Maneuvering through the proposed rules for post-transaction accounting methods.

• Author: Rohrs, Jane

EXECUTIVE SUMMARY

* The IRS and Treasury have issued proposed regulations under Secs. 381(c)(4) and (c)(5) for determining and changing methods of accounting following certain corporate transactions.

* Similar to the current regulations, the proposed regulations generally would require a continuation of pre-transaction accounting methods of both the distributing and surviving corporation where their respective trades or businesses are not integrated post-transaction. Additionally, if the trades or businesses are integrated post-transaction, the continuing method generally is the method of the corporation with both the greatest asset bases and the greatest gross receipts. If neither corporation meets this requirement, the surviving corporation's method generally is deemed to continue.

* The proposed regulations generally would conform accounting method change procedures and Sec. 481(a) adjustment spread periods with general accounting method change guidance; however, in certain cases, the proposed regulations would deny the audit protection normally afforded accounting method changes.

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The IRS and Treasury have issued proposed regulations that address the process for determining and changing methods of accounting following certain corporate reorganizations and liquidations. (1) Accounting methods represent tax attributes that could carry over to a corporation--including a newly formed corporation--that survives a reorganization or liquidation (the surviving corporation). (2)

The current regulations in this area create confusion by using different regimes to identify and implement carryover methods for inventory and noninventory methods. This confusion, coupled with the fact that accounting methods are generally evaluated in conjunction with tax provision or tax return preparation and not as part of the transaction, has resulted in noncompliance. Without departing from the fundamental concepts of the current regulations, the proposed regulations would establish greater consistency between separate rules governing inventory methods and most noninventory methods. (3)

Although the accounting methods of a corporation that distributes or transfers assets (the distributing corporation) generally carry over to a surviving corporation, (4) the proposed regulations would clarify the carryover process as well as prescribe rules for situations in which parties to a transaction had used different methods. Most important, the proposed regulations would provide rules for determining what method a surviving corporation must use if it operates the parties' trades or businesses (the businesses) as a single business after the transaction.

The proposed regulations would continue to reflect a complex process that taxpayers must navigate in order to determine the accounting methods carrying over to a surviving corporation. This article explains the anticipated improvements to this process and explores opportunities created and issues left unresolved by the proposed regulations.

Rules for Determining Post-Transaction Accounting Methods

Operating Separate and Distinct Businesses

Continuation of accounting methods: The proposed regulations would generally require a continuation of accounting methods where the businesses of a distributing corporation will operate as separate and distinct businesses from the surviving corporation's businesses. (5) In essence, each pretransaction business would operate independent of the others, such that the methods of the distributing corporation's businesses would carry over to the surviving corporation, and the surviving corporation would continue using its methods for its own businesses. Because no accounting methods would change, the surviving corporation could continue or use each permissible method without securing IRS consent.

Example 1: A Corp. merges with and into B Corp. in a transaction qualifying under Sec. 38 l(a). B will operate its pre-transaction financial consulting business separate and distinct from A's business of selling financial products. B has used the nonaccrual experience method to account for amounts that it does not anticipate receiving from customers, whereas A has used the specific write-off method to deduct bad debts. Under the proposed regulations, B would continue to use the nonaccrual experience method for its financial consulting business and would use the specific write-off method for its newly acquired financial products business.

The proposed regulations themselves provide no additional guidance about how taxpayers would identify separate and distinct businesses, stating that "[s]eparate and distinct trades or businesses has the same meaning as provided in [section]1.446-l(d)." (6) At a minimum, a taxpayer could not have separate and distinct businesses unless it maintains complete and separate books and records for each business. (7) However, mere compliance with this recordkeeping requirement would not be sufficient where the use of different accounting methods creates or shifts profits and losses between businesses in a way that prevents a clear reflection of the taxpayer's income. (8) In any event, the proposed regulations would look at how the surviving corporation operates the businesses, in either a separate or combined manner, taking into account any planned integration activities rather than focusing exclusively on the state of operations at the date of the transaction. (9)

Observation: Taxpayers have often relied on the fact that the businesses had not been integrated as of the end of the year that included the transactions to support the position that changes to the principal methods were not required. The current regulations do not specifically address when taxpayers determine post-transaction integration. By including any planned integration activities, the proposed regulations would more accurately define the time flame for assessing whether the rules for integrated businesses apply.

The proposed regulations do not explicitly address what rules would apply where a surviving corporation operates separate and distinct businesses as well as integrated businesses after a transaction. Although it seems reasonable that methods should continue for separate and distinct businesses, the proposed regulations would require a surviving corporation to determine principal methods whenever it operates an integrated business after a transaction.

The rules for principal methods would control the determination of overall methods as well as methods for particular items without limiting their scope to integrated businesses. To the extent that methods for particular items are business specific, the rules for separate and distinct businesses and the rules for integrated businesses would reach the same result; otherwise, the principal methods determined for integrated businesses would become the method for all businesses with that item.

Example 2: Assume the same facts as Example 1, except that B had a business of selling financial products in addition to its business of providing financial consulting services, and B had been operating these businesses as separate and distinct businesses. If B will operate its financial products business and A's financial products business as an integrated business after the merger without combining the consulting business, B's ability to continue using the nonaccrual experience method for its consulting business, which is operated as a separate and distinct business after the merger, would depend on whether the nonaccrual experience method constitutes a principal method.

The proposed regulations appear to contemplate that a surviving corporation could find itself with an overall hybrid method (i.e., use of cash method for some items and accrual method for other items) after a transaction even though no party used a hybrid method before the transaction. The overall hybrid method would result where different overall methods had been used for separate and distinct businesses and the surviving corporation continues to use those different methods for the businesses after the transaction. The continuation of those methods results in a new overall method for the surviving corporation.

Example 3: C Corp. used an overall cash method for its personal service business, and D Corp. used an overall accrual method for its manufacturing business. D merged with and into C, and C now operates the two pre-merger businesses as separate and distinct businesses. After the merger, under the proposed regulations, C would use an overall hybrid method.

Impermissible carryover methods: Under the proposed regulations, a surviving corporation generally would not carry over an impermissible accounting method from a distributing corporation. (10) Instead, the surviving corporation would need IRS consent to use a different method. In the event that the impermissible nature of the distributing corporation's method results solely from the fact that a taxpayer must use a single method for a particular item in all the taxpayer's businesses, the surviving corporation would determine the principal method (under the rules, described below, applicable to integrated businesses) and would use a permissible principal method for each of its businesses in the future without first securing IRS consent. (11)

Example 4: Assume the same facts as Example 1, except that A had been using an impermissible reserve method to account for bad debts. Under the proposed regulations, B would continue to use the nonaccrual experience method for its financial consulting business but would need IRS consent to use the specific write-off method as an alternative to A's impermissible method.

The proposed regulations would generally classify an impermissible method as a method that "fails to clearly reflect" the surviving corporation's income, with the clear reflection standard determined under Sec. 446(b) principles. Although the courts have generally...