Success-based fees safe harbor: A ruling raises concerns

Editor: Mo Bell-Jacobs, J.D.

A success-based fee is an amount that is paid contingent on a transaction’s closing successfully. In Letter Ruling 202308010 (released Feb. 24, 2023), the IRS addressed a taxpayer’s request for relief under Regs. Secs. 301.9100-1 through -3 (9100 relief) to elect to deduct a success-based fee under the Rev. Proc. 2011-29 safe harbor. Going beyond mere denial of relief, the IRS concluded that a success-based fee paid to a financial adviser was a capitalizable cost incurred by the majority shareholder, a private-equity fund, instead of a cost of the target (see Regs. Sec. 1.263(a)-1(e)(1)). It further asserted that the seller would obtain a double tax benefit were the target permitted to deduct the success-based fee.

This conclusion runs contrary to past ruling practice and cuts against the intent of Rev. Proc. 2011-29 to reduce controversy over substantiating the deductibility of success-based fees. If indicative of a larger change in IRS policy, it would call into question a target’s ability to deduct success-based fees paid to financial advisers for their assistance with a sale and engagement with buyers, particularly when owned by a private-equity fund. Notably, the IRS recently granted 9100 relief to a privately held corporation that “had no majority controlling shareholder” prior to the transaction (see Letter Ruling 202349003). This suggests Letter Ruling 202308010 views private-equity-owned companies as deserving special scrutiny when analyzing deductions for success-based fees.

Overview of success-based fees

Taxpayers are required to capitalize transaction costs incurred to facilitate a covered transaction. An amount facilitates a transaction if it is paid in the process of investigating or otherwise pursuing such a transaction (see Sec. 263(a) and Regs. Sec. 1.263(a)-5). Generally, taxpayers must capitalize success-based fees unless they retain documentation sufficient to show that the fee is allocable to activities that do not facilitate the covered transaction (see Regs. Sec. 1.263(a)-5(f)).

Historically, the question of what types of records are needed to substantiate a success-based fee deduction was a source of disagreement between taxpayers and the IRS (see e.g., Letter Rulings 200953014 and 200830009 and Technical Advice Memorandum (TAM) 201002036). To address this controversy, the IRS provided a safe harbor in Rev. Proc. 2011-29 for the allocation of success-based fees between facilitative and nonfacilitative costs in order to eliminate much of this controversy. Instead of maintaining documentation under Regs. Sec. 1.263(a)-5(f), taxpayers can make an irrevocable election to treat 70% of success-based fees as deductible, nonfacilitative costs.

Letter ruling denying 9100 relief to make an election under Rev. Proc. 2011-29

The facts of Letter Ruling 202308010 are similar to those of the numerous other taxpayers that have claimed a deduction for success-based fees under Rev. Proc. 2011-29. A private-equity fund was the majority owner of Parent. Parent wholly owned Taxpayer, a subsidiary engaged in Business A. The financial adviser provided services in connection with the sale of Parent stock, including identifying and screening prospective purchasers, managing communications, and assisting Taxpayer with preparing materials for prospective purchasers. Taxpayer’s executive team “took the lead and primarily engaged in communication with Financial Advisor regarding prospective buyers and in gathering information for prospective buyers.” Taxpayer was obligated to pay the financial adviser a success-based fee contingent upon a sale of Taxpayer. At closing, the buyer transferred a portion of the “gross sales price” (presumably, out of closing proceeds) in satisfaction of certain liabilities, including the successbased fee and other transaction costs.

The ruling emphasizes that under the transaction agreement, the selling shareholders reduced the gross sales price by the amount of the success-based fee. If Taxpayer deducts the success-based fee, the ruling claims, this adjustment to the gross sales price creates a double benefit by reducing the shareholders’ amount realized on the transaction and, by extension, their gain by the amount of the fee. Instead, it concludes that the successbased fee is a capitalized transaction cost incurred by the private-equity fund (majority owner) under Regs. Sec. 1.263(a)- 1(e)(1) for several reasons:

• The selling shareholders benefited from the services of the financial adviser because they received the sales proceeds from the transaction; and
• Parent was majority-owned by a private-equity fund, which profited from the purchase and sale of portfolio company businesses.

Private-equity funds generally are investment vehicles similar to a venture capital or mutual fund. Though they often take controlling positions in and are engaged in the direction of their portfolio investments, private-equity-owned portfolio companies are separate businesses with their own boards and management.

A double benefit?

The IRS’s assertion of a double tax benefit is not well founded and misunderstands the economic realities of merger-and-acquisition (M&A) transactions. In most arm’s-length transactions involving a cash purchase of stock, the parties agree to a value of the target using its “enterprise value.” The enterprise value is neither the stock’s purchase price nor the target’s equity value. Rather, it is generally the company’s value before adjustments for debt, debtlike items, and cash and cash equivalents. A transaction agreement typically arrives at the purchase price for a target by adjusting the enterprise value (base purchase price) as follows:

• Plus: (1) cash on hand and (2) excess working capital;
• Less: (1) debt, (2) debtlike items, (3) target transaction expenses, and (4) stock option payments and transaction bonuses.

Example: Assume the target has a $500 million enterprise value and a $30 million target working capital. At closing, the target has $200 million of debt and $20 million of cash, but its net working capital is only $10 million. The target’s resulting equity value (before extraordinary costs) is $300 million: $500 million less $200 million (debt), plus $20 million (cash), less $20 million (working capital deficit). The target incurs $10 million in transaction costs (including a success-based fee) and $15 million in stock option payouts and transaction bonuses for employees, reducing its final equity value to $275 million. The selling shareholders receive only $275 million in exchange for the target stock. While public statements and documents may characterize such a transaction as a $500 million deal, that amount does not represent the target’s equity value of $275 million.

Letter Ruling 202308010 views the selling shareholders as reducing their amount realized by the amount of the success-based fee, creating a double tax benefit. However, reducing the equity value for a target’s success-based fee liability to arrive at the final sales proceeds is no different than also making adjustments for debt, working capital, and compensation items. The amount realized by the sellers is equal to the final equity value of the target, which appropriately reflects transaction-related costs, compensation items, and debt.

Who incurs the cost?

It is not unusual for a target to incur transaction costs for financial advice, legal services, due diligence, or payments to employees arising out of a change in control. The IRS’s conclusion in Letter Ruling 202308010 that the success-based fee is a cost of the selling shareholder runs contrary to existing authorities and past IRS ruling practice (see Wells Fargo Co., 224 F.3d 874 (8th Cir. 2000) (target may deduct investigatory costs related to potential acquisition)).

The IRS has issued several rulings (pre-2011) that shed light on the party entitled to lay claim to deductions for transaction-related costs (see Letter Rulings 200830009 and 200953014). In each case, the IRS concluded that the target was the party entitled to deduct the costs associated with transaction-related expenses because the services were rendered on behalf of and/or for the benefit of the target (see also Square D Co., 121 T.C. 168 (2003)).

Whether a target is publicly held, closely held, or owned by private equity does not affect whether it incurred a success-based fee related to the investigation of its potential sale. Creating an unwritten policy through the private letter ruling process that treats taxpayers incurring the same costs differently based upon shareholder make-up is inappropriate. In each case, target companies engage financial advisers to perform the same type of services.

TAM 201002036 involved the payment of two success-based fees for investment banking services, one recipient of which was an affiliate of the selling private-equity group, in a fact pattern largely indistinguishable from Letter Ruling 202308010. Once again, the IRS acknowledged that the services the advisers provided were rendered on behalf of and/or for the benefit of the target. Letter Ruling 201732013 involved a target owned primarily by private equity that was sold to a buyer. In granting the target company 9100 relief to make a Rev. Proc. 2011-29 election, the IRS noted that the company’s tax adviser originally viewed the safe harbor as in-applicable because the success-based fee was paid out of closing proceeds.

Finally, related parties can pay transaction costs of another company, as Letter Ruling 202308010 seems to acknowledge (see Regs. Sec. 1. 263(a)-5(k)). In M&A deals, however, all transaction-related costs, debt payments, legal fees, future working capital needs, and sales proceeds are usually wired out of closing funds. Given the fungibility of cash, it is rarely clear which party is actually “paying” a given cost (e.g., buyer funds or target cash).

Policy considerations: Documentation requirement

Letter Ruling 202308010 runs contrary to existing authorities and past IRS rulings, treating companies that are owned by private equity differently than other taxpayers. If the Service adopts this position at the exam level, it will increase controversy over the deductibility of these fees and cut against the policy goals of Rev. Proc. 2011-29. It would also require taxpayers to thoroughly document the services provided to the corporation in order to establish deductibility.

Editor Notes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.

For additional information about these items, contact the author(s) of this item: Nick Gruidl, CPA (Nick.Gruidl@rsmus.com), and Eric D. Brauer, J.D., LL.M. (Eric.Brauer@rsmus.com), Washington, D.C..

Contributors are members of or associated with RSM US LLP.