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8.6 Impact of business combinations on tax status
Publication date: 31 Dec 2022
us Income taxes guide
Business combinations may give rise to changes in tax status of acquired entities. The accounting for the change in tax status varies depending on whether it is considered a voluntary or involuntary change.
8.6.1 Involuntary change as part of a business combination
If a C corporation acquires an S corporation, ownership by the C corporation may make the S corporation’s election void. In situations where the transaction will be accounted for as a business combination for financial reporting purposes, this raises the question which guidance applies to the deferred tax accounting for this event—the change in the tax status guidance in ASC 740-10-25-32 or the business combination guidance in ASC 805-740-25-3 through ASC 805-740-25-4.
We believe that if the S corporation election is invalidated by the acquisition of the entity, then business combination accounting is appropriate. Therefore, deferred tax assets and liabilities should be recorded in acquisition accounting for the differences between the assigned values for financial reporting and the tax bases of the assets acquired and liabilities assumed.
However, if the S corporation issued stand-alone financial statements without the application of “pushdown” accounting, the effect of the business combination (i.e., loss of S corporation status) should be accounted for as a change in the tax status of the entity. Accordingly, in the separate financial statements of the acquired entity, the effect of recognizing a deferred tax liability or asset should be included in income from continuing operations at the business combination date.
In some situations, the deferred taxes of the acquired entity are affected not only by the change in tax status, but also by changes in the individual tax bases of its assets and liabilities. This situation could arise where the acquiring entity made an IRC Section 338(h)(10) election under the US tax code. In the separate financial statements of the acquired entity, the tax effect of changes in the tax bases of the assets and liabilities are recorded in equity pursuant to ASC 740-20-45-11 (i.e., the new tax basis created by the 338(h)(10) election), while the tax effect of the change in tax status is recorded in continuing operations (i.e., the book-tax basis difference that existed before the election). The application of ASC 740-20-45-11 on separate financial statements of a subsidiary is discussed further in TX 14.6.
8.6.2 Voluntary change as part of a business combination
An acquirer may choose to change the tax status of an acquired entity. The question arises whether the tax effects of a “voluntary” status change of acquired entities (e.g., an election to change from a C corporation to an S corporation) should be recorded as part of the acquisition accounting or in continuing operations in accordance with ASC 740-10-45-19.
In general, a voluntary change in tax status of an acquired entity following an acquisition (even when occurring during the measurement period) should be accounted for in continuing operations in accordance with ASC 740-10-40-6. However, there may be circumstances where we believe it would be appropriate to account for a voluntary change in tax status as part of the acquisition. Items to consider when making this determination include whether:
- As of the acquisition date, the entity qualified for and intended to make the election. The acquirer should be able to demonstrate that the status change was part of the plans for acquiring the target and not based on factors occurring after the entities were acquired.
- The election is effective at (or applied retroactively to) the acquisition date.
- No consideration is paid to the taxing authority to effectuate the change in tax status.
8.6.3 Common-control merger involving an S corporation
If a C corporation acquires an S corporation in a transaction that will be accounted for as a merger of entities under common control, the combined financial statements for periods prior to the transaction should not be adjusted to include income taxes for the S corporation.
ASC 740-10-25-32 requires the recognition of deferred taxes at the date a nontaxable entity becomes a taxable entity, which in this case is the date of the common control merger. This adjustment should be included in income from continuing operations.
Although historical financial information included in the primary financial statements should not be adjusted to reflect income taxes for the S corporation, it is generally appropriate to include supplemental pro-forma historical financial information that includes taxes for the S corporation as though it had been combined with the C corporation for all periods presented.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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