Taxpayers typically incur significant transaction costs when undergoing a transaction involving a restructuring, acquisition, disposition, sale of assets, or sale of stock. The default rule under section 263 is that all transaction costs that facilitate a transaction must be capitalized.1 An allocation of transaction costs that treats certain costs as other than capitalized can be supported if such an allocation is made before filing the tax return. The allocation must be based on a review of the relevant services provided, the timing of the services, and applicable law addressing the tax treatment of the services. Even with a detailed allocation and a finding that many costs can be treated as nonfacilitative of a transaction, a taxpayer will still find that a significant amount of the transaction costs incurred will be required to be capitalized. However, some costs can still be deducted. This article provides a general overview of certain circumstances when capitalized costs can be recovered and discusses the IRS’s view of certain recovery theories under section 165 as summarized in an LB&I Transaction Unit issued on April 30, 2019.2
Section 162(a) generally allows a current deduction for 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. In the case of a transaction involving the acquisition of an ownership interest in an entity, courts have found that costs that are incurred in the process of these transactions generally produce significant long-term benefits to the entity being acquired or to the party acquiring the entity and, thus, must be capitalized.3
Proper allocation of expenses between those that are currently deductible and those that are required to be capitalized is grounded on the "origin of the claim" doctrine. Under this doctrine, "the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense is deductible or not."4 To avoid the default position of capitalizing all transaction costs, the taxpayer must apply the origin of the claim test to support an allocation of certain transaction costs to noncapitalized categories, such as general business activities, employee related costs, financing activities, etc.
With respect to the determination of the proper tax treatment of transaction costs, Treasury Regulations section 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: (1) costs deductible under sections 162 and 165; (2) costs capitalizable and amortizable under sections 167, 168, 195, 197 and 248 or other authorities; and (iii) costs capitalizable under section 263.
Under Treasury Regulations section 1.263(a)-5(a), a taxpayer must capitalize an amount paid to facilitate any one of 10 specified transactions.5 Thus, even if a taxpayer performs an allocation of its transaction costs, a significant portion of the costs incurred in a transaction will be treated as capitalized if the transaction falls within one of the enumerated transactions.
With respect to the capitalization of transaction costs, Treasury Regulations section 1.263(a)-5(g) provides authority for how to treat certain types of capitalized transaction costs. For example, capitalized transaction costs paid by a target company in an asset sale are treated as an offset to the purchase price. Thus, these costs generally will reduce any gain realized by the target company upon the sale. In addition, capitalized transaction costs paid by the acquiring company in the acquisition of the stock or assets of the target company are added to the tax basis of the stock or assets. These costs may decrease any gain on the subsequent sale of the target stock, or allow increased depreciation or amortization of costs that are capitalized to the target assets acquired.
In addition to the rules regarding transaction costs provided in section 263, several Code provisions address the treatment of capitalized costs. Examples include:
Section 1060 (costs identified with the acquisition of a particular asset can be added to the cost basis of the asset and recovered over its useful life). An example includes the costs associated with the valuation of a particular building that might be part of a larger asset purchase. The cost of that valuation can be added to the tax basis of the building acquired.
Section 338 (stock purchase treated as an asset purchase that allows acquisition costs to be allocated to the assets purchased and recovered over the life of the assets acquired, or reduce the gain if the assets are sold).
Section 197 (costs associated with acquiring certain section 197 intangibles can be added to the cost basis of the assets and amortized over the life of the asset — typically 15 years). Note that transaction costs are not considered section 197 assets.
Section 248 (certain organizational costs can be amortized over 15 years).
Section 195 (preliminary, investigative costs and other startup costs can be amortized over 15 years).
Section 165 (allows recovery for costs that are incurred for a transaction that is "abandoned"). This provision typically requires significant documentation and analysis of when a transaction, an entity or an asset is "abandoned."
The LB&I Transaction Unit (LTU) describes a potential position that taxpayers may take to recover previously capitalized transaction costs when the entity or business that was acquired is distributed in a section 355 transaction. The LTU states that costs incurred to separate two businesses are not deductible, but must be capitalized, unless the separation is required by law, regulatory mandate or court order, or the separation transaction is abandoned. However, facts may support recovery of certain previously capitalized transaction costs as a result of a section 355 distribution if the property was acquired through a transaction where the previously incurred transaction costs were capitalized and where the distribution is viewed as an abandonment of the business and/or the stock acquired. If the facts support the section 355 distribution as an abandonment, a potential section 165 abandonment deduction may be appropriate.
The LTU notes that, to consider qualification as an abandonment loss under section 165, it must be shown that the distributing corporation "abandoned the controlled corporation’s stock" in the distribution and that the separation caused a "bonafide, uncompensated loss evidenced by closed and completed transactions, and fixed by identifiable events, as required under Treas. Reg. 1.165-1(b)."6 The LTU also notes that an abandonment loss may be asserted by a taxpayer when the taxpayer also reflects the abandonment in the financial statement disclosures indicating the previously capitalized costs are part of discontinued operations or permanent impairments.
In addition, a controlled corporation may be able to support a section 165 deduction of certain previously capitalized costs incurred in a prior acquisition of stock or assets if the distribution of the controlled corporation represents an abandonment of that acquired business. In order to support a potential abandonment position for tax purposes, the distribution of the previously acquired business assets, or the previously acquired stock of a corporation, the taxpayer claiming the section 165 deduction must establish that (a) any "synergistic and resource benefits associated with the controlled corporation’s affiliation with the distributing corporation terminated in the corporate separation;"7 (b) the separation of the controlled corporation’s affiliation with the distributing corporation caused an "bonafide, uncompensated loss evidenced by closed and completed transactions, and fixed by identifiable events, as required under Treas. Reg. 1.165-1(b);" and (c) the "controlled corporation has provided sufficient evidence to support that it is entitled to deduct the previously capitalized costs that facilitated the acquisition of its stock."8 In order to take the abandonment position contemplated by the LTU, the previously acquired business assets or the corporation stock would presumably be part of the controlled entity or its group of corporations that are being distributed in the section 355 transaction.
Previously capitalized costs can be recovered only if a rigorous factual and legal analysis is performed. To facilitate this analysis, for every transaction, the taxpayer should document the transaction costs incurred as part of their tax files associated with the subject transaction. This will assist with the preservation of information that relates to the existence of capitalized costs, such as who incurred the costs, the amount of the costs, and whether the costs can be allocated to the stock basis or asset basis. Even though these types of previously capitalized transaction costs (the INDOPCO costs) will not be on a tax basis balance sheet, they should be included on the balance sheet of the entity that capitalized the costs as a line item with no tax basis.
In addition, if the capitalized costs can be allocated to and added to the tax basis of the stock acquired, or to the tax basis of a particular asset or group of assets that were acquired, the taxpayer should keep detailed records in the tax files documenting the specific allocations. In addition, for any company acquiring a target company, the acquiring company should determine if the target company has any previously capitalized transaction costs, and make sure to "carry over" this information upon any merger or liquidation into another group member in its intercompany restructuring transactions. Also, if the business of the target company is abandoned, becomes part of other discontinued operations, or is subject to distribution under section 355, the taxpayer should make sure to review potential abandonment positions for the previously capitalized transaction costs that may be taken as outlined in the LTU.9 Also, note that a liquidation transaction where the business assets are retained by a group of taxpayers, but are held by another group member after the liquidation, does not give rise to a Section 165 deduction, because the business has not been distributed, sold, or otherwise discontinued or abandoned.10
Capitalized transaction costs routinely represent a significant amount of the costs that are incurred in a transaction, and these costs are typically not amortizable or recoverable for tax purposes. While, authority addressing the ability to recover these types of costs is very limited, we do know that certain tax positions cannot be taken with respect to capitalized transaction costs; for example, these costs are not section 197 assets and, thus, cannot be amortized as a section 197 asset. However, a taxpayer can support the recovery of capitalized transaction costs if the required significant factual analysis and legal analysis are performed to identify the taxpayer’s positions. Such an analysis could prove very beneficial if a taxpayer has significant capitalized transaction costs that otherwise would not be available for recovery. The LTU provides one approach that taxpayers may consider.
1 Treas. Reg. § 1.263(a)-5(a).
2 LB&I Transaction Unit – (04/30/19) Book 225, Chapter 4 – Treatment of Costs in a Corporate Separation. Note that an LB&I Transaction Unit is not to be cited as authority, but merely indicates an approach by the IRS on the issues addressed therein.
3 INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 89 (1992); Woodward v. Comm’r, 397 U.S. 572, 575-76 (1970).
4 United States v. Gilmore, 372 U.S. 39, 49 (1963).
5 The list of transactions includes, but is not limited to: (1) asset acquisition of a trade or business; (2) acquisition of an ownership interest in a business entity if, immediately thereafter, the acquiring and target companies are related under section 267(b) or section 707(b); (3) an acquisition of an ownership interest in the taxpayer other than by a redemption or other purchase of taxpayer’s equity by the taxpayer; (4) a reorganization under section 368; (5) a disposition under section 355; (6) a section 351 or 721 transaction; (7) a formation of a disregarded entity; (8) an acquisition of capital; (9) a stock issuance; and (10) bankruptcy transactions.
6 LB&I Transaction Unit (04/30/19).
9 An abandonment analysis under section 165 is highly factual and requires significant documentation and analysis of the event creating the abandonment, and timing of the abandonment, and, thus, is beyond the scope of this article.
10 See Tech. Adv. Mem. 200502039 (Jan. 14, 2005).
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.