When acquiring a business, the acquirer will incur significant costs for planning, negotiating, brokering and conducting due diligence on the transaction. Depending on the facts and circumstances, portions of those costs may be immediately deductible, capitalized and amortized over as many as 15 years, or even capitalized permanently until the business is disposed. Understanding the rules that apply to the capitalization of transaction costs is critical to maximizing the acquirer’s current deductions.

Generally, costs made to increase the value of property must be capitalized. Regulations issued in 2003 addressed both costs incurred to create or acquire intangibles and costs incurred to facilitate the acquisition of a trade or business, capital structure shifts and certain other transactions. Prior to the issuance of these regulations, much of the analysis used to determine whether costs facilitated a transaction was based on the Supreme Court case INDOPCO Inc. v. Commissioner, 503 U.S. 79 (1992). The regulations adopt many of the underlying theories of the INDOPCO and later decisions, as well as clarify rules specific to certain contentious issues. The terms “facilitate” and “facilitative” are pivotal to the ultimate result.

General Rule of Capitalization

In general, under Code Section 263(a), a taxpayer must capitalize costs incurred to facilitate certain transactions, whether the transaction comprises a single step or multiple steps and regardless of whether gain or loss is recognized. These are the so-called “covered” transactions:

• An acquisition of assets that constitutes a trade or business (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition);
• An acquisition by the taxpayer of an ownership interest in a business entity if, immediately after the acquisition, the taxpayer and the business entity are related;
• An acquisition of an ownership interest in the taxpayer;
• A restructuring, recapitalization or reorganization of the capital structure of a business entity;
• A tax-free capital contribution to a corporation or partnership;
• A formation or organization of a disregarded entity;
• An acquisition of capital;
• A stock issuance;
• A borrowing; and
• Writing an option.
  
  

Facilitative Costs

Whether a cost incurred in connection with a covered transaction is facilitative to the transaction is a question of facts and circumstances and includes costs incurred “in the process of investigating or otherwise pursuing the transaction.” The regulations clarify that determination of “the value or price of a transaction is an amount paid in the process of investigating or otherwise pursuing that transaction.” In applying the facts and circumstances to the costs, a “but for” the transaction analysis is relevant but not determinative.

Therefore, the fact that a taxpayer would not have incurred a cost without entering into the transaction does not automatically require capitalization of the cost. The cost paid to acquire tangible or intangible property, including target shareholder stock, is not facilitative of a covered transaction. Rather, it represents the cost of the property acquired.

Special Rules for Certain Costs

Regulation sections 1.263(a)-5(c)(1) through (8) provide special rules for certain covered transaction or associated costs:

• Borrowing in and of itself is a covered transaction; therefore, costs facilitating a borrowing do not facilitate another transaction.
• Costs incurred facilitating an asset sale facilitate only the asset sale and do not facilitate any related covered transactions.
• Costs incurred facilitating mandatory stock distributions do not require capitalization if the distribution is “required by law, regulatory mandate, or court order.” Similarly, costs incurred to organize an entity to carry out the divestiture are not subject to capitalization nor are the costs associated with transferring assets into an entity for purposes of complying with the mandate.
• Costs incurred facilitating a bankruptcy represent a covered transaction.
• Costs associated with the integration of businesses do not facilitate a covered transaction, no matter when the integration occurs.
• Fees paid to registrar and transfer agents do not facilitate a covered transaction unless the costs relate to a specific covered transaction.

Exceptions and Simplifying Conventions

Additional costs that are not subject to capitalization include:

• Employee compensation (salary, bonuses, and commissions paid to common law employees as well as compensation in the form guaranteed payments to partners, compensation to directors, and amounts “paid for secretarial, clerical, or similar administrative support services”);
• Overhead; and
• De minimis costs (if a taxpayer incurs more than $5,000 in aggregate facilitating a covered transaction, then all costs are subject to capitalization).

Other Special Rules for Capitalization

Acquisitive Transactions

In addition to the general rule of capitalization for covered transactions, the following acquisitive transactions are subject to special capitalization requirements:

• A taxable acquisition by the taxpayer of assets that constitute a trade or business;
• A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related; and
• Most tax-free reorganizations.

These transactions are subject to a “bright line date”, where all costs incurred investigating or pursuing a transaction after a specific date are deemed facilitative, as well as a rule that deems certain costs “inherently facilitative” and therefore subject to capitalization no matter when the costs were incurred.

Bright Line Date

Costs are considered facilitative if they are incurred investigating or pursuing an acquisitive transaction on or after the earlier of two dates:

• The letter of intent, or
• The agreement of material terms.

The letter of intent date is the “date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target.” The agreement of material terms date is the date that the target board of directors or otherwise authorized personnel approve or authorize the agreement of the parties, except that where no authorization is required, the material terms date is the date the parties execute a binding written agreement that includes all material terms.

Inherently Facilitative Costs

Inherently facilitative costs are defined as costs incurred:

• Securing an appraisal, formal written evaluation or fairness opinion related to the transaction;
• Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction (for example, obtaining tax advice on the application of Code Section 368);
• Preparing and reviewing the documents that effectuate the transaction (for example, a merger agreement or purchase agreement);
• Obtaining regulatory approval of the transaction, including preparing and reviewing regulatory filings;
• Obtaining shareholder approval of the transaction (for example, proxy costs, solicitation costs, and costs to promote the transaction to shareholders); or
• Conveying property between the parties to the transaction (for example, transfer taxes and title registration costs).

As such, to the extent a taxpayer incurs inherently facilitative costs in an acquisitive transaction, all such costs are subject to capitalization. However, it is important to consider the entirety of a transaction in determining whether a cost is inherently facilitative. For example, costs associated with disposing of unwanted assets do not represent costs inherently facilitative of an acquisition. Ongoing tax advice and compliance services may not directly relate to an acquisition. Also, note that not all valuation techniques and general transaction due diligence fit into the categories above and are not inherently facilitative.

Success-Based Fees on Covered and Acquisitive Transactions

Prior to the issuance of the regulations, the treatment of success-based fees was probably the most contentious issue between taxpayers and the IRS, with the fight typically concerning deductible due diligence costs performed prior to the bright line date. Success-based fees are fees contingent upon the closing of a transaction, and are generally paid to investment bankers and others involved in brokering transactions. Although the fee is contingent upon a closed transaction, the services performed by the service provider generally take place both before and after the bright line date, and in the case of acquisitive transactions, are both inherently facilitative and general due diligence. Economic performance on the fee occurs as the service provider provides services; however, the liability remains contingent on a closed transaction; therefore, the all-events test is not met until a transaction closes. The delay of establishing that all events have occurred to fix the liability should not cause capitalization of otherwise deductible costs.

The regulations create a presumption of capitalization unless the taxpayer can prove otherwise with documentation created before filing the tax return (including extensions). Furthermore, an allocation between facilitative and deductible fees is not sufficient; rather, the taxpayer must support the allocation with supporting records such as invoices, time sheets, or other records. Although this information may not seem overly burdensome, it is generally not the practice of investment bankers to keep such detailed records.

Safe Harbor Election for Allocating Success-Based Fees

The IRS has provided a simplified safe harbor election for allocating a success-based fee between activities that facilitate a covered transaction and activities that do not facilitate a covered transaction (Rev. Proc. 2011-29). The IRS will not challenge a taxpayer's allocation of a success-based fee between activities that facilitate a covered transaction and activities that do not facilitate the transaction if the taxpayer:

• Treats 70 percent of the amount of the success-based fee as an amount that does not facilitate the transaction;
• Capitalizes the remaining 30 percent as an amount that does facilitate the transaction; and
• Attaches 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.

An election applies only to the transaction for which the election is made and, once made, is irrevocable. The election applies with respect to all success-based fees paid or incurred by the taxpayer in the transaction for which the election is made. An election under this revenue procedure for any transaction does not constitute a change in method of accounting for success-based fees generally, so a section 481(a) adjustment is neither permitted nor required. The safe harbor is effective for success-based fees paid or incurred in taxable years ending on or after April 8, 2011.

Under a 2013 IRS directive, examiners would not challenge a taxpayer’s treatment of “eligible milestone payments” when the taxpayer had elected the success-based fee safe harbor. “Milestone” was defined as one of certain specified events other than a successful closing of the transaction, as long as it did not occur before a bright line date. This meant that the same type of payment could be treated differently depending on when it was earned. To correct this, the IRS amended the definition of “milestone” to end the bright line date limitation. Now “milestone” means an event, including the passage of time, occurring in the course of a covered transaction (whether the transaction is ultimately completed or not). “Milestone payment” means a nonrefundable amount that is contingent on the achievement of a milestone, and “eligible milestone payment” means a milestone payment paid for investment banking services that is creditable against a success-based fee.

Conclusion

Whether fees and costs incurred in buying a business can be deducted currently or must be capitalized and amortized over time is a complicated area. It is imperative to get your tax advisors involved early so you know how to optimize the timing of your write-offs. Make your CBIZ MHM tax professional is part of the transaction team as soon as you start thinking about buying any type of new business.

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