by Matthew J. Mittman, CPA, Oak Brook, IL, and Thomas J. Brecht, CPA, Elkhart, IN
Expenses & Deductions
The treatment of success-based fees that are paid or incurred in connection with the successful closing of business acquisitions or reorganizations described in Regs. Sec. 1.263(a)-5(e)(3) (covered transactions) continues to be the subject of controversy between the IRS and taxpayers. Specifically, numerous disagreements have arisen regarding what documentation is necessary to establish that a portion of the success-based fee is allocable to activities that do not facilitate a business acquisition, which could result in an immediate deduction to the taxpayer.
In an effort to eliminate the controversy over the allocation of success-based fees and corresponding documentation requirements, the IRS issued Rev. Proc. 2011-29, providing taxpayers with a safe-harbor election for allocating 70% of success-based fees paid or incurred in a covered transaction described in Regs. Sec. 1.263(a)-5(e)(3) to activities that do not facilitate the transaction. The remaining 30% of the success-based fees must be capitalized as an amount that facilitates the transaction. The election is available for success-based fees paid or incurred in tax years ending on or after April 8, 2011.
Taxpayers that choose not to make the election must maintain documentation under Regs. Sec. 1.263(a)-5(f) to establish that a portion of the success-based fees are allocable to activities that do not facilitate the transaction. As addressed below, the safe-harbor election under the revenue procedure attempts to eliminate the controversy over the allocation of success-based fees and the documentation requirements for only certain transactions.
Background
Under Sec. 263(a)(1) and Regs. Sec. 1.263(a)-2(a), capitalization is required and no immediate deduction is allowed for any amount paid for property that has a useful life substantially beyond the tax year of the taxpayer. In the case of an acquisition or reorganization of a business entity, acquisition costs that generate significant long-term benefits must be capitalized.
Under Regs. Sec. 1.263(a)-5, a taxpayer must capitalize amounts paid that facilitate transactions, including business acquisitions and reorganizations, described in Regs. Sec. 1.263(a)-5(a). An amount paid or incurred in the process of investigating or otherwise pursuing the transaction is an amount paid to facilitate a transaction described in Regs. Sec. 1.263(a)-5(a), unless the services were performed prior to the date the letter of intent was signed or the material terms of the transaction were agreed to by representatives of the acquirer and the target (this date is referred to as the bright-line date and is described in Regs. Sec. 1.263-5(e)(1)). (See Regs. Sec. 1.263-5(e)(2) for exceptions to Regs. Sec. 1.263-5(e)(1).)
A success-based fee paid or incurred on the closing of a transaction described in Regs. Sec. 1.263(a)-5(a) is presumed to facilitate the transaction under Regs. Sec. 1.263(a)-5(f). To rebut the presumption that a success-based fee paid or incurred is facilitative of a covered transaction, the taxpayer must maintain sufficient documentation in accordance with Regs. Sec. 1.263(a)-5(f). Covered transactions under 1.263(a)-5(e)(3) consist of:
* A taxable acquisition by the taxpayer of assets that constitute a trade or business;
* A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer or the target in the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of Sec. 267(b) or 707(b); and
* A reorganization described in Sec. 368(a)(1)(A), (B), or (C) or one described in Sec. 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Sec. 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).
The IRS and Treasury expect that much of the controversy surrounding the treatment of success-based fees and the type and extent of documentation required to establish that a portion of a success-based fee is allocable to activities that do not facilitate a covered transaction can be eliminated by giving taxpayers a simplified method for allocating a success-based fee paid in a covered transaction. Accordingly, Rev. Proc. 2011-29 provides a safe harbor for allocating a success-based fee between activities that facilitate a covered transaction and activities that do not facilitate a covered transaction.
Making the Safe-Harbor Election and Its Impact
Instead of taxpayers having to maintain the documentation required under Regs. Sec. 1.263(a)-5(f) to substantiate the allocation of success-based fees between activities that facilitate and those that do not facilitate a covered transaction described in Regs. Sec. 1.263(a)-5(e)(3), the IRS will not challenge the taxpayer’s allocation of a success-based fee if the taxpayer:
* Treats 70% of the amount of the success-based fee as an amount that does not facilitate the transaction;
* Capitalizes the remaining 30% as an amount that does facilitate the transaction; and
* Attaches a statement to its original federal income tax return for the tax year the success-based fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction, and stating the success-based fee amounts that are deducted and capitalized.
The 70% of the success-based fees that is treated as not facilitative of the transaction is essentially treated the same as nonfacilitative costs incurred prior to the bright-line date would have been had the taxpayer completed an analysis and allocation of the actual time incurred.
An election under Rev. Proc. 2011-29 is irrevocable and applies only with respect to all success-based fees paid or incurred by the taxpayer in the transaction for which the election is made. An election for any acceptable transaction generally does not constitute a change in the taxpayer’s method of accounting for success-based fees. Accordingly, a Sec. 481(a) adjustment is neither permitted nor required.
Immediate Deduction or Start-up Cost
If the purchasing entity (Purchaser) acquires the corporate stock of a target entity (Target) or the assets that constitute the trade or business of Target in a covered transaction under Regs. Secs. 1.263(a)-5(c)(3)(i) and (ii), and Purchaser is currently in the same line of trade or business as Target, the portion of expenses that are not facilitative of the transaction is immediately deductible by Purchaser under Sec. 162 as an ordinary business expense. Accordingly, a safe-harbor election under Rev. Proc. 2011-29 can result in an immediate deduction for 70% of the success-based fees paid by Purchaser. If Purchaser is not in the same trade or business as Target, the costs incurred that are not facilitative of the transaction, including 70% of the success-based fee, are deductible as they are amortized under Sec. 195.
In the acquisition of Target’s stock or assets that constitute the trade or business of Target (asset acquisition) by a non-strategic buyer, such as a private equity group, Purchaser is commonly a newly formed corporate entity (Newco). If Target is an add-on to one of the private equity group’s existing portfolio companies, and Newco acquires the stock or assets of Target and makes the safe-harbor election under the revenue procedure, 70% of the success-based fee paid by Newco is not facilitative of the covered transaction. However, as explained below, the portion of the success-based fee that is not facilitative of the transaction is not immediately deductible by Newco.
In Specialty Restaurants Corp., T.C. Memo. 1992-221, the Tax Court held that a parent corporation could not deduct the start-up expenses of subsidiaries incorporated to open and operate theme restaurants as Sec. 162 business expenses because the restaurants had not been opened and therefore the expenses were not related to trade or business. The amounts paid should have been either capitalized under Sec. 263 or amortized under Sec. 195. Accordingly, 70% of the success-based fee paid by Newco is not immediately deductible under Sec. 162 as an ordinary business expense but instead is a start-up expense subject to Sec. 195.
Bargain Purchase
If Purchaser acquires Target in an asset acquisition, the costs that facilitate the transaction are capitalized and allocated to the basis of the acquired assets under Regs. Sec. 1.263(a)-5(g)(2)(i). As discussed above, an election made by Purchaser under Rev. Proc. 2011-39 to treat 70% of the success-based fee paid as nonfacilitative of the transaction results in an immediate deduction if Purchaser is currently in the same line of trade or business as Target. If Purchaser is not in the same line of trade or business as Target, the nonfacilitative costs are subject to Sec. 195.
In the case of a bargain purchase (an asset acquisition where total purchase consideration—i.e., amounts paid plus liabilities assumed—is less than the fair market value (FMV) of Target’s assets), Purchaser might recognize income immediately after the transaction. For example, if, after allocating total purchase consideration in accordance with Sec. 1060(a) and Regs. Sec. 1.338-8(b), Purchaser’s tax basis in acquired inventory is less than its FMV and Purchaser subsequently sells the inventory, Purchaser has taxable income equal to the difference between the sales price and tax basis of the inventory. When there is a bargain purchase of Target and Purchaser is not in the same line or business as Target, the amount of the success-based fee that is not facilitative of the transaction under the revenue procedure is a start-up cost under Sec. 195. If the amount of nonfacilitative costs exceeds the annual deduction allowed under Sec. 195, Purchaser will obtain a tax benefit for this amount over a period of 15 years. However, if Purchaser does not make the safe-harbor election under the revenue procedure, the entire success-based fee is allocated to the assets acquired as discussed above. Accordingly, Purchaser will realize a tax benefit for the amount of the fee paid in the first tax year subsequent to the transaction, assuming the entire success-based fee is allocated to the acquired inventory and all inventory is sold shortly thereafter.
Legal and Other Fees
Rev. Proc. 2011-29 appears to apply only to success-based fees paid or incurred in a covered transaction. However, Purchaser typically incurs legal, accounting, and consulting fees that are not success based in conjunction with a covered transaction. If Purchaser does not want to capitalize the other costs incurred into either the stock basis of Target or the basis of Target’s assets, Purchaser must analyze the various costs paid or incurred in the transaction to determine which amounts are not facilitative of the transaction and are immediately deductible as Sec. 162 normal business expenses, or subject to Sec. 195.
Success-Based Fees Allocable to Debt Issuance Costs
In business acquisitions by private equity groups, Newco’s purchase of Target’s stock or assets is typically funded by new borrowings and capital equity. Many private equity groups also charge a success-based fee upon the close of the business acquisition, of which a portion is attributable to the time spent in obtaining the financing. Based on Regs. Sec. 1.263(a)-5, the amount of a private equity group’s success-based fee that is allocated to debt issuance costs and amortized under Regs. Sec. 1.446-5 is determined by the percentage of the private equity group’s time spent arranging the financing.
Under Regs. Sec. 1.263(a)-5(c)(1), an amount paid to facilitate a borrowing is not facilitative of another transaction that is described under Regs. Sec. 1.263(a)-5(a). Accordingly, a private equity group that obtains financing to fund the purchase of Target’s stock or assets has two separate transactions identified under Regs. Sec. 1.263(a)-5(a). However, a success-based fee paid to the private equity group is related to the successful closing of both transactions, which are integrally related to the private equity group.
As discussed above, the election under Rev. Proc. 2011-29 is available only to covered transactions. However, a transaction that constitutes a borrowing is not one of the covered transactions listed under Regs. Sec. 1.263(a)-5(e)(3). As such, it appears that the safe-harbor election under the revenue procedure does not apply to the allocation of a success-based fee to debt issuance costs.
There is some uncertainty in this interpretation, though as the revenue procedure also states, “[t]he election applies with respect to all success-based fees paid or incurred by the taxpayer in the transaction for which the election is made” (Rev. Proc. 2011-29, §4.02; emphasis added). It appears that the reference to the transaction within the revenue procedure is to a covered transaction. The plain language seems to indicate that a borrowing that takes place in conjunction with a covered transaction is a separate and distinct transaction. Consequently, it appears that the costs associated with the borrowing are not includible in the revenue procedure election.
If the success-based fee allocated to the financing transaction is not subject to Rev. Proc. 2011-29, presumably it is reasonable for the taxpayer to first allocate the fee between the debt issuance costs and the covered transaction, then make the safe-harbor election under the revenue procedure for the portion of the success-based fee allocated to the covered transaction. Accordingly, the taxpayer could end up with the ability to capture a larger portion of the overall success-based fee paid through amortization or immediate deduction. However, the taxpayer must obtain proper documentation to substantiate the allocation of success-based fees paid to the debt origination and the covered transaction, which defeats the purpose of the revenue procedure. The IRS needs to provide further clarification to confirm this understanding.
Conclusion
It is important to consider that the election under Rev. Proc. 2011-29 is available to success-based fees paid or incurred (including the sell-side costs, which this item does not explicitly address) in a covered transaction. Generally, costs incurred in a transaction that a taxpayer is not required to capitalize under Regs. Sec. 1.263(a) or Sec. 195 are deductible as ordinary and necessary expenses. As a result, it is important to analyze the timeline of the transaction and determine the bright-line date when considering whether to make the election under the revenue procedure. If more than 70% of the activities that generated the success-based fee occurred prior to the bright-line date, the election might not be beneficial. The tax benefit might be larger in specific fact patterns when making the election under the revenue procedure; however, the net present value of the tax benefit might still be larger without making the election due to the timing of the resulting deductions. One must consider both the amount and the timing of the deductions with and without the election. Further clarification is needed from the IRS regarding the application of Rev. Proc. 2011-29 to a success-based fee paid or incurred in a transaction that is composed of both a debt issuance and a covered transaction, as commonly encountered by private equity groups.
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