Deducting Success-Based Financial Advisory Fees

The deduction of success-based financial advisory fees related to business transactions has been, and continues to be, an area of significant taxpayer uncertainty. While the context of the issue has historically centered on the overall deductibility of these fees, the debate has shifted in recent years to the adequacy of the underlying documentation supporting the deduction. The subjective nature of the documentation often used to support these deductions creates uncertainty. However, there have been recent favorable developments in this area from the IRS National Office. Taxpayers must be aware of these developments and the documentation requirements provided by regulation if they wish to minimize the uncertainty surrounding these deductions.

Background

It is well established through judicial precedent that success-based financial advisory fees are deductible to the extent the taxpayer can demonstrate that a portion of the services provided under the fee arrangement relate to deductible activities. The leading case directly applicable to success-based financial advisory fees is A.E. Staley Mfg. Co., 119 F.3d 482 (7th Cir. 1997). In this case, the court relied on the origin of claim doctrine to conclude that the nature of the services provided under a financial advisory engagement determines their deductibility, not the relationship of the fee to the successful closing of a particular transaction.

In 2003, Treasury issued final regulations under Regs. Sec. 1.263(a)-5 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 (described below) for determining which costs facilitate a transaction and which costs 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 (where one taxpayer acquires another), a bright-line date is used to segregate facilitative and nonfacilitative costs. The bright-line date is the earlier of:

• 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
• 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 or, in the case of a taxpayer that is not a corporation, the date on which the material terms of the transaction are authorized or approved by the appropriate governing officials of the taxpayer.

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 are generally presumed to be investigatory in nature (nonfacilitative) and are therefore 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. Inherently facilitative costs are 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 opinions, or fairness opinions related to the transaction; structuring the transaction; 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.

Documentation Requirements

The final regulations acknowledge the longstanding judicial precedent that success-based financial advisory fees can be allocated to the various services provided by the financial advisers for purposes of determining their deductibility. Thus, to the extent the taxpayer can demonstrate that a portion of the financial advisory fee relates to services (other than inherently facilitative services) provided by the financial advisers before the bright-line date, the taxpayer can deduct that portion. The taxpayer must capitalize portions of the fee allocated to services that are inherently facilitative or that are performed on or after the bright-line date.

While the regulation does not provide any special rules for determining the deductible portion of success-based fees, it does impose specific requirements for the documentation necessary to support the deduction. The ability to deduct any portion of the success-based fee depends upon meeting these documentation requirements.

The documentation requirements contain the following provisions:

• The documentation must 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;
• The documentation must consist of more than merely an allocation between those activities that facilitate the transaction and those that do not; and
• The documentation must consist of supporting records (for example, time records, itemized invoices, or other records) that identify:
• The various activities performed by the service provider;
• The amount of the fee (or percentage of time) that is allocable to each of the various activities performed;
• The amount of the fee (or percentage of time) that is allocable to the performance of an activity before and after the bright-line date (if not otherwise inherently facilitative); and
• The name, business address, and business telephone number of the service provider.

While it is clear from a reading of the documentation requirements that itemized hourly timesheet information would be the ideal source of this documentation (similar to what taxpayers often provide to support hours-based fee charges from service providers such as attorneys and accountants), such information is generally not available from financial advisory firms. Most such firms do not charge hours-based fees and 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 face the prospect of documenting these deductions using other types of supporting information.

The most common form of documentary evidence used in the marketplace to support success-based financial advisory fee deductions is a letter procured from the financial advisory firm indicating:

• The various activities performed for the taxpayer in connection with a particular transaction;
• The dates these activities were performed; and
• The estimated percentage of total time spent by the financial advisory firm on each of these activities.

In addition, taxpayers often gather corroborating information to support the percentage of time allocations provided by the financial advisory firm. Most often, this corroborating information consists of written reports and financial analyses prepared by the financial advisory firm for the taxpayer in the course of the engagement, board minutes or other forms of timeline evidence to document the course of the financial advisory relationship, and written descriptions of the timeline of the financial advisory relationship provided in various SEC filings (if applicable). This information is then analyzed against the bright-line date and the inherently facilitative rule to determine what portion of the total success-based financial advisory fee relates to nonfacilitative (i.e., deductible) activities.

While the written testimony of the financial advisory firm provided in the standard letter certainly consists of “more than merely an allocation between those activities that facilitate the transaction and those that do not,” IRS field examiners have often challenged whether such a letter, combined with the other corroborating evidence, satisfies the definition of a supporting record. Such a challenge usually is based upon the assertion that, in the absence of hourly timesheet information or something very similar, the documentation does not meet the requirement of a supporting record because it relies largely upon subjective allocations made by the financial advisory firm.

Taxpayers have argued that the documentation requirements provided in the regulations clearly do not require time records or itemized invoices as the only source of documentation acceptable as a supporting record. The regulations permit other records to qualify as supporting records as long as they address the documentation requirements enumerated in the body of the regulation. There is no specific requirement prohibiting the good-faith testimony of the financial advisory firm from qualifying as a supporting record, especially when the other sources of corroborating information point to the accuracy of this testimony.

Insights into the IRS National Office’s View

Although there has been significant disagreement surrounding the documentation of success-based fee deductions since it finalized the regulations in 2003, the IRS has not issued any further public guidance on the issue. In September 2007, officials were quoted as saying that the IRS intends to issue a revenue ruling regarding the supporting documentation required under the regulations, but no such guidance has been issued to date. However, the IRS National Office has addressed this issue on two occasions for specific taxpayer situations—one in the form of a private letter ruling and one in the form of a technical advice memorandum. While these forms of guidance are applicable only to the individual taxpayers at issue, they do provide insight into the IRS National Office view.

In Letter Ruling 200830009, the IRS affirmed that:

• Success-based financial advisory fees can be segregated into deductible and nondeductible components according to the rules found in Regs. Sec. 1.263(a)-5; and
• Supporting records other than time records can be used to satisfy the supporting records requirement of the regulations.

This ruling was helpful to taxpayers because it stated forthrightly that supporting records other than timesheet-based records could be given equal consideration in the documentation of success-based fee deductions.

The IRS National Office issued a much more significant and beneficial ruling in Technical Advice Memorandum (TAM) 201002036. This ruling is of greater significance because it directly addresses the process often used by taxpayers in the marketplace to document success-based financial advisory fee deductions. The TAM was issued to provide guidance to an examining agent as to whether the letter received from the financial advisory firm satisfies the requirements for a supporting record.

Under the facts of the TAM, the taxpayer incurring the financial advisory fees was the target in a stock purchase transaction. Throughout the course of its consideration of the transaction, the taxpayer engaged the services of two financial advisory firms, both of which were to receive a lump-sum contingent fee only if the transaction successfully closed. In order to determine the nonfacilitative (i.e., deductible) portion of each fee, the taxpayer engaged the services of a third-party accounting firm. The accounting firm interviewed each financial adviser and, based upon those discussions, prepared a spreadsheet listing all the significant activities performed by each firm throughout their engagement and the timing of those activities. The accounting firm then asked each financial adviser to populate the spreadsheet with their best estimate of the percent of their total time allocable to those individual activities. The taxpayer presented these spreadsheet allocations, along with various other forms of corroborating information such as written reports prepared by the financial advisory firms, invoices, retainer agreements, etc., as complete support for the portion of the financial advisory fees the taxpayer deducted on its income tax return. No time records or itemized invoice information were available.

The IRS concluded that the allocation spreadsheet prepared by the accounting firm and populated by the financial advisory firms as to the percentage of time allocations did qualify as a supporting record under Regs. Sec. 1.263(a)-5(f). In reaching this conclusion, the IRS reasoned that there is no limitation on the types of other records that can qualify as supporting records under the regulation and that the focus of the inquiry should be on whether the documents presented, taken as a whole, provide the information required by the regulation. The TAM states that the financial advisers “clearly engaged in activities that were non-facilitative in nature” and that Regs. Sec. 1.263(a)-5(f) “should not be read in a manner that would automatically preclude the deductibility of Taxpayer’s non-facilitative costs merely because the Taxpayer is unable to provide time records or itemized invoices” from the financial advisory firms.

Conclusion

The deduction of success-based financial advisory fees will likely continue to be a significant area of uncertainty for taxpayers until the IRS issues formal clarifying guidance. Recent National Office rulings directed at specific taxpayers have been encouraging, but those rulings have limited official applicability to other taxpayers. Until further guidance is issued, taxpayers should continue pressing their financial advisers for as much objective documentary evidence as possible to support the deductible portion of success-based financial advisory fees, argue aggressively under examination for the acceptance of financial adviser testimony as adequate documentation, and consider the potential uncertainty in this area as they prepare financial statements and other disclosures related to uncertain tax positions.

Editor: Frank J. O’Connell Jr., CPA, Esq.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

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