Deductibility of Transaction Costs for an S-Corporation Target
Nov. 29, 2016
By Tiffany Richardson, CPA, and David Strong, CPA
The IRS recently issued guidance about the ability of an S-corporation target to rely on the safe harbor election to deduct 70 percent of success-based fees in merger and acquisition transactions.
Merger and acquisition (M&A) transactions are on the rise among financial services companies. The banks involved in these transactions may find it advantageous to rely on the safe harbor, provided for in Revenue Procedure 2011-29, that allows them to deduct 70 percent of success-based fees without maintaining contemporaneous documentation. However, the recently issued Chief Counsel Advice (CCA) 201624021 indicates the safe harbor is not available to targets involved in Section 338(h)(10) transactions. As a result, these acquisition targets could end up with a smaller ordinary income deduction than expected.
Capitalization of Facilitative Costs
Typically, in M&A transactions, professional fees incurred must be capitalized if they are “facilitative” to the transaction. Costs determined to be “nonfacilitative” generally can be deducted. An amount is considered facilitative if it is paid in the process of investigating or otherwise pursuing the transaction on or after the bright-line date, which is the earlier of either of the following:
- The date on which a letter of intent, exclusivity agreement, or similar written communication is executed
- The date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors
Success-based fees – which are contingent on the successful closing of a merger or acquisition – are generally presumed to be facilitative. The taxpayer can, however, rebut the presumption by maintaining sufficient contemporaneous documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. The most common type of success-based fees in bank M&A transactions are the amounts paid to investment banking firms.
Safe Harbor for Success-Based Fees
Revenue Procedure 2011-29 provided a safe harbor election that allows taxpayers to allocate success-based fees between activities that facilitate the M&A transaction and those activities that do not facilitate the transaction. Under the safe harbor, success-based fees incurred in certain transactions can be treated as 70 percent nonfacilitative (deductible) and 30 percent facilitative (capitalizable).
The safe harbor generally can be quite favorable for the parties involved in the transaction. In some cases, if the parties actually had to compile the necessary documentation to establish that a portion of the costs were nonfacilitative, the resulting breakdown between facilitative and nonfacilitative costs might not prove as advantageous as the safe harbor. Before Revenue Procedure 2011-29 was issued, in fact, the IRS repeatedly challenged taxpayers’ deductions of nonfacilitative success-based fees, disallowing many ordinary deductions on the basis that the taxpayers’ documentation didn’t support their position. The safe harbor applies to the following covered transactions:
- A taxable acquisition of assets that constitute a trade or business, but only for the purchaser. It is important to note that the seller in a taxable asset sale is not entitled to use the safe harbor
- A taxable acquisition of a controlling ownership interest in a business entity
- A tax-free reorganization
IRS Position on the Availability of the Safe Harbor in Section 338(h)(10) Transactions
The Section 338(h)(10) election allows the parties in a transaction to treat a qualified stock purchase as a taxable asset acquisition for federal income tax purposes. An acquirer wants this treatment if it will receive a stepped-up basis to the fair market value of the target corporation’s assets. The Section 338(h)(10) election commonly is made in the acquisition of an S corporation because S corporations are not subject to corporate level tax.
The recent CCA considered a situation in which a target S corporation incurred success-based investment banker fees in a transaction for which Section 338(h)(10) election was made. The target made the election to allocate the investment banker fees according to the safe harbor. Under examination, the IRS National Office concluded that the safe harbor election was not available to the target corporation because a Section 338(h)(10) election was outside the definition of a covered transaction.
Consequences to Targets
The conclusion in the CCA will have less impact on target C corporations that make a Section 338(h)(10) election because the corporate tax rates are not based on the character of the income (ordinary versus capital). For an S corporation, reducing ordinary income rather than capital gain can result in a reduction in the amount of taxes paid by the shareholders in a sale transaction.
Say, for example, that an S-corporation target is sold, and a Section 338(h)(10) election is made. The target incurred $1 million in investment banker fees that were not payable unless the transaction closed. With the safe harbor, $300,000 of the fees would be a reduction of sales proceeds that would produce a tax benefit at the 20 percent capital gains rate, and $700,000 would produce a tax benefit at the 39.6 percent ordinary income tax rate (assuming the highest individual rate applies). If the safe harbor is not available, though, the amount deductible at the higher ordinary income tax rates will probably be less.
Plan Ahead to Avoid Negative Consequences
Financial services companies contemplating a possible sales transaction involving a Section 338(h)(10) election should alert their service providers at the outset so they know to compile the necessary documentation of their work. Without the safe harbor, contemporaneous documentation is critical for determining the proper allocation of the target’s success-based fees between facilitative and nonfacilitative costs. Without sufficient documentation, the target could lose out on the optimal amount of ordinary income tax deductions.
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