In Chief Counsel Advice (CCA) 201624021, the IRS outlined its position regarding the ability of a target in a Sec. 338(h)(10) transaction to use the safe-harbor election provided by Rev. Proc. 2011-29. Under Rev. Proc. 2011-29, success-based fees (those contingent on the successful closing of a transaction) incurred in certain transactions can be treated as 70% nonfacilitative and 30% facilitative. Because much has been written about the treatment of success-based fees (see, e.g., Salza, "The Application of the Success-Based Fee Safe Harbor to Milestone Payments," 45 The Tax Adviser 718 (October 2014)), this item provides only a brief summary of their treatment before turning to the specific facts addressed in CCA 201624021.
The general rule for success-based fees is that amounts incurred that facilitate certain acquisitions must be capitalized to the property acquired. If the costs incurred in connection with a transaction do not facilitate that transaction, the costs would be considered investigatory and possibly deducted currently, depending on the specific circumstances. Past rules required taxpayers to document the allocation of success-based fees incurred in a transaction between facilitative and nonfacilitative costs prior the filing of their tax return. Controversy existed, though, regarding the type and extent of documentation required to establish a taxpayer's allocation of costs between facilitative and nonfacilitative activities. As a way to reduce the controversy, the IRS issued Rev. Proc. 2011-29, which allows a taxpayer in certain transactions to make a safe-harbor election to allocate the success-based fees between nonfacilitative and facilitative activities based on an established percentage (the 70%/30% split described earlier).
This safe-harbor election was expressly limited to covered transactions as defined in Regs. Sec. 1.263(a)-5(e)(3). The regulations define a covered transaction as any of the following:
(i) A taxable acquisition by the taxpayer of assets that constitute a trade or business.
(ii) A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of section 267(b) or 707(b).
(iii) A reorganization described in section 368(a)(1)(A), (B), or (C) or a reorganization described in section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under section 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).
In CCA 201624021, the target S corporation incurred contingent fees in a transaction where a Sec. 338(h)(10) election was made. The target elected the safe-harbor allocation under Rev. Proc. 2011-29 and allocated the success-based fees as 70% nonfacilitative and 30% facilitative. Upon examination, the IRS concluded that the safe-harbor election of Rev. Proc. 2011-29 was unavailable to the S corporation target because a Sec. 338(h)(10) election was outside the definition of a covered transaction, holding that a deemed asset acquisition under a Sec. 338(h)(10) election did not constitute a covered transaction for the acquired company.
The CCA noted that Regs. Sec. 1.263(a)-5(e)(3)(i) uses the phrase "taxable acquisition by the taxpayer," which the IRS views to mean that this subsection applies only to acquiring taxpayers and not to acquired taxpayers or targets. The Chief Counsel's Office came to this conclusion because Regs. Sec. 1.263(a)-5(e)(3)(i) did not, like Regs. Sec. 1.263(a)-5(a), contain language indicating that the subsection applied to the acquirer and the target. In addition, the taxpayer's transaction did not qualify as one of the covered transactions in Regs. Sec. 1.263(a)-5(e)(3)(ii) or (iii). Absent the ability to use the Rev. Proc. 2011-29 safe harbor, a Sec. 338(h)(10) target will need to analyze and allocate costs under Regs. Sec. 1.263(a)-5.
The conclusion in the CCA will have less impact on C corporations sold with a Sec. 338(h)(10) election made, due to the fact that the corporate tax rates are not based on the character of the income (ordinary versus capital). For an S corporation shareholder, reducing ordinary income versus capital gain can result in a reduction in the amount of taxes paid on the gain in a transaction.
Example: An S corporation target is sold. A Sec. 338(h)(10) election is made, and $1 million of investment banker fees are incurred by the target. The investment banker fees are not payable unless a transaction closes.
If the safe harbor is available, $300,000 of the fees would benefit the seller at the 20% capital gains rate, and $700,000 could benefit the seller at the 39.6% ordinary income rate (if the highest individual rate applies). If the seller is unable to avail itself of the safe harbor, the amount deductible at ordinary income rates typically will be less. It remains to be seen if the IRS will actively assert this position in audits, but it does give S corporation sellers food for thought as they structure their transactions.
While the CCA was limited to an S corporation sold with a Sec. 338(h)(10) election, the IRS's posture can be expected to be the same with a Sec. 336(e) election. Regs. Sec. 1.336-1(a) provides that the principles of Sec. 338 apply to the extent they are not inconsistent with the provisions of Sec. 336(e). Accordingly, the IRS would be expected to reach the same conclusion in the case of success-based fees in a Sec. 336(e) transaction.
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.
