August 1, 2018 Taxpayer denied success-based fee deduction because investment banker allocation letter failed to meet documentation requirements under Reg. Section 1.263(a)-5(f) In CCA 201830011, released July 27, 2018, the IRS concluded that an allocation letter from an investment banker that estimated the percentage of time spent on facilitative and non-facilitative activities, but stated that it should not be relied on because the investment banker did not keep time records, failed to meet the documentation requirements for deducting a success-based fee under Reg. Section 1. 263(a)-5(f). Background 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. An amount is paid to facilitate a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction.1 Under Reg. Section 1.263(a)-5(f), an amount paid that is contingent on the successful closing of a transaction "is an amount paid to facilitate the 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." The 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." Additionally, the documentation "must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction, and must consist of supporting records (for example, time records, itemized invoices, or other records) that identify": — The activities performed by the service provider — The amount of the fee (or percentage of time) that is allocable to each of the various activities performed — If 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) that is allocable to the performance of that activity before and after the relevant date — The name, business address and business telephone number of the service provider Facts The taxpayer engaged an investment banker to explore a possible sale of the taxpayer and identify prospective buyers. The taxpayer agreed to pay the investment banker a fee that would be determined as a percentage of the total transaction consideration on successful closing of the transaction (success-based fee). The fee was not based on an hourly rate. Instead, the fee was based on a variety of factors, including the investment banker's experience. The investment banker performed its services, resulting in the successful close of the transaction, and the taxpayer paid the success-based fee. After the transaction closed, the taxpayer asked the investment banker for an estimate of the amount of time it spent on various activities relating to the transaction. The investment banker sent the taxpayer a letter, stating that it did not keep time records and that its fee was not based on an hourly rate. The letter also stated that the investment banker could not provide detailed estimates based on the amount of time spent on some aspects of the transaction, but could approximate percentages of time spent on various activities. The investment banker estimated that it spent approximately: (1) 92% of its time on identifying a buyer;2 (2) 2% of its time on drafting a fairness opinion; 3 (3) 4% of its time on reviewing drafts of the merger agreement;4 and (4) 2% of its time on performing services after the identified bright line date.5 The letter included a caveat stating that the percentages were only 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 2011-296 for allocating success-based fees, but chose to deduct 92% of the success-based fee based on the investment banker's letter. When the IRS audited the return, the taxpayer provided the investment banker's letter as documentation under Reg. Section 1.263(a)-5(f). Exam requested more documentation and the taxpayer provided a PowerPoint presentation the investment banker presented to the taxpayer's board of directors. The PowerPoint presentation had information on the taxpayer and the explored acquisition strategies. Analysis The IRS concluded the investment banker's letter was "merely an allocation between activities that facilitated and did not facilitate the transaction," which is forbidden by Reg. Section 1.263(a)-5(f). The IRS recognized the taxpayer attempted to provide time estimates from the investment banker; however, Reg. Section 1.263(a)-5(f) "requires the supporting records to identify the amount of the fee that is allocable to each activity (percentage of time is just in a parenthetical)." Additionally, the PowerPoint presentation provided evidence that the investment banker performed non-facilitative services, but it did not identify the amount of the fee or percentage of time that was allocable to each activity. Therefore, the IRS concluded that, without further documentation, the taxpayer's deduction is zero and it must capitalize 100% of the success-based fee. Implications In the CCA, the IRS concluded the investment banker letter could not satisfy the documentation requirements because it is "merely an allocation" and "has no effect under the rules of [Reg. Section] 1.263(a)-5(f)." It has long been our understanding that in drafting Reg. Section 1.263(a)-5(f), Treasury intended to distinguish between: (i) allocation letters that merely provide a percentage attributable to facilitative and non-facilitative activities (e.g., 80% non-facilitative and 20% facilitative) vs. (ii) allocation letters that provide a robust description of the services provided and the percentage of time/fees attributable to those services (the former being forbidden under the rules). Here, the IRS seems to imply that any type of allocation letter is not sufficient to satisfy the requirements under Reg. Section 1.263(a)-5(f), without further documentation, and that only documents that identify the amount of the fee allocable to each activity suffices. The CCA appears to be inconsistent with prior IRS guidance, including PLR 20083009, PLR 200953014 and TAM 201002036, regarding what constitutes sufficient documentation for purposes of Reg. Section 1.263(a)-5(f). For example, in PLR 20083009, the IRS stated that "[Reg. Section 1.263(a)-5(f)] does not require time records" and that "other records may be used to establish an appropriate allocation." In PLR 200953014, the IRS reaffirmed the position set forth in PLR 200853014 and elaborated on the types of documentation that taxpayers may rely on, stating: "Although [S]ection 1.263(a)-5(f) provides detailed rules concerning the necessary documentation, that section does not require time records. Other records may be used to establish an appropriate allocation. Courts have considered "the [taxpayer's] records, the files of attorneys, the testimony of witnesses who know the facts, and opinion testimony," including materials such as board meeting minutes, and presentations, "even if the apportionment derived … is 'less scientific'." Significantly, the IRS specified that the following documents should be considered in determining whether an investment banker's fee is non-facilitative: invoices, engagement letters, meeting minutes, calendar entries, service provider documents produced for the client, transaction documents and assorted other documents. Further in TAM 201002036, the IRS was asked to provide technical advice on whether the allocation spreadsheets developed by an accounting firm based on interviews with the investment banker qualify as "other records" within the meaning of Reg. Section 1.263(a)-5(f). The IRS concluded as follows: "Under [S]ection 1.263(a)-5(f), records other than time records or itemized invoices can qualify as "other records" for purposes of substantiating the non-facilitative portions of a success-based fee. The term "other records" is not defined in the regulations and there are no limitations on the type or source documents that can qualify as "other records." ———————————————
——————————————— 1 Reg. Section 1.263(a)-5(b). 2 Reg. Section 1.263(a)-5(e)(1) provides, in part, that, except for certain inherently facilitative amounts listed in Reg. Section 1.263(a)-5(e)(2), an amount paid pursuing a covered transaction (as defined in Reg. Section 1.263(a)-5(e)(3)) facilitates the transaction only if it relates to activities performed on or after the "bright line date" (as defined in Reg. Section 1.263(a)-5(e)(1)). Here, the bright line date was the date the taxpayer's board of directors approved the buyer; therefore, activities performed in identifying the buyer occurred before the bright-line date and are not required to be capitalized. 3 Reg. Section 1.263(a)-5(e)(2) provides that amounts paid for securing a fairness opinion are inherently facilitative, regardless of when the activities are performed, and must be capitalized. 4 Reg. Section 1.263(a)-5(e)(2) provides that amounts paid for preparing or reviewing a merger agreement are inherently facilitative, regardless of when the activities are performed, and must be capitalized. 5 Pursuant to Reg. Section 1.263(a)-5(e)(1), activities performed after the bright-line date must be capitalized. 6 Revenue Procedure 2011-29 provides a safe harbor election for allocating success based fees paid in a covered transaction (as defined in Reg. Section 1.263(a)-5(e)(3)). In lieu of maintaining the documentation required by Reg. Section 1.263(a)-5(f), electing taxpayers may treat 70% of the success-based fees as an amount that does not facilitate the transaction, and the remaining 30% must be capitalized as an amount that facilitates the transaction. | |||||||||||||||
| |||||||||||||||
