Editor: Mark G. Cook, CPA, CGMA
Determining when accrued liabilities are deductible is often complicated in the normal course of business, let alone during merger-and-acquisition (M&A) transactions. For cash-method taxpayers, the rules are straightforward — liabilities are typically deductible in the tax year in which they are paid. For accrual-method taxpayers, however, the rules are a bit more complicated. Under Sec. 461, the liability is generally deductible in the tax year in which the three prongs of the “all events” test have been met: (1) all the events have occurred that establish the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred with respect to the liability (Regs. Sec. 1.461-1(a)(2)).
After describing the all-events test in more detail, this item discusses the rules for deducting accrued liabilities in M&A transactions and then provides an illustration by looking at a recent IRS technical advice memorandum.
Three-pronged all-events test
In the first prong of the all-events test, the fact of the liability must be established. Generally, this condition is satisfied when (1) the event fixing the liability occurs, whether that be the required performance or other event, or (2) payment therefore is due, whichever happens earlier (Regs. Sec. 1.461-1(a)(2) and Rev. Rul. 2007-3). It is important to note that the mere execution of a contract is generally not enough to satisfy the fact of a liability.
In the second prong of the all-events test, the amount of the liability must be determined with “reasonable accuracy.” Thus, taxpayers generally do not need to establish the exact amount of a liability for it to be deductible in a given tax year. If an exact amount cannot be determined, this will generally not prevent a taxpayer from taking into account that portion of the amount of the liability that can be computed with reasonable accuracy within the tax year.
Example 1: A renders services to B during the tax year, for which A charges $10,000. B admits a liability to A for $6,000 but contests the remainder. B may take into account only $6,000 as an expense for the tax year in which the services were rendered. (This example is taken from Regs. Sec. 1.461-1(a)(2)(ii).)
In the third and final prong of the all-events test, economic performance must occur with respect to the liability. A detailed analysis of this requirement is beyond the scope of this discussion. In general, the determination of when economic performance occurs depends upon the type of liability at hand, as there are different rules for different types of liabilities. For example, economic performance generally occurs once payment has been made for liabilities including (but not limited to): workers’ compensation, torts, breaches of contract, violations of law, rebates and refunds, awards, prizes, jackpots, insurance, warranties, etc. (Regs. Sec. 1.461-4(g)). For other types of liabilities, however, including (but not limited to) accrued compensation, taxes, services, rent, interest, etc., the determination of when economic performance occurs may be governed by other various Internal Revenue Code sections and/or Treasury regulations. These special rules are beyond the scope of this discussion. It is important to note that the general economic performance rules do not override other Code sections that specifically dictate the timing of when certain items may be deductible.
Deducting liabilities in M&A transactions
Turning now to M&A transactions, the determination of when accrued liabilities are deductible can be even more delicate because these transactions generally have lots of moving pieces. Frequently, buyers will assume certain liabilities (often, working capital liabilities). In a taxable asset acquisition (or a taxable stock acquisition treated as an asset acquisition for income tax purposes), the purchase price is generally increased by the amount of liabilities assumed by the buyer, pursuant to Regs. Sec. 1.1001-2. From the seller’s perspective, the amount realized is also increased, which, in turn, increases the seller’s taxable gain on the sale of assets. Consider the following situation involving accrued liabilities in an M&A transaction.
Example 2: Company A has assets with a fair market value (FMV) of $10 and liabilities of $4 as of the most recent balance sheet date. If a buyer acquires all the assets of Company A without assuming Company A’s liabilities, then the buyer would have a basis in the assets acquired of $10 (the FMV of Company A’s assets), and Company A, as the seller, would have an amount realized of $10. Company A would use $4 of the $10 to pay off its liabilities, resulting in ending cash of $6.
Continuing with the above example and modifying the facts, if the buyer acquires all the assets of Company A while also assuming Company *A’*s liabilities, the result would generally be the same. The purchase price in this case would be $6 (since the buyer is assuming $4 of liabilities); however, for income tax purposes, the purchase price would be adjusted to $10 ($6 of cash paid by the buyer to the seller, plus $4 of liabilities assumed by the buyer). Company A as the seller would have an amount realized of $10 and ending cash of $6, which is the same as in the original example.
The question of note is: Assuming the $4 of liabilities are deductible liabilities (such as accounts payable), who is entitled to claim this deduction — the buyer or Company A as the seller? In the original example, the buyer did not assume the liabilities. Thus, when Company A receives $10 of cash from the sale of its assets, it would presumably pay off the $4 of liabilities and receive a deduction for this amount. In the modified example, however, the buyer assumed the $4 of liabilities. Even in this instance, the seller would normally receive this deduction pursuant to Sec. 461. This is because, although the seller does not actually satisfy the liabilities by making direct payments to the ultimate obligees, by accepting less cash than it otherwise would have received in exchange for assumption of liabilities, it effectively paid the liabilities at the time of sale (see Commercial Security Bank, 77 T.C. 145 (1981)).
Though this may seem straightforward at first, in practice, determinations in M&A transactions involving accrued liabilities can be much more complicated. The nature of specific liabilities being assumed by buyers should be carefully reviewed as well as the application of the all-events test and economic performance rules pursuant to Sec. 461 to determine the timing of these types of deductions and whether these items can be deducted by buyers or sellers. In some cases, the economic performance requirement may not be met until sometime in the future, and, therefore, the buyer may not be able to benefit from increased basis until economic performance occurs. Every M&A transaction will have its own set of facts and circumstances that should be carefully reviewed to ensure proper tax accounting treatment.
A recent technical advice memorandum (TAM) illustrates the type of issues that can arise in the M&A context. In TAM 202116012, the IRS considered whether a subsidiary company could deduct product liabilities as part of a deemed acquisition by its parent company.
An insolvent corporation that was part of a consolidated group had converted to a limited liability company (LLC) by making a “check the box” election. Upon the conversion, the company was classified for U.S. federal income tax purposes as a disregarded entity, and, therefore, all of its assets and liabilities were deemed to be acquired by its parent (the sole owner of the company). At the time of the conversion, the company had entered into master settlement agreements (MSAs) with various groups of claimants to resolve certain product claims. Upon converting to an LLC, the company included the fixed and determinable portion of the settled MSA liabilities in its amount realized on the deemed liquidation event and deducted these amounts under Regs. Sec. 1.461-4(d)(5).
The case focused on whether the parent company had assumed the company’s liabilities such that the economic performance standard was met for the subsidiary to deduct the liabilities. The IRS held that since the company was insolvent at the time of the check-thebox election, the parent must be treated as purchasing the company’s assets and either assuming the liabilities (the case if the shareholder is directly liable to the claimants) or taking the assets subject to the liabilities (where the shareholder is not directly liable to the claimants). As such, the company could deduct the amount of product liabilities because economic performance was satisfied under Regs. Sec. 1.461-4(d)(5).
Determining the deductibility and timing of accrued liability deductions in M&A transactions can be complicated, depending upon the nature of liabilities at hand, the application of the all-events test, and other factors. It is often prudent to have the purchase/sale agreement identify such liabilities and the parties’ intended tax treatment with respect to the assumption of liabilities. This, along with careful consideration and planning, can help ensure the parties to a transaction can claim rightful deductions for accrued liabilities that may exist when a transaction closes.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif. For additional information about these items, contact Mr. Cook at 949-623-0478 or email@example.com. Contributors are members of or associated with SingerLewak LLP.