United States

IRS confirms no success based fee safe harbor in deemed asset sales

Deemed asset sale treated as asset sale when applying success based fees

TAX ALERT  | 

Chief council advice (CCA) follows fictional tax treatment in determining application of Rev. Proc. 2011-29

In CCA 201624021 an S corporation shareholder sold their stock to a buyer in a qualified stock purchase that included an election under section 338(h)(10). The section 338(h)(10) election treats the target S corporation (Old T) as selling all of its assets to newly created corporation (New T). Old T incurred success based fees in the transaction and claimed 70 percent of the success based fees under the safe harbor provided in Rev. Proc. 2011-29. The benefit to the S corporation shareholder in Old T deducting 70 percent of the success based fee comes in the ability to claim ordinary deductions as opposed to reduced gain on sale that would likely represent capital gain.

Rev. Proc. 2011-29 provides a safe harbor allowing taxpayers to exclude 70 percent of success based fees from capitalization under Reg. section 1.263(a)-5 if the cost is incurred in certain defined "covered transactions." Asset sales do not fall within this definition. Sale of an S corporation stock in the transaction at issue in the CCA would have represented such a transaction but for the section 338(h)(10) election. The effect of the section 338(h)(10) is to treat the transaction as an asset sale by Old T for all federal income tax purposes, and the IRS ruled that included application of Rev. Proc. 2011-29. As a result, the taxpayer was required to capitalize the success based fees, resulting in a reduction in the overall gain on the transaction, but likely at capital gain rates. The CCA confirms the treatment that many practitioners have believed applied to the transaction at issue.

One positive note from the CCA is that the IRS also confirmed that the taxpayer did have the ability to deduct the success based fees if proper documented as required in the regulations. While not surprising, there has been some question as to whether the IRS view was that all of such costs represented a reduction to the purchase price. The CCA seems to alleviate that concern and confirm that a seller of assets representing a trade or business can in fact incur ordinary section 162 deductions to the extent they are not subject to Reg. section 1.263(a)-5.

For a more detailed analysis of the rules surrounding merger and acquisition transaction costs see our white paper: Merger and acquisition transaction costs 2015 redux: Who gets the benefit?

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