By Evan Adams, J.D., LL.M., Grant Thornton LLP, Washington, D.C.
Editor: Alexander J. Brosseau, CPA
Under Regs. Sec. 1.263(a)-5(a), a taxpayer must capitalize an amount paid to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions. An amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction.
The regulations require taxpayers to satisfy a special documentation requirement for success-based fees, which are amounts paid that are contingent on the successful closing of a transaction. Under Regs. Sec. 1.263(a)-5(f), a success based fee is treated as facilitative, and therefore capitalized, unless the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. Such documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction.
Taxpayers that engage in a “covered transaction” under Regs. Sec. 1.263(a)- 5(e)(3) may take advantage of a safe harbor provided by Rev. Proc. 2011-29, which allows those taxpayers to avoid the documentation rules as long as they treat 70% of the success-based fee as an amount that does not facilitate the transaction and capitalize the remainder as facilitative. A covered transaction means (1) a taxable acquisition by the taxpayer of assets that constitute a trade or business; (2) a taxable acquisition of at least 50% of the ownership interest in a business entity; or (3) certain reorganizations described in Sec. 368(a)(1).
Rev. Proc. 2011-29 was published over a decade ago with the goal of reducing the controversy between taxpayers and the IRS over the allocation of success-based fees between facilitative and nonfacilitative activities. While the safe harbor has been largely successful in its goals, taxpayers still face several areas of uncertainty in analyzing success-based fees. This item surveys four such areas.
Milestone payments
In addition to receiving success-based fees, investment bankers are often paid milestone payments that are contingent on something other than the successful closing of a transaction. For example, a banker might receive a retainer payable upon the execution of the engagement letter between the banker and the taxpayer, a signing fee contingent on the execution of the deal agreement, or a fairness opinion fee contingent upon the provision of a fairness opinion by the banker to the taxpayer. These fees are generally creditable against the success based fee, meaning the amount of success-based fee owed by the taxpayer is reduced by the amount of the milestone payments.
In 2014, the Large Business and International (LB&I) Division of the IRS issued a directive instructing its examiners to not challenge the application of the Rev. Proc. 2011-29 safe harbor to milestone payments creditable against success-based fees (LB&I-04-0114-001). This directive was not an official pronouncement of law and is not permitted to be used, cited, or relied on as such. However, it gave some taxpayers comfort that the simplified approach of Rev. Proc. 2011-29 could also be applied to certain milestone payments.
In a memorandum dated Jan. 26, 2022 (LB&I-04-0122-0002), LB&I announced the withdrawal of the 2014 directive. In the memorandum, LB&I explained that the reason for the withdrawal was to provide for consistent treatment of compliance issues and to address “egregious positions.” The withdrawal of the directive was effective Jan. 26, 2022.
Even if milestone payments are creditable against success-based fees, they are generally required to be paid regardless of whether a transaction closes. Thus, taxpayers face an uphill battle in arguing that these amounts are success-based fees within the definition of Regs. Sec. 1.263(a)-5(f) (i.e., “an amount paid that is contingent on the successful closing of a transaction”). Indeed, this was the result faced by the taxpayer in Chief Counsel Advice (CCA) 201234027, in which the IRS concluded that milestone payments were not eligible for the safe harbor because they were “guaranteed payments incurred upon the occurrence of a specified milestone or upon some other date or event.”
Without application of Rev. Proc. 2011-29, milestone payments are subject to the same regime as other costs incurred in investigating a covered transaction. One element of concluding that costs are not facilitative under this regime is establishing that such costs are not “inherently facilitative,” meaning the service provider was not paid for services on a list of proscribed activities that includes securing a fairness opinion related to the transaction and negotiating the structure of the transaction (among many others). In practice, investment banks often do not provide taxpayers with detailed records of the various services they perform in exchange for a given fee, making it difficult for taxpayers to establish that a milestone payment does or does not relate to inherently facilitative services. In essence, taxpayers analyzing milestone payments are often faced with the same absence of information that made analyzing success-based fees so difficult before the publication of the Rev. Proc. 2011-29 safe harbor.
Timely filed elections
As discussed above, taxpayers that do not apply the Rev. Proc. 2011-29 safe harbor to a success-based fee must satisfy a documentation requirement to treat any part of a success-based fee as not facilitating a transaction. The documentation supporting this conclusion must be completed “on or before the due date of the taxpayer’s timely filed original federal income tax return (including extensions) for the taxable year in which the transaction closes” (Regs. Sec. 1.263(a)-5(f)). Rev. Proc. 2011-29, on the other hand, provides that the taxpayer must attach “a statement to its 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.” There is no explicit requirement that the election statement be attached to a “timely” return, only that it be attached to an “original” return.
Based on the plain language of Rev. Proc. 2011-29, some taxpayers may take the position that they can make a safe-harbor election by attaching a statement to a late (but original) tax return. Alternatively, taxpayers that read an implicit timeliness requirement into Rev. Proc. 2011-29 may conclude that they need a ruling from the IRS under the late-election relief provisions of Regs. Sec. 301.9100-3 to make a valid election (9100 relief). This ambiguity is complicated by a pair of 2017 IRS letter rulings that appear to reach contradictory conclusions on this question.
In IRS Letter Ruling 201717002, the taxpayer was the parent of a consolidated group that incurred success-based fees in a transaction that cut off its tax year. The taxpayer’s tax department erroneously determined the due date of its short-period tax year, causing the taxpayer to file late the return for the short period. The taxpayer included the Rev. Proc. 2011-29 election statement in its late filed return and applied the safe-harbor allocation to the success-based fees. In the letter ruling, the IRS noted that Rev. Proc. 2011-29 requires the statement “to be attached to the original federal income tax return for the taxable year the success-based fee is paid or incurred” and concluded that since the safe-harbor election had been properly filed, 9100 relief was not necessary for an effective election.
Letter Ruling 201741011 also involved a taxpayer that incurred success-based fees in a transaction that cut off its tax year. This taxpayer filed its short-period return late because its accounting firm inadvertently failed to file an extension. In this letter ruling, the IRS stated that because the taxpayer’s return was not timely filed, “the safe harbor election described in section 4 of Rev. Proc. 2011-29 for success-based fees associated with this tax return was not timely filed.” Based on this conclusion, the IRS granted 9100 relief to the taxpayer, giving the taxpayer an extension of time to file the Rev. Proc. 2011-29 statement. Given these rulings, it is difficult to ascertain the IRS’s position on whether a Rev. Proc. 2011-29 statement in an original but not timely return can be effective.
Debt-issuance services
The Rev. Proc. 2011-29 safe harbor only applies to success-based fees for “services performed in the process of investigating or otherwise pursuing” a covered transaction. It is possible, however, that a success-based fee compensates a service provider for services outside this scope.
Taxpayers engaging in capital transactions frequently issue debt concurrently with the capital transaction. Investment bankers may assist the taxpayer in negotiating and obtaining this financing and may be compensated for these services with the success-based fee contingent on the capital transaction rather than any separately stated fee. Under Regs. Sec. 1.263(a)-5(c)(1), an amount paid to facilitate a borrowing facilitates only the borrowing and is not treated as facilitating any related transactions. If some piece of a success-based fee relates to services performed in investigating or otherwise pursuing a borrowing rather than a covered transaction, then the Rev. Proc. 2011-29 safe harbor arguably does not apply to that portion of the fee. There is no clear guidance on whether it is necessary to allocate a success-based fee between a covered transaction and a borrowing and, if such an allocation is necessary, the methodology that should be used.
The lack of guidance in this area is meaningful because there are several conceivable approaches that may or may not be supportable. To illustrate some potential approaches by example, consider a $1 million success-based fee, of which 10% is appropriately treated as facilitating a borrowing:
- The taxpayer could treat all of the success-based fee as eligible for the safe harbor (i.e., $700,000 as nonfacilitative, $300,000 as facilitative, and $0 as related to the borrowing).
- The taxpayer could first allocate a portion of the fee to the borrowing and apply the safe harbor to the remaining fee (i.e., $630,000 as nonfacilitative, $270,000 as facilitative, and $100,000 as related to the borrowing).
- The taxpayer could first apply the safe harbor and allocate the debt portion from the nonfacilitative amount (i.e., $600,000 as nonfacilitative, $300,000 as facilitative, and $100,000 as related to the borrowing). As demonstrated in these examples, the choice of approach in this area can have substantive consequences to a taxpayer’s taxable income.
Traditional allocation of success-based fees
The Rev. Proc. 2011-29 safe harbor is an optional election. At least in theory, taxpayers are free to pursue their own allocation of success-based fees if they can meet the Regs. Sec. 1.263(a)-5(f) documentation requirement discussed above. However, taxpayers have no way to be certain that they have assembled sufficient documentation to satisfy the IRS’s apparently exacting standards, and the consequences of failing to meet the documentation requirement can be severe.
The regulations do not mandate that certain types of records be included, but they do state that the documentation must consist of supporting records (e.g., time records, itemized invoices, or other records) that identify (1) the activities performed by the service provider; (2) the amount of the fee (or percentage of time) that is allocable to each of the various activities performed; (3) where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and (4) the name, business address, and business telephone number of the service provider.
In Letter Rulings 200830009 and 200953014, the IRS stated that detailed time records are not always necessary to support an allocation. In Technical Advice Memorandum (TAM) 201002036, the IRS advised that allocation spreadsheets completed by service providers allocating their time between facilitative and nonfacilitative activities are generally “other records” that are an acceptable form of supporting documentation for an allocation, but that the determination of whether the documentation requirement is met is based on all the supporting documentation provided by the taxpayer. Examples of evidence used to substantiate an allocation may include retainer agreements, invoices, lists of potential buyers, transaction timelines, presentations, meeting agendas, taxpayer records, the files of the attorneys, and board meeting minutes.
In CCA 201830011, the taxpayer treated 92% of a success-based fee as nonfacilitative and 8% as facilitative. The taxpayer’s documentation for this treatment consisted of (1) an allocation letter from the investment banker estimating the amount of time it spent on various activities relating to the transaction and (2) a Microsoft PowerPoint presentation that the investment banker presented to the taxpayer’s board and that contained basic information regarding the taxpayer and explored possible acquisition strategies. The IRS concluded that the taxpayer failed to meet the documentation requirement and was required to treat 100% of the success-based fee as an amount that facilitated the transaction. In so concluding, the IRS stated that the investment banker’s letter was insufficient because it was “merely an allocation between activities that facilitated and did not facilitate the transaction.” The IRS also noted that the PowerPoint presentation was insufficient documentation because it did not identify the amount of the fee or the percentage of time that was allocable to each activity.
On Sept. 18, 2020, LB&I announced a campaign on “Allocation of Success-Based Fees Without Rev. Proc. 2011-29.” (Campaigns are specific issues that LB&I has selected for scrutiny, based on the goals of improving return selection, identifying issues representing a risk of noncompliance, and making the greatest use of limited resources.) The announcement did not include a detailed description of any changes to LB&I’s approaches to examining success-based fees, merely a statement that the “goal of this campaign is to ensure taxpayer compliance with current law.”
Taxpayers that spurn the Rev. Proc. 2011-29 safe harbor should look to the list of potentially supporting items in TAM 201002036 and develop a beefier documentation file than the taxpayer had in CCA 201830011. However, any taxpayer attempting a traditional allocation of a success-based fee should be aware that this is an area of heightened scrutiny from IRS examiners and that the failure to meet the documentation requirement could result in 100% of a fee being capitalized.
Editor Notes
Alexander J. Brosseau, J.D., CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP. For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.
This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.
