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.
The rules governing costs incurred in partnership transactions can be complex. Taxpayers who incur such transaction costs should consider a timely and thorough transaction cost study. Doing so can help ensure they are adequately prepared and positioned to obtain the greatest possible tax benefit.