In legal advice 20163701F, the IRS held that a company incurred a capital loss when it paid a breakup fee to another corporation as the result of a failed merger.
The buyer and the target had entered into a merger agreement. Although the specific terms of the agreement are heavily redacted in the legal advice, it appears that a new company was formed that would own both the buyer and the target, and shareholders of both would receive stock in the new company. Due to subsequent issues that adversely affected the transaction, the buyer withdrew its recommendation for the transaction. Under the terms of the agreement, the target was eligible for a breakup fee if the buyer did not recommend the transaction, which the buyer subsequently paid.
At issue is whether the breakup fee is considered an ordinary business deduction or a capital loss. The IRS analyzed the breakup fee under the rules of Section 1234A that apply to amounts paid or received for options to buy or sell property and concluded that the breakup fee should be treated as a capital loss. Section 1234A states that any gain or loss is capital if it is attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property that would be a capital asset if acquired by the taxpayer. Because in this case buyer was acquiring stock in target corporation that would have been a capital asset to buyer, the IRS concluded that the breakup fee only would be deductible as a capital loss.
IRS legal advice is nonbinding advice provided relevant to a specific taxpayer’s situation. However, this legal advice is useful in determining the position of the IRS, and it should be considered when developing any tax position relative to the deduction of a merger break fee. It remains to be seen if this issue will be litigated.