Detailed recordkeeping and documentation assembling a factual and business narrative relating to the relevant services and associated fees are important to the allocation of costs.
For many decades, taxpayers and the Internal Revenue Service (the Service) have worried about how to allocate costs incurred by a business as either "ordinary and necessary" costs, which are deductible under section 162, or costs that must be capitalized. Taxpayers have preferred, in most instances, to categorize a cost as an "ordinary and necessary" expense for a business such that the amount should be viewed as currently deductible by the taxpayer. In determining if specific costs can be treated as "ordinary and necessary" expenses, the Service and the courts have looked to the "origin of the claim" and other factual analyses to determine the specific tax treatment of a specific expense.1 This concept of examining the origin of an expense and reviewing what the relevant payer received in exchange for its fee is a consistent approach taken in allocating costs between deductible and capitalized categories for federal income tax purposes.2
In a recent private letter ruling, Priv. Ltr. Rul. 2015-18-012 (Jan. 26, 2015), the Service addressed the specific issue of whether payments made by a taxpayer pursuant to a termination agreement entered into by the parties of a management agreement were required to be capitalized. In the management agreement, the contemplated services included, in general, ongoing monitoring and business advisory services provided to the taxpayer in an effort to turn around the taxpayer’s business and make it profitable. The contract was terminated, and the service recipient was required to make a payment to the service provider. In discussing the origin and the nature of the payment made to terminate the existing management agreement, the Service discussed how the management agreement arose, which service providers were providing the monitoring and business advisory services, and if the termination fees arose because of a corporate transaction.3 In addition, the Service reviewed information as to whether any of the fees were required to be paid because of work performed in furtherance of a contemplated IPO.
In concluding that the termination payments were not required to be capitalized under section 263, the Service focused on several key facts:
- The management agreement listed several business operational activities that were to be provided to the taxpayer during the term of the agreement.
- The agreements were extended when the original terms expired.
- The agreements were not exclusive, such that the taxpayer was freely able to hire similar third-party advisors as the need arose to provide the same or similar services.
- In arriving at the termination fee, the taxpayer provided comparable information from similar providers undergoing similar transactions and utilized the services of an advisory firm in setting the fee for the termination payment.
- The termination payment was not dependent on a successful IPO because, if the IPO did not occur, the parties could have continued the existing management arrangement or entered into a renegotiated termination agreement.
- The manager did not provide services that were considered to be generally related to an IPO.
- The services were provided in advance of the IPO and related exclusively to "turning around" the taxpayer’s business.
- The taxpayer objectively demonstrated that the turnaround of the business occurred in advance of the IPO.
- Even though the termination payment was made out of proceeds from the IPO, the taxpayer had other funds to pay the amount.
- Specific representations were made by the taxpayer as to the scope, timing and value of the services provided by the manager to the taxpayer; the financial statement treatment of the termination payment and the monitoring payments; and the ability to engage third-party vendors for similar management services.
The very detailed and comprehensive review of the documents and the facts demonstrated that the Service engaged in a taxpayer-specific evaluation in determining whether the payment of the termination fee was required to be capitalized. This detailed taxpayer specific-evaluation is extremely helpful to taxpayers in other situations that are facing the decision of whether a specific fee is deductible or must be capitalized. It indicates that not every fee paid on or around a corporate transaction must be viewed as related to the transaction, but can be explained as a routine expense if, in fact, the services provided to the taxpayer (or others) were for the benefit of the taxpayer’s ongoing business. In the private letter ruling, the Service did not merely look at the present transaction, an IPO, and the source of the payment for the termination fee, i.e., the proceeds from the IPO. Rather, the Service took a significant amount of time reviewing agreements, third-party documentation and the taxpayer’s unique situation and factual descriptions to step away from a "knee jerk" reaction of capitalization because it was close in time with an IPO, and found that the facts supported deductibility. The taxpayer was able to demonstrate that the termination fee was associated with its ordinary business operations and, thus, was eligible for deductibility under section 162.
Private letter ruling 2015-18-012 validates the long-held judicial doctrine of "origin of the claim," which continues to have specific applicability as taxpayers and the Service seek to allocate costs incurred in and around corporate transactions as deductible or capitalizable. Therefore, detailed recordkeeping and documentation assembling a factual and business narrative relating to the relevant services and associated fees are important to the allocation of costs. Such detailed recordkeeping and information will assist taxpayers in identifying costs that can be deducted, regardless if they are paid in or around a corporate transaction.