When a taxpayer incurs success-based fees—for example, payments to professional service providers that are contingent upon the successful closing of an acquisition or restructuring transaction—the determination of whether the fees are currently deductible, as opposed to capitalizable, depends on whether the taxpayer can establish contemporaneously that all or a portion of the fees are allocable to activities that do not facilitate the transaction. Taxpayers can establish that fees are not facilitative, and therefore deductible, through supporting records (for example, time records, itemized invoices, or other records). The IRS recently released Technical Advice Memorandum (TAM) 201002036, concluding that allocation spreadsheets developed by a taxpayer’s accounting firm qualify as “other records” and therefore satisfy the documentation requirement, despite the lack of time records or itemized invoices.
Summary of TAM 201002036
A taxpayer hired an investment bank to evaluate the taxpayer’s potential suitors. The service agreement obligated the taxpayer to pay the investment bank a contingent, or success-based, fee if the taxpayer entered into a sale agreement with a suitor. The investment bank found an acquirer who purchased the taxpayer’s stock. The investment bank provided the taxpayer with invoices for its contingent fee without time reports or a detailed breakdown of its services.
The taxpayer engaged an accounting firm to evaluate the tax treatment of the investment bank fees. The accounting firm discussed the investment bank’s fees and services with employees of the acquirer and the investment bank. Based upon the investment bank’s best guess, the accounting firm created allocation spreadsheets of activity categories to summarize how much time the investment bank’s employees spent on each activity, including, when relevant, the percentage of time spent before and after the date on which the taxpayer’s board of directors approved the proposed form, terms, and provisions of the transaction. In support of the allocation spreadsheets, the taxpayer provided numerous forms of documentation supporting the investment bank’s work product, including documentation of potential buyers, financial models for various scenarios, contracts, agreements, spreadsheets, presentation materials, employee notes, and invoices. The taxpayer, relying on the accounting firm’s spreadsheets and the supporting documentation, deducted a portion of the contingent fees.
In the TAM, the IRS considered whether the spreadsheets developed by the accounting firm in conjunction with the assistance of employees of the taxpayer and the investment bank qualified as other records, required by the regulations to support the deduction.
Regs. Sec. 1.263(a)-5
Regs. Sec. 1.263(a)-5(a) requires a taxpayer to capitalize amounts paid to “facilitate” (i.e., paid in the process of investigating or pursuing) several types of covered transactions. Covered transactions include, among other things, a taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer or the target) if immediately after the acquisition the acquirer and the target are related within the meaning of Secs. 267(b) or 707(b).
Regs. Sec. 1.263(a)-5(e) establishes the bright-line date for categorizing costs as facilitative. Generally, a cost facilitates a covered transaction if it relates to activities performed on or after the bright-line date—the earlier of the date a letter of intent or similar communication is executed or the date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors. In addition, costs that are inherently facilitative (such as costs of securing an appraisal, structuring and negotiating the transaction, preparing and reviewing the transaction documents, and obtaining regulatory and shareholder approval of the transaction) facilitate a transaction regardless of when the costs are incurred.
Regs. Sec. 1.263(a)-5(f) categorizes contingent or success-based fees as facilitative costs, except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. This documentation must be completed no later than the due date of the taxpayer’s extended timely filed original federal income tax return for the tax year during which the transaction closes. Further, Regs. Sec. 1.263(a)-5(f) states:
the documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction, and must consist of supporting records (for example, time records, itemized invoices, or other records) that identify—(1) The various activities performed by the service provider; (2) The amount of fee (or percentage of time) that is allocable to each of the various activities performed; (3) Where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and (4) The name, business address, and business telephone number of the service provider.
Analysis and Conclusion
The taxpayer was acquired in a covered transaction, so the regulations require the taxpayer to capitalize costs incurred to facilitate the transaction. Except for inherently facilitative costs, costs incurred prior to the bright-line date—in this case the board of director’s approval date—were considered nonfacilitative. Further, because the fee paid to the investment bank was a success-based fee, the regulations require that the taxpayer must maintain sufficient, contemporaneous documentation to support an allocation among facilitative, inherently facilitative, and nonfacilitative costs, including the amount allocable to activities prior to the bright-line date. The taxpayer contended that the accounting firm spreadsheets qualified as other records and that it provided sufficient documentation to support the claimed deduction. However, the IRS Large and Mid-Size Business (LMSB) Division argued that the taxpayer did not provide other records or sufficient documentation to prove that some of the success-based fees were attributable to nonfacilitative activities; thus, the entire amount paid facilitated the acquisition and must be capitalized.
The IRS National Office concluded that the accounting firm’s allocation spreadsheets qualified as other records within the meaning of Regs. Sec. 1.263(a)-5. Accordingly, the LMSB must evaluate the spreadsheets to determine whether the taxpayer maintained sufficient documentation to support its allocation. The National Office noted that the rules in Regs. Sec. 1.263(a)-5(f) were not intended to create a more stringent rule for success-based fees than for noncontingent fees; thus, taxpayers who pay success-based fees are entitled to deduct certain costs incurred before the bright-line date, provided the taxpayer can substantiate those costs. The National Office pointed out that Regs. Sec. 1.263(a)-5(f) does not define what is meant by “other records,” nor does it limit the type or source of documentation or records that can substantiate the amount deductible, so the regulation should not be read in a manner that would automatically preclude the deductibility of nonfacilitative costs simply because the taxpayer is unable to provide time records or itemized invoices from the investment bank. Furthermore, the National Office considered the spreadsheets prepared by the accounting firm, coupled with the other records provided, to be an acceptable form of documentation even though they were not directly produced by the investment bank. However, the National Office further stated that the existence of other records does not automatically ensure the deductibility of the taxpayer’s claimed allocation of nonfacilitative costs. Rather, the LMSB should determine, based on all the documentation provided, whether the taxpayer made an appropriate allocation of the success-based fees to nonfacilitative activities, which requires weighing the sufficiency of the evidence provided.
Other Rulings and Their Impact
The conclusion and line of reasoning in TAM 201002036 is consistent with two recent private letter rulings. Letter Rulings 200830009 and 200953014 address similar situations in which the taxpayers entered into acquisitive transactions (tax-free mergers) and incurred success-based fees. Consistent with the rulings, taxpayers should maintain sufficient documentation to establish and document the specific nonfacilitative activities performed by the service providers. In the absence of time records and itemized invoices, taxpayers may rely on other records that identify the items required by Regs. Sec. 1.263(a)-5(f).
Allocation spreadsheets completed by the service providers allocating their time between activities facilitating and not facilitating the transaction generally are an acceptable form of documentation, but they must be supported by other corroborating evidence sufficient to substantiate the allocations. Examples of other forms of internal documentation or documentation provided by the investment bank may include retainer agreements, invoices, lists of potential buyers, transaction timelines, presentations, meeting agendas, and other notes. As noted in Letter Ruling 200953014, courts have considered the taxpayer’s records, the files of the attorneys, the testimony of witnesses who know the facts, and opinion testimony, including materials such as board meeting minutes and presentations, “even if the apportionment derived . . . is ‘less scientific’” ( Putnam-Greene Financial Corp., 308 F. Supp. 2d 1374 (M.D. Ga. 2004), citing Estate of Morgan, 332 F.2d 144 (5th Cir. 1964), and Dye, 122 F.3d 1399 (5th Cir. 1974)). Letter Ruling 200830009 states that whether the supporting records establish an appropriate allocation is a question to be determined upon examination.
The IRS’s 2009–2010 Priority Guidance Plan, which sets forth pending government guidance projects, includes an item relating to guidance on the support documentation required under Regs. Sec. 1.263(a)-5(f) to allocate success-based fees between activities that facilitate a transaction and activities that do not facilitate a transaction. It is important to note that under Sec. 6110(k)(3), private letter rulings and technical advice memoranda are taxpayer-specific rulings that cannot be used or cited as precedent. Nevertheless, the rulings discussed above may foreshadow what future guidance might provide, in the form of a regulation or other official pronouncement.
Availability of Sec. 9100 Relief
Regs. Sec. 1.263(a)-5(f) requires a taxpayer to maintain sufficient documentation to establish that a portion of the success-based fee is allocable to activities that do not facilitate the acquisition, and further requires the documentation to be completed on or before the due date of the taxpayer’s timely filed original federal income tax return (including extensions) for the tax year during which the transaction closes. In certain cases, however, the IRS has granted Sec. 9100 relief when the taxpayer did not properly extend the original tax return for the year the transaction closed. See Letter Rulings 200907018, 200945007, 200837005, and 200817010.
Without a proper extension, the supporting documentation is generally required to be prepared by the unextended due date of the original tax return. In these private letter rulings, the IRS granted relief under Regs. Sec. 301.9100-3 when the taxpayers did not properly extend their original tax returns, due to either insufficient postage or administrative oversight (such as failure to file because of employee turnover, incorrect advice from a professional service provider, or erroneous determination of the tax return due date), but completed the required documentation by the date on which the returns would have been due if properly extended.
Regs. Sec. 301.9100-1(c) grants the IRS discretion to grant a reasonable extension of time to make a regulatory election, provided that the taxpayer acted reasonably and in good faith and that granting relief will not prejudice the government’s interests. In these private letter rulings, the IRS viewed the timely documentation of success-based fees as an election, although this characterization is not apparent from the language in the regulation. But see Letter Ruling 200737035, in which relief was denied because the IRS held that the requirement to complete documentation on or before the return due date does not constitute an election under Regs. Sec. 301.9100-1(b). Based on this conflict, it is unclear whether the IRS views the documentation requirement as an election. Further, although the IRS has been willing to grant relief in some situations in which the taxpayer failed to file a tax return extension but otherwise prepared the necessary documentation by what would have been the extended due date, it is unclear whether the government would provide relief, and what facts would have to exist, in a situation in which the taxpayer has not completed the documentation by the extended due date.
Editor: Mary Van Leuven, J.D., LL.M.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
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This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.