On April 8, 2011, the Internal Revenue Service (IRS) issued Revenue Procedure 2011-29, providing a safe harbor election for allocating success based fees paid in business acquisitions or reorganizations. This marks the latest development in the “capitalization vs. deduction” debate that has been going on in the tax world for almost 20 years.
In 1992, the U.S. Supreme Court decided the case of INDOPCO, Inc. v. Commissioner. In Indopco, the Court held that any expenses incurred in facilitating a merger or reorganization that produce "significant long-term benefits" must be capitalized. The IRS initially interpreted this ruling to require capitalization of nearly all costs incurred in an acquisition, merger or reorganization.
In the years following the INDOPCO case, taxpayers vigorously opposed IRS treatment of transaction costs. In particular, taxpayers objected to capitalizing costs which were investigative of the transaction, as opposed to costs which were facilitative of the transaction.
In 2003, The IRS issued final regulations on the issue, known as the “INDOPCO regulations.” These new rules provided a “bright-line” test that generally treats transaction costs incurred before the decision date (the date a letter of intent or a merger or reorganization agreement is entered into) as non-facilitative investigatory costs. Costs incurred on or after the decision date are generally deemed to facilitate the transaction and must be capitalized. Certain expenses are considered "inherently facilitative" and must be capitalized regardless of when incurred. These costs include amounts paid to secure an appraisal, structure the transaction, prepare legal documents, obtain regulatory and shareholder approval, and convey property between the parties.
The INDOPCO regulations also provided rules for the documentation and allocation of “success-based fees.” The regulations provide that Amounts that are contingent on the successful closing of an acquisition, merger or reorganization are presumed to facilitate a transaction unless taxpayer documentation could establish that a portion of the fee is allocable to non-facilitative expenses. These ambiguous documentation rules have been a source of uncertainty and dispute for taxpayers and the IRS.
In Revenue Procedure 2011-29, the IRS provides a safe harbor election for the allocation of success-based fees. Under this new guidance, the IRS will not challenge a taxpayer’s allocation of success-based fees provided that the taxpayer treats 70 percent of the costs as non-facilitative and 30 percent of the costs as facilitative.
In order to elect this safe harbor provision, taxpayers must attach a statement to their original federal income tax return for the taxable year 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. Rev. Proc. 2011-29 is effective for success-based fees paid or incurred in taxable years ending on or after April 8, 2011.
It is important to note that just because a cost is considered “non-facilitative” under the safe harbor method described above, it does not mean the non-facilitative costs are immediately deductible on a current year tax return. Other Internal Revenue Code Sections such as Section 195, dealing with start-up expenditures paid or incurred in connection with investigating the creation or acquisition of an active trade or business, may ultimately govern the deductibility of the success-based fees allocated to non-facilitative costs.
This safe harbor should go a long way to resolve many possible disputes between taxpayers and the IRS regarding the proper allocation of business transaction costs. However, a facts and circumstances analysis of a particular transaction may still warrant a greater allocation of non-facilitative costs. Schneider Downs would be pleased to assist you with preparing a proper analysis of these business transaction costs.
For further information, please contact Marty DiGiovine, Tax Advisory Services.
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