Tax and Financial Reporting Differences in an Allocation of Purchase Price

In a corporate transaction different requirements exist for the allocation of purchase price according to U.S. GAAP and U.S. federal tax codes. In this issue of the Tax Insight, we provide an overview of the key differences between valuations for tax and financial reporting purposes.

Some may think that the purchase price is the same for tax and financial reporting. However, factors such as contingent consideration, transaction costs, and accrued liabilities generally result in a different purchase price for tax and financial reporting purposes.

The following chart outlines the purchase price differences under U.S. GAAP and Internal Revenue Code rules:

Fair Value vs. Fair Market Value

One of the key differences in valuations for tax vs. financial reporting lies in the definition of value. Those on the financial reporting side use the fair value standard mandated in Accounting Standards Codification (ASC) 820 (formerly Statement of Financial Accounting Standards (SFAS) 157, Fair Value Measurements). ASC 820 contains the following key concepts:

  • Price is measured using all assumptions market participants would use.
  • Market participants are buyers and sellers in the principal market who are independent of the reporting entity, knowledgeable, have the ability to transact and are willing to transact.

For tax reporting, the standard of value is fair market value, which assumes a hypothetical transaction between a willing buyer and a willing seller. While the standard of value is similar for book and tax purposes, to the extent an asset is valuable to a market participant it must be recorded at fair value for book purposes. Therefore, in certain situations, the valuation may encompass defensive assets and assets that may not be used by the acquirer.

Allocation

For financial reporting purposes, the purchase price is allocated at the reporting unit level. However, for tax reporting, the allocation is performed at the legal entity level.

Under Accounting Standards Codification (ASC) 805 (formerly SFAS No. 141 and 141R), an acquirer must recognize any assets acquired and liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at fair value as of that date. Assets most commonly meeting the identification criteria include tangible assets, such as real and personal property, and intangible assets, such as trademarks, technology and customer relationships. Intangible assets with finite lives are amortized over their useful lives, while indefinite-lived intangibles (like goodwill) are not amortized but, rather, tested for impairment.

Under Internal Revenue Code (IRC) Section 1060, the purchase price must be allocated to the assets under the residual method per IRC Section 338(b)(5). The purchase price is allocated, in order, to each of the following classes (listed below with examples of the types of assets included in the class), based on the value of the assets:

  • Class I: Cash and cash equivalents
  • Class II: Actively traded personal property (or_Section 1092(d)), certificates of deposit, and foreign currency
  • Class III: Accounts receivables, mortgages, and credit card receivables
  • Class IV: Inventory
  • Class V: All assets not in classes I – IV, VI and VII (equipment, land, building)
  • Class VI: Section 197 intangibles, except goodwill and going concern
  • Class VII: Goodwill and going concern

Section 197 of the IRS tax code requires straight-line amortization of all intangible assets (including goodwill) over 15 years only in the following transactions:

  • Asset acquisition or
  • Stock acquisition with a Section 338 election.

Intangible assets are not amortized for tax purposes in stock acquisitions absent a Section 338 election.

Our valuation specialists are experienced in purchase price engagements for both tax and book purposes. For more information contact your VRC representative.