The Journal Summer 2012
M&A Accounting
ASC 805: A Quick Look
By Baskar Venkatraman, CPA, CFE, CISA, CITP
ASC 805 has redefined a business combination as a “transaction or other event in which an acquiring entity obtains control of one or more businesses.” As a result, the standard applies to a wide range of transactions and events, including acquisitions of some development-stage companies, combinations of mutual entities, acquisitions without the exchange of consideration, and the initial consolidation of a variable interest entity that is a business. The ASC 805 does not apply to companies under common control or to not-for-profit entities. The previous standard applied only to business combinations in which control was obtained by transferring net assets or equity. Boards of directors and management need to carefully weigh this expanded definition in structuring new transactions.
Consideration: Consideration is required to be measured at fair value on the closing date (or date control is obtained). Equity issued as purchase price consideration is valued at the closing date even though the number of shares to be exchanged may be agreed to prior to closing. This could result in purchase price volatility in many situations and may affect goodwill impairment/bargain purchase scenarios.
Every M&A deal has its unique challenges in terms of structuring and consummating the transation.
All acquisition-related costs such as accounting, valuation and integration costs are required to be expensed. However, costs incurred to finance the transaction by issuance of equity or debt will continue to be treated in accordance with existing U.S. GAAP.
Valuation of Assets and Liabilities: Assets and liabilities must be recorded at fair value on the acquisition date.
Purchase Price Recording: Based on an estimate of the total purchase price, provisional accounting is required to be made on the acquisition date and disclosed in the financial statements. Subsequent revisions to this provisional estimate are reflected through retrospective application in the financial statements (for a period of up to one year after the closing date of the transaction).
Bargain Purchase Price: The excess of net assets acquired (fair value) over the purchase price must be recorded immediately as a gain in the income statement rather than an extraordinary item.
Earn-Outs: Companies using earn-outs (contingent consideration) must report the estimated fair value of such consideration as part of the initial acquisition accounting. Depending on the terms of the contingent consideration, acquirers may be required to subsequently record the contingent consideration at fair value for each reporting period, contributing to earnings volatility. Adjustments to contingent consideration obligations classified as equity are recognized only within the shareholders equity section, and earnings will remain unaffected.
Recent polls conducted by a Big Four accounting firm regarding the revised M&A accounting standard ASC 805 have revealed the following emerging patterns on the deal:
- Timing of the Deal: Transactions have become more sensitive with respect to the timing of the closing. Data suggests that acquirers attempt to close the deal earlier rather than later in the quarter in order to provide sufficient time to compile the fair value estimates.
- Deal Structure: Use of earn-outs has remained substantially constant notwithstanding the potential for increased volatility of earnings. Increasingly, deals are completed on a negotiated basis rather than on auction-based transactions.
Every M&A deal has its unique challenges in terms of structuring and consummating the transaction. M&A teams should consider the following options to better manage some of the challenges from ASC 805:
- Explore a deal structure using equity as all or a majority of the contingent consideration to reduce the potential earnings impact.
- Consider the use of alternative structures (e.g., more cash) to minimize potential purchase price volatility that may result from changes in share price between the initiation of the deal and the actual closing date.
- Use caps and floors when stocks are issued as price consideration.
- Perform detailed due diligence, integrated and coordinated among the various professionals, early in the process to minimize surprises later in the deal.
- Negotiate specific indemnifications as part of the agreement.
- Prepare detailed models of the impact of acquisition accounting requirements on earnings under various scenarios and determine the probability that the deal will be earnings accretive or dilutive.
- Communicate the benefits and risk of volatility to stakeholders.
TAXABILITY OF S CORPORATION DISTRIBUTIONS: A STEP-BY-STEP GUIDE
By Melissa Crowe
A distribution out of an S corporation that was always an S corporation is a nontaxable return of the shareholders’ basis in the corporation’s stock. If the distribution exceeds shareholder basis, the distribution remaining is taxed as a capital gain and, as such, is taxed at the favorable capital gain rates.
When an S corporation was previously a C corporation, however, the taxability of the S corporation’s distributions are another matter entirely. When a C corporation makes the election to become an S corporation, any accumulated earnings and profits (E&P) from C corporation years carries over to the S corporation and is held until it is distributed as a taxable dividend to shareholders. As a result, any E&P from previous C corporation years must be taken into consideration when the S corporation makes a distribution.
Only when E&P is present does an S corporation’s AAA account become relevant in determining the taxability of the corporation’s distributions. In brief, AAA is a corporate attribute that tracks the balance of the corporation’s taxable income, which has passed through to shareholders but not yet been distributed in cash. In its most basic form, the account is increased by an S corporation’s profit and decreased by its losses and distributions. Although losses can decrease an AAA account below zero, distributions cannot; an important thing to remember when adjusting AAA to account for a distribution.
There are three steps to consider when a distribution is made from an S corporation with E&P.
Step One
To the extent of a corporation’s positive balance in its AAA, any distributions are treated exactly the same as if the corporation did not have E&P. Thus, this portion of the distribution is tax free to shareholders to the extent of their basis in the corporation’s stock, with any amount in excess of such basis taxed as capital gain.
Step Two
When the distribution exceeds the balance of the AAA and reduces it to zero, the S corporation’s E&P balance will then be reduced and this portion of the distribution will be treated as a taxable dividend to shareholders. The shareholder’s basis will not be affected by a distribution from the E&P account.
Step Three
Once an S corporation has fully distributed its E&P, the corporation is treated as if it had never been a C corporation for the purposes of distributions, and a shareholder’s stock basis is all that is relevant in determining the taxability of distributions. If the E&P balance is reduced to zero and there is still a portion of the distribution remaining, the balance is first a nontaxable reduction of a shareholder’s basis to zero and any remaining distribution is treated as a capital gain to the shareholder.
To illustrate, let’s assume that a C corporation has made the election to become an S corporation and has a balance in its AAA account of $200, E&P carried over from previous C corporation years of $100, and the sole shareholder’s basis in the corporate stock is $300. The S corporation makes a distribution of $500 in the current year. The steps necessary to determine the taxability of this distribution would be as follows:
Step One
REDUCE THE BALANCE IN THE AAA TO ZERO WITH THE FIRST $200 OF DISTRIBUTION.
$$$ First $200 of Distribution > Reduce AAA Balance to Zero = This also reduces the shareholder’s basis in the corporation’s stock. The AAA balance is reduced from $200 to zero, and stock basis is reduced from $300 to $100. This portion of the distribution is tax free to the shareholder. There now remains $300 to be distributed.
Step Two
REDUCE THE CORPORATION’S E&P ACCOUNT BY THE NEXT $100 OF DISTRIBUTION.
$$$ Next $100 of Distribution > Reduce E&P Account to Zero = The E&P account is now reduced from $100 to zero. Remember, the shareholder’s basis is not affected by distributions from E&P. This portion of the distribution is treated as a taxable dividend to the shareholder. There now remains $200 to be distributed.
Step Three
REDUCE THE SHAREHOLDER’S STOCK BASIS BY THE REMAINING $200 OF DISTRIBUTION.
$$$ Remaining $200 of Distribution > Shareholder’s Basis to Zero = The basis is now reduced from $100 to zero, and this $100 is treated as a tax free distribution. The remaining $100 is treated as a capital gain to the shareholder.
These three steps provide an easy guide to managing S corporation distributions and ensuring their proper tax treatment.
EMPLOYER-GRANTED STOCK OPTION
By Lorri K. Morris, CPA
An employer-granted stock option is the right to purchase a company’s stock in the future at a fixed price. When you exercise an option, you purchase shares of the company’s stock directly from them. The grant price (the exercise price) is the amount you pay for each share of stock. This price is determined by the company at the time the stock option grant is made (also known as the grant date).
When is a good time to consider exercising your stock option? You should exercise the stock options when the company’s stock price is greater than the grant price. Keep in mind that there may be a vesting schedule, which affects the timing of when you can exercise your options. A typical vesting schedule allows for the vesting of 20% of the options each year over a five-year period.
With ISOs, the grant price cannot be less than the stock price on the grant date, and the option term cannot be longer than ten years. The cost basis of the options is the grant price multiplied by the number of shares you exercise. There is no taxable event when you exercise the ISOs. However, the difference between your cost basis and the stock price on the exercise date represents a tax preference item for alternative minimum tax in the year the exercise occurs.
When is a good time to consider exercising your stock option? You should exercise the stock options when the company’s stock price is greater than the grant price.
When you sell ISOs, the gain (difference between the stock’s selling price and your cost basis) is taxable as long-term capital gain as long as you have held the stock for at least one year from the exercise date and two years from the grant date. Currently, long-term capital gains tax rates are more favorable compared to the tax rates for ordinary income.
With NSOs, a taxable event occurs when you exercise them. Upon exercise, you must recognize ordinary income on the tax spread (difference between the cost basis and the grant price on the exercise date). This income is considered compensation and is included on your Form W-2, subject to federal and state income tax, as well as social security tax (FICA and Medicare). Once you exercise the stock, your cost basis becomes the stock price on the exercise date. When you sell the shares, you recognize capital gain on the difference between the sales price and your cost basis (exercise price). If you sell within one year of the exercise price, the gain is short-term. If you sell the shares more than one year after the exercise date, the gain is considered long-term.
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