Winter 2025

Over the years, merger and acquisition (M&A) activity increasingly has become an integral part of many corporations’ overall growth strategy. An important aspect to consider upon completing an acquisition or other business combination is properly accounting for the income tax impact under Financial Accounting Standards Board Accounting Standard Codification Topics 740, Income Taxes (ASC 740).

Is It a Stock or Asset Acquisition?

The first step is determining if a transaction is considered a stock or asset acquisition for income tax purposes. While the transaction may commercially be a stock or asset deal under Generally Accepted Accounting Principles (GAAP), taxes don’t rely on GAAP treatment. So, a tax adviser should read and understand the purchase agreement, analyze if any specific pre-close restructuring was done to effectuate the transaction, the legal entity types involved, and if the transaction is considered a tax-free reorganization under Section 368 of the Internal Revenue Code (IRC). Additionally, with the use of certain tax elections, it is possible for a stock acquisition to be treated as an asset acquisition for income tax purposes via an IRC Section 338(h)(10) or Section 336(e) election. After understanding how the transaction would be viewed from an income tax standpoint, the next step is determining the tax basis of the acquired assets or stock as discussed below. Depending on the type of acquisition, a buyer may be entitled to a step-up in the assets acquired to fair market value or may only obtain carryover basis in such assets.

Asset Acquisition

In an asset deal, the acquirer buys specifically identified assets and liabilities from the target. GAAP will write up the acquired assets to their fair value, resulting in stepped up cost basis and the added financial benefit of increased depreciation and amortization expense amounts. For tax purposes, IRC Section 1060 provides guidance on how to allocate the purchase price among the acquired assets so that the characterization of the assets is consistent between both parties. The purchase price is first allocated to hard assets such as receivables, inventory, and fixed assets up to their respective fair market value. Any excess purchase price is allocated to intangible assets, such as goodwill, which can be amortized over 15 years as acquired Section 197 intangible property. Any existing tax attributes, such as net operating losses (NOLs) or tax credits, would stay with the target and not be acquired.

The buyer and seller must both file IRS Form 8594, agreeing to allocate the purchase price based on an agreed fair market value. While sellers would prefer to allocate more of the purchase price to goodwill rather than hard assets – resulting in a lower tax bill due to the amount allocated to goodwill being taxed at the capital gains tax rate versus ordinary tax rate – the buyer would prefer to allocate more of the purchase price to hard assets, resulting in tax basis for those acquired assets that are subject to accelerated depreciation.

Generally, the cost basis of acquired assets is equally stepped up under both GAAP and tax, which results in no change to the purchaser’s cumulative deferred tax assets (DTA) or deferred tax liabilities (DTL). However, if the buyer and seller agree to allocate the purchase price differently for tax as compared to GAAP (as allowed under IRC Section 1060), there may be DTAs or DTLs on certain asset classes. But since the purchase price is the same, the gross DTAs and DTLs would generally net to zero.

Stock Acquisition

In a stock acquisition, the acquirer becomes the new shareholder of the target and inherits all the target’s historical assets and liabilities, both known and unknown. Under this scenario, the acquirer would not be entitled to a step up in tax basis of the assets acquired, and instead would receive carryover tax basis. However, under a stock acquisition, tax attributes such as NOLs and tax credits carryover from the target to the acquirer as a DTA, subject to certain annual limitations under IRC Sections 382 and 383.

For financial reporting purposes, GAAP will mark the newly acquired assets to fair value despite the fact that tax would retain historical basis and continue depreciating and amortizing the assets over their remaining useful life. The difference between GAAP basis and tax basis would likely result in the recording of DTLs, while the recording of the acquired tax attributes would result in the recording of DTAs. This is generally accomplished through an opening balance sheet journal entry to accurately reflect the company’s updated DTAs and DTLs because of the acquisition with an offset to goodwill. However, there are unique rules prescribed within ASC 740 that do not permit the initial recording of DTLs for goodwill when the book basis exceeds the tax basis.

Goodwill

In a stock acquisition, amortization expense related to goodwill is only deductible when that goodwill previously existed on the target’s tax basis balance sheet prior to acquisition. Often, GAAP and tax treatment of goodwill will differ, resulting in a DTA or DTL. Not all companies will amortize goodwill for GAAP; specifically, public companies cannot, and private companies are required to, make an election. Instead of amortizing goodwill, GAAP requires public companies to perform an impairment test, comparing fair value of goodwill against book value of goodwill. However, since private companies can elect to amortize goodwill, it’s typical to see book-to-tax differences related to goodwill.¹

Under ASC 740, there are two types of goodwill: commonly referred to as “Component 1” and “Component 2” goodwill. Component 1 equals the lesser of book and tax goodwill; whereas Component 2 goodwill is the excess goodwill, whether book basis exceeds tax basis or vice versa. While Component 1 is deductible for tax purposes, Component 2 is generally not unless it represents an excess of tax basis over book basis.²

Conclusion

ASC 740 considerations are integral to the accounting for income taxes in the context of stock or asset acquisitions.

The treatment of deferred taxes, valuation allowances, uncertain tax positions, and the interaction with other accounting standards such as ASC 805 can significantly impact the acquirer’s financial statements. Understanding these considerations is essential for accurate financial reporting and compliance with U.S. regulations.

While this article summarizes a few of the larger income tax concepts and their respective nuances within ASC 805, it’s important to consult with a tax professional to fully understand the implications between an asset or stock deal.

¹ When goodwill is not amortized under GAAP, this results in what is commonly referred to as a “naked” or “hanging” tax credit, which is a DTL that cannot be netted against a DTA or offset by a valuation allowance since the goodwill is considered to have an indefinite life and not amortizable under GAAP.

² In the case where the carryover tax basis of assets acquired exceeds the purchase price (i.e., GAAP/fair value), Component 2 goodwill would be deductible.

Tom Lemon, CPA, is managing director at Stout in Philadelphia. He can be reached at tlemon@stout.com.

Greg Rineberg, CPA, is senior vice president, tax advisory services, at Stout in Philadelphia. He can be reached at grineberg@stout.com.

Over the years, merger and acquisition (M&A) activity increasingly has become an integral part of many corporations’ overall growth strategy. An important aspect to consider upon completing an acquisition or other business combination is properly accounting for the income tax impact under Financial Accounting Standards Board Accounting Standard Codification Topics 740, Income Taxes (ASC 740).

Is It a Stock or Asset Acquisition?

The first step is determining if a transaction is considered a stock or asset acquisition for income tax purposes. While the transaction may commercially be a stock or asset deal under Generally Accepted Accounting Principles (GAAP), taxes don’t rely on GAAP treatment. So, a tax adviser should read and understand the purchase agreement, analyze if any specific pre-close restructuring was done to effectuate the transaction, the legal entity types involved, and if the transaction is considered a tax-free reorganization under Section 368 of the Internal Revenue Code (IRC). Additionally, with the use of certain tax elections, it is possible for a stock acquisition to be treated as an asset acquisition for income tax purposes via an IRC Section 338(h)(10) or Section 336(e) election. After understanding how the transaction would be viewed from an income tax standpoint, the next step is determining the tax basis of the acquired assets or stock as discussed below. Depending on the type of acquisition, a buyer may be entitled to a step-up in the assets acquired to fair market value or may only obtain carryover basis in such assets.

Asset Acquisition

In an asset deal, the acquirer buys specifically identified assets and liabilities from the target. GAAP will write up the acquired assets to their fair value, resulting in stepped up cost basis and the added financial benefit of increased depreciation and amortization expense amounts. For tax purposes, IRC Section 1060 provides guidance on how to allocate the purchase price among the acquired assets so that the characterization of the assets is consistent between both parties. The purchase price is first allocated to hard assets such as receivables, inventory, and fixed assets up to their respective fair market value. Any excess purchase price is allocated to intangible assets, such as goodwill, which can be amortized over 15 years as acquired Section 197 intangible property. Any existing tax attributes, such as net operating losses (NOLs) or tax credits, would stay with the target and not be acquired.

The buyer and seller must both file IRS Form 8594, agreeing to allocate the purchase price based on an agreed fair market value. While sellers would prefer to allocate more of the purchase price to goodwill rather than hard assets – resulting in a lower tax bill due to the amount allocated to goodwill being taxed at the capital gains tax rate versus ordinary tax rate – the buyer would prefer to allocate more of the purchase price to hard assets, resulting in tax basis for those acquired assets that are subject to accelerated depreciation.

Generally, the cost basis of acquired assets is equally stepped up under both GAAP and tax, which results in no change to the purchaser’s cumulative deferred tax assets (DTA) or deferred tax liabilities (DTL). However, if the buyer and seller agree to allocate the purchase price differently for tax as compared to GAAP (as allowed under IRC Section 1060), there may be DTAs or DTLs on certain asset classes. But since the purchase price is the same, the gross DTAs and DTLs would generally net to zero.

Stock Acquisition

In a stock acquisition, the acquirer becomes the new shareholder of the target and inherits all the target’s historical assets and liabilities, both known and unknown. Under this scenario, the acquirer would not be entitled to a step up in tax basis of the assets acquired, and instead would receive carryover tax basis. However, under a stock acquisition, tax attributes such as NOLs and tax credits carryover from the target to the acquirer as a DTA, subject to certain annual limitations under IRC Sections 382 and 383.

For financial reporting purposes, GAAP will mark the newly acquired assets to fair value despite the fact that tax would retain historical basis and continue depreciating and amortizing the assets over their remaining useful life. The difference between GAAP basis and tax basis would likely result in the recording of DTLs, while the recording of the acquired tax attributes would result in the recording of DTAs. This is generally accomplished through an opening balance sheet journal entry to accurately reflect the company’s updated DTAs and DTLs because of the acquisition with an offset to goodwill. However, there are unique rules prescribed within ASC 740 that do not permit the initial recording of DTLs for goodwill when the book basis exceeds the tax basis.

Goodwill

In a stock acquisition, amortization expense related to goodwill is only deductible when that goodwill previously existed on the target’s tax basis balance sheet prior to acquisition. Often, GAAP and tax treatment of goodwill will differ, resulting in a DTA or DTL. Not all companies will amortize goodwill for GAAP; specifically, public companies cannot, and private companies are required to, make an election. Instead of amortizing goodwill, GAAP requires public companies to perform an impairment test, comparing fair value of goodwill against book value of goodwill. However, since private companies can elect to amortize goodwill, it’s typical to see book-to-tax differences related to goodwill.¹

Under ASC 740, there are two types of goodwill: commonly referred to as “Component 1” and “Component 2” goodwill. Component 1 equals the lesser of book and tax goodwill; whereas Component 2 goodwill is the excess goodwill, whether book basis exceeds tax basis or vice versa. While Component 1 is deductible for tax purposes, Component 2 is generally not unless it represents an excess of tax basis over book basis.²

Conclusion

ASC 740 considerations are integral to the accounting for income taxes in the context of stock or asset acquisitions.

The treatment of deferred taxes, valuation allowances, uncertain tax positions, and the interaction with other accounting standards such as ASC 805 can significantly impact the acquirer’s financial statements. Understanding these considerations is essential for accurate financial reporting and compliance with U.S. regulations.

While this article summarizes a few of the larger income tax concepts and their respective nuances within ASC 805, it’s important to consult with a tax professional to fully understand the implications between an asset or stock deal.

¹ When goodwill is not amortized under GAAP, this results in what is commonly referred to as a “naked” or “hanging” tax credit, which is a DTL that cannot be netted against a DTA or offset by a valuation allowance since the goodwill is considered to have an indefinite life and not amortizable under GAAP.

² In the case where the carryover tax basis of assets acquired exceeds the purchase price (i.e., GAAP/fair value), Component 2 goodwill would be deductible.

Tom Lemon, CPA, is managing director at Stout in Philadelphia. He can be reached at tlemon@stout.com.

Greg Rineberg, CPA, is senior vice president, tax advisory services, at Stout in Philadelphia. He can be reached at grineberg@stout.com.