IRS Reverses Itself on Applying 70% Safe-Harbor Deduction for Success-Based Fees to Certain Milestone Payments

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

Expenses & Deductions

In recent years, the deduction of success-based financial advisory fees related to business acquisitions has been an area of significant taxpayer uncertainty because taxpayers often could not meet the regulations’ stringent documentation requirements for supporting these deductions. In 2011, the IRS issued Rev. Proc. 2011-29 to offer an elective safe harbor to deduct 70% of qualified success-based fees, thereby eliminating the uncertainty for many taxpayers. Shortly afterward, the IRS indicated that certain “milestone payments” common to acquisition transactions would not qualify for the safe-harbor election, but this position was later reversed for certain “eligible milestone payments.” Taxpayers involved in acquisition transactions need to be aware of these developments to understand the extent of the available elective safe harbor and which costs fall outside its scope. Failure to properly apply the safe harbor could result in lost 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 relates to deductible activities. The leading case directly applicable to success-based financial advisory fees is A.E. Staley Manufacturing Co., 119 F.3d 482 (7th Cir. 1997). In this case, the court relied upon the “origin of the 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 (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 (described below) 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 (i.e., 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 (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, 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 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 when they are incurred is irrelevant. These include costs for securing appraisals, formal 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.

Documentation Requirements

Regs. Sec. 1.263(a)-5 acknowledges the long-standing judicial precedent 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. 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. Portions of the fee allocated to services that are inherently facilitative or that are performed on or after the bright-line date must be capitalized. 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 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;
• Consist of more than merely an allocation between activities that facilitate the transaction and those that do not; and
• Consist of supporting records, e.g., 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 the documentation requirements that itemized hourly timesheet information would be the ideal source of this documentation (i.e., similar to what is often provided to support hourly fee charges from service providers such as attorneys and accountants), such information is generally 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 their employees working on a particular transaction. Consequently, taxpayers are often required to base supporting documentation upon subjective input. The IRS frequently challenges such support on the basis that it does not meet the documentation requirements in the regulations.

Rev. Proc. 2011-29

In an effort to reduce uncertainty related to success-based fee deductions, the IRS issued Rev. Proc. 2011-29 on April 8, 2011. It offers taxpayers an elective safe harbor to deduct 70% of any qualifying success-based fee, provided they capitalize the remaining 30%. The election does not require the taxpayer to gather supporting documentation or prepare supporting calculations regarding 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, and that are incurred in a tax year ending on or after April 8, 2011. The safe harbor is available to both the buyer and the seller on a per-transaction basis. If the safe harbor is elected, the taxpayer must apply the safe harbor to all success-based fees the taxpayer pays with respect to a particular transaction. If the safe harbor is not elected, the taxpayer must justify any deductible amount based upon the documentation standards in the regulations (described above), which may lead to some uncertainty as to the sustainability of the deduction under examination. If the taxpayer does not elect the safe harbor on the original return, it cannot rely upon the 70% deduction as a fallback position under examination.

Example 1: T is a target in a takeover transaction that qualifies as a tax-free reorganization under Sec. 368. In 2012, T incurs a $1 million success-based fee payable to its investment banker that is contingent upon the successful closing of the transaction.

T has two alternatives for deducting some portion of this fee:

• Elect the safe harbor and deduct $700,000 of the fee (capitalize $300,000) with no requirement to gather supporting documentation regarding the deductible portion of the fee; or
• 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 in the regulations and the consequent risk that the deduction could be disallowed in whole or in part under examination.

IRS Offers Initial View on Nonrefundable Milestone Payments

On July 16, 2012, the IRS issued Chief Counsel Advice (CCA) 201234027 to clarify its position on the application of the 70% elective safe-harbor deduction to success-based fees involving various nonrefundable “milestone payments” that are credited toward the overall success-based fee. The need for clarification was not surprising, given that many success-based investment advisory fee arrangements call for numerous nonrefundable payments to be made throughout the course of closing a transaction, rather than only one amount payable upon closing.

The facts presented in this CCA involve an acquisition transaction and a related success-based fee of $10 million payable to an investment banker in three nonrefundable installments: $1 million upon signing of the merger agreement, $1 million upon securing shareholder approval of the transaction, and $8 million upon successful closing of the transaction.

The IRS reasoned that a success-based fee is an amount paid or incurred that is contingent upon the successful closing of a qualified transaction. Given that the first two $1 million installments were nonrefundable and were contingent upon events (i.e., milestones) other than the successful closing of the transaction, the IRS ruled that they fell outside the scope of the 70% elective safe-harbor deduction and could therefore be deducted only under the stringent documentation requirements set forth in the regulations. Thus, notwithstanding the fact that the taxpayer elected the 70% deduction safe harbor, the taxpayer would still have to gather the necessary supporting documentation to justify the deductible portion of the two $1 million installments and would be subject to potential challenge under examination for these deductions based upon the adequacy of this documentation. This is precisely what the elective safe harbor sought to avoid.

IRS Reverses Initial Position on Certain Milestone Payments

The conclusion reached in CCA 201234027 was not well-received by taxpayers because it diluted the effectiveness of the safe harbor, the goal of which was to eliminate the need for taxpayers to gather the type of documentation necessary to meet the strict—often unattainable—standards for success-based fees. Given that many investment advisory fee arrangements call for nonrefundable milestone payments during an acquisition transaction, the IRS ruling would have required taxpayers to gather this supporting documentation, notwithstanding the safe harbor, to deduct the portion of the milestone payments deemed to be investigatory.

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, that effectively reversed 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 milestone payments related to a covered acquisition transaction described in Regs. Sec. 1.263(a)-5(e)(3), provided the milestone payment:

• Relates to investment banking services;
• Is nonrefundable;
• Is credited toward an overall success-based fee that is contingent upon the successful closing of the transaction; and
• Is contingent upon achievement of a milestone.

A milestone can be an event described in Regs. Sec. 1.263(a)-5(e)(1)(i) or (ii), or any other specified event that does not occur before the bright-line date, i.e., the first occurrence of an event described in Regs. Sec. 1.263(a)-5(e)(1)(i) or (ii). If these conditions are satisfied and the taxpayer elects the safe harbor, the 70% safe-harbor deduction applies to these eligible milestone payments in addition to the final success-based fee due upon closing of the transaction.

Example 2: T is a target in a takeover transaction that qualifies as a tax-free reorganization under Sec. 368. In 2012, T incurs a $1 million success-based fee payable to its investment banker that is payable as follows (all payments are nonrefundable):

• $50,000 upon board approval of the material terms of the transaction;
• $100,000 upon the issuance of a fairness opinion after the bright-line date;
• $100,000 upon securing shareholder approval; and
• $750,000 ($1 million less credit for the three installments paid to date) upon closing.

If the safe harbor is elected, 70% of each installment is deductible, and 30% must be capitalized. Thus the total deduction would be $700,000.

Example 3: Assume the same facts as Example 2, except that the first milestone payment of $50,000 is payable upon execution of the engagement letter with the investment banker, and this event occurs before the bright-line date in Regs. Sec. 1.263(a)-5(e)(1).

In this situation, the first installment of $50,000 is not an eligible milestone payment because it occurs before the bright-line date in Regs. Sec. 1.263(a)-5(e)(1). The remaining payments, however, do constitute eligible milestone payments and qualify for the 70% deduction safe harbor. Thus, if the safe harbor is elected, the 70% deduction is applied to each of the final three installments for a total deduction of $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 in the regulations. This deduction would not be protected by the safe harbor and could therefore be challenged by the IRS under examination. According to the regulations, if the necessary supporting documentation is not gathered timely with respect to this payment, then it would have to be fully capitalized.

The directive stipulates that if any of the eligible milestone payments are paid or incurred in a tax year before the transaction closes, the taxpayer can claim the 70% deduction in the tax year in which the milestone payment is paid or incurred but must document in its books and records that it intends to elect the safe harbor for the year in which the transaction will close. Of course, the taxpayer may have to amend the return on which these preclosing milestone deductions are claimed if the taxpayer does not ultimately elect the safe harbor and the deductible portion of the milestone payments is determined to be something other than 70%.

Interestingly, the directive enables only milestone payments related to investment banking services to qualify as eligible milestone payments. While not nearly as common, some law firms and other service providers charge success-based fees with milestone payments. As the LB&I directive is currently written, milestone payments for these services would not qualify for the 70% elective safe-harbor deduction.

Understanding the Milestones

The deductibility of success-based financial advisory fees related to acquisition transactions has historically been a considerable source of disagreement between taxpayers and the IRS. However, Rev. Proc. 2011-29 eliminated much of this uncertainty. If the safe harbor is elected, taxpayers must understand which milestone payments qualify for the safe harbor and which do not, as failure to properly apply the rules could result in lost deductions.

EditorNotes

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

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.