Deal termination fees
Termination (or breakup) fees in merger and acquisition agreements are essentially intended to deter parties to a proposed acquisition from backing out of the deal. An acquisition agreement may impose a potential termination fee on the target company or on the acquirer. In many situations, however, the agreement has no provision for any termination fee. Where breakup fees apply, the fee amounts often represent a fixed percentage of the transaction value, generally between 0.5% and 5%.
Capital loss versus ordinary deduction
Capital losses generally be used only to offset capital gains. Ordinary tax deductions are preferable since they can offset nearly any sort of income. The tax benefit resulting from payment of a sizable termination fee as a result typically is less if the fee produces a capital loss rather than an ordinary deduction.
The current IRS view is that the deal termination fee produces a capital loss to the extent it relates to the purchase or sale of a capital asset. For example, corporate stock would be a capital asset to most taxpayers, and the IRS would view a stock purchase agreement breakup fee as a capital loss.
Over time, it seems the IRS changed its approach on this issue. Some years ago, taxpayers typically would claim ordinary deductions for deal breakup fees. That approach was consistent with older IRS rulings concluding that the fees represented ordinary income to the recipient. See LTR 200823012; TAM 200438038.
In 2016, the IRS concluded in ILM 201642035 and in FAA 20163701F that the party paying a breakup fee should treat the fee as a capital loss because section 1234A applied. In 2022, the IRS is adhering to that view in ILM 202224010.
The taxpayer in ILM 202224010 paid termination fees under one agreement under which it would have made an acquisition, and another agreement under which it was on the sell-side. The IRS held that section 1234A applied to both fees and denied the taxpayer’s claimed ordinary deductions.
Section 1234A says that gain or loss is capital in character if it is attributable to termination of a right or obligation with respect to property which is (or would be) a capital asset in the hands of the taxpayer. An ordinary deduction position with respect to termination fee is stronger to the extent that the terminated deal involved an acquisition (or sale) of trade or business assets that would not be capital assets. For example, a terminated acquisition to acquire depreciable (or amortizable) property categorized under the Tax Code as section 1231 assets could result in an ordinary tax deduction for a breakup fee. See, e.g., CRI-Leslie, LLC v. Comm’r, 882 F.3d 1026 (11th Cir. 2018) (forfeited deposit on uncompleted sale of property did not give rise to capital gain under section 1234A).
The IRS is sticking to its view that ordinary tax deductions are not available for termination fees relating to the breakup of an agreement to acquire or sell capital assets. Any acquirer or seller required to pay a termination fee should not assume that it is entitled to the tax benefit or an ordinary deduction. Instead, the character of any fee deduction should be closely considered in consultation with tax advisors.