Publish Date
Mar 27, 2025
A&M Tax Advisor Weekly
Breaking up is hard to do, especially when it comes to financial reporting. Whether a company is spinning off a division, preparing for an IPO, or divesting a business unit, carve-out financial statements bring a unique set of challenges. If you think accounting for income taxes is tricky in a consolidated environment, just wait until you apply it to a standalone entity that never actually stood alone.
Deferred tax assets (DTAs) and liabilities (DTLs) may need to be allocated, valuation allowances reconsidered, and uncertain tax positions reassessed — all without the comfort of a fully established tax profile. It’s like trying to figure out who gets the dog, the house and the Netflix password all at once. Add in state and local tax considerations and push-down adjustments, and you’ve got a recipe for complexity that rivals any messy breakup.
So, how do you navigate the tax accounting twists and turns of a carve-out? Let’s break it down.
Just like deciding who gets this weekend’s concert tickets, splitting up deferred tax balances requires careful consideration and fairness. Carve-out entities often file as a part of a larger consolidated tax group before separation, making it difficult to determine which DTAs and DTLs belong to them. Companies must decide how to allocate tax attributes that were historically incurred at the consolidated level. For example, net operating losses and tax credits may have been generated in the consolidated group, but how much should be assigned to the carve-out, and who should benefit if one entity’s losses are used by another? This may be determined by a tax sharing agreement (see more on this below), which may or may not align with the requirements under ASC 740, Income Taxes. Similarly, temporary differences that exist under the parent’s tax structure might not align with the standalone entity’s new tax profile. As an example, interest expense may be limited due to lack of taxable income on a hypothetical standalone basis but not at the consolidated level.
The Securities and Exchange Commission prefers an allocation method known as the separate return method. This method requires you to view the carved-out operations as if they were their own taxable group, separate from the existing consolidation.[1] Other reasonable allocation methods are permitted, but they generally draw more scrutiny. The choice of allocation method, whether following the separate return method or another reasonable allocation methodology, can significantly impact the financial statements and future tax expense of the carve-out entity.
Sometimes, breakups are unexpected. For deferred tax assets, a valuation allowance can be the surprise they didn’t see coming. A carve-out entity might not have a track record of generating standalone taxable income, which raises the question: Will it be able to utilize its DTAs? Under ASC 740, companies must assess the realizability of their DTAs based on sources of future taxable income. However, predicting a new standalone entity’s future profitability is no small task. Companies must consider various factors, including:
If there’s uncertainty about the carve-out entity’s ability to generate taxable income, a valuation allowance may be required.
When it comes to tax reserves, sometimes you have to decide who’s obligated to take on the risk. It’s not personal, it’s just tax. In a consolidated environment, tax risks, such as disputes over transfer pricing, deductions or tax credits, are typically managed at the parent level. But once a carve-out steps into the world on its own, it must determine whether it inherits any of these risks. The key challenge is identifying how pre-separation tax reserves should be allocated between the parent and the carve-out. This may be easy in the case of a reserve in a jurisdiction that isn’t included in the carve-out, but can be more difficult when assessing an R&D credit reserve that was generated and utilized by multiple entities in the consolidated group. These determinations can have a direct impact on the carve-out’s tax reserves and financial disclosures.
One of the most overlooked challenges in carve-out tax accounting is determining how to allocate taxes payable. In a consolidated group, tax payments are typically made by the parent, much like one partner handling all the bills. The carve-out entity, akin to the partner who never had to pay the bills, may have never directly settled tax obligations with the taxing authorities. To further complicate matters, the current tax expense computed based on the carve-out financials often will not closely align with the actual cash tax paid. This raises the all-important breakup question: Should the carve-out entity recognize a tax payable, or should the historical tax allocations be reflected in additional paid-in capital? If the carve-out never independently paid taxes, there’s a strong argument that its share of historical tax obligations should be recorded as an equity adjustment rather than as a liability. However, just like a prenup can influence who gets what, tax-sharing agreements between the parent and the carve-out entity can sway this decision. A well-documented approach to a tax payable allocation is critical to ensuring an accurate reflection of historical tax settlements and avoiding material misstatements in the financial statements. After all, you don’t want any financial skeletons popping out of the closet.
Just because you’re moving out doesn’t mean you can ignore your old “couple friends;” each state will now want to know if you’ve been “using their stuff” — a.k.a. establishing nexus. Carve-out financial statements present significant state tax challenges due to the need to establish a new, standalone tax profile. Key concerns revolve around nexus, apportionment and the availability of tax attributes. Firstly, the carved-out entity must establish its own nexus footprint, which may differ significantly from the parent company’s. This necessitates a thorough review of sales, property and payroll activities in each state to determine tax filing obligations. Secondly, apportionment formulas, previously calculated on a combined basis in many states, must now be recalculated based on the carved-out entity’s separate activity. This can lead to substantial shifts in state tax liabilities, particularly if the entity’s operations are geographically concentrated. Finally, the ability to utilize state tax attributes, such as net operating losses or tax credits, may be restricted or eliminated in the carve-out scenario. States often impose limitations on the transfer or sharing of these attributes, requiring the carved-out entity to generate its own tax benefits independently. This necessitates detailed analysis of state-specific regulations and potential restructuring strategies to optimize the entity’s tax position.
Push-down adjustments force the carved-out entity to inherit the parent’s accounting baggage, impacting its tax provision. Suddenly, corporate overhead, equity compensation and reserve balances — once comfortably shared — become solo acts. Each of these types of adjustments demand close scrutiny as they can have material impacts to the tax provision. Push-down of fair value adjustments related to historical transactions can have impact to the carved-out entity’s deferred tax liability. Certain items that are treated as permanent disallowances under the tax code can create effective tax rate increases, and there can also be disparate income statement and balance sheet accounts pushed down that could create permanent differences in certain scenarios.
Sure, after a break-up you can always look back and think about what you would have done differently. But much like in real life, you can’t change the past when it comes to carve-out financials. While you may want to reassess historical consolidated group management assertions, tax reserves and elections, this is generally not allowed. And although having perfect hindsight in a relationship may save a lot of heartbreak, it’s also not permitted when assessing valuation allowance for prior period carve-out financials. (You are supposed to only use the information available at the end of each historical year.)
Carve-out tax accounting is full of surprises, and without careful planning the transition can quickly become a compliance nightmare. The key to success in carve-out financial statements lies in early involvement from tax teams, clear documentation of historical tax positions, and a well-thought-out allocation method. By addressing the considerations raised above, companies can minimize disruptions and ensure that the carve-out entity starts its standalone journey on solid financial footing. Breaking up may be hard, but with the right ASC 740 strategy, you can avoid much of the heartache.
A&M’s TAS practice specializes in providing comprehensive income tax accounting solutions under U.S. (GAAP – ASC 740) and international (IFRS – IAS 12) standards. Our team combines deep technical expertise with innovative tools to deliver efficient, tailored solutions to meet client needs.
[1] Securities and Exchange Commission, “Codification of Staff Accounting Bulletins,” Topic 1.B.1, Question 3, https://www.sec.gov/interps/account/sabcodet1.htm
