CPA & Business Advisory Blog

Documentation Necessary to Take a Deduction for Success-Based Fees in Acquisition

Investment banking fees are one of the biggest costs in any acquisition.  Since the 263(a) regulations were issued in December, 2003, the documentation requirements for deducting such fees under Treasury Regulation §1.263(a)-5(f) have resulted in significant controversy between taxpayers and the IRS.

In general, under Treasury Regulation §1.263(a)-5(a), a taxpayer must capitalize amounts paid to facilitate an acquisition of assets that constitute a trade or business and stock acquisitions.  An amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction.  With respect to an amount paid that is contingent on the successful closing of a transaction, Treasury Regulation §1.263(a)-5(f) provides the documentation requirements to support a deduction for fees allocable to activities that do not facilitate the transaction.  In short, the documentation, which must be completed contemporaneously with the tax return for the taxable year in which the transaction closes, must consist of more than merely an allocation between the activities that facilitate the transaction and activities that do not facilitate the transaction.  The documentation must consist of supporting records such as time records, itemized invoices, or “other records.”

Under a recent Technical Advice Memorandum’s (“TAM”) facts, a taxpayer hired a private equity firm and investment banker to assist with a potential sale of the Company.  The Company agreed to pay the private equity firm and investment banker a lump-sum contingent fee if a sale was consummated within a certain time frame.  After the successful transaction, the private equity firm and investment banker invoiced the Company, but neither provided a detailed breakdown of the services rendered by time or fee.  The Company then hired an accounting firm to conduct a transaction cost study to determine what portion of the fees was deductible or capitalizable.  At issue were spreadsheets created in connection with the study, based on discussions and correspondence with representatives of the private equity firm and investment bankers. 

The IRS said the Company was required to capitalize costs incurred to facilitate the transaction.  To the extent the Company could demonstrate that some activities provided by the private equity firm and the investment banker were allocable to activities that did not facilitate the transaction, the Company could deduct a portion of the fees paid.  The IRS argued that the Company failed to provide sufficient documentation that a portion of the success-based fees was attributable to non-facilitative activities and thus amounts were to be capitalized under §263(a).  The Company argued that the spreadsheets prepared by the accounting firm qualified as “other records” and hence were sufficient to meet the documentation requirements even though the documentation did not include time records or detailed invoices.  Since private equity firms and investment bankers do not keep time records or provide itemized invoices like law firms and accounting firms, the Company was unable to provide time records or itemized invoices to support its allocation.

The TAM acknowledges that the term “other records” is not defined, and there are no limitations on the type or source of documentation that can qualify for such.  Thus, any document, whether or not labeled a “time record” or “itemized invoice,” can serve to establish the deductible portion of success-based fees, and this is true even where the document was not produced directly by the service provider (i.e., private equity firm or investment banker) but was based on interviews of employees who had worked for the service provider.

The TAM is favorable to taxpayers because it makes it easier to support a deduction for success-based fees.  The IRS National Office has clearly stated that Treasury Regulation §1.263(a)-5(f) should not be read in a manner that would automatically preclude the deductibility of non-facilitative costs simply because the taxpayer is unable to provide time records or itemized invoices.

For more information on fees related to mergers and acquisitions, post a comment below or contact our Transaction Advisory Services Group at 440-449-6800.

Some information courtesy of BDO.

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