Practical considerations for deducting abandoned M&A transaction costs

Editor: Jessica L. Jeane, J.D.

Although merger-and-acquisition (M&A) activity has accelerated recently (Factset Insight, “U.S. Mergers & Acquisitions Monthly Review: May 2026” (June 23, 2026)), many pending transactions have been delayed or terminated due to economic uncertainty, geopolitical developments, financing costs, regulatory challenges, and valuation disputes. The parties to an abandoned deal have often incurred significant fees in pursuit of the transaction, including legal, accounting, investment banking, consulting, and other transaction-related costs. Determining whether, when, and how those costs may be recovered for federal income tax purposes can present complex issues that depend heavily on the underlying facts and circumstances.

This discussion provides a high–level overview of the general rules governing the treatment of transaction expenses paid by targets and acquirers in connection with failed transactions, including termination or breakup fee payments that might be required under a transaction agreement when one party elects not to complete the transaction.

General transaction cost rules

Regs. Sec. 1.263(a)-5 provides rules for determining the federal income tax treatment of amounts paid or incurred to facilitate an acquisition of a trade or business and other transactions. Regs. Sec. 1.263(a)-5(a)(1) lists 10 transactions subject to these rules, including taxable asset and equity acquisitions; Sec. 721 and Sec. 351 transfers; restructurings; recapitalizations; reorganizations; stock issuances; and borrowings.

Under Regs. Sec. 1.263(a)-5(a), a taxpayer generally must capitalize an amount paid to facilitate any of the transactions enumerated in the regulation, “without regard to whether the transaction is comprised of a single step or a series of steps carried out as part of a single plan” and without regard to whether gain or loss is recognized. Thus, deal activities should be viewed holistically rather than in isolation, which can have material implications for abandoned transaction costs. Consequently, applying the rules requires comprehensive knowledge of the facts, the transaction process’s chronology, and the intentions and activities of the parties, all of which often occur over multiple tax years. As a result, a lengthy deal process can complicate and delay the ability to claim a current deduction for abandoned transaction costs.

The term “facilitate” is broadly defined in Regs. Sec. 1.263(a)-5(b) to mean an amount paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in that process is determined based on all the facts and circumstances. However, there are several exceptions to the general capitalization rule, two of which are particularly relevant here: the mutual–exclusivity rule and the bright–line date exception for covered transactions.

Mutual-exclusivity rule

The treatment of expenses incurred for a failed transaction described in Regs. Sec. 1.263(a)-5 is determined under a “mutual–exclusivity” provision in Regs. Sec. 1.263(a)-5(c)(8). Under this rule, an amount paid to terminate or facilitate the termination of a transaction described in Regs. Sec. 1.263(a)-5(a) is treated as facilitating a second transaction described in Regs. Sec. 1.263(a)-5(a) only if the transactions are mutually exclusive. Transactions are generally treated as mutually exclusive if the taxpayer could not have implemented both the failed transaction and the successfully completed transaction.

Thus, for example, if a target incurs transaction expenses in a failed attempt to sell all of its equity to acquirer A but later finds another buyer, acquirer B, and completes the sale, any capitalizable costs incurred for the abandoned transaction are treated as facilitating the completed transaction. This is because the target could not have sold all of its equity to two separate acquirers; the transactions are mutually exclusive (see Regs. Sec. 1.263(a)-5(l), Example (13)). Significantly, the IRS has asserted that the mutual–exclusivity standard may apply over a lengthy period. See Field Attorney Advice (FAA) 20133101F (costs for abandoned initial public offering (IPO) transactions were required to be capitalized to a successfully completed IPO that occurred three years later).

Although Regs. Sec. 1.263(a)-5(c)(8) focuses on whether the transactions are mutually exclusive, the preamble to the regulation indicates that the rule was intended to apply where “the transactions are mutually exclusive and the agreement is terminated to enable the taxpayer to engage in a second transaction” (T.D. 9107, Section III.C.7; emphasis added). Accordingly, taxpayers should carefully evaluate whether a sufficient nexus exists between the abandoned and completed transactions before concluding that costs from the failed transaction must be capitalized to the later consummated transaction.

Conversely, if the taxpayer could complete both transactions, the transactions are not mutually exclusive within the meaning of Regs. Sec. 1.263(a)-5(c)(8), and capitalizable costs incurred for the abandoned transaction may potentially qualify for an abandonment loss deduction under Sec. 165, depending on the facts. The application of these loss deduction rules to abandoned transactions is addressed below.

Bright-line date exception for covered transactions

A special rule in Regs. Sec. 1.263(a)-5(e)(1) provides that certain expenses (other than certain “inherently facilitative amounts” — see below) related to activities performed on or after a “bright–line date” for a “covered transaction” — typically, costs for investigatory and due–diligence activities — facilitate the transaction. Thus, expenses paid before the bright–line date may potentially be recovered sooner than they otherwise would be under the general rule in Regs. Sec. 1.263(a)-5(a).

The bright–line date is the earlier of either the date on which a letter of intent, exclusivity agreement, or similar written communication is executed by representatives of the acquirer and target or the date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors or governing officials. If a transaction does not require authorization or approval by the taxpayer’s board or governing officials, the bright–line date is the date on which the acquirer and target execute a binding written contract, such as a purchase or merger agreement, reflecting the terms of the transaction. In practice, the execution date of a letter of intent or exclusivity agreement often occurs first and establishes the bright–line date.

Covered transactions include: (1) a taxable acquisition by the taxpayer of assets that constitute a trade or business; (2) a taxable acquisition of an ownership interest in a business entity, whether the taxpayer is the acquirer or the target, if immediately after the acquisition the acquirer and the target are related within the meaning of Sec. 267(b) or 707(b); and (3) certain reorganizations described in Sec. 368(a)(1)(A), (B), (C), or (D).

Conversely, expenses incurred in covered transactions for inherently facilitative amounts enumerated in Regs. Sec. 1.263(a)-5(e)(2) must be capitalized regardless of whether the services are rendered before the bright–line date. These inherently facilitative amounts include costs of:

• Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction;
• Structuring the transaction, including negotiating the transaction’s structure and obtaining tax advice on the structure;
• Preparing and reviewing documents that effectuate the transaction, such as a merger agreement or purchase agreement;
• Obtaining regulatory approval, including preparing and reviewing regulatory filings;
• Obtaining shareholder approval, including proxy costs, solicitation costs, and costs to promote the transaction to shareholders; and
• Conveying property between the parties, including transfer taxes and title registration costs.

Application of the mutual-exclusivity and bright-line date rules

Regs. Sec. 1.263(a)-5(l) provides examples illustrating the mutual–exclusivity standard and the interaction with the bright–line date exception. In Example (13), noted above, Y corporation, a public company, becomes the target of a hostile takeover attempt by Z. Y’s investment banker finds W, a “white knight,” and Y and W execute a letter of intent. Under the letter of intent, Y must pay W a $10 million breakup fee if the merger with W does not occur. Z then increases its offer, and Y accepts Z’s offer instead. Y pays its investment banker $500,000 for inherently facilitative services with respect to the potential W merger and $2 million for due–diligence activities, $1 million of which relates to services performed on or after the letter–of–intent date.

Because Y could not merge with both W and Z, the transactions are mutually exclusive. Accordingly, Y must capitalize the $500,000 of inherently facilitative costs, the $1 million of post–bright–line due–diligence costs, and the $10 million termination payment as amounts facilitating the completed Z transaction. However, the $1 million of due–diligence costs incurred prior to the letter of intent’s execution for the W transaction is deductible under the bright–line date exception. Conversely, if the failed W transaction had not been a covered transaction, the bright–line date exception would not have been available, and all of the foregoing expenses incurred for the failed W transaction would have been subject to capitalization.

Example (13) is useful because it shows that different categories of costs incurred in the same failed transaction can be treated differently. Essentially, the analysis with respect to the treatment of the failed transaction’s costs turns not only on whether the failed transaction and completed transaction are mutually exclusive but also on the type of transaction (covered or not covered), the nature of the activities performed (inherently facilitative or due diligence), and the timing of any non—inherently facilitative services (pre– or post–bright–line date). Accordingly, a taxpayer seeking a deduction for abandoned transaction costs should segregate fees by service type, date, and transaction rather than treat all invoices as a single pool of failed–deal costs.

The following sections highlight key issues that can arise under Secs. 165 and 1234A in the context of claiming loss deductions for failed M&A transactions. The discussion is general and high–level; taxpayers should consult their advisers regarding the application of these rules to their specific facts.

Abandonment loss provisions

A common scenario not addressed by the foregoing capitalization rules is when a transaction is delayed or paused temporarily rather than abandoned entirely. In recent years, transactions have been delayed by factors such as economic uncertainty, trade and tariff policy volatility, interest rates and inflation, geopolitical tensions that hinder cross–border deals, and new tax laws that affect transaction economics. Often, the parties and their advisers initially pause the transaction process while they develop and negotiate a solution, including the evaluation of alternatives. Once a consensus is reached, the deal resumes, and a transaction is ultimately completed.

Under Sec. 165, a taxpayer generally may not claim a loss deduction for a transaction that is temporarily paused rather than abandoned entirely. Regs. Secs. 1.165–1(b) and 1.165–2(a) require the loss to be evidenced by a closed and completed transaction and fixed by identifiable events occurring during the tax year. The IRS and courts have interpreted these provisions to require both an intent to abandon the transaction and an affirmative act of abandonment (see, e.g., CRST, Inc., 92 T.C. 1249, 1257 (1989), aff’d, 909 F.2d 1146 (8th Cir. 1990), and Field Attorney Advice (FAA) 20124603F).

Importantly, an affirmative act requires “some overt act or statement reasonably calculated to give a third party notice of the abandonment” (Echols, 935 F.2d 703, 707 (5th Cir. 1991); see also FAA 20124603F (intracompany communications were insufficient to give third parties notice of abandonment); and Hopkins, 15 T.C. 160, 173 (1950), acq., 1951–1 C.B. 2 (notification to a broker to discontinue offering property for sale can be an act of abandonment)).

Applying these principles to an abandoned M&A transaction, examples of an affirmative act might include notifying the counterparties that the taxpayer has abandoned the transaction; disengaging transaction advisers or instructing them to stop work; withdrawing regulatory filings; and, if appropriate, releasing a public announcement that the deal has been abandoned. Conversely, failing to notify third parties or merely pausing the transaction while continuing negotiations; pursuing legal remedies; or investigating alternate, potentially mutually exclusive transactions generally would not satisfy the requirements to claim an abandonment loss under Sec. 165.

Because Sec. 165 imposes a strict timing requirement, the identifiable events and affirmative acts should be carefully documented in writing to establish that the loss was sustained during the tax year. Documentation is particularly important where the transaction history is prolonged or fluid. Board minutes, correspondence with counterparties, adviser termination letters, engagement amendments, withdrawal of filings, and public announcements may all help establish the taxpayer’s intent and the timing of the identifiable event.

Application of Sec. 1234A to certain M&A transactions

In addition to satisfying Sec. 165, a taxpayer should assess whether Sec. 1234A applies to classify an abandoned transaction loss as capital rather than ordinary. Given the substantial dollar amounts often involved, capital loss treatment can result in materially adverse consequences, particularly for a C corporation subject to the restrictive capital loss limitation and carryover rules in Secs. 1211(a) and 1212(a).

Sec. 1234A generally provides that gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property that is, or on acquisition would be, a capital asset in the taxpayer’s hands is treated as gain or loss from the sale of a capital asset.

The application of Sec. 1234A to M&A transactions is an evolving area. Sec. 1234A may or may not apply to abandoned M&A transaction costs, depending on various factors, including deal structure (asset or stock acquisition); which party incurred the transaction costs (acquirer or target); whether the transaction agreement creates a right or obligation with respect to a capital asset (a binding agreement); and the purpose of the termination fee as expressed in the transaction documents (to incentivize completion of the deal or to reimburse the other party’s transaction expenses).

For further discussion of the potential implications of Sec. 1234A for M&A transaction costs, see Meade, “Capital Loss Rules Limit Deduction of Fees Paid to Terminate Merger Agreement,” 53-10 The Tax Adviser 15 (October 2022), and Beavers, “Company’s $1.6 Billion ‘Break Fee’ Payment Treated as Ordinary Deduction,” 56-9The Tax Adviser 80 (September 2025). Because the potential ordinary-versus-capital characterization issue may substantially affect the value of any loss deduction, this analysis should be considered early in the deal process and again when a termination or abandonment becomes likely.

Implications

The tax rules governing transaction costs are highly nuanced and require a detailed, fact–specific analysis; assessment of numerous and sometimes competing authorities; and compilation of supporting documentation to sustain a deduction. In light of ongoing uncertainty in the M&A market, taxpayers and advisers should proactively incorporate transaction cost tax planning into the M&A deal process and negotiations.

Editor

Jessica L. Jeane, J.D., is director of tax policy, national tax, with Baker Tilly in McLean, Va.

For additional information about these items, contact Jeane at Jessica.Jeane@bakertilly.com.

Contributors are members of or associated with Baker Tilly.

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