Editor: Mark Heroux, J.D.
The IRS's Large Business and International Division in 2018 released a practice unit, "Examining a Transaction Costs Issue" (available at www.irs.gov, regarding the U.S. federal income tax treatment of transaction costs incurred in certain business transactions. Taxpayers often incur millions of dollars in professional and advisory fees paid to bankers, attorneys, accountants, and other service providers in connection with corporate transactions. The tax rules governing the treatment of these costs are complex, generally do not follow book treatment, and may require an extensive, facts-and-circumstances analysis to meet the subjective technical requirements and extensive documentation standards.
Consequently, the area has historically generated significant uncertainty and IRS controversy. Although the practice unit is designed to provide IRS personnel with technical and procedural guidance in auditing transaction costs and may not be relied upon as legal authority, it nonetheless provides helpful insight regarding the approach and positions the IRS is likely to take on exam. Therefore, taxpayers and practitioners should review the guidance and consider it when determining and substantiating the tax treatment of transaction costs.
In general, taxpayers must capitalize costs that "facilitate" a transaction described in Regs. Sec. 1.263(a)-5(a). Under this provision, a transaction is broadly defined to include acquisitions of the stock or assets of a trade or business, reorganizations or restructurings, borrowings, stock issuances, and changes to a company's capital structure. The term "facilitate" generally refers to a cost that, based on the facts and circumstances, is incurred to investigate or otherwise pursue a transaction (see Regs. Sec. 1.263(a)-5(b)). Special rules and exceptions apply to certain transaction costs described as "inherently facilitative" (capitalizable) or, alternatively, as nonfacilitative (potentially deductible), such as integration expenses, employee compensation, and amounts eligible under the "bright-line" date rule described in Regs. Sec. 1.263(a)-5(e)(1).
Transaction costs practice unit
The practice unit addresses the application of Sec. 263, Regs. Sec. 1.263(a)-5, and other authorities relevant to costs incurred in connection with certain business transactions. It includes illustrative examples, flowcharts, questionnaires, documentation lists, and legal authority citations and sets forth the following three-step process for examining and determining the appropriate tax treatment of such costs:
1. Determine whether the taxpayer is the proper legal entity to take the transaction costs into account for tax purposes;
2. Determine whether the costs facilitate the transaction; and
3. Determine how the taxpayer should treat facilitative costs it must capitalize, depending on the party (target or acquirer) and the type of transaction (e.g., asset, stock, or tax-free acquisition).
Highlighted below are two areas addressed in the practice unit that often generate significant exam exposure because they are overlooked, the rules are misapplied, or the taxpayer erroneously follows the financial reporting treatment:
Party required to account for the transaction costs (Step 1): As noted, multiple service providers are typically engaged to render services to one or more parties in connection with the transaction (e.g., bankers, attorneys, and accountants). Determining which party is the proper entity to take the transaction costs into account is often complicated by the facts that multiple parties may benefit from an expenditure and that different parties may have engaged, received services or benefits from, or paid the respective transaction advisers. As concerns the appropriate treatment of such "indirect" transaction costs pertaining to services procured or paid for by other parties to the transaction, Regs. Sec. 1.263(a)-5(k) provides that an amount paid to or by a party includes an amount paid on behalf of that party.
IRS guidance and judicial precedent have generally established that the party "directly and proximately" receiving the services or benefits (e.g., loan proceeds) must take the costs into account for tax purposes, even if another party engaged the provider, indirectly benefited from the services, or paid the fees and expenses. If a provider renders services to multiple transaction parties, the fees and expenses must be allocated to the respective parties (see IRS Letter Rulings 200830009 and 200953014).
In the event a party other than the service recipient/beneficiary pays the transaction costs (a typical occurrence), well-established legal principles provide that the payment is treated by the respective parties as a capital contribution, a loan, or a distribution, depending on the transaction facts and the relationship of the parties. The application of these concepts is illustrated in the following example reproduced and edited from the practice unit:
Example: X, a partnership, owns 75% of the stock of Y, a corporation; the remaining 25% of Y's stock is widely held. In 2015, Merger Sub, a wholly owned subsidiary of P, which is unrelated to X and Y, merges with and into Y, with Y surviving. In the transaction, P acquires all the stock of Y, and Y becomes a subsidiary ofP.
X has a working relationship with an investment banker and arranges for the investment banker to provide services to Y in connection with the transaction. Y executes a contract with the investment banker for advisory services to include locating a potential buyer for Y's stock, conducting due diligence on the identified buyer, and negotiating the terms of the transaction. The investment banker bills Y for the services it performed; however, since X has an ongoing relationship with the investment banker, X pays the invoice on Y's behalf. Y reimburses X for the fees paid.
Since Y directly benefited from the advisory services, Y is the proper legal entity to take the investment banker's fees into account as a deduction or as a capital expenditure, as appropriate. This is true even though X initially paid the investment banker on Y's behalf.
If Y did not reimburse X for the fees, Y would still be the proper legal entity to take the advisory fees into account since it directly benefited from the advisory services provided. Regs. Sec. 1.263(a)-5(k) treats Y as paying the fees X paid on Y's behalf. X is deemed to make a nondeductible capital contribution to Y. Y is treated as using the funds deemed received from X to pay the investment banker.
Nonfacilitative costs required to be capitalized (Step 2): A common misconception is that expenses determined to be "nonfacilitative" under Regs. Sec. 1.263(a)-5 are currently deductible in all cases. However, Regs. Sec. 1.263(a)-5(j) specifically provides that "[n]othing in this section changes the treatment of an amount that is specifically provided for under any other provision of the Internal Revenue Code (other than section 162(a) or 212) or regulations thereunder."
Consequently, transaction costs determined to be nonfacilitative (not capitalizable) under Regs. Sec. 1.263(a)-5 may nevertheless be capitalizable under another provision of the Code. For example, transaction costs incurred by a newly formed acquirer entity that did not conduct a trade or business prior to acquisition of the target may be capitalizable as startup expenses under Sec. 195 (see Specialty Restaurants Corp., T.C. Memo. 1992-221). Similarly, insurance premiums for representation and warranty coverage or directors' and officers' policies with terms of more than a year are generally subject to capitalization under Regs. Sec. 1.263(a)-4(d)(2)(i)(D).
The treatment of transaction costs is a complex, often controversial area that requires detailed knowledge of the facts and a wide array of legal authorities. The foregoing summary highlights just two of the many technical issues that can arise in a typical transaction. Although it may not be relied upon as precedent, the practice unit provides helpful insight into the positions and approach likely to be taken by the IRS when examining certain transaction costs, which may assist taxpayers to better analyze and document the tax treatment of these costs for IRS audit purposes.
Mark Heroux, J.D., is a principal with the Specialty Tax Services Group at Baker Tilly Virchow Krause LLP.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.