While a new Revenue Procedure establishes a safe harbor election allowing qualifying taxpayers to deduct 70 percent of “success-based fees," it may not be the most beneficial route. A recent transaction cost study resulted in tax savings of more than $166,000 to a client who did not elect the 70 percent safe harbor.
Regulation Section 1.263(a)-5
Regulation Section 1.263(a)-5 requires a taxpayer to capitalize amounts paid to facilitate an acquisition of a trade or business, a change in capital structure, and other specified transactions.
Under Sec. 1.263(a)-5(f), “success-based fees" (contingent upon the successful closing of a transaction) are specifically deemed to be paid to facilitate the transaction, except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction.
Recent tax law developments
Rev. Proc. 2011-29 (applicable for taxable years ending on or after April 8, 2011) establishes a safe harbor election in lieu of maintaining the documentation required under Sec. 1.263(a)-5(f) for “success-based fees." This safe harbor permits qualifying taxpayers to treat 70 percent of their success-based fees as currently deductible expenditures. The remaining 30 percent of the fees must be capitalized as an amount that facilitates the transaction.
This safe harbor election applies only to taxpayers incurring fees for services performed in the process of investigating or otherwise pursuing a “covered transaction."
A "covered transaction" means the following transactions:
- A taxable acquisition by the taxpayer of assets that constitute a trade or business
Note: This appears to exclude a taxable sale 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 within the meaning of section 267(b) or 707(b)
Note: This appears to exclude a taxable sale by multiple taxpayers of 100 percent of the membership units to an LLC or partnership to a single buyer, as the target would be a disregarded entity of the acquirer since it would not meet the related-party definitions under 267(b) or 707(b).
- A reorganization described in section 368(a)(1)(A), (B), or (C) or a reorganization described in section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization)
The safe harbor election is made by attaching a statement to the taxpayer’s original federal income tax return for the taxable year the success-based fee is paid or incurred. The election is irrevocable once made and it does not constitute a change in method of accounting.
Although the leniency provided in recent tax law developments have made full transaction cost studies less critical, there are still several instances where abbreviated studies prove to be beneficial. Baker Tilly can undertake limited scope engagements to provide tax savings opportunities to clients through the following:
- Evaluating fees other than “success-based fees" - Since the safe harbor election applies only to success-based fees, taxpayers still need to determine proper treatment of other transaction costs, including legal and accounting fees.
- Evaluating transaction fees for transactions which the 70/30 safe harbor does not apply - Since the safe harbor election applies only to “covered transactions," taxpayers still need to determine proper treatment of success-based fees incurred in transactions not meeting the covered transaction definitions.
- Evaluating “success-based fees" where the facts indicate more than 70 percent of fees are not facilitative - Transactions where a majority of time and effort is expended prior to the ultimate decision to enter into a transaction (bright-line date) may be able to achieve a deduction for their “success-based fees" greater than the 70 percent safe harbor.
Baker Tilly achieved significant tax savings for a client in a recently completed transaction cost study incorporating all three opportunities. Our client, an LLC, entered into a transaction to sell 100 percent of its membership interest units to another corporation. The transaction was completed on March 14, 2011, pending additional regulatory approval to be completed within the next month.
The transaction did not qualify for the 70 percent safe harbor election due to both the nature (100 percent membership interest to single buyer) and the timing (before April 8, 2011) of the transaction. In addition, the transaction also resulted in legal fees that were not contingent on the success of the transaction.
Baker Tilly completed an abbreviated study that involved the standard work program of a full transaction cost study, but excluded the formal report. The work program included:
- Obtaining and reviewing the purchase agreement, transaction invoices, and other related documents
- Drafting a transaction timeline to determine when the ultimate decision to enter into a transaction occurred
- Identifying and interviewing key individuals to the transaction regarding activities performed and time spent on those activities
- Preparing a matrix to document the allocation of success-based fees between facilitative and nonfacilitative activities
Based on the facts gathered from the transaction documents and the interviews, Baker Tilly identified and documented over 88 percent of the $2.59 million success-based fee as being nonfacilitative and therefore currently deductible. This deduction was $475,000 more than the deduction under the 70 percent safe harbor, which translated to an additional $166,000 in tax savings at a 35 percent tax rate.