Accounting for Transaction Costs and
Earn-outs in M&A
Daniel Lundenberg, Grant Thornton LLP (Canada) and Brice Bostian, Ernst & Young
This Note provides an overview of certain key financial accounting (book) and US federal income tax (tax)
considerations when accounting for M&A transactions.
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This Note provides an overview of certain key financial accounting
(book) and US federal income tax (tax) considerations when
accounting for business combinations. A business combination
generally is a transaction or an event in which an acquiror obtains
control of one or more businesses, including the acquisition of:
„„All
of the outstanding stock of one company by another
company.
„„All
of the assets of a division or line of business of one
company from another company.
This Note discusses the general book and tax treatment of:
„„Transaction
„„Contingent
costs.
consideration (specifically, earn-outs).
For more information about earn-outs, see Practice Note, Earnouts (http://us.practicallaw.com/0-500-1650) and Standard
Clause, Purchase Agreement: Earn-out with EBITDA Targets
(http://us.practicallaw.com/2-501-7344).
BOOK AND TAX ACCOUNTING FOR TRANSACTION COSTS
Both buyers and sellers incur various costs in connection with a
business combination. These costs can include:
„„Professional
fees (for example, legal, accounting and
investment banking fees).
„„Regulatory
and filing fees.
„„Transaction
financing fees.
There can be a significant difference between book and tax when
accounting for these transaction costs. In fact, there can be a
divergence of desired results between the accountants and tax lawyers:
„„For
tax purposes, transaction costs are currently deductible or
capitalized to the basis of the acquired stock or assets, or both.
„„For
book purposes, different rules apply for expensing or
capitalizing depending on the type of transaction cost.
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Often, tax lawyers want current deductibility for transaction costs
because this generates a current tax deduction that can be used
to offset taxable income. However, accountants often want longterm capitalization of the same expenses (instead of a current
book expense) because a current book expense can result in an
immediate negative impact to the earnings per share charge.
Book Tax versus Cash Tax
The tax treatment of transaction costs and the book treatment
under FAS Statement 141(R) (FAS 141(R)) can be different and
can have a meaningful effect on taxpayers depending on whether
they focus on:
„„Book
tax, which is the company’s financial accounting that
affects earnings per share and effective tax rate.
„„Cash
tax, which is the total of actual cash that is owed to
various jurisdictions that affects after-tax cash flows.
Generally, large publicly traded companies tend to focus on book
tax because earnings per share figures are meaningfully impacted
by this figure. However, portfolio companies owned by private
equity funds often focus on the company’s cash tax because this
figure impacts the after-tax cash flows. The areas of a particular
company’s focus do not always fit into these broad categories.
Accounting and tax advisors must consider the business and
other objectives of their particular client when considering how
best to balance the book tax and cash tax effect of business
combinations.
Tax Treatment of Transaction Costs
For tax purposes, transaction costs generally are allocated to:
„„Costs
that are deductible (see IRC §§ 162 & 165; Deductible
Costs).
„„Costs
required to be capitalized (see IRC § 263; Capitalized
Costs).
Deductible Costs
The tax rules specify that certain business costs can be deducted
currently. For example, IRC Section 162 allows a current
deduction for ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or business.
These include ordinary and necessary expenses taxpayers incur
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Accounting for Transaction Costs and Earn-outs in M&A
to improve and expand their existing business as part of the active
conduct of their trade or business. In addition, IRC Section 165
permits a deduction for losses sustained during the taxable year
that are not reimbursed by insurance or otherwise.
the capitalized costs as a loss under IRC Section 165 when the
transaction is abandoned (see Deductible Costs). In addition,
certain capitalized costs can be recovered through depreciation or
amortization deductions.
When a taxpayer considers transactions for a specific business
purpose, it often incurs legal, accounting and investment banking
costs to analyze various options. Although only one of these
options is ultimately accepted, the facts and circumstances
surrounding these costs must be analyzed to determine if a
portion of these costs are:
Depending on the investment and business objectives of the
particular taxpayer, the time value of money benefit of the tax
deduction may be significantly (or completely) diminished if
required to be capitalized and recovered over several years. For
example, private equity investors typically purchase companies
with a five-year investment horizon. If a deduction for transaction
costs is unavailable within that investment horizon, the investor
may never receive the cash benefit from it. However, the private
equity investor may seek to recover some of the tax benefit
through commercial means in their negotiations on exit (for
example, as an increase in the sales price for future tax benefits
that a buyer can expect to receive).
„„Allocable
to the rejected option or options so properly
characterized as a currently deductible IRC Section 165 loss.
„„Allocable
to the pursued option so required to be capitalized
into the basis of the acquired stock or assets (see Capitalized
Costs).
Capitalized Costs
Special Rules for Success-based M&A Fees
Costs that would otherwise be deductible are not currently
deductible if considered a “capital expenditure.” Generally, a
capital expenditure is a cost that yields future benefits to the
taxpayer’s business (see IRC § 263).
The issue of how to treat success-based fees paid in connection
with an M&A transaction has been the subject of controversy
between the IRS and taxpayers. In 2011, the IRS issued Revenue
Procedure 2011-29, which provides a safe harbor election
for companies to currently deduct success-based fees paid
in connection with specified business acquisitions (including
mergers, asset purchases and acquisitions of majority interests
in target companies). Success-based fees are contingent on the
closing of an acquisition or merger and often include investment
banker fees.
Costs incurred by an acquiring taxpayer while investigating
or otherwise pursuing a transaction may be required to be
capitalized under IRC Section 263. This means the costs are
not currently deductible. Instead, these costs are added to the
basis of the acquired stock or assets and recovered over several
tax years (generally, the depreciable or amortizable life of the
underlying property).
Under the Revenue Procedure, a company can elect to deduct
70% of a success-based fee related to a particular transaction and
must capitalize the remaining 30%. By contrast, existing treasury
regulations generally require a company to capitalize successbased fees unless it maintains adequate documentation (such
as time records) to support a deduction for the portion of the fee
allocable to activities that do not “facilitate” the acquisition (for
example, bankers’ fees for investigating a transaction prior to the
date the company decided to proceed with the acquisition). Under
the new safe harbor election, a company does not need to maintain
this documentation to deduct 70% of the success-based fees.
The tax rules generally require taxpayers to capitalize amounts
paid in the process of investigating or otherwise pursuing each of
the following transactions (regardless of whether the transaction
is carried out in a single step or a series of steps that are part of a
single plan):
„„An
acquisition of assets that constitute a trade or business.
„„An
acquisition of an ownership interest in a business entity.
„„An
acquisition of an ownership interest in the taxpayer.
„„A
restructuring, recapitalization or reorganization of the capital
structure of a business entity.
Whether an amount is paid in the process of investigating or
otherwise pursuing the transaction depends on all of the facts
and circumstances of the transaction. For example, in auction
scenarios when a company has multiple bidders, much of the
transaction costs of bidders before the selection of the winning
bidder (known as the bright-line date) generally can be currently
deducted, rather capitalized. Costs incurred before the brightline date generally are not considered inherently facilitative for
purposes of investigating or otherwise pursuing a transaction and
are currently deductible.
Book Treatment of Transaction Costs
While certain costs incurred in investigating or otherwise pursuing
a transaction may be required to be capitalized even if the
transaction never occurs, a taxpayer may able to currently deduct
For book purposes, transaction costs are not part of the fair value
of the exchange between the buyer and seller for the acquired
business. As a result, direct and indirect transaction costs are
Copyright © 2012 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved.
For book purposes, transaction costs are categorized as:
„„Direct
costs (costs for services of lawyers, investment bankers,
accountants and others).
„„Indirect
costs (certain recurring internal costs, for example,
the cost of maintaining a corporate development or planning
department).
„„Financing
costs (costs to issue debt or equity instruments used
to effectuate the transaction).
2
costs that are capitalized for tax purposes are generally included
in the basis of the acquired stock or assets (for example, an
inclusion in tax deductible goodwill) and could result in a deferred
tax liability to the extent that it is deducted for tax but not book
purposes. If the transaction is a non-taxable stock acquisition (for
example, a stock for stock type B reorganization), the transaction
costs that are capitalized for tax purposes do not result in a
deferred tax asset or liability because no future tax deduction is
reasonably expected. Although a reduced gain on a future sale
may be expected, these generally are not recorded as temporary
book or tax differences that would create a deferred tax asset
or liability. For more information about tax-free reorganizations,
see Practice Note, Tax-Free Reorganizations: Acquisitive
Reorganizations (http://us.practicallaw.com/0-386-4212).
not accounted for as part of the consideration paid. This means
that these costs do not generate goodwill and are otherwise not
considered part of the basis of the acquired stock or assets.
Instead, direct and indirect transaction costs are accounted for
separately as transactions in which the buyer makes payments in
exchange for the services received. Therefore, direct and indirect
transaction costs are charged as a book expense in the period
that the related services are received.
However, financing costs are treated differently. Debt issuance
costs generally are deferred and amortized over the term of the
related debt. The costs of registering and issuing equity securities
are generally treated as a reduction of the proceeds from the
securities issued. This means that the issuer is treated as issuing
an amount less than the face amount of securities sold.
Deferred Tax Assets
BOOK AND TAX ACCOUNTING FOR EARN-OUTS
Although the financial accounting rules require that direct and
indirect transaction costs be charged to a book expense in the
period the related services are rendered, these costs may not
be immediately deductible for tax purposes. Further, because
these costs are incurred before closing the transaction, the tax
treatment of these costs may be unknown when the costs are
incurred. For example, the costs may be currently deductible for
tax purposes if the transaction is never consummated, but may
be required to be capitalized and included in the tax basis of the
acquired stock or assets if the transaction is completed.
In a perfect world, the exact value of assets and the finite liabilities
associated with those assets could be readily determined and
deals would be negotiated on these terms. Unfortunately, this is
rarely the case, and parties often disagree on both asset values
and the liabilities associated with business enterprises in their
negotiations. As a result, most mergers and acquisitions have
some contingent aspect associated with them, either in the form
of contingent consideration (for example, earn-outs) or contingent
liabilities (for example, environmental liabilities).
When buyers and sellers disagree on the value of a business
enterprise, one common method of negotiating the difference is to
agree to an earn-out which can be paid out in one or more future
payments. These future payments can be contingent on future
earnings or cash-flow targets for the company (for example, different
EBITDA targets). The following discussion highlights some of the
common book and tax treatments and considerations for earn-outs.
One approach to accounting for the tax effects of transaction costs
is to assess the tax consequences based on the circumstances
that exist on the date the costs are incurred, without assuming
the business combination will ultimately occur. This approach is
consistent with the book principle that these costs are accounted
for separately from the business combination. Therefore, if the
transaction cost will result in a future tax deduction should the
business combination not occur, the acquiror reports a deferred
tax asset for book purposes when the related cost is charged to
book expense. However, if the transaction costs will result in a
tax benefit only if the business combination is consummated, a
deferred tax asset for book purposes should not be recognized.
For more information about earn-outs, see Practice Note, Earnouts (http://us.practicallaw.com/0-500-1650) and Standard
Clause, Purchase Agreement: Earn-out with EBITDA Targets
(http://us.practicallaw.com/2-501-7344).
Tax Treatment of Earn-outs
In general, deferred tax assets are recorded amounts for book
purposes that result in a lower cash tax than book tax expense in
a future period. One common example of a deferred tax asset is
a company’s net operating loss carryforward (NOL carryforward).
For tax purposes, if a company reports a net loss on its tax return
and can carryforward that loss to offset its future taxable income,
the company may be able to record a deferred tax asset for book
purposes. This deferred tax asset represents the tax effected value
of the future tax deduction for the NOL carryforward (meaning, the
amount of the NOL carryforward multiplied by the effective tax rate).
Earn-outs can create some interesting tax considerations and
consequences for both the buyer and the seller.
Buyer
From a buyer’s perspective, the main tax issue with an earn-out
is its basis in the acquired stock or assets. In general, the buyer
does not receive basis in the acquired stock or assets until the
amount of any contingent consideration is fixed and determined.
Under IRC Section 1012, a taxpayer’s basis in purchased property
generally is the cost of that property. If a cost is not fixed or cannot
be determined, that cost may not be properly includable in a
taxpayer’s basis for the property until fixed or determined.
If a deferred tax asset for book purposes is reported for
transaction costs, once the business combination is completed,
the acquiror must assess whether the deferred tax asset continues
to exist or whether it must be written off for book purposes. If the
transaction is a taxable business combination, the transaction
3
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Accounting for Transaction Costs and Earn-outs in M&A
Seller
From a seller’s perspective, the main tax issues with an earn-out are:
„„The
Trap for the Unwary: Basis Recovery Rules under the
Installment Method
characterization of the earn-out payment:
„„as
deferred purchase price; or
„„as
a payment of compensation income.
Special basis recovery rules that apply to earn-out
payments reported under the installment method operate
as a trap for the unwary and may improperly accelerate
the recognition of gain by the seller. These special tax
rules for basis recovery depend on whether there is:
„„The
timing of gain recognition on any payments of deferred
purchase price.
The tax characterization of an earn-out payment as deferred
purchase price or as compensation income is important to the
seller because:
„„A
cap on the earn-out. If there is a cap on the earnout, the tax rules assume that the total capped selling
price is the selling price. This rule may have the effect
of deferring (or back-loading) basis recovery and
improperly accelerating gain recognition, particularly if
the potential amount of earn-out payments is high and
the likelihood of receiving the full payment is low.
„„Payments
of deferred purchase price are generally taxable as
capital gains. Long-term capital gain of a non-corporate seller
currently is taxed at a preferential rate (maximum rate of 15%,
see IRC § 1(h)(1)).
„„Payments
of compensation income are taxed at ordinary
income rates, which can be as high as 35%, and are subject
to employment taxes (for example, Social Security and
Medicare taxes).
„„A
fixed term for the earn-out. If the earn-out is
not subject to a cap but has a fixed term, the seller
recovers its basis ratably over the fixed term. This rule
benefits the seller if earn-out payments are smaller in
earlier years and larger in later years.
If the seller is not performing services for the buyer or the target
company after an acquisition, the earn-out generally is treated as a
payment of deferred purchase price that is potentially taxable at the
lower capital gain rates. On the other hand, the earn-out payments
may be treated as compensation income if the seller provides
services for the buyer or the target company after the acquisition or, in
certain cases, provides a non-compete. Earn-out payments that are
characterized as compensation generally are deductible by the buyer.
„„Neither.
If there is neither a cap nor a fixed term, the
seller generally recovers its basis ratably over 15 years.
tax consequences for the taxpayer. For example, if a taxpayer
elects out of the installment sale rules, the true-up to the amount
of gain or loss reported in year one is either capital or ordinary in
character. One characterization of transaction is that the character
of the income or loss on the true-up follows that of the original
transaction, which means that it could be capital in character
(see Arrowsmith v. Comm’r, 344 U.S. 6 (1952)). Another
characterization is that the transaction is closed as a result of
the election out of the installment sale rules. Based on this
characterization, the character of the income or loss on the trueup could be ordinary rather than capital. Taxpayers do not have
definitive guidance on the tax treatment of true-up payments.
Because the tax characterization is dependent on the particular
facts and circumstances of a given situation, taxpayers often have
strong arguments supporting either characterization.
The installment sale rules under IRC Section 453 also must be
considered when there is an earn-out. The timing of income
recognition by a seller depends on whether the gain is reported
under the installment method. Under the installment method, gain
recognition is deferred until earn-out payments are made (see IRC §
453). If the consideration that a seller receives in a transaction spans
at least past the taxable year the transaction closes, the default rule
is that the installment sale provisions of IRC Section 453 generally
apply to the transaction. If a transaction meets the requirements for
an installment sale, the installment method must be used unless the
seller formally elects not to have it apply (see IRC § 453(d)).
If the installment method applies, the seller’s recognition of gain
on the earn-out payments is tax deferred. The seller recognizes
gain as earn-out payments are made based on the amount
realized in that year and the basis allocated to that year. However,
special basis recovery rules that apply to earn-out payments
reported under the installment method operate as a trap for the
unwary and may improperly accelerate the recognition of gain by
the seller (see Box, Trap for the Unwary: Basis Recovery Rules
under the Installment Method).
While a corporate entity may not be as concerned about the
character of the income because there currently is no difference
between the corporate ordinary income rates and the capital gain
rates, corporations can be affected by the character of a loss
to the extent that they do not have (and do not expect to have)
capital gains against which to use a capital loss. Therefore, in
a capital loss scenario, a corporation may recognize a deferred
tax asset for the capital losses, only to set up a full valuation
allowance (meaning, a full reduction to the book asset) because
the corporation cannot reasonably expect to use it.
If a seller elects not to apply the installment method, the seller
recognizes a gain equal to the amount realized on the sale and
its basis in the stock. The amount realized includes the fair
market value of the right to receive the future earn-out payments.
Electing out of the installment sale rules can have unintended
Copyright © 2012 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved.
For more information about the installment method in stock
acquisitions, see Practice Note, Stock Acquisitions: Tax Overview
(http://us.practicallaw.com/9-383-6719).
4
Book Treatment of Earn-outs
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Under FAS 141(R), buyers are required to record potential earnout payments at fair value on the date of acquisition and then
re-measure their fair value periodically until all potential payments
are made. Any annual changes in the fair value of the earn-outs
are recorded as a gain or loss on the buyer’s income statement.
The estimated fair value of earn-out payments must reflect the
present value of the future payments and the probability of these
payments being paid out based on factors within the acquisition
agreement. Accuracy of the estimated fair value is important
for the buyer because differences between the estimated fair
value and the amounts paid are reflected as a gain or loss on the
buyer’s income statement. Inaccurate estimates can cause the
buyer’s earnings to seem volatile. In addition, an overestimation
creates larger goodwill on the buyer’s balance sheet than is
supported by the financial performance of the target company.
As a result, the buyer may need to record a goodwill-impairment
charge if the earn-out is not actually paid out.
To reduce the uncertainty and accounting issues presented by
FAS 141(R), buyers may try to shorten the earn-out period to
make estimating fair value easier. In some cases, buyers may try
to avoid an earn-out arrangement altogether.
FAS 141(R) does not apply to earn-out payments that are
characterized as compensation rather than as part of the purchase
price. This can happen when the earn-out arrangement is structured
as compensation for services, use of property or a profit-sharing
arrangement. There are many different factors that can lead to this
characterization. One of the more common factors is when the earnout payments are made contingent on the continued employment of
the seller. In this case, buyers account for compensation earn-outs
as expenses in the periods in which they are paid. Compensation
earn-outs can have adverse tax consequences for the seller (see Tax
Treatment of Earn-outs: Seller).
05-12
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