On June 10, 2016, the Internal Revenue Service released a Chief Counsel Memorandum dated July 8, 2015, addressing the issue of whether a target S-corporation, which participated in a transaction in which the parties made a Section 338(h)(10) election, could avail itself of the safe harbor election of Revenue Procedure 2011-29 for purposes of deducting certain success-based fees. As described below, the Service’s view is that the target S-corporation cannot make such an election, and all deductible expenses need to be determined under the applicable law.

General Rules for Deduction vs. Capitalization of Transaction Costs

In general, Treas. Reg. Section 1.263(a)-5, et seq., was adopted to provide a regulatory regime for the treatment of transaction costs incurred to facilitate an acquisition of a trade or business. The Internal Revenue Code, Treasury Regulations, Service rulings and case law have historically found that taxpayers may divide transaction-related costs into three categories: (i) costs deductible under Sections 162 and 165; (ii) costs capitalizable and amortizable under Sections 167, 168, 195, 197 and 248 or other authorities; and (iii) costs capitalizable under Section 263, INDOPCO v. Commissioner1 and other authorities

Section 162(a) generally allows a current deduction for those ordinary and necessary business expenses incurred in a taxpayer’s trade or business. A cost that is otherwise deductible may not be immediately deducted if it is considered a "capital expenditure" — a cost that yields future benefits to the taxpayer’s business. Section 263 requires capitalization of certain nondeductible expenditures.

Under Treas. Reg. Section 1.263(a)-5(a), a taxpayer must capitalize an amount paid to facilitate any one of 10 specified transactions. The Treasury Regulations clarify that investigatory costs are considered facilitative unless there is a specific exception.2 Treas. Reg. Section 1.263(a)-5(e) provides a significant exception for certain transaction costs that are incurred in connection with "covered transactions," which include (i) "[a] taxable acquisition by a taxpayer of assets that constitute a trade or business," (ii) a taxable acquisition of the ownership interests in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) where the acquirer and the target are related immediately after the transaction, and (iii) a reorganization generally described in Section 368(a)(1)(A), (B) and (C) and, in certain instances, Section 368(a)(1)(D).

Success-Based Fees

Treas. Reg. Section 1.263(a)-5(f) provides that an amount paid that is contingent on the successful closing of a transaction specifically described in Treas. Reg. Section 1.263(a)-5(a) (a "success-based fee") is deemed an amount paid to facilitate such transaction. Treas. Reg. Section 1.263(a)-5(f) provides that a taxpayer may maintain sufficient documentation that establishes that a part of the success-based fee is allocable to activities that did not facilitate the transaction, allowing the taxpayer to deduct the portion of the success-based fee sufficiently substantiated as not facilitative of the transaction.

To resolve difficult issues for both the Service and taxpayers in providing relevant documentation for success-based fees, on April 8, 2011, the Service issued Revenue Procedure 2011-29, which provides a safe harbor method for allocating success-based fees between those activities that are facilitative of a transaction and those that are not. The Revenue Procedure applies only to transactions that are covered transactions as defined in Treas. Reg. Section 1.263(a)-5(e)(3), and it allows taxpayers to elect to treat 70 percent of the success-based fees paid or incurred by the taxpayer in taxable years ended on or after April 8, 2011 as amounts that do not facilitate a transaction under Treas. Reg. Section 1.263(a)-5, while requiring that the remaining 30 percent of the success-based fees be capitalized.

CCA 201624021 (July 8, 2015)

The issue before the Chief Counsel’s office was whether a target S-corporation, which used the Section 338(h)(10) election to treat the stock sale as a deemed asset sale, could make the safe harbor election under the Revenue Procedure and treat 70 percent of its success-based fees as nonfacilitative fees. The Service stated that, "[w]ith regard to an acquired taxpayer in an asset acquisition, the transaction is not a ‘covered transaction’ under Treas. Reg. § 1.263(a)-5(e)(3)."

In denying the ability of the target corporation to make the safe harbor election, the Service focused on the language of the covered transaction rule in Treas. Reg. § 1.263(a)-5(e)(3)(i), which "uses the phrase ‘taxable acquisition by the taxpayer’" (emphasis in original), and found that, in the present case, the "taxpayer" did not make a taxable acquisition. Here, the taxpayer was the seller of the assets, not the buyer. The Service did acknowledge that the taxpayer could perform a traditional analysis with respect to its transaction costs and, if consistent with its facts, could document that a portion of the success-based fees at issue were properly deductible.

Pepper Perspective

The Service took the view that the specific language in Treas. Reg. 1.263(a)-5(e)(3)(i) must be followed and thus disallowed the safe harbor election under the Revenue Procedure to a target corporation electing to treat the sale of its stock as a deemed asset sale under Section 338(h)(10). This approach seems consistent with the historical view of the treatment of transaction costs in an asset sale, which is that such costs are generally treated as an offset to the sales proceeds received in exchange for the assets. See Treas. Reg. § 1.263(a)-5(g)(2)(ii) and Section 1060. Thus, rather than taking what might be an ordinary deduction under Section 162 for 70 percent of the success-based fees, the taxpayer is required to treat such selling costs as an offset to the sales proceeds in the deemed asset sale. This alternative treatment can result in the reduction of capital gains in certain situations (where a significant amount of the assets being sold are capital assets), and, thus, it may be less desirable than a deduction of such costs under Section 162 on the S-corporation’s final tax return. Presumably, the same conclusions would be reached by the Service if an election were made under Section 336(e) to treat certain stock sales as asset sales. In those situations, as with the CCA, the target corporation would not be able to make the safe harbor election under the Revenue Procedure. The highly factual nature of the analysis of transaction costs demonstrates the need for contemporaneous documentation during the pendency of the transaction and consultation with a tax advisor who is familiar with these rules to maximize the potential recovery of costs associated with corporate transactions. Consultation with a tax advisor on these types of issues becomes very important if the parties to the transaction are providing for the benefits of the anticipated transaction cost deductions as part of the deal terms. This approach is becoming more common, and, thus, the federal income tax treatment of transaction costs needs to resolved, in many of these cases, prior to the close of the transaction. Taxpayers cannot determine the deductibility of a particular cost through a provision in their agreements. They can provide for the economic benefits of any potential deductions to be allocated between the contracting parties, but it is a matter of federal income tax law whether or not a particular transaction cost can be deducted.