Partnerships are commonly engaged in significant M&A activity, and any time partnership interests or assets are exchanged, the partnership and its partners can incur significant transaction costs. These costs are capitalized, amortized or deducted, with each treatment capable of producing drastically different tax outcomes. For instance, the ability to deduct a portion of certain success-based fees or items not deemed to facilitate the transaction, like overhead, borrowing and some compliance costs, can provide an immediate benefit. On the other hand, capitalization of facilitative costs may not provide a benefit for several years, if at all.
Determining the proper treatment, however, is governed by extremely complex rules and can be influenced by varying factors and conditions. It may even require taking certain requisite steps, such as documentation and analysis, long before an election is made. A timely and thorough transaction cost study can help identify tax savings, properly document necessary records and make prompt elections, which can ultimately result in significant tax benefits.
This article discusses key concepts to consider when analyzing the federal income tax treatment of transaction costs incurred by a partnership or its partners.
Overview of transaction costs
Default rule requires capitalization
Taxpayers must determine whether costs incurred in connection with a transaction should be capitalized, immediately deducted, or subject to amortization. Treas. Reg. Sec. 1.263(a)-5 sets forth rules regarding the treatment of certain costs incurred in a variety of transactions. Additional guidance can be found in case law and administrative pronouncements.
The regulations contain a general default rule that requires capitalization unless an exception applies. Taxpayers, including partnerships, must capitalize costs paid to facilitate certain transactions specified in Treas. Reg. Sec. 1.263(a)-5(1) to (9), which include:
- An acquisition of assets that constitute a trade or business, whether the taxpayer is the acquirer or the target in 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 under Sections 267(b) or 707(b)
- An acquisition of an ownership in the taxpayer
- A restructuring, recapitalization or reorganization of the capital structure of a business entity
- A transfer to a corporation described in Section 351 (whether the taxpayer is the transferor or the transferee)
- A transfer to a partnership described in Section 721 (whether the taxpayer is the transferor or the transferee)
Payments are treated as facilitating a transaction if made in the process of investigating or otherwise pursuing one of these transactions and often include those remitted to attorneys, investment bankers, accountants, and consultants for services in connection with a transaction.
Exception for costs that do not facilitate the transaction
The regulations include exceptions to the default rule for costs deemed not to facilitate a transaction. For instance, an amount to facilitate a borrowing does not facilitate a transaction other than the borrowing. Other excepted costs include integration, employee compensation and overhead.
The judicially developed “origin-of-the-claim” doctrine offers a second, related exception. It provides that costs do not facilitate a transaction when they do not originate in a business acquisition. For example, certain compliance costs, such as the preparation of financial statements or certain general consulting costs, may be deductible even though the transaction may have been the catalyst for their payment.
Exception for certain costs incurred in covered transactions
Another exception to the default rule applies to certain costs paid in connection with a covered transaction. A covered transaction is defined in Treas. Reg. Sec. 1.263(a)-5(e)(3) and includes:
- A taxable acquisition by a 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 or the target, if the acquirer and target are related after the acquisition under Sections 707(b) or 267(b)
- Certain reorganizations under Section 368
Costs incurred as part of a covered transaction are generally only required to be capitalized if they relate to activities performed on or after the “bright-line date” or are considered “inherently facilitative.” The bright-line date is generally the earliest date on which the parties to a covered transaction come to an agreement on the material terms of the deal. In other words, this exception provides that taxpayers are not required to capitalize costs incurred before the bright-line date as long as the costs are not within the definition of inherently facilitative. For example, due diligence incurred in a covered transaction before the bright-line date is usually treated as non-facilitative under this rule.
The regulations provide a list of inherently facilitative costs that must be capitalized, regardless of whether such costs are incurred before or after the bright-line date. Examples include amounts incurred negotiating the structure of the transaction, obtaining tax advice on the structure of the transaction and preparing the documents that effectuate the transaction.
Special rules apply to fees that are contingent on the successful closing of a transaction, such as many financial advisory fees paid to investment bankers or private-equity sponsors. These success-based fees are deemed to facilitate a transaction and must be capitalized unless certain documentation requirements are satisfied or the taxpayer makes a safe-harbor election.
The documentation rule permits a taxpayer to treat a portion of a success-based fee as non-facilitative if the taxpayer maintains sufficient documentation to establish that such portion is allocable to activities that did not facilitate an acquisition.
Alternatively, a taxpayer may elect to apply the safe harbor under Rev. Proc. 2011-29 to success-based fees paid in a covered transaction. The safe harbor permits electing taxpayers to treat 70% of a success-based fee as an amount that does not facilitate the transaction. The remaining portion of the fee must be capitalized as an amount that facilitates the transaction. The election applies to all success-based fees incurred by a taxpayer in a transaction.
Grant Thornton Insight:
A taxpayer’s ability to obtain a tax deduction for certain pre-bright-line date costs and other non-facilitative costs depends on documenting and analyzing the various costs incurred in connection with the transaction. Because capitalized costs may not provide a tax benefit for several years, if ever, taxpayers incurring transaction costs should strongly consider a transaction cost study to determine the extent such costs could be immediately deducted.
Determining the proper taxpayer
The various rules on the treatment of transaction costs should be applied to the proper taxpayer that incurred such costs. In order to take transaction costs into account for U.S. federal income tax purposes, a taxpayer must generally establish that the taxpayer paid or reimbursed the fees associated with the underlying services and the services were rendered to the taxpayer (or for the benefit of the taxpayer).
Treatment of capitalized facilitative costs
If a taxpayer is required to capitalize transaction costs, the taxpayer must next determine the proper treatment of such capitalized costs.
In the case of an asset acquisition, the acquirer should add capitalized transaction costs to the basis of the acquired assets. The seller should treat its capitalized costs as a reduction in the amount realized on the sale of the assets.
In the case of stock acquisition, the acquirer should add capitalized transaction costs to the basis of the acquired stock. The regulations are reserved on how the target entity’s capitalized transaction costs should be treated. Target entities in this situation generally treat such capitalized amounts as non-deductible and non-amortizable.
Treatment of non-facilitative costs
The treatment of non-facilitative costs (i.e., costs not required to be capitalized) depends on whether the costs were incurred in connection with the expansion of an existing business or in the start-up of a new business.
A target entity’s non-facilitative costs are usually incurred with respect to its existing business and thus immediately deductible under Section 162. An acquiring entity’s non-facilitative costs are frequently incurred to acquire a new trade or business. Those costs must be treated as start-up costs by the acquiring entity and amortized under Section 195 over a 15-year period. If the acquiring entity is already engaged in a trade or business that it expands in the acquisition, its non-facilitative costs are immediately deductible under Section 162.
Partnerships and transaction costs
The rules discussed above can apply to any business entity, including a partnership. If a partnership is the target of an acquisition, whether a purchase of its equity or assets, various unique issues arise.
Partnerships and capitalized facilitative costs
The regulations do not directly address the treatment of capitalized costs incurred by the purchaser of a partnership interest. Adding such costs to the basis of the acquired partnership interest, however, is consistent with the rules governing acquisitions of corporate stock and other general tax principles.
When the outstanding interests in a partnership are acquired, sell-side transaction costs must first be allocated between the selling partners and the target partnership by applying the two-part test discussed above for determining the proper taxpayer. Capitalized costs incurred by selling partners generally reduce the amount realized by the partners on the sale of their interests. Capitalized costs incurred by the target partnership are generally non-deductible and non-amortizable.
If a partnership sells its assets, the partnership generally treats its capitalized transaction costs as a reduction to its amount realized on the sale.
Partnerships and non-facilitative costs of establishing a joint venture
As discussed above, if an acquiring entity incurs non-facilitative costs to acquire a new trade or business, the costs must be amortized as start-up costs over a 15-year period.
Some uncertainty exists where non-facilitative costs are incurred by a newly formed joint venture partnership in connection with its acquisition of one more businesses from its partners. Courts have generally reasoned that the joint venture partnership is a new entity with a separate existence that should be respected, thus denying an immediate deduction and requiring the new entity to amortize non-facilitative transaction costs as start-up costs.
Note that facilitative costs incurred by the new joint venture partnership must be capitalized under Section 263.
Application of covered transaction rules when partnership is the target
Certain favorable rules apply to costs incurred in a covered transaction under the regulations, but their application to partnership transactions is not always clear.
The following examples illustrate an issue that can arise when the target entity in a transaction is a partnership.
PRS1 is a limited liability company classified as a partnership for U.S. federal income tax purposes. PRS1 is owned 10% by Partner 1 and 90% by Partner 2. Partner 2 sells its 90% interest in PRS1 to Corporate Buyer. Partner 1 retains its 10% interest in PRS1. In connection with the transaction, PRS1 incurs a $10 million success-based fee for financial advisory services that it pays to an investment bank.
PRS1 would like to elect the safe harbor provision under Rev. Proc. 2011-29 with respect to the success-based fee. The transaction must qualify as a covered transaction, however, for PRS1 to make such an election.
In this example, Corporate Buyer is related to PRS1 under Section 267(b)(10) immediately after the transaction because the same persons own 50% or more of each of Corporate Buyer and PRS1. Accordingly, this is a covered transaction with respect to PRS1, and PRS1 may elect to use the safe harbor contained in Rev. Proc. 2011-29 to treat 70% of the $10 million success-based fee as an amount that does not facilitate the transaction. PRS1 is entitled to claim a deduction of $7 million under Section 162.
The facts are the same as in Example 1, except that Corporate Buyer purchases 100% of the interests in PRS1 from Partner 1 and Partner 2.
The tax treatment of the transaction in this example is likely governed by Rev. Rul. 99-6, situation 2. As a result of the transaction, PRS1 terminates and becomes an entity disregarded as separate from Corporate Buyer (i.e., a disregarded entity).
Interestingly, the transaction in this example does not appear to satisfy the literal definition of a covered transaction with respect to PRS1 under Treas. Reg. Sec. 1.263(a)-5(e)(2). Although after the transaction, Corporate Buyer owns 100% of PRS1, Corporate Buyer and PRS1 are technically not related within the meaning of Section 267(b) or 707(b). Sections 267(b) and 707(b) define certain relationships between corporations, partnerships and partners, but they do not describe relationships involving disregarded entities.
An argument can be made, however, that the transaction in this example adheres to the general tax policy of the underlying covered transaction rule, which is intended to apply only when at least a controlling interest in a business entity is acquired. Thus, it may be reasonable in certain circumstances to view this type of transaction under Rev. Rul. 99-6 as a covered transaction or to restructure the transaction in a manner that makes it clear that it is a covered transaction.
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