. 1.1502-76 should be applied when determining the short tax year in which a target should report certain deduction items with respect to liabilities that the target incurs on the date it joins or leaves a group. The deduction items considered are (1) the target’s nonqualified stock options and SARs that vested on the date of a change in control; (2) the target’s financial advisory and investment banking fees that were incurred in connection with the acquisition and that became fixed and determinable on the change in status date; and (3) outstanding target debt that was retired at a premium on the acquisition date but after the closing.

The advice memorandum presented the following facts: Acquiring is the common parent of a consolidated group (Acquiring Group). On Nov. 30, 201X, a member of Acquiring Group effected a reverse subsidiary taxable cash merger with Target, with Target being the surviving company. The Target shareholders received cash in exchange for their Target stock. Pursuant to Rev. Rul. 90-95, the transaction is treated as a purchase of Target stock. A Sec. 338 election is not made. Acquiring Group and Target are calendar-year corporations. The advice memorandum assumes that each of the three items listed above is deductible by Target on Nov. 30, 201X, the acquisition date. The Regs. Sec. 1.1502-76 treatment of each item is discussed below.

Item 1. Stock options and SARs: At the time of the acquisition, Target had outstanding nonqualified stock options and SARs issued to certain employees. The options did not have a readily ascertainable fair market value within the meaning of Regs. Sec. 1.83-7. In addition, neither the options nor the SARs provided for deferred compensation within the meaning of the Sec. 409A regulations. Under the terms of Target’s agreements with its employees, Target was obligated to pay the employees certain amounts for their stock options and SARs in the event of a change in control. Acquiring Group’s purchase of the Target stock constituted a change of control that obligated Target to pay its employees under the stock option and SAR agreements. Hence, Target’s obligation to make such payments became fixed and determinable on the acquisition date. Target paid its employees a few days after the acquisition date using its own funds or funds provided by other members of Acquiring Group.

Item 2. Target’s financial advisory and investment banking fees: Target engaged financial advisory and investment banking firms to provide consulting services for Target in connection with the acquisition. Target’s obligation to pay for these services was contingent upon the successful closing of the acquisition, at which time these fees became fixed and determinable.

Item 3. Target debt retired at a premium: In contemplation of the acquisition, Acquiring Group requested that Target retire some of its outstanding debt. Prior to the acquisition date, Target and Acquiring Group agreed that Target would make a nonbinding tender offer to its bondholders to tender their bonds for redemption at an amount that exceeded Target’s adjusted issue price. Under the terms of the tender offer, the bondholders could tender their bonds to Target (or, having done so, could withdraw their tender) on or before the acquisition date, but Target was not obligated to accept the tendered bonds. On the acquisition date but after closing, Target accepted the tendered bonds for redemption. Later that same day, Target retired the tendered bonds at a premium using its own funds or funds received from Acquiring Group.

Analysis: Target became a member of Acquiring Group at the end of the day on the acquisition date, Nov. 30, 201X. Pursuant to Regs. Sec. 1.1502-76(b)(1)(ii)(A)(1), the last day of Target’s tax year as a stand-alone C corporation was the acquisition date. Consequently, Target had two short tax years during 201X. The first year (a separate return year) began on Jan. 1, 201X, and ended on Nov. 30, 201X. The second tax year (as a member of Acquiring Group) began on Dec. 1, 201X, and ended on Dec. 31, 201X. As a threshold matter, the advice memorandum noted that the proration election described in Regs. Sec. 1.1502-76(b)(2)(ii)(B)(1), which permits subsidiaries that join or leave a group to prorate certain items between the two short years, did not apply with respect to the three deduction items described above because they were extraordinary items.

Items 1 and 2. End-of-the-day rule: The advice memorandum noted that Target’s deduction items relating to (1) its nonqualified stock options and SARs vested on the acquisition date and (2) its financial advisory and investment banking fees that were incurred in connection with the acquisition became fixed and determinable on the acquisition date. The advice memorandum reasoned that it would be inappropriate to apply the next-day rule to these items because they did not arise with respect to a transaction involving Target’s stock, even though the consummation of the acquisition fixed Target’s obligation to pay the deduction items. Instead, both items related to transactions that preceded the acquisition date and to services provided by Target’s employees and consultants. Accordingly, the advice memorandum concluded that it would not be reasonable or appropriate to allocate these items to Target’s post-closing period. Hence, both items should be allocated to Target’s preclosing short-period tax return pursuant to the end-of-the-day rule.

Item 3. Next-day rule: In contrast to its conclusions regarding Items 1 and 2, the advice memorandum commented that Target’s deduction item relating to its retirement of the tendered bonds at a premium on the acquisition date but after the closing could properly be allocated to Target’s post-closing short period under the next-day rule. The advice memorandum reasoned that the deduction item arose as a result of Target’s post-closing decision made on the acquisition date. Although not expressly mentioned, a relevant consideration may have been that Target retired its bonds at the request of Acquiring Group.

Planning Opportunity

Although the advice memorandum may not be cited as legal precedent, it provides some insight into the IRS’s view on how certain deduction items should be allocated between short tax periods when a subsidiary joins or leaves a consolidated group. Unfortunately, the practical utility of the advice memorandum is somewhat limited because the facts associated with the deduction items were somewhat contrived, particularly with respect to the application of the next-day rule. Nevertheless, practitioners and taxpayers may be able to optimize the application of the Regs. Sec. 1.1502-76 rules with careful planning.


Anthony Bakale is with Cohen & Co. Ltd., Baker Tilly International, Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.

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