The tax treatment of costs incurred in a transaction can represent a significant deduction for the taxpayers involved. Even in the case of a corporation that is now taxed at the corporate rate of 21 percent, the deduction for transaction costs continues to provide a significant tax benefit. Since 2011, the IRS has allowed taxpayers that pay certain success-based fees in a "covered transaction" to elect to treat 70 percent of those fees as nonfacilitative and, therefore, not subject to capitalization.1 Before the issuance of Revenue Procedure 2011-29, taxpayers were generally required to assemble significant documentation as to the nature of the services provided by the success-based service provider, the timing of such services, any time records for the success-based service provider, and detailed information on the personnel providing the services.2 Because of the detailed information required to take a deductibility position for success-based fees, most taxpayers choose to elect the safe harbor of Revenue Procedure 2011-29. In IRS Legal Memorandum 201830011, issued on July 30, the IRS reiterated that if the safe harbor election is not made and a deduction for all or a portion of the success-based fees is intended to be taken, the taxpayer must assemble the requisite documentation as was required before the availability of the safe harbor election, or the deduction for such costs will be zero.
General Rules for Deduction vs. Capitalization of Transaction Costs
In general, Treasury Regulations § 1.263(a)-5, et seq., was adopted to provide a regulatory regime for the treatment of transaction costs incurred to facilitate an acquisition of a trade or business. The Internal Revenue Code, Treasury Regulations, Service rulings and case law have historically found that taxpayers may divide transaction-related costs into three categories: (i) costs deductible under Sections 162 and 165; (ii) costs capitalizable and amortizable under Sections 167, 168, 195, 197 and 248 or other authorities; and (iii) costs capitalizable under Section 263, INDOPCO v. Commissioner,3 and other authorities.
Section 162(a) generally allows a current deduction for those ordinary and necessary business expenses incurred in a taxpayer’s trade or business. A cost that is otherwise deductible may not be immediately deducted if it is considered a "capital expenditure" — a cost that yields future benefits to the taxpayer’s business. Section 263 requires capitalization of certain nondeductible expenditures.
Under Treasury Regulations § 1.263(a)-5(a), a taxpayer must capitalize an amount paid to facilitate any one of 10 specified transactions. The Treasury Regulations clarify that investigatory costs are considered facilitative unless there is a specific exception.4 Treasury Regulations § 1.263(a)-5(e) provides a significant exception for certain transaction costs that are incurred before a "bright-line" date in connection with "covered transactions," which include (i) "[a] taxable acquisition by a taxpayer of assets that constitute a trade or business," (ii) a taxable acquisition of the ownership interests in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) where the acquirer and the target are related immediately after the transaction, and (iii) a reorganization generally described in Section 368(a)(1)(A), (B) and (C) and, in certain instances, Section 368(a)(1)(D).
Treasury Regulations § 1.263(a)-5(f) provides that an amount paid that is contingent on the successful closing of one of the 10 transactions described in Treasury Regulations § 1.263(a)-5(a) (a "success-based fee") is deemed to be an amount paid to facilitate the transaction. Thus, the default position is that all of these types of costs are required to be capitalized. Treasury Regulations § 1.263(a)-5(f) provides that a taxpayer may maintain sufficient documentation that establishes that a part of the success-based fee is allocable to activities that did not facilitate the transaction. This will allow the taxpayer to deduct the portion of the success-based fee that is considered to be not facilitative of the transaction. Private Letter Ruling 20100236 lists examples of the type of comprehensive documentation and information that the IRS found, at least in this one situation, to substantiate that a portion of a success-based fee is nonfacilitative. An investment banker provided the following information:
To resolve difficult issues for both the IRS and taxpayers in providing relevant documentation for success-based fees, the IRS issued Revenue Procedure 2011-29, which provides a safe harbor method for allocating success-based fees between those activities that are facilitative of a transaction and those that are not. The Revenue Procedure applies only to transactions that are covered transactions as defined in Treasury Regulations § 1.263(a)-5(e)(3). It allows taxpayers to elect to treat 70 percent of the success-based fees paid or incurred by the taxpayer in taxable years ended on or after April 8, 2011 as amounts that do not facilitate a transaction under Treasury Regulations § 1.263(a)-5, while requiring that the remaining 30 percent of the success-based fees be capitalized.
Internal Legal Memorandum 201830011
In ILM 201830011, the issue before the Chief Counsel’s office was whether a taxpayer that did not elect the safe harbor provided in Revenue Procedure 2011-29 could deduct any of the success-based fees paid to an investment banker upon the successful close of a transaction in which the taxpayer was sold to an unrelated buyer. The IRS stated that, because the taxpayer did not elect the safe harbor of Revenue Procedure 2011-29, it was required to "satisfy the documentation requirements of § 1.263(a)-5(f) or the amount deductible is zero."
In the ILM, the taxpayer hired the investment banker to identify potential buyers and signed an engagement letter with the investment banker detailing the services to be provided and the fee to be paid upon a successful closing of a transaction described in the engagement letter. The IRS noted that the fee was not based on an hourly rate but on "a number of factors, including Investment Banker’s experience." The investment banker ultimately identified a buyer suitable to the taxpayer and continued to perform services with respect to the transaction until the parties closed.
After the close of the transaction, the taxpayer began to assemble information needed to allocate its transaction costs incurred in the transaction and, in pursuit of that goal, sent a letter to the investment banker asking it to "estimate the amount of time it spent on various activities relating to the transaction." In the two-page response letter, the investment banker provided allocation percentages to various services, including identifying a buyer, drafting a fairness opinion, reviewing drafts of the merger agreement, and services provided after the bright-line date. In the response letter, the investment banker specifically stated that it did not keep detailed time records and provided the percentage estimates by speaking with team members who were involved in the transaction. The letter did not include the specific personnel who worked on the transaction or information that the team members reviewed in order to estimate the percentage of the fee to each of the identified categories of services. Based on the allocation percentages provided by the investment banker, the taxpayer deducted 92 percent of the success-based fees on its timely filed tax return.
When the tax return for the year in which the success-based fees were taken into account came under audit, the taxpayer submitted the investment banker’s two-page letter to support the deduction of 92 percent of the success-based fees. The examination team requested additional documentation. In response, the taxpayer provided a PowerPoint presentation that was made by the investment banker to the taxpayer that "contained basic information regarding Taxpayer and explored possible acquisition strategies." In denying the target corporation’s entire deduction for success-based fees, the IRS focused on the language of Treasury Regulations § 1.263(a)-5(f)(2), which "requires the supporting records to identify the amount of the fee that is allocable to each activity." It concluded that the documentation provided by the taxpayer was insufficient to support a deduction of the success-based fee because the investment banker letter was a mere allocation between facilitative and nonfacilitative activities, which is not sufficient to support a deduction for success-based fees. As a result of this lack of supporting documentation, the taxpayer was not allowed to deduct any of the success-based fee.
The IRS took the view that, absent an election of the safe harbor for success-based fees, the specific language in Treasury Regulations § 1.263(a)-5(f) must be followed or the deduction amount will be zero. This is a harsh result, and a caution for taxpayers to assess the strength and amount of their documentation with respect to their success-based fees when deciding between making the safe harbor election or choosing to perform a "traditional" transaction cost allocation for the success-based fees as outlined in Technical Advice Memorandum 20100236. As noted in this memorandum and in other guidance issued by the IRS and addressed by courts before the issuance of Revenue Procedure 2011-29, assembling the documentation can be burdensome and time-consuming, but it must be done to support a deduction outside the safe harbor election for success-based fees.
The highly factual nature of the analysis of transaction costs demonstrates the need for evaluating the contemporaneous documentation during the pendency of the transaction, and consultation with a tax advisor who is familiar with these rules is critical. Consultation with a tax advisor on these types of issues is especially crucial if the parties to the transaction are taking into account the benefits of the anticipated transaction cost deductions as part of the deal terms. This approach is becoming more common, and, thus, the federal income tax treatment of transaction costs needs to be resolved in many of these cases before the transaction closes. It should also be noted that taxpayers cannot determine the deductibility of a particular cost through a provision in their agreements. They can provide for the economic benefits of any potential deductions to be allocated between the contracting parties, but it is a matter of federal income tax law whether or not a particular transaction cost can be deducted.
1 Rev. Proc. 2011-29, 2011-1 C.B. 746 (Apr. 8, 2011).
2 Tech. Adv. Mem. 20100236 (Sept. 21, 2009)
3 503 U.S. 79 (1992). See, e.g., I.R.S. Priv. Ltr. Rul. 2008-30-009 (Apr. 11, 2008) (determining that allocation of transaction costs among various categories appropriate).
4 Treas. Reg. § 1.263(a)-(5)(b), (e).
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.