United States: The IRS Creates A 70% Safe-Harbor For Deductibility Of Investment Banking And Other Success-Based Fees Contingent On The Closing Of A Transaction

The IRS has released Revenue Procedure 2011-29 which provides taxpayers with a safe-harbor for deducting a portion of certain success-based fees that are contingent on the closing of certain acquisition and reorganization transactions. Generally, a taxpayer is required to capitalize such fees. A current deduction for such fees is available only to the extent that the taxpayer has sufficient contemporaneous documentation that establishes the portion of the fee allocable to activities that do not facilitate the transaction. Practitioners have been expressing a wide variety of views as to how much of a typical investment banking fee is deductible with appropriate documentary evidence, with estimates varying from 30% to 90%. The new IRS safe-harbor provides taxpayers with the ability to currently expense 70% of such fees and should provide a significant cash flow benefit to financial sponsors and strategic investors with success-based fees.

Requirement to Capitalize Fees Contingent on the Successful Closing of a Transaction

Generally, a taxpayer is required to capitalize amounts paid to facilitate transactions that include acquisitions of a business, various restructurings and reorganizations and capital transactions. Depending on the underlying transaction, capitalization may mean that the tax deduction for the fee is effectively spread over a number of years, deferred until a future liquidity event, or never realized. The applicable Treasury Regulations contain various rules for determining whether an amount is paid to facilitate the transaction and is therefore subject to the capitalization requirement. In the case of certain acquisitions and reorganizations the application of these rules depends in part on when the services were performed, whether the amount paid is on a list of inherently facilitative amounts set forth in the Treasury Regulations, and whether the amount is contingent on the successful closing of the transaction.

Under the Treasury Regulations, success-based fees that are contingent on the successful closing of certain acquisitions and reorganizations are deemed amounts paid to facilitate the transaction (and thus are generally required to be capitalized). Such success-based fees are deductible only to the extent that the taxpayer has sufficient contemporaneous documentation to establish that a portion of the fee is allocable to investigatory or other activities that do not facilitate the transaction. This rule generally applies to typical investment banking fees and other contingent closing fees paid in connection with the acquisition or disposition of a business and frequently results in all or a significant portion of such fees being capitalized.

New Safe-Harbor for Expensing 70% of Fees Contingent on the Successful Closing of a Transaction

Under the new IRS safe-harbor, a taxpayer is able to elect to treat 70% of fees contingent on the successful closing of certain acquisitions and reorganizations as not paid to facilitate the transaction (i.e., currently deductible). If the taxpayer makes the safe-harbor election, then the taxpayer will be required to capitalize the remaining 30% of the fees. Therefore, the election should be beneficial to taxpayers that do not have documentation supporting an allocation of more than 70% of a fee contingent on the successful closing of a transaction to activities that do not facilitate the transaction, that do not wish to obtain and maintain such documentation, or that want to avoid a dispute with the IRS as to the proper allocation between the portion of the fee that has to be capitalized and the portion that can be deducted currently. Depending on the underlying transaction, a taxpayer making the safe-harbor election should consider the potential application of the rules that govern the deductibility and capitalization of start-up expenditures. Generally, these rules provide that a taxpayer may make an election to deduct a de minimis amount of start-up expenditures and is required to amortize the remainder over a 180 month period. Otherwise, start-up expenditures are not deductible.

The new safe-harbor election for success-based fees is made on a transaction-by-transaction basis and is irrevocable once made. The safe-harbor election is made by attaching a statement to the taxpayer's original income tax return for the year the success-based fee is paid or incurred containing a statement that the taxpayer is making the election, identifying the transaction for which the election is being made, and stating the success-based fee amounts that are deducted and capitalized.

The safe-harbor election is effective for success-based fees paid or incurred in the taxable year ending on or after April 8, 2011 (e.g., in the case of a calendar year taxpayer, the taxpayer could make the election with respect to any success-based fees paid or incurred after December 31, 2010).

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.