IRS Broadens 70% Safe-Harbor Deduction for Investment Advisory Milestone Payments

By David A. Thornton, CPA, and James D. Slivanya, CPA, New York City

Editor: Howard Wagner, CPA

Expenses & Deductions

The deduction for success-based financial advisory fees related to business acquisitions has continued to evolve in a taxpayer-favorable direction over the past several years. While this area had been a source of considerable disagreement between taxpayers and the IRS, the issuance of Rev. Proc. 2011-29 significantly defused the issue for many taxpayers by offering a 70% elective safe harbor for success-based fees related to most business-acquisition transactions. However, subsequent guidance issued by Treasury on how to apply the safe harbor to certain investment advisory milestone payments has been somewhat contradictory and sporadic. The latest round of guidance issued in January 2014 (LB&I-04-0114-001) is favorable to taxpayers and simplifies the determination of which milestone payments qualify for the 70% elective safe harbor.

Background

In 2003, Treasury issued final regulations under Regs. Sec. 1.263(a)-5 (T.D. 9107) regarding the deductibility of costs related to a variety of business transactions, including asset acquisitions, stock or other equity acquisitions, restructurings, recapitalizations, reorganizations, stock issuances, and borrowing transactions. These regulations provide a general blueprint for determining which costs facilitate a transaction and which do not. Facilitative costs must be capitalized, and nonfacilitative costs can be deducted under Sec. 162 (or amortized under Sec. 195 if the taxpayer is entering a new trade or business).

For acquisitive transactions, a bright-line date is used to segregate facilitative and nonfacilitative costs. The bright-line date is the earlier of (1) the date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target or (2) the date on which the material terms of the transaction (as tentatively agreed to by representatives of the acquirer and the target) are authorized or approved by the taxpayer's board of directors. In the case of a taxpayer that is not a corporation, the bright-line date is the date on which the material terms of the transaction are authorized or approved by the appropriate governing officials.

Transaction costs incurred for services provided on or after the bright-line date are presumed to be facilitative and must be capitalized. Costs incurred for services provided before the bright-line date generally are presumed to be investigatory in nature (nonfacilitative) and therefore are deductible. However, Regs. Sec. 1.263(a)-5(e)(2) provides an important exception to the deductibility of pre-bright-line costs that are inherently facilitative—those that relate to activities determined to be so directly facilitative to the transaction that the timing of incurrence is irrelevant. These include costs for securing appraisals, written evaluations, or fairness opinions related to the transaction; structuring the transaction (including tax opinions); preparing and reviewing documents (such as acquisition or merger agreements) that effectuate the transaction; and obtaining shareholder or regulatory approval for the transaction.

In a typical transaction, financial advisory fees are likely to fall into all three categories—facilitative, nonfacilitative, and inherently facilitative.

Regs. Sec. 1.263(a)-5 acknowledges that success-based financial advisory fees contingent on the successful closing of a transaction can be allocated to the various services provided by the financial advisers for purposes of determining their deductibility. However, this regulation imposes a documentation requirement that often is difficult to meet. Taxpayers are required to gather objective and auditable supporting records beyond mere allocations of time spent on deductible activities.

While itemized hourly timesheet information would be the ideal source of this documentation (similar to what is often provided to support hourly fee charges from service providers such as attorneys and accountants), such information often is not available from financial advisory firms. Most financial advisory firms do not charge hourly fees and either cannot, or will not, provide hours-based information for the various employees of the financial advisory firm working on a particular transaction. Consequently, taxpayers often are required to compile support that is based on subjective input from the investment advisers. Such support frequently has been challenged by the IRS as failing to meet the documentation requirements set forth in the regulations.

Rev. Proc. 2011-29

To eliminate a considerable amount of uncertainty related to success-based fee deductions, the IRS issued Rev. Proc. 2011-29 on April 8, 2011. This pronouncement offers taxpayers an elective safe harbor to deduct 70% of any qualifying success-based fee, provided the remaining 30% is capitalized. If the safe harbor is elected, there is no requirement for the taxpayer to gather any supporting documentation or prepare any supporting calculations related to the deductible portion of the fee. The election is irrevocable and requires a formal attachment to the tax return for the year in which the qualified success-based fee is paid or incurred. Qualified success-based fees include only those that relate to a transaction described in Regs. Sec. 1.263(a)-5(e)(3), which includes most acquisitive transactions, that are incurred in a tax year ending on or after April 8, 2011.

Example 1: A taxpayer is a target in a takeover transaction that qualifies as a tax-free reorganization under Sec. 368. In 2014, the taxpayer incurs a $1 million success-based fee payable to its investment banker that is contingent upon the successful closing of the transaction.

The taxpayer has two alternatives for deducting some portion of this fee:

  1. Elect the safe harbor and deduct $700,000 of the fee (capitalize $300,000) with no requirement to gather any supporting documentation regarding the deductible portion.
  2. Forgo the safe harbor and deduct whatever portion of the success-based fee that can be supported as investigatory (rather than facilitative) with adequate documentation, keeping in mind the stringent documentation requirements set forth in the regulation and the risk that the deduction could be disallowed (in whole or in part) under examination, based on the adequacy of this supporting documentation.
IRS Guidance on Investment Advisory Milestone Payments

On July 16, 2012, the IRS issued Chief Counsel Advice (CCA) 201234027 to clarify its position on applying the 70% elective safe harbor to success-based fees involving various nonrefundable milestone payments that are credited toward the overall success-based fee. The need for such clarification is not surprising, given that success-based investment advisory fee arrangements often call for one or more nonrefundable payments to be made upon achieving certain milestones (such as signing the merger agreement or securing shareholder approval) in the course of closing a transaction, rather than only one amount payable upon closing. The IRS initially reasoned that such nonrefundable milestone payments do not qualify for the 70% safe harbor because they are conditioned on events other than the actual closing of the transaction, even though these payments are credited toward the overall success-based fee due at closing.

This guidance was not well-received by taxpayers because it diluted the effectiveness of the elective safe harbor. The goal of the 70% elective safe harbor was to eliminate the need for taxpayers to gather the type of documentation necessary to meet the strict—and often unattainable—standards set forth in the regulations with respect to success-based fees. Given that many investment advisory fee arrangements call for nonrefundable milestone payments throughout the course of an acquisition transaction, the IRS ruling would have required taxpayers to gather this supporting documentation, notwithstanding the safe-harbor election, because the milestone payments would fall outside the scope of the safe harbor. Failing to meet the documentation requirement would render the entire milestone payment nondeductible.

To allay taxpayer concerns, on April 29, 2013, the IRS issued an examination directive from within the Large Business and International Division, LB&I-04-0413-002, effectively reversing the conclusion reached in CCA 201234027 for certain eligible milestone payments. This directive holds that the IRS will not challenge a taxpayer's application of the 70% elective safe-harbor deduction to a milestone payment related to an acquisition transaction, provided it satisfies the following conditions:

  • It relates to investment banking services.
  • It is nonrefundable.
  • It is creditable toward an overall success-based fee that is contingent upon the successful closing of the transaction.
  • It is contingent upon an event occurring in the course of a covered transaction.
  • It is not contingent upon an event that occurs before the event establishing the bright-line date in Regs. Sec. 1.263(a)-5(e)(1).

Under this directive, the 70% safe-harbor deduction will apply to these eligible milestone payments in addition to the final success-based fee due upon closing of the transaction.

Example 2: A taxpayer is a target in a takeover transaction that qualifies as a tax-free reorganization under Sec. 368. In 2014, the taxpayer incurs a $1 million success-based fee payable to its investment banker as follows (all payments are nonrefundable):

  • $50,000 upon signing the financial advisory engagement letter (pre-bright-line date);
  • $100,000 upon board ­approval of the material terms of the transaction;
  • $100,000 upon securing shareholder approval; and
  • $750,000 ($1 million, less credit for the three installments paid to date) upon closing.

Assuming the safe harbor is elected, the directive holds that the first installment of $50,000 is not an eligible milestone payment because it occurs before the bright-line date set forth in Regs. Sec. 1.263(a)-5(e)(1). The remaining payments, however, do constitute eligible milestone payments and qualify for the 70% safe harbor. Thus, the total deduction under the safe harbor would be $665,000 ([$100,000 × 70%] + [$100,000 × 70%] + [$750,000 × 70%]).

The $50,000 installment is deductible to the extent the taxpayer can support that this payment relates to activities that are investigatory (rather than facilitative) and can meet the stringent documentation requirements set forth in the regulations. This deduction would not be protected by any safe harbor and therefore could be challenged by the IRS under examination. According to the regulations, if the necessary supporting documentation is not timely gathered with respect to this payment, then it would have to be fully capitalized.

IRS Broadens the Definition of Eligible Milestone Payments

While the IRS guidance expanding the elective 70% safe-harbor deduction to eligible milestone payments was favorably received, taxpayers criticized the definition of eligible milestone payments based on the bright-line date in Regs. Sec. 1.263(a)-5(e)(1) as being out of touch with fee structures common to investment advisory relationships. Investment banking engagements commonly require an upfront payment that is creditable toward the overall success-based fee, and this payment often is due before the bright-line date. Taxpayers argued that disallowing the 70% elective safe-harbor deduction for these payments would be inconsistent with the goal of Rev. Proc. 2011-29 because the supporting information described in Regs. Sec. 1.263(a)-5(f) still would have to be gathered to support the deductible portion of these payments, notwithstanding the fact that the taxpayer elected the 70% safe harbor with respect to the transaction.

On Jan. 27, 2014, the IRS obviated taxpayers' concerns by issuing a revised examination directive (LB&I 04-0114-001). This directive instructs IRS examining agents not to challenge a taxpayer's application of the 70% safe harbor to an otherwise eligible milestone payment that is contingent on the occurrence of an event occurring before the bright-line date described in Regs. Sec. 1.263(a)-5(e)(1). This new directive applies only to investment banking fees that otherwise meet the definition of an eligible milestone payment (incurred in the course of pursuing a covered transaction and that is nonrefundable, contingent upon the occurrence of an identified milestone, and credited toward an overall success-based fee).

Notwithstanding the guidance provided in LB&I-04-0413-002, the updated definition of an eligible milestone payment provided in LB&I-04-0114-001 holds that, for the taxpayer in Example 2, the first installment of $50,000 is indeed an eligible milestone payment, and therefore, 70% of this amount can be deducted because the taxpayer made the safe-harbor election. Thus, the total deduction under the safe harbor would be $700,000 ([$50,000 × 70%] + [$100,000 × 70%] + [$100,000 × 70%] + [$750,000 × 70%]).

The guidance provided in LB&I-04-0114-001 can be applied only to original, timely filed returns and not to refund claims.

Conclusion

The deductibility of success-based financial advisory fees related to acquisition transactions historically has been an area of considerable disagreement between taxpayers and the IRS. However, in 2011 the IRS eliminated the uncertainty for many taxpayers by issuing Rev. Proc. 2011-29, which offers an elective safe harbor to deduct 70% of these fees without the need to gather supporting documentation. The applicability of this safe harbor to milestone payments for investment advisory services has evolved over the past two years in a taxpayer-favorable direction. While some of the recent guidance in this area has been contradictory and sporadic, LB&I-04-0114-001 should eliminate much of the confusion in this area and offer a taxpayer-favorable solution for applying the 70% safe harbor to eligible milestone payments.

EditorNotes

Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.

For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

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