IRS denies success based fee deduction due to insufficient documentation

Tax Hot Topics newsletterIn a recent Chief Counsel Advice (CCA 201830011), the IRS Office of Chief Counsel concluded that a taxpayer failed to satisfy the documentation requirement for success-based fees under Treasury rules.

Treas. Reg. Section 1.263(a)-5(a) provides that a taxpayer must capitalize an amount paid to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions. An amount is paid to facilitate a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction.

The regulations include a heightened documentation requirement for a success-based fee, which is an amount paid that is contingent on the successful closing of a transaction. Under Treas. Reg. Section 1.263(a)-5(f), a success-based fee is treated as an amount paid to facilitate a 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.

Such documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not. The regulations do not mandate certain types of records be included, but do state that the documentation must consist of supporting records (for example, time records, itemized invoices, or other records) that: (1) identify the activities performed by the service provider; (2) the amount of the fee (or percentage of time) 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) allocable to performance of that activity before and after the relevant date; and (4) the name, business address, and business telephone number of the service provider.

In the CCA, the taxpayer engaged an investment banker to help it identify potential buyers. After the transaction closed, the taxpayer paid the investment banker a success-based fee. The investment banker provided the taxpayer with a letter in which it estimated the amount of time it spent on various activities relating to the transaction as follows: 92% of its time on identifying a buyer; 2% of its time on drafting a fairness opinion; 4% of its time on reviewing drafts of the merger agreement; and (4) 2% of its time on performing services after the identified bright-line date. The investment banker caveated its estimate with a statement that the percentages were merely estimates and should not be relied on by the taxpayer.

On its federal income tax return, the taxpayer did not elect the safe harbor provided in Revenue Procedure 2011-29 for allocating success-based fees, which would have allowed the taxpayer to treat 70% of the success-based fee as an amount that did not facilitate the transaction and 30% of the success-based fee as an amount that did facilitate the transaction. Instead, taxpayer treated 92% of the success-based fee based as non-facilitative based on the investment banker's letter. 

On audit, the taxpayer provided the investment banker's estimate as documentation under Reg. Section 1.263(a)-5(f). When the IRS requested more documentation, the taxpayer provided a PowerPoint presentation the investment banker presented to the taxpayer's boards which contained basic information regarding the taxpayer and explored possible acquisition strategies.

The IRS concluded the taxpayer failed to meet the documentation requirement and was required to treat 100% of the success-based fee as an amount that facilitated the transaction. It stated: (1) the investment banker’s letter was insufficient because it was “merely an allocation between activities that facilitated and did not facilitate the transaction;” and (2) the PowerPoint presentation was insufficient because it did not identify the amount of the fee or percentage of time that was allocable to each activity.

This CCA highlights a lingering uncertainty on the IRS view about when a taxpayer has met the documentation requirement with respect to success-based fees. Taxpayers should be aware of the Rev. Proc. 2011-29 safe-harbor and consider that approach when it is available.

Dave Auclair
National Managing Principal, Washington National Tax Office
T +1 202 521 1515

Josh Brady
Principal , Washington National Tax Office
T +1 202 521 1563

Bryan Keith
Managing Director, Washington National Tax Office
T +1 202 861 4116

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