In ILM 201624021, the IRS concluded that a target corporation may not use the safe harbor under Revenue Procedure 2011-29 because the transaction is not a "covered transaction" under Reg. Section 1.263(a)-5(e)(3). Instead, the target must capitalize success-based fees, unless it can establish with documentation that the fees are allocable to activities that did not facilitate the transaction.

Facts

The shareholders of an S corporation (Target) sold all of their outstanding stock to an acquiring corporation (Acquirer), in a taxable transaction. Target and Acquirer jointly elected to treat the transaction as a taxable asset acquisition under Section 338(h)(10). Target incurred success-based and non-success based fees leading up to the close of the transaction.

Target attached a statement to its 2012 Form 1120-S, US Income Tax Return for an S Corporation, electing the safe harbor allocation under Revenue Procedure 2011-29. Target capitalized 30% of its success-based fees and claimed a transaction cost deduction, including 70% of its success-based fees under Revenue Procedure 2011-29.

Analysis

Under Reg. Section 1.263(a)-5(f), success-based fees are presumed to facilitate a transaction and must be capitalized. However, Reg. Section 1.263(a)-5(f) also allows a taxpayer to overcome this presumption and deduct the fees, if the taxpayer maintains sufficient documentation to establish that a portion of the success-based fees is allocable to activities that did not facilitate the transaction.

Revenue Procedure 2011-29 contains a safe harbor election that allows a taxpayer to allocate success-based fees between activities that facilitate a transaction and activities that do not facilitate a transaction, instead of maintaining the documentation required by Reg. Section 1.263(a)-5(f). The safe harbor election is available only for covered transactions listed in Reg. Section 1.263(a)-5(e)(3).

Reg. Section 1.263(a)-5(e)(3) defines a "covered transaction" as either: (1) a taxable acquisition by the taxpayer of assets that constitute a trade or business, (2) a taxable acquisition of an ownership interest in a business entity if, immediately after the acquisition, the acquirer and the target are related within the meaning of Section 267(b) or 707(b), or (3) a reorganization described in Section 368(a)(1)(A), (B), or (C), or in Section 368(a)(1)(D) in which stock or securities of the acquiring corporation are distributed in a Section 354 or Section 356 transaction.

Under Section 338(h)(10), subject to certain requirements, a purchasing corporation and the selling shareholders can elect to treat a stock acquisition as a purchase of the underlying assets if the purchasing corporation acquires 80% of the total voting power and value of a target corporation in a taxable transaction within 12 months (i.e., a qualified stock purchase or QSP).¹ Targets that are members of an affiliated group and S corporations are eligible for the election.² If a Section 338(h)(10) election is made, old target is treated as if it transferred all of its assets to an unrelated person for consideration. Old target recognizes gain from the deemed sale while a member of the selling consolidated group or owned by S corporation shareholders.³ Old target is then treated as if it distributed the sales proceeds to its shareholders and ceased to exist.⁴

The IRS determined that Target cannot treat the transaction as a covered transaction because: (1) a "covered transaction" under Reg. Section 1.263(a)-5(e)(3)(i) "only applies to the acquiring taxpayers and not the acquired taxpayers"; (2) the transaction was not a taxable acquisition of an ownership interest in a business entity described in Reg. Section 1.263(a)-5(e)(3)(ii); and (3) the transaction was not one of the specific type of reorganizations listed in Reg. Section 1.263(a)-5(e)(3)(iii).

Accordingly, the IRS concluded Target is not eligible for safe harbor treatment under Revenue Procedure 2011-29 and must capitalize the success-based fees that it claimed as a current expense on its 2012 return, unless Target can prove through documentation that the fees are allocable to activities that did not facilitate the transaction.

Implications

In the context of an asset acquisition, ILM 201624021 confirms that a "covered transaction" only applies to the acquiring entity, and not to the target entity. Only the acquiring taxpayer — not the target corporation — qualifies for the success-based fee safe harbor when the parties make a Section 338(h)(10) election to treat the stock sale as a sale of the underlying assets of target. Specifically, on the selling side, the transaction is treated as if the target sold its assets in a taxable asset sale. Although the ILM states that the success-based fee must be capitalized, the capitalized success-based fee would operate as a reduction of old target's amount realized on the deemed sale of its assets. This is consistent with Reg. Section 1.263(a)-5(g)(2)(ii), which provides for the treatment of a target's capitalized costs in a taxable asset acquisition or deemed asset acquisition under Section 338.

Typically, because the selling expenses of a target, including success-based fees, in a taxable asset acquisition reduce the amount realized, taxpayers do not treat a portion of the success-based fee as non-facilitative under Reg. Section 1.263(a)-5(f). ILM 201624021 makes clear that, should a taxpayer desire to treat a portion of a success-based fee incurred in selling its assets as non-facilitative, the presumption that success-based fees are capitalizable can be overcome by sufficient documentation in a covered or non-covered transaction. Such documentation may include an allocation letter from a service provider that establishes at least a portion of the success-based fees were allocable to activities that did not facilitate the transaction.

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ENDNOTES

¹ Section 338(d)(3).

² Reg. Section 1.338(h)(10)-1(c)(1).

³ Reg. Section 1.338(h)(10)-1(d)(3).

⁴ Reg. Section 1.338(h)(10)-1(d)(4). The deemed distribution by old target does not automatically qualify as a liquidation under Section 331 or Section 332.