Tax Consequences of Transaction Costs

By Larry Witner, LL.M., CPA, and David Casten, LL.M., CPA

EXECUTIVE
SUMMARY

  • Generally, transaction costs related to property purchases are capitalized. Transaction costs related to property sales generally are expensed if the property sold is inventory and capitalized if the property is not inventory.
  • Subject to specific requirements, taxpayers are not required to capitalize certain de minimis expenses (including transaction costs) related to property purchases.
  • There are two types of transaction costs incurred in acquiring tangible property, investigatory costs and facilitative costs. Generally, investigatory costs are costs incurred before the decision to acquire a particular property is made, and facilitative costs are incurred after the decision is made. Certain costs specified in the regulations are considered inherently facilitative and are treated as facilitative costs regardless of the time they are incurred.
  • The rules for the treatment of costs to acquire or create the various types of intangible assets are found in Regs. Secs. 1.263(a)-4 and 1.263(a)-5.

When dealing with property, a taxpayer may incur transaction costs, sometimes called indirect costs. Such costs facilitate a transaction, and they include such things as commissions, advertising fees, appraisal fees, transfer fees (e.g., transfer taxes), meals, travel, and professional fees (e.g., accounting and legal). This article discusses the tax consequences of transaction costs in four settings: in general, when acquiring or producing tangible assets, when acquiring or creating intangible assets, and when acquiring a business. As authority, the article often cites the proposed regulations regarding deduction and capitalization of property. 1 While such regulations are not definitive, they reveal IRS thinking, may be enough to avoid penalties, and portend the future.

Transaction Costs—Sales of Property

In general, transaction costs have the following tax consequences:

  1. If a taxpayer incurs transaction costs while selling dealer property (inventory), they are ordinary and necessary business expenses, otherwise known as selling expenses. 2 As such, they are deductible.
  2. If a taxpayer incurs transaction costs while selling or disposing of property other than inventory, transaction costs are capitalized. Under the general rule, capitalized transaction costs are (1) in the year of sale, subtracted in arriving at the amount realized, or (2) in the year the sale is abandoned, deducted as a loss under Sec. 165, if permissible. 3 Under an alternate rule, taxpayers add capitalized transaction costs to adjusted basis in situations involving securities, like-kind exchanges, and installment sales.

Example 1: When taxpayer T sells securities (adjusted basis = $70,000; FMV = $100,000) for their fair market value (FMV), T pays a commission of $1,000. The commission is a transaction cost on disposition. Under the general rule, the commission is subtracted in arriving at the amount realized of $99,000: $100,000 (selling price) – $1,000. Under the alternate rule, the commission is added in arriving at an adjusted basis of $71,000: $70,000 + $1,000. As Exhibit 1 reveals, both treatments produce the same result.


Example 2: T owns a truck that is business or income-producing property. In late year 1, T decides to sell the truck and pays $500 for an appraisal to determine a reasonable asking price. In early year 2, T sells the truck for $20,000. In year 1 T capitalizes $500 and in year 2 subtracts $500 in arriving at the amount realized of $19,500 ($20,000 – $500). 4


Example 3: The facts are the same as in Example 2, except in early year 2 T decides not to sell the truck. In year 1, T capitalizes $500, and in year 2, when the sale is abandoned, T deducts a loss of $500 under Sec. 165. 5


Example 4: The facts are the same as in Example 3, except the truck is personal-use property, not business or income-producing property. T abandons the sale in year 2 but cannot deduct a loss of $500 because the truck is not business or income-producing property. 6

Transaction Costs—Acquisitions of Property

In general, taxpayers must capitalize costs to acquire or produce tangible property that is a unit of property, is not materials or supplies, and is not de minimis. 7 In addition, taxpayers, with certain exceptions, must capitalize transaction costs. 8

De Minimis Item Exception

Taxpayers capitalize amounts paid or incurred to acquire or produce property. There is a de minimis item exception to this general rule. According to this exception, items are deductible, provided the taxpayer: 9

  1. Maintains applicable financial statements; 10
  2. Has a written financial accounting procedure for expensing items costing less than a certain dollar amount;
  3. Treats this amount as an expense on its financial statements in accordance with its written financial accounting procedure; and
  4. The total amount paid for de minimis items not capitalized does not distort the taxpayer’s income.

Taxpayers may elect to capitalize amounts that would otherwise be de minimis items. 11 Thus, if the amounts are used in business or income-producing endeavors, they would be deductible over time through depreciation, not deductible currently.

Example 5: To acquire property, among other costs, T pays an appraisal fee of $400. Assume that T meets the four-part test of the de minimis item exception. Specifically, with regard to test 2 above, T has a written financial accounting procedure to expense all costs of less than $500. T has a choice to either capitalize $400 or expense $400.

Transaction Costs to Acquire or Produce Tangible Property

When acquiring property, there are two types of transaction costs: investigatory costs and facilitative costs. 12 Investigatory costs are incurred during the pre-decision phase when taxpayers undertake the “whether and which” analysis. During this analysis, taxpayers consider whether to acquire property and, if so, which property to acquire. 13 Facilitative costs are incurred during the post-decision phase when taxpayers attempt to acquire a particular property.

With regard to the tax consequences of transaction costs on acquisition, in general taxpayers capitalize investigatory costs and facilitative costs. 14 But in the case of real property, taxpayers deduct investigatory costs (other than those that are inherently facilitative under Prop. Regs. Sec. 1.263(a)-2(d)(3)(ii)(B)) and capitalize facilitative costs. 15

Example 6: In acquiring tangible property, T pays investigatory costs of $50,000 and facilitative costs of $150,000. If the property is personal property (e.g., equipment), T capitalizes $200,000 ($50,000 + $150,000). If the property is real property, T deducts $50,000 and capitalizes $150,000.

The following items are inherently facilitative and are capitalized into the cost of acquired property: 16

  • Transporting property (e.g., shipping fees, moving costs);
  • Securing an appraisal;
  • Negotiating terms of an acquisition and obtaining tax advice on the acquisition;
  • Application fees and bidding costs;
  • Preparing and reviewing documents that effectuate the acquisition of property (e.g., preparing the bid, offer, sales contract, or purchase agreement);
  • Examining and evaluating the title of the property;
  • Obtaining regulatory approval of an acquisition or securing permits related to the acquisition, including application fees;
  • Conveying property between parties, including sales and transfer taxes and title registration costs;
  • Finders’ fees or brokers’ commissions;
  • Architectural, geological, engineering, environmental, or inspection services pertaining to particular properties; and
  • Services provided by a qualified intermediary or other facilitator of a Sec. 1031 exchange.

Example 7: T, a taxpayer who is a tenant, pays a fee to a real estate broker for services rendered in locating suitable office space to purchase. T capitalizes the broker’s fee because it is inherently facilitative. 17


Example 8: Taxpayer T purchases the assets of XYZ Company and pays a moving company to transfer storage tanks from XYZ’s plant to T’s plant. T capitalizes the moving costs because they are inherently facilitative. 18


Transaction Costs to Acquire or Create Intangible Assets

The INDOPCO regulations 19 require capitalization of six categories of expenditures relating to intangible assets. These categories are numbered and summarized in Exhibits 2 and 3. Of these six categories, 1–4 pertain to direct costs (Exhibit 2) and 5–6 to indirect costs (Exhibit 3), also known as transaction costs.

Category 5 transaction costs are those paid or incurred to acquire or create category 1–4 intangible assets. Taxpayers add such costs to the basis of category 1–4 intangible assets acquired or created. 20

Example 9: FE, a franchisee, and FR, a franchisor, are in the process of concluding a deal. That is, they entered into a letter of intent and are engaged in ironing out the details. To close the deal, FE pays legal fees of $18,000, consulting fees of $30,000, appraisal fees of $9,000, and meal and travel costs of $3,000. FE pays a franchise fee of $120,000.

Under the INDOPCO regulations, $120,000 is capitalized because the franchise fee is a category 2 intangible asset, and $60,000 ($18,000 + $30,000 + $9,000 + $3,000) is capitalized because this amount represents category 5 transaction costs. The initial basis of the franchise is $180,000 ($120,000 + $60,000). The franchise is an amortizable Sec. 197 intangible asset, subject to 15-year amortization. Consequently, FE’s monthly amortization deduction is $1,000 ($180,000 ÷ 180).

Transaction Costs to Acquire a Business

The tax consequences of category 6 transaction costs are summarized as follows:

  • In the context of taxable acquisitions, category 6 transaction costs are:
    • Added to the basis of assets if assets are acquired; 21 or
    • Added to the basis of stock if stock is acquired. 22
  • In the context of nontaxable acquisitions (i.e., Sec. 368 reorganizations), which are not addressed in the INDOPCO regulations, category 6 transaction costs are added to a separate intangible asset (e.g., acquisition costs) and not amortized. 23 In this case, costs are recovered when the entity is dissolved. Specifically, at the time of dissolution, gain is decreased or loss is increased.
Business Acquisition Costs: Investigatory vs. Facilitative

With regard to business acquisition costs, there is a tension between Secs. 195 and 263. That is, when acquiring a business:

  • If costs are investigatory within the meaning of Sec. 195, they are start-up costs, and they are capitalized and deducted/amortized, 24 commencing in the month when business begins.
  • If costs are facilitative within the meaning of Sec. 263, they are category 6 transaction costs with the tax consequences mentioned above and illustrated below.

To distinguish between investigatory costs and facilitative costs, the INDOPCO regulations provide an inherently facilitative rule and some bright-line dates. Business acquisition costs are facilitative (category 6 transaction costs) only if: 25

  1. They are inherently facilitative of the acquisition; 26 or
  2. They relate to activities performed on or after the earlier of:
    1. The date on which a letter of intent or similar written communication is executed by representatives of the acquirer and the target;
    2. The date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors (if a corporation) or governing officials (if not a corporation); or
    3. The date on which the acquirer and the target execute a binding written contract if the transaction does not need the authorization or approval of the taxpayer’s board of directors or governing officials.

Examples

The following facts and dates are relevant to examples 10–13:

  • In year 1, to explore the possibilities of expanding its operations, A hired investment banker IB for $600,000.
  • On January 1, year 2, based on IB’s recommendation, A’s board of directors authorized its representatives to pursue acquiring target TG, a competitor.
  • In year 2, while pursuing the acquisition, A incurred professional fees of $900,000: $500,000 of legal fees, $320,000 of investment banking fees, and $80,000 of appraisal fees.
  • In year 3, A acquired TG.

Example 10: On January 1, year 2, A’s board of directors authorized pursuit of TG. According to the INDOPCO regulations, this is the date before which there cannot be category 6 transaction costs. Assuming that the $600,000 of year 1 investment banking fees is not inherently facilitative, those fees ($600,000) are not category 6 transaction costs. (They are Sec. 195 start-up costs, subject to deduction/amortization.)

Since tax treatment of the year 1 investment banking fees has been determined, the topic is not dealt with in Examples 11–13.

The year 2 professional fees of $900,000 are category 6 transaction costs because they are incurred for services performed on or after January 1, year 2, and they are facilitative.

Example 11: A acquires TG in a taxable acquisition wherein A purchases all of TG’s assets for $8 million. A’s initial basis in acquired assets is $8,900,000 ($8 million + $900,000). A recovers this amount through cost recovery and when assets are sold. Any amount of the $8,900,000 that is allocable to goodwill is subject to 15-year amortization.


Example 12: A acquires TG in a taxable acquisition wherein A purchases all of TG’s stock for $8 million. A’s initial basis in the stock is $8,900,000 ($8 million + $900,000). A recovers this cost when the stock is sold.


Example 13: A acquires TG in a nontaxable acquisition. Specifically, A issues its stock in exchange for all of TG’s stock in a type B reorganization or for all of TG’s assets in a type C reorganization. Category 6 transaction costs of $900,000 are capitalized into a separate intangible asset (e.g., acquisition costs). These costs are not recovered until A dissolves, at which time gain is decreased or loss is increased.

Conclusion

Taxpayers considering the acquisition, disposition, or improvement of property need to review the applicability of Sec. 263 and the regulations thereunder to determine the proper treatment of costs incurred to effect these transactions. In most cases, the costs must be capitalized, added to the basis of the underlying property, and recovered in the same manner as the basis in the underlying property. In some cases, these costs must be capitalized as a separate asset that can be recovered only upon disposition of the underlying property. In other situations, these costs are currently deductible. The tax treatment will depend on the type of asset acquired and the type, timing, and amount of the costs incurred.

Footnotes

1 REG-168745-03, 73 Fed. Reg. 12837 (3/10/08).

2 Prop. Regs. Sec. 1.263(a)-1(d)(1).

3 Prop. Regs. Sec. 1.263(a)-1(d)(2).

4 Prop. Regs. Sec. 1.263(a)-1(d)(3), Example (3).

5 Prop. Regs. Sec. 1.263(a)-1(d)(3), Example (4).

6 Prop. Regs. Sec. 1.263(a)-1(d)(3), Example (6).

7 Prop. Regs. Secs. 1.263(a)-2(d)(1) and (4).

8 Prop. Regs. Sec. 1.263(a)-2(d)(3).

9 Prop. Regs. Sec. 1.263(a)-2(d)(4)(i).

10 For a definition of applicable financial statements, see Prop. Regs. Sec. 1.263(a)-2(d)(4)(vi).

11 Prop. Regs. Sec. 1.263(a)-2(d)(4)(v).

12 This discussion takes liberties with terminology. The proposed regulations for tangible property refer to costs that facilitate the acquisition of real or personal property. The discussion subdivides these costs into investigatory costs and facilitative costs, which enables a better understanding of tax consequences in general and the relationship between Secs. 195 (start-up costs) and 263 (capital expenditures) in particular. It also enables consistent tax treatment between transactions to acquire or produce tangible property and transactions to acquire a business).

13 Prop. Regs. Sec. 1.263(a)-2(d)(3)(ii)(C).

14 Prop. Regs. Sec. 1.263(a)-2(d)(3)(i).

15 Prop. Regs. Sec. 1.263(a)-2(d)(3)(ii)(C).

16 Prop. Regs. Sec. 1.263(a)-2(d)(3)(ii)(B).

17 Prop. Regs. Sec. 1.263(a)-2(d)(3)(iv), Example (1).

18 Prop. Regs. Sec. 1.263(a)-2(d)(3)(iv), Example (3).

19 Regs. Secs. 1.263(a)-4 and -5, so named after INDOPCO, Inc., 503 U.S. 79 (1992). In this case, the Supreme Court held that capital additions (improvements) are costs that result in significant future benefits, whether or not they produce a separate and distinct asset.

20 Regs. Sec. 1.263(a)-4(g)(1).

21 Regs. Sec. 1.263(a)-5(g)(2)(i).

22 Id.

23 INDOPCO, note 19 above.

24 Sec. 195(b)(1).

25 Regs. Sec. 1.263(a)-5(e)(1).

26 For a list of inherently facilitative costs, see Regs. Sec. 1.263(a)-5(e)(2).

EditorNotes

Larry Witner is an associate professor at Bryant University in Smithfield, RI. David Casten is a practicing attorney in Providence, RI, and an adjunct professor at Boston University’s School of Law, Graduate Tax program. He is a retired partner at KPMG. For more information about this article, contact Prof. Witner at lwitner@bryant.edu.

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