IRS Denies Taxpayer Attempt to Deduct Actual Investment Banker Success-Based Fees

By Jennifer L. Drews, CPA, and Bonnie B. Koppenol, CPA
| 11/28/2018
The IRS released Chief Counsel Advice (CCA) memorandum 201830011 that addresses the issue of whether a taxpayer can satisfy the documentation requirements of income tax regulations by providing a letter from an investment banker that estimates the time spent on facilitative versus nonfacilitative activities. 

Facilitative activities

Generally, a taxpayer must capitalize amounts paid to facilitate a merger or acquisition of a trade or business. An amount is considered facilitative if it is paid in the process of investigating or otherwise pursuing the transaction on or after the “bright-line date,” which is the earlier of the following:
  • The date on which a letter of intent, exclusivity agreement, or similar written communication is executed
  • The date on which the material terms of the transaction are authorized or approved by the taxpayer’s board of directors.
In a merger or acquisition setting, a success-based fee is an amount that is contingent on the successful closing of a merger or acquisition. Such a fee is presumed to facilitate the transaction and therefore must be capitalized. However, the taxpayer can rebut the presumption by maintaining sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction.

Documentation requirements

The requirements under Income Tax Regulations Section 1.263(a)-5(f) state that the documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction. The documentation must consist of supporting records, such as time records, itemized invoices, or other records that identify all of the following:
  • The activities performed
  • The amount of the fee (or percentage of time) that is allocable to each of the activities performed
  • The date of the activity
  • The name, business address, and business telephone number of that service provider 
This documentation must be completed on or before the due date of the taxpayer’s timely filed original federal income tax return (including extensions) for the taxable year during which the transaction closes.

Safe harbor 

In lieu of obtaining the required documentation outlined above, IRS Revenue Procedure 2011-29 provides a safe harbor option for eligible taxpayers when allocating the success-based fees between facilitative and nonfacilitative costs. Under the safe harbor, a taxpayer can elect to treat 70 percent of the success-based fees incurred as nonfacilitative costs (in other words, they may deduct these costs). The remaining 30 percent must be capitalized as facilitative costs.  

CCA 201830011

In CCA 201830011, the taxpayer (the Target) agreed to and paid a success-based fee to an investment banker after a successful sale transaction. The buyer was one of many potential buyers the investment banker identified. The fee, determined as a percentage of the total transaction consideration, was not based on an hourly rate but was based on a number of factors, including the investment banker’s experience.
 
After the transaction closed, the Target requested that the investment banker provide an estimate of the time spent on the various activities performed related to the transaction. The Target also informed the investment banker that the bright-line date was the day the board of directors approved the transaction. In its response, the investment banker stated that it could not provide detailed estimates based on time since time records were not kept. However, the letter also stated that after discussions with acquisition team members, an estimate of 92 percent was arrived at for time allocated to identifying a buyer and the remaining 8 percent was allocated to time spent either on facilitative services or services performed after the bright-line date. The investment banker did not disclose names or contact information for the acquisition team members. Additionally, a caveat in the letter specifically stated that the percentages were merely estimates and should not be relied upon by the Target. 
 
Based on the percentage estimates provided by the investment banker, the Target deducted 92 percent of the total success-based fee paid to the investment banker rather than electing the safe harbor provided in Rev. Proc. 2011-29. Therefore, the Target had to satisfy the documentation requirements of Income Tax Regulation Section 1.263(a)-5(f). Upon audit, the Target provided the letter from the investment banker and a summary presentation containing basic information as support for the deduction. Since the letter was merely an allocation between facilitative and nonfacilitative activities (which the regulation specifically states is insufficient), the Target did not satisfy the regulation’s requirements. As the Target did not elect the 70/30 safe harbor provided under Rev. Proc. 2011-29, it had to capitalize the entire success-based fee. 

Summary

The documentation requirements to support success-based fee allocations have been, and continue to be, an area of focus in IRS examinations. If a taxpayer is considering deducting actual success-based fees instead of electing Rev. Proc. 2011-29 safe harbor, care should be taken to strictly follow the documentation requirements or risk losing the deduction entirely.  
 

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Jen Drews
Bonnie Koppenol
Bonnie B. Koppenol
Managing Director