Category: Corporations
Subject: Mergers/Accounting Methods
Title: Survival of Method of Accounting After Merger
IRC Sections: 381
Filename: 1023.html
Date Produced: 2/98

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background

The two parties to the proposed merger, which I will refer to as ProfitCo and LossCo, use two different methods of accounting. LossCo uses the cash method of accounting and ProfitCo uses the accrual method. Arguably because sale of inventory type items is a material income-producing factor, LossCo should have been using the accrual method all along. The tax basis of ProfitCo's assets greatly exceeds that of LossCo as do ProfitCo's gross receipts for any relevant time period.

The two companies will merge effective 2/28/98 under Section 368(a)(1)(A) with ProfitCo surviving the merger. ProfitCo has a 2/28 fiscal year and LossCo has a 5/31 fiscal year. As of 2/28/98 it is estimated that if LossCo changed from the cash to the accrual method, net income would increase by approximately $17,000.

After the merger, LossCo's business will be operated as an integral part of ProfitCo.

The issue here is how to deal with the disparate methods of accounting.

Discussion

Section 381(c)(4) addresses this issue. In general, a method of accounting is a tax attribute that can be carried over in a transaction to which Section 381 applies. (See my memo dated February 4, 1998. NOL's; Survival of tax attributes after merger between commonly controlled entities; IRC 381, 382.) If two companies merge in such a transaction and the merged company operates the business of the distributing company (LossCo in this case) as an integral part of the business conducted by the surviving company (ProfitCo), then the resulting merged business must use what is referred to as the principal method of accounting. That is the method of accounting used by the company with the higher A) tax basis in assets; and B) gross receipts.

Clearly ProfitCo has the greater asset basis and gross receipts; accordingly, its method of accounting, the accrual method, must be used by the resulting business.

The issue becomes how to mechanically effect the change from cash to accrual with respect to LossCo. While Section 381(c)(4) forces the change, it does not make clear how the change should be accomplished or how the resulting Section 481(a) adjustment is handled.

One is sorely tempted to use Rev. Proc. 97-37, the automatic accounting method change procedure--which includes a change from the cash to the accrual method in order to make this change. By so doing, the combined business would be assured of a spread period for the Section 481(a) adjustment, and prior LossCo years would be protected from an IRS assertion that the accrual method of accounting should have been used prior to the year in which it was actually adopted.

Unfortunately, this is not possible. Sec. 4.02(7) of Rev. Proc. 97-37 provides that the automatic change procedure is not available if the taxpayer engages in a transaction to which Code Sec. 381(a) applies within the proposed tax year of change determined without regard to any potential closing of the year under Code Sec. 381(b)(1).

I believe it would be possible to file for the change under the general (non- automatic) accounting method change procedure, Rev. Proc. 97-27. If successful, a forward spread of the Section 481(a) adjustment might be allowed and the taxpayer would achieve back-year audit protection similar to that obtained if the change were filed under Rev. Proc. 97-37. The down side to filing under Rev. Proc. 97-27 is the user fee and the administrative cost of the filing. Plus, it is my view that the application would be rejected out of hand. Given that Section 381(c)(4) requires a change, I do not think the IRS would allow a voluntary change on a more favorable basis.

This leaves us with the uncertainty surrounding the mechanics of a Section 381(c)(4)-required change. Apparently, there are three ways to go about this if X merges into Y with Y surviving and Y's accounting method is the principal method of accounting. These methods are discussed in GCMs 39436 (5/30/85) and 34674 (11/10/71).

1. X changes its accounting method on its final separate return. The increase or decrease in tax resulting from this change is taken into account by Y as transferee liability.

2. X uses its old accounting method in its final return. X hypothetically changes its accounting method in its final return, and recomputes its tax liability for that year. The increase or decrease in tax for the final year would be taken into account by acquiring Company Y. The increase or decrease in tax results from taking the 481(a) adjustment into income as if the change were made as of the first day of Y's last separate year plus (or minus) the change in tax resulting from using the new method in Y's final tax year.

3. X files its final return under the old method of accounting. The Section 481(a) adjustment is taken into account Company Y.

The two GCM's conclude that the second method set forth above is the proper method. Proposed Regulation 1.381(c)(4)-1(d) allows the third method, but this regulation has not been finalized.

I object to the second method on theoretical grounds. In effect, the taxpayer is required under the second method to change accounting methods for the year prior to the Section 381 transaction. This seems to me unwarranted. In additional, it is totally beyond my ability to comprehend how the second method would be disclosed and handled mechanically in a tax return.

Note that General Counsel Memoranda (GCM's) are more-or-less internal IRS documents discussing what future regulations or published rulings should say. They are not authoritative statements of policy or interpretation, per se. Given that the regulations proposed ended up with the third method, not the second, I would go with the third method. The third method is comprehensible from a tax filing point of view. In addition, the third method puts the accounting change where it belongs, in my opinion: after the merger. Further, in this case I think the result of using the third method is the same or very nearly the same as using the second method: the 481(a) adjustment is simply a reduction in LossCo's NOL carryover. I would be careful, however, to allocate enough AMT exemption to LossCo for the stub period ended 2/28/98 to handle the NOL utilization without creating AMT just in case the Service forces the second method on audit. Also, I would disclose in the return that the methodology set forth in the proposed regulation is being relied on.