In Chief Counsel Advice (CCA) 201624021, the IRS affirmed that taxable asset acquisitions are "covered" transactions for acquirers but not for targets, and, therefore, targets are ineligible to deduct success-based transaction costs using the elective safe-harbor method because the election is available only for covered transactions. Although it may not be used or cited as precedent, the CCA provides helpful insight to taxpayers planning or negotiating merger and acquisition transactions.
Facts of the CCA
On Dec. 31, 2012, the shareholders of an S corporation sold all of their outstanding stock to a corporation. The parties jointly elected to treat the stock acquisition as a taxable asset acquisition under Sec. 338(h)(10). In connection with implementing the transaction, the target S corporation incurred transaction costs consisting of success-based fees paid to an investment bank and non-success-based expenses to draft information memoranda, review contracts, and prepare letters of intent. With respect to the success-based costs, the target S corporation attached a statement to its timely filed original 2012 federal income tax return electing to deduct 70% of these costs and to capitalize the remaining 30%, under the safe-harbor allocation method described in Rev. Proc. 2011-29.
Transaction Costs Generally Capitalized
Regs. Sec. 1.263(a)-5 largely governs the federal income tax treatment of transaction costs incurred in connection with 10 types of transactions listed in Regs. Secs. 1.263(a)-5(a)(1) through (10), with the first being "[a]n acquisition of assets that constitute a trade or business (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition)."
Regs. Sec. 1.263(a)-5(a) provides that transaction costs paid to "facilitate" any of the enumerated transactions must generally be capitalized, regardless of "whether the transaction is comprised of a single step or a series of steps carried out as part of a single plan and without regard to whether gain or loss is recognized in the transaction."
Exception: Covered Transactions Safe Harbor
However, Regs. Sec. 1.263(a)-5 also provides several exceptions and special rules that permit taxpayers an accelerated deduction for expenses of certain covered transactions, including the "bright-line" date exception in Regs. Sec. 1.263(a)-5(e), under which transaction costs are not required to be capitalized to the extent they are incurred to investigate or otherwise pursue a covered transaction and satisfy certain other technical requirements.
Regs. Sec. 1.263(a)-5(e)(3) describes three covered transactions, including "a taxable acquisition by the taxpayer of assets that constitute a trade or business." Note that the regulations do not include a taxable sale of assets by the taxpayer as a covered transaction.
Amounts paid contingent on the successful closing of the covered transaction, such as success-based fees incurred to investment bankers, are subject to additional provisions of Regs. Sec. 1.263(a)-5(f) requiring taxpayers to properly document with supporting records the portion of the success-based fee allocable to activities that do not facilitate the transaction (i.e., the potentially deductible portion).
In an effort to reduce the controversy surrounding the success-based fee documentation requirements, the IRS issued Rev. Proc. 2011-29, which provides a safe-harbor election for allocating success-based fees paid in connection with covered transactions. Eligible taxpayers that elect to apply these safe-harbor provisions may treat 70% of the success-based fee pertaining to the covered transaction as an amount that does not facilitate the transaction (i.e., potentially deductible). The remaining 30% of the success-based fee must be capitalized as an amount that facilitates the transaction.
With regard to a target's treatment of capitalized transaction costs pertaining to a taxable asset acquisition, Regs. Sec. 1.263(a)-5(g)(2)(ii)(A) provides that:
[I]n the case of an acquisition, merger or consolidation . . . that is treated as an acquisition of the assets of the target for federal income tax purposes, an amount required to be capitalized under this section by the target is treated as a reduction of the target's amount realized on the disposition of its assets.
Safe Harbor Not Available: Transaction Not Covered
Applying the foregoing authority to the facts in CCA 201624021, the IRS affirmed that a taxable asset acquisition is a covered transaction only to acquiring taxpayers and not to acquired taxpayers (i.e., targets). This is because the covered transaction description in Regs. Sec. 1.263(a)-5(e)(3)(i) pertaining to asset acquisitions is limited to a "taxable acquisition by the taxpayer" and does not include the more expansive definition under Regs. Sec. 1.263(a)-5(a)(1) that applies to asset acquisitions "whether the taxpayer is the acquirer in the acquisition or the target of the acquisition." Although the other two covered transactions listed in Regs. Sec. 1.263-5(e)(3) apply to both parties in a transaction (acquirers and targets), the IRS determined that the asset acquisition described in CCA 201624021 does not qualify as a "taxable acquisition of an ownership interest in a business entity" under Regs. Sec. 1.263(a)-5(e)(3)(ii) with respect to the target S corporation because the acquired taxpayer cannot demonstrate stock ownership post-acquisition, nor is it eligible as one of the acquisitive reorganizations listed in Regs. Sec. 1.263(a)-5(e)(3)(iii). Consequently, because the transaction that generated the success-based fees at issue is not a covered transaction, the taxpayer is not eligible to make a safe-harbor election for the success-based transaction costs under Rev. Proc. 2011-29 and must therefore capitalize the costs it deducted on its 2012 tax return to the extent the amounts facilitated the transaction.
CCA 201624021 serves as an important reminder to take transaction costs into account when structuring and planning mergers and acquisitions, particularly for targets that tend to incur significant success-based costs to investment bankers and financial advisers.
First, qualifying the transaction as one of the three covered transactions is critical to maintain eligibility to deduct both success-based and non-success-based transaction costs under the bright-line date exception, including the ability to elect the safe harbor for any success-based amounts. For example, had the target S corporation in CCA 201624021 not made the deemed asset election, it likely would have been eligible to deduct 70% of its success-based transaction costs under the safe-harbor method because, unlike taxable asset acquisitions, a taxable stock acquisition is generally a covered transaction for both acquirers and targets. Although the tax treatment of transaction costs should not be the only or the most important factor to consider when structuring mergers and acquisitions, the ability to deduct transaction costs is often a key negotiating point between the parties when the amounts involved are material.
Second, timely analysis and documentation of transaction costs are essential to successfully identify and support potentially deductible amounts that either do not facilitate the transaction (e.g., recurring business matters unrelated to the transaction) or that may qualify for one of the special rules under Regs. Sec. 1.263(a)-5 (e.g., integration costs, de minimis amounts, or certain abandoned-transaction costs). Documentation is particularly important to sustain a deduction for success-based costs because, as the IRS notes in CCA 201624021, a taxpayer generally "must capitalize the success-based fees . . . unless it establishes through documentation that a portion of the costs are allocable to activities that do not facilitate the transaction."
Finally, although targets are ineligible for the favorable tax treatment afforded to costs incurred in covered transactions when they implement taxable asset acquisitions, these taxpayers still obtain a tax benefit from the transaction costs (i.e., as an offset to the sale proceeds), albeit often at less optimal capital gain tax rates.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.