United States

Investment banker allocation letter insufficient to claim deduction

Success based fee deductions denied due to lack of documentation

TAX ALERT  | 

IRS denies taxpayer deduction of M&A transaction fee due to lack of sufficient documentation. The taxpayer elected not to claim the 70 percent safe harbor allowed to taxpayers for success based fees incurred in an M&A transaction, instead claiming a higher percentage based upon an allocation letter from an investment banker.

On June 21, 2018, the Office of Chef Counsel issued CCA 201830011 confirming the Service’s position that an allocation letter from an investment banker is not enough to support a deduction of any portion of a success fee paid in pursuit of certain acquisitive transactions.

Treasury Regulation section 1.263(a)-5 requires that costs incurred in pursuit of certain acquisitive transactions must be capitalized under. Further, where the transaction is defined as (1) the taxable acquisition of the assets constituting a trade or business, (2) the acquisition of an ownership interest in the taxpayer where, after the transaction, the parties are related under 267(b) or 707(b), or (3) certain tax free reorganizations, the regulations provide specific bright-line rules for when costs must be capitalized versus when they may be recovered over time or through a current deduction. These bright-line rules look to both the underlying service provided as well as when the service was provided.

Historically there was significant controversy over the treatment of the success based fees paid to investment bankers. This was due to the fact that investment bankers are typically paid upon successful closing of the transaction and do not keep time records. Treasury Regulation section 1.263(a)-5(f) establishes a taxpayer-unfavorable presumption of capitalization by stating:

An amount paid that is contingent on the successful closing of a transaction described in paragraph (a) [covered transactions] of this section is an amount 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.

In addition, the required documentation must be completed on or before the due date (including extensions) of the tax return for the tax year during which the transaction closes. Furthermore, an allocation between facilitative and deductible fees is not sufficient. Rather, the taxpayer must support the allocation with invoices, time sheets or other records and must identify the following:

  1. The various activities performed by the service provider;
  2. The amount of the fee (or percentage of time) that is allocable to each of the various activities performed;
  3. Where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and
  4. The name, business address, and business telephone number of the service provider.1

In 2011, the IRS published Revenue Procedure 2011-29 to provide a safe-harbor election for taxpayers that incurred success-based fees in pursuit of the aforementioned acquisitive transactions. By making this election, the taxpayer will be allowed to treat as non-facilitative costs 70 percent of any success-based fee related to the transaction, with the remaining 30 percent treated as facilitative. This safe harbor was seen as very taxpayer friendly when released as it did allow 70 percent of the success-fee to be amortized or deducted. As a result, since release of this Revenue Procedure, most taxpayers have elected the safe-harbor treatment. Nonetheless, this Revenue Procedure only provides an elective safe-harbor and taxpayers are still free to meet the documentation requirements of the regulations if they wish to deduct more than the safe harbor amount.

Such was the case in CCA 201830011 where the taxpayer deducted 92 percent a success-fee on its tax return. Upon audit, the taxpayer provided the exam agent with a power point presentation that its investment banker presented to its BOD and two-page letter from the investment banker allocating its time. The letter stated that the investment banker did not keep time records and that its fee allocation was made after talking with members of the acquisition team to approximate percentages of time spent on various activities. However the investment banker also did not disclose the names of or contact information for the team members consulted. In citing to the documentation requirements in Treasury Regulation section1.263(a)-5(f), Chief Counsel concluded that the allocation letter has no effect under the rules of Treasury Regulation section 1.263(a)-5(f) and that without other documentation, the Taxpayer’s deduction is zero.

While the conclusion reached in this CCA may not surprise, it serves as a harsh reminder that when the safe harbor is not applied, taxpayers must meet the strict documentation rules of Treasury Regulation section 1.263(a)-5(f) to substantiate any sort of deduction. A mere allocation letter and one additional form of documentation such as the power point presentation will not suffice. Additionally, while the safe harbor applies to the acquisitive transactions noted above, there are transactions to which the safe harbor does not apply where success fees are incurred, such as the fees incurred by a target in a 338(h)(10). In those cases, it is also recommended that the taxpayer similarly meet the stricter regulatory documentation standards.

For a more detailed discussion on transaction costs incurred in acquisitive transactions, see our article here.


1. Treasury Regulation section 1.263(a)-5(f).

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