Treasury and the Internal Revenue Service (“IRS”) recently released proposed regulations (REG-100400-14, RIN 1545-BM14) (the “Proposed Regulations”) addressing the apportionment of items of income and expense when an acquired corporation leaves or joins a consolidated group. The Proposed Regulations would restrict the so-called “next-day rule” so that certain transaction-related costs, such as success-based fees or stock option cash outs, would be apportioned to the acquired corporation’s short tax year that ends on the date the corporation leaves or joins the consolidated group.
Under the current consolidated return regulations, when a corporation joins or leaves a consolidated group, its taxable year closes at the end of the day on which the transaction occurs (the “Closing Date”). The corporation’s new taxable year (including, potentially, as part of a new consolidated group) starts on the day following the Closing Date. Accordingly, any income, deductions, losses or gains for the acquired corporation that are incurred on the Closing Date are generally included in the corporation’s short tax year that ends at the end of the Closing Date (the “end-of-day rule”). Therefore, if a corporation is leaving a consolidated group through the transaction, the selling consolidated group will generally include any items of income, deductions, losses or gains that were incurred by the acquired corporation on the Closing Date.
There are, however, two exceptions to the general end-of-day rule described above. The first exception relates to the sale of an S Corporation. In order to avoid requiring an S Corporation to file a one-day tax return as a C Corporation, the consolidated return regulations provide that an S Corporation’s taxable year ends at the end of the day preceding the Closing Date. The second exception is the “next-day rule,” under which the regulations currently provide that the transacting parties must treat some transactions that occur on the Closing Date as if they occurred on the day following the Closing Date, thereby apportioning any income, deductions, gains or losses to the corporation’s new taxable year. Any determination by the parties that the next-day rule applies must be “reasonable” and “consistently applied by all affected persons.” Although the regulations provide factors to consider when determining whether or not it is “reasonable” to allocate a transaction to the next day, giving taxpayers leeway in determining which items are covered, there has been disagreement over whether certain transactions may be subject to the next-day rule.
Certain transaction-based compensation and fees, such as transaction bonuses, payments to cancel stock options, or success-based fees paid to investment bankers or management companies, are examples of transactions over which the IRS and taxpayers have disagreed on whether they must be allocated to the next day. The IRS has taken the position that the next-day rule does not apply to success-based fees or option cash outs.* However, many taxpayers have continued to apportion these payments to the next day. To eliminate the uncertainty, Treasury and the IRS released the Proposed Regulations. If adopted, the Proposed Regulations would not allow parties the discretion to apportion these compensation expenses to either the acquired company’s short taxable year closing on the Closing Date or the next day.
The Proposed Regulations would require taxpayers to include “extraordinary items” in the next day if the extraordinary item is the result of a transaction that (i) occurs on the Closing Date but after the acquired corporation joins or leaves the consolidated group and (ii) would be taken into account by the acquired corporation on the Closing Date. However, to be allocated to the next day, the extraordinary item must occur after the consummation of the closing and cannot arise simultaneously with the closing. The Proposed Regulations provide examples of items that would be extraordinary items, and give guidance regarding whether or not the items would be allocated to the next day. Transaction-based compensation, such as success-based fees and option cash outs, would be considered extraordinary items. Significantly, though, they would not be allocated to the next day because the expenses arise simultaneously with the closing of the transaction. In contrast, if the acquired corporation sells unwanted assets on the Closing Date, but after the closing of the transaction, the gain or loss from the sale would be allocated to the next day.
The Proposed Regulations, therefore, limit the flexibility that some practitioners believe the current consolidated return regulations provide in apportioning expenses such as transaction-based compensation. Accordingly, if a target corporation or its consolidated group cannot take advantage of deducting the expenses of certain transaction-based compensation due to its losses, potential sellers may want to consider avoiding arrangements that pay out simultaneously with the closing of the sale and use arrangements that may pay out after the closing for the best tax results.
*See Technical Advice Memorandum (TAM) 200548022 and General Legal Advice Memorandum (GLAM) 2012-010.