September 23, 2020
IRS LB&I Division identifies campaign on the allocation of success-based fees without Revenue Procedure 2011-29
On September 18, 2020, the IRS Large Business & International Division (LB&I) identified four new compliance campaigns that expand its focus areas under its issue-based examination and compliance process, including a campaign on the allocation of success-based fees without Revenue Procedure 2011-29.
The four campaigns were identified through LB&I data analysis and suggestions from IRS compliance employees.
Allocation of success-based fees without Revenue Procedure 2011-29
Treas. Reg. Section 1.263(a)-5 (the Regulations) contains rules requiring taxpayers to capitalize amounts paid to "facilitate" (within the meaning of Treas. Reg. 1.263(a)-5(b)) 10 specifically identified transactions.1 Subject to certain exceptions,2 an amount is incurred to facilitate a transaction described in Treas. Reg. 1.263(a)-5(a) if the amount is incurred "in the process of investigating or otherwise pursuing" the transaction. Whether an amount is incurred in the process of investigating or otherwise pursuing the transaction is based on all the facts and circumstances.
Treas. Reg. Section 1.263(a)-5(f) generally considers a payment that is contingent upon the success of a transaction (i.e., a success-based fee) to be a payment 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 return (including extensions) for the tax 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":
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 must also be included.
Success-based fees are often the most significant fees paid in a transaction, and the treatment of those fees has been one of the more contentious issues between taxpayers and the IRS. The difficulty posed by success-based fees is the allocation of the fee between nonfacilitative and facilitative services and the substantiation of the allocation, especially when a success-based fee is paid to advisors who do not keep time records.
In an effort to resolve much of the controversy between taxpayers and IRS agents regarding the type and extent of documentation needed to satisfy the requirements of Treas. Reg. Section 1.263(a)-5(f), the IRS issued Revenue Procedure 2011-29 on April 8, 2011. Revenue Procedure 2011-29 creates a safe-harbor election (the Safe Harbor) for taxpayers seeking to allocate success-based fees between facilitative and nonfacilitative amounts for "covered transactions" described in Treas. Reg. Section 1.263(a)-5(e)(3). In lieu of requiring the documentation specified in Treas. Reg. Section 1.263(a)-5(f) to support the allocation of success-based fees, the Safe Harbor allows a taxpayer to treat 70% of the success-based fee as nonfacilitative and capitalize the remaining 30% as facilitative of the transaction.
The Safe Harbor only applies to services to investigate or otherwise pursue a covered transaction described in Treas. Reg. Section 1.263(a)-5(e)(3), which includes:
The campaign description indicates that the campaign's goal is to ensure taxpayers comply with current law (as previously described). The campaign follows the release of an LB&I Process Unit on the Allocation of [Success-Based] Fees in a Covered Transaction on June 13, 2019 (see Tax Alert 2019-1273). The campaign and release of the Process Unit, in conjunction with the issuance of CCA 20183001 (see Tax Alert 2018-1543), shows continued interest by the IRS in success-based fees.
The ability to deduct success-based fees can have significant financial ramifications for taxpayers, as such fees typically represent a substantial portion of the costs incurred in a transaction, particularly investment banker fees. Taxpayers often rely on allocation letters, as investment bankers usually do not maintain time records or provide itemized invoices. With the potential for increased scrutiny by the IRS on success-based fees, taxpayers should thoroughly consider whether to use the documentation rules under Treas. Reg. Section 1.263(a)-5(f) or the Safe Harbor election under Revenue Procedure 2011-29. In light of recent guidance and the campaign, taxpayers should carefully review the requirements under Treas. Reg. Section 1.263(a)-5(f) and work closely with investment bankers and other service providers to ensure they obtain sufficient documentation to support the deductibility of success-based fees should they forgo the Safe Harbor.
1 Transactions falling within the ambit of Treas. Reg. Section 1.263(a)-5 include: (1) an acquisition of assets that constitute a trade or business (whether the taxpayer is the acquirer or the target); (2) an acquisition by the taxpayer of an ownership interest in a business entity if, immediately after the acquisition, the taxpayer and the business entity are related within the meaning of IRC Sections 267(n) or 707(b); (3) an acquisition of an ownership interest in the taxpayer (other than an acquisition by the taxpayer of an ownership interest in the taxpayer, whether by redemption or otherwise); (4) a restructuring, recapitalization or reorganization of the capital structure of a business entity (including a reorganization described in IRC Section 368 and a distribution under IRC Section 355); (5) a transfer described in IRC Section 351 or IRC Section 721 (whether the taxpayer is the transferor or transferee); (6) a formation or organization of a disregarded entity; (7) an acquisition of capital; (8) a stock issuance; (9) a borrowing; and (10) writing an option.
2 The primary exceptions to the capitalization requirement of Treas. Reg. Section 1.263(a)-5 are found in the "special rules" and "simplifying conventions" sections of Treas. Reg. Section1.263(a)-5(c) and (d) and the special acquisitive transaction rules of Treas. Reg. Section 1.263(a)-5(e).