Often overlooked by selling shareholders are the tax benefits that can be derived from the expenses incurred by the shareholders when selling the corporation. Generally, expenses incurred in connection with selling capital assets must be capitalized for federal income tax purposes, effectively reducing the capital gain reported by the seller. If the seller is a foreign person who does not pay any capital gains tax or is a tax-exempt entity, no tax benefit results from those expenditures.
Most sellers recognize that compensation expenses arising from change in control bonuses or payments required to cancel employee stock options are deductible by the target corporation in the year of the stock sale. Taxpayer friendly Treasury Regulations also permit the target corporation to deduct additional expenses associated with the transaction. Two recent rulings from the IRS highlight the advantages of deductions for these items in the year of the sale. In one of the rulings, PLR 200953014 (December 31, 2009), the IRS ruled on the tax treatment of various costs associated with a transaction. In a second ruling, TAM 201002036 (September 21, 2009), the IRS ruled on what types of records would satisfy the requirements for documenting the allocation of success based fees for purposes of determining the deductible portion.
Generally, amounts paid in connection with the acquisition of intangibles must be capitalized. Treasury Regulation section 1.263(a)-5 requires a taxpayer to capitalize amounts paid to facilitate the acquisition of a trade or business, including the acquisition of the ownership interest in a business entity that operates a trade or business. For example, costs incurred in connection with borrowing funds for the acquisition must be capitalized. However, under the Treasury Regulations an amount is treated as facilitative of a transaction only if it relates to activities performed on or after the earlier of (i) the date of which a letter of intent or similar agreement is executed or (ii) the date on which the occurrence of a transaction is authorized by the board of directors, or the expense is one deemed inherently facilitative, regardless of the time at which they are incurred. Treas. Reg. §1.263(a)-5(e)(1). For example, amounts paid to secure an appraisal or fairness opinion, to structure the specific transaction or obtain tax advise on the transaction structure, to prepare and review documents and to obtain shareholder approval are deemed inherently facilitative.
In the case of a sale of a C corporation, non-facilitative deductions incurred by the target corporation (even if the transaction is in the form of a stock sale) can be deductible by the target. If the expenses exceed the taxable income for the tax year in which the closing occurs (frequently corporate acquisitions result in the termination of the target’s tax year on the closing date, so it may be short year) the net operating loss can be carried back to prior years to obtain a refund of prior taxes. If there still remains a loss generated by the expense deductions, the loss can be carried forward by the buyer, subject to limitations under Section 382 of the Code. A seller may seek to include the tax benefit as part of the purchase price, either paid at closing or when the buyer realizes the tax benefit.
For example, expenses incurred prior to the bright-line date might include a portion of legal and accounting fees advising the company on corporate governance, reviewing strategic considerations, reviewing bids from potential buyers, and attending management presentations. Expenses incurred by financial advisors investigating various alternatives available to the company including strategic alternatives, and consideration of transactions with purchasers other than the eventual buyer all can be deducted currently, assuming proper documentation is provided. In addition to these costs that are not inherently facilitative and occur before the bright-line date, a target corporation may deduct compensation bonuses, payments to cash out stock options and other fees that are not directly related to the specific transaction.
The Treasury Regulations provide specific rules for success based fees. The Regulation requires that documentation must be completed on or before the due date for the taxpayer’s timely filed original federal income tax return, including extensions, for the taxable year during which the transaction closes. The documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction. The Treasury Regulation provides that documentation must consist of supporting records; for example, time records, itemized invoice or records that identify the various activities performed by the service provider, the amount of the fee that is allocable to each of the activities and the name, business address and telephone number of the service provider.
In TAM 201002036, a taxpayer utilized an allocation provided in general spreadsheets developed by an accounting firm to determine the allocation of the success based fees to facilitative and non-facilitative activities and deducted the amounts paid for the non-facilitative activities. The taxpayer did not provide time records or itemized invoices to support its allocation but provided records in the form of general spreadsheets developed through interview and the memory of employees regarding activities. The IRS ruled that the fact that the taxpayer was unable to provide time records or itemized invoices from the investment banker did not preclude the deductions. The ruling indicated that the IRS will determine, based on all the documentation provided, whether the taxpayer made an appropriate allocation of success based fees.
The deduction for expenses incurred in the disposition of a corporation can result in a significant increase in the proceeds received by the sellers. Sellers should ensure that service providers, particularly those who are paid on a success fee basis, provide adequate information to permit an appropriate allocation of the fees between nonfacilitative activities and facilitative activities. While the recent TAM indicates that there is no specific type of records required, sellers are recommended to include in agreements with service providers a requirement to provide adequate records to allow the deductions.