Two recent IRS releases confirmed certain points regarding the deductibility of success-based fees in stock acquisitions for federal income tax purposes. A fuller explanation of the tax issues associated with investment banking fees was distributed by our firm. There are additional requirements associated with the deductibility of investment banking fees beyond what is covered in this article.

In the context of drafting and negotiating investment bankers’ engagement letters, consideration should be given to maximizing the amount conditioned on the closing, to the extent possible.

Pre-Closing Nonrefundable Payments to Investment Bankers Not Eligible for Safe Harbor Tax Deduction Treatment

Many investment bankers’ engagement letters provide for a fixed fee paid on certain events prior to closing, such as on the signing of a merger agreement or on shareholder approval of the acquisition. The amounts paid on these pre-closing events are not refundable in the event the transaction does not close, and they are treated as a prepayment against the aggregate fee that would otherwise be payable at closing.

Last year the IRS issued Rev. Proc. 2011-29, which provides a safe harbor allowing for the deductibility of 70 percent of the investment banking fees that are contingent on closing. This rule is favorable because it avoids the documentation that would be necessary (under pre-existing regulations) for deductibility based on the investment banker’s efforts allocated to periods prior to certain bright-line dates (e.g., letter of intent date) – a difficult task.

Chief Counsel Advice 201234027 concludes that "success-based fees" within the meaning of the Rev. Proc. excludes nonrefundable payments that are not contingent on the successful closing of a transaction. This means that payments due and payable on the signing of a merger document or shareholder approval (rather than on the closing) are not success-based fees within the meaning of the IRS safe-harbor guidance. If a taxpayer has to rely on the bright-line date test, pre-closing investment bankers’ fees related to an acquisition are generally more difficult to deduct, rather than capitalize. This is because of the inability to obtain the requisite information from investment bankers (and the challenge with properly documenting the timeline of services rendered) and because the bright-line test might allow only a small portion of such fees to be deductible even if proper documentation can be developed.

An interesting aspect of the IRS release is that pre-closing payments contingent on shareholder approval could, in certain instances, be very close in time to the closing. It is unclear from the release at what point in the timeline shareholder approval was obtained.

Go Shop Provision in Agreement Does Not Delay Bright-Line Date

A second IRS release (CCA201234026) discusses the application of the bright-line date in the situation where the merger agreement contained a "go shop" provision and the favorable Rev. Proc. 2011-29 70 percent safe harbor is not used by the taxpayer. In situations where the parties do not have a letter of intent or an exclusivity agreement, the merger agreement might mark the bright-line date. In that case, the documentation needs to illustrate how much of the success-based fees and related investment bankers’ services are allocable to periods prior to such date.

The IRS concludes that though the merger agreement contains a go shop provision, it does not delay the bright-line date. This is consistent with the IRS position that the nonbinding aspect of a letter of intent does not delay the bright-line date. Because a letter of intent is signed early in the acquisition process, the deduction available without regard to Rev. Proc. 2011-29 would be less than 70 percent.

In many instances, the favorable safe harbor of Rev. Proc. 2011-29 provides a better tax result than the application of the bright-line date that has existed in the regulations for eight years. The taxpayer in the recent release might have been striving for a deduction that exceeds 70 percent of the success-based fee under the bright-line test.