In general, for federal income tax purposes a taxpayer is required to capitalize certain costs paid or incurred to “facilitate” certain acquisitions and capital transactions. The IRS has recently created a safe harbor election for the deduction of 70 percent of “success-based” fees (e.g., fees paid contingent upon successful closing of a purchase and sale transaction) arising in connection with a purchase and sale transaction in the year of closing of the transaction. Once the election is made, the taxpayer is not required to maintain any documentation to support the deduction of 70 percent of the success-based fees. The remaining 30 percent of the success-based fees must be capitalized.
Prior to this favorable safe harbor election for the deduction of 70 percent of success-based fees, a great deal of uncertainty existed for taxpayers in determining (i) the amount of success-based fees not paid to facilitate the purchase and sale transaction and thus the amount that was properly deductible in the year of the purchase and sale transaction and (ii) the proper level of documentation required to show that such amount was properly deductible, in large part because investment bankers often do not keep time records meeting the regulatory documentation requirements.
A taxpayer is generally required to capitalize and thus may not currently deduct any amount paid to facilitate any of the following transactions:
- an acquisition of assets that constitute a trade or business;
- an acquisition by the taxpayer of an ownership interest in a business entity if, immediately after the acquisition, the taxpayer and the business entity are related (generally, more than a 50 percent ownership interest in the business entity);
- an acquisition of an ownership interest in the taxpayer;
- a restructuring, recapitalization or reorganization of the capital structure of a business entity (including tax-free reorganizations and divisions);
- a tax-free contribution of capital to a partnership or corporation;
- a formation or organization of an entity disregarded for federal income tax purposes (e.g., single member limited liability company);
- a stock issuance; and
- a borrowing.
An amount is paid to facilitate a transaction if the amount is paid in the process of investing or otherwise pursuing the transaction. An amount paid to facilitate a transaction includes the amount which relates to activities performed on or after the earlier of (i) the date on which a letter of intent, exclusivity agreement or similar written communication is executed by representatives of the acquirer and target, or (ii) the date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors or other appropriate officials.
Without the safe harbor provisions, in order to support that success-based fees are not incurred to facilitate the transaction, the taxpayer must maintain sufficient documentation. Such documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction and must consist of supporting records (for example, time records, itemized invoices or other records) that identify, among other things, the various activities performed, the amount of the fee allocable to such activities and relevant dates of performance and identifying information of the service provider. This documentation is often difficult or impossible to obtain. The safe harbor only applies with respect to success-based fees for certain mergers and acquisitions as specified in the IRS safe harbor.
A taxpayer makes the safe harbor election by attaching a statement to its original federal income tax return for the taxable year in which the success-based fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction and stating the success-based fee amounts that are deducted and capitalized. The election is irrevocable and does not constitute a change of method of accounting.