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In PLR 202308010, the IRS denied a taxpayer's request to make a late election under Revenue Procedure 2011-29 to deduct 70% and capitalize 30% of a contingent fee paid to a financial advisor upon the completion of a transaction, concluding the seller incurred the fee, so the taxpayer (i.e., target) was not eligible for the election.

Facts

Parent, the common parent of a consolidated group, submitted a request under Treas. Reg. Sections 301.9100-1 and -3 on behalf of Taxpayer, a direct wholly owned subsidiary of Parent, for an extension of time for Taxpayer to make a safe harbor election under Revenue Procedure 2011-29. The safe harbor election allows eligible taxpayers to treat 70% of a success-based fee as non-facilitative of a transaction (i.e., deductible) and the remaining 30% as facilitative of a transaction (i.e., capitalizable).

The transaction

Seller, a domestic limited partnership and closed private equity investment fund, was appointed as the representative for Parent's shareholders (collectively with Seller, "Selling Shareholders"). Seller invests in and then later sells companies. Before selling its ownership in Parent, Seller owned a percentage of Parent's stock, and the remainder was owned by minority shareholders. During negotiations with Buyer, a limited liability company, Seller's representatives discussed, reviewed and approved the sale transaction terms sent to Buyer.

Buyer and the Selling Shareholders entered into a stock purchase agreement (Sale Agreement) under which Buyer agreed to purchase all of Parent's outstanding shares of common stock. Taxpayer and Parent were not parties to the Sale Agreement but were the subject of the taxable stock acquisition transaction, which required Selling Shareholders to transfer their Parent stock to Buyer.

The Sale Agreement required certain sales-related expenses, including the Contingent Fee (defined below), to be paid out of the sales proceeds payable to Selling Shareholders. Additionally, the Sale Agreement required Taxpayer to make a Revenue Procedure 2011-29 safe harbor election for success-based fees incurred during the transaction.

Engagement with financial advisor

Initially, Taxpayer contracted with a financial advisor (Financial Advisor) to provide services related to (1) a sale of Taxpayer's stock or substantially all of its assets; (2) a recapitalization; or (3) an extraordinary dividend to Taxpayer's equity holders. As the transaction form evolved, Financial Advisor ended up providing services in connection with the sale of Parent's stock, including identifying and screening potential purchasers, managing communications, and assisting Taxpayer with marketing materials. Under the contract with Financial Advisor, Taxpayer agreed to pay Financial Advisor a fee equal to a percentage of the base purchase price that was contingent upon the completion of a successful transaction (Contingent Fee). The Financial Advisor initially worked with Taxpayer's management as Taxpayer's executives took the lead and primarily engaged in communication with Financial Advisor throughout the deal process and later worked with Seller on the transaction.

Financial Advisor issued an invoice to Taxpayer for its services. Before Buyer disbursed the sales proceeds to Selling Shareholders, it transferred a portion of the proceeds to Seller to satisfy certain liabilities, including the Contingent Fee. On the same day, Seller wired funds to pay the Contingent Fee to Financial Advisor, thereby reducing sales proceeds payable by Buyer.¹

Taxpayer and Seller had a management consulting agreement that required Taxpayer to reimburse Seller for any amounts Seller paid for consulting services, including services rendered by financial advisors. There is no evidence that Taxpayer recorded a payable or reimbursed Seller for the Contingent Fee. Moreover, as previously noted, the Sale Agreement obligated Seller to pay fees (including the Contingent Fee) out of closing proceeds if they were not paid before closing.

The Selling Shareholders accounted for the Contingent Fee by reducing their gain from the sale of the stock by the amount of the Contingent Fee. Taxpayer failed to make a timely safe harbor election for the Contingent Fee and therefore requested an extension of time under Treas. Reg. Section 301.9100-1 et seq. to make a late election to deduct 70% of the Contingent Fee.² The IRS referred to the Selling Shareholders' reduced gain on the sale of Parent's stock, together with the additional tax benefit of Taxpayer deducting 70% of the Contingent Fee by claiming the safe harbor election, as the "duplicative tax benefit."

Taxpayer arguments

Taxpayer asserted it incurred the Contingent Fee, not Seller, because it entered into the contract with Financial Advisor and Seller paid the Contingent Fee on Taxpayer's behalf. Taxpayer alternatively argued that Buyer paid the fee on its behalf.

Additionally, Taxpayer claimed it benefitted from the sale of Parent because Buyer could provide Taxpayer with greater access to capital to expand its business. Taxpayer also asserted that it primarily benefitted from Financial Advisor's services because Taxpayer was actively involved in the negotiation of the stock sale, which allowed Taxpayer to obtain funding for its expansion efforts. Taxpayer noted any benefit to Seller from the engagement of Financial Advisor was incidental.

Finally, Taxpayer argued that a duplicative tax benefit is justified because "(a) Seller should be deemed to have made a capital contribution to Taxpayer equal to the Contingent Fee (thereby increasing Seller's basis in Parent and reducing Seller's gain on the sale), and (b) Taxpayer should be deemed to have paid the Contingent Fee eligible for the success-based fee safe harbor election under [Revenue Procedure] 2011-29."

Analysis

The IRS denied Taxpayer's request to make a late election under Revenue Procedure 2011-29 for three primary reasons, each of which is discussed below.

The IRS has discretion to deny a taxpayer relief to make a late election for which it fails to qualify

The IRS notes that, under Treas. Reg. Section 301.9100-1(a), "[a]n extension of time is available for elections that a taxpayer is otherwise eligible to make," and "the granting of an extension of time is not a determination that a taxpayer is otherwise eligible to make the election." Further, in the interest of sound tax administration, the Commissioner has the discretion to deny a request to make a late election if the taxpayer does not meet the requirements to make the relevant election. Thus, where taxpayers seek an extension to make a late election for which they do not qualify, the IRS may deny that relief. The remainder of the analysis explains why Taxpayer fails to qualify to make the Revenue Procedure 2011-29 election.

Treas. Reg. Section 1.263(a)-1(e)(1) governs the taxation of the Contingent Fee, thereby rendering Treas. Reg. Section 1.263(a)-5 rules inapplicable

The IRS concluded that the Contingent Fee is a cost paid to facilitate the sale of property under Treas. Reg. Section 1.263(a)-1(e)(1); as such, the rules in Treas. Reg. Section 1.263(a)-5 (including Revenue Procedure 2011-29) do not apply to the Contingent Fee. Taxpayer relied upon Treas. Reg. Section 1.263(a)-5(a), which applies to amounts paid to facilitate an acquisition of ownership interest in a taxpayer. Under Treas. Reg. Section 1.263(a)-5(b)(2), however, an amount required to be capitalized under Treas. Reg. Section 1.263(a)-1 does not facilitate a transaction described in Treas. Reg. Section 1.263(a)-5.

The IRS provided that Treas. Reg. Section 1.263(a)-1(e)(1) does not allow taxpayers to deduct commissions and other transaction costs paid to facilitate the sale of property under IRC Section 162 or 212. Rather, it treats those amounts as "capitalized costs that reduce the amount realized in the [tax year] in which the sale occurs." The IRS reasoned that the Contingent Fee fell squarely within the scope of Treas. Reg. Section 1.263(a)-1(e)(1) as it was paid under the Sale Agreement, which obligated Seller to pay the Contingent Fee and other transaction costs at closing out of its own funds or out of the sale proceeds it would receive from Buyer. As such, "selling costs must be accounted for as an offset to sales proceeds payable to Selling Shareholders under [Treas. Reg. Section] 1.263(a)-1(e)(1) and longstanding case law."

Further, the IRS noted that the "Contingent Fee is precisely the type of cost that is required to be capitalized as an offset to the amount realized by Seller and Selling Shareholders so as to match the sales proceeds with the cost of generating that revenue." Citing Woodward v. Comm'r, 397 U.S. 572 (1970), the IRS pointed out that "'[it] has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as capital expenditures.'" The IRS also noted that the Supreme Court in Woodward "explained that legal, brokerage, accounting and similar costs of acquisitions and dispositions are treated by courts as capital expenditures because 'such ancillary expenses incurred in acquiring or disposing of an asset are as much part of the cost of that asset as is the price paid for it.'" Accordingly, the IRS concluded "the Duplicative Tax Benefit sought by Seller and Taxpayer is neither allowed nor justified."

Treas. Reg. Section 1.263(a)-1(e) and Supreme Court authority on the capitalization of selling costs are not rendered inapplicable based upon Taxpayer's claim that the Contingent Fee was its cost for IRC Section 162 or IRC Section 263(a) purposes

The IRS also rejected Taxpayer's argument that the Contingent Fee was its cost because it entered into the contract with the Financial Advisor and directly benefited from the Financial Advisor's services. The IRS provided several reasons for rejecting Taxpayer's argument. First, the IRS asserted that the deductibility of third-party costs is not governed by which party contracted to pay or paid the cost. Citing relevant case law, the IRS noted that courts have regularly rejected the notion that the party that contractually obligates itself to pay a third-party expense is the rightful party to take a deduction for such expense. Instead, "courts have generally focused on the connection of the expense to the respective businesses of those parties."

Next, the IRS explained that the Contingent Fee was directly and proximately connected to the Seller's activity of investing in and selling portfolio companies. Specifically, the IRS noted that the Contingent Fee "was paid to facilitate a sale and to generate substantial proceeds for Seller." By contrast, the IRS noted that Parent and Taxpayer were the objects of the sale, and Taxpayer did not receive any of the sales proceeds, which "were the ultimate objective of the Seller's business of investing in Parent and Taxpayer, along with other portfolio companies." Further, the IRS found it noteworthy that (1) the amount of the Contingent Fee depended on a successful sale and the amount of sale proceeds generated; and (2) Seller's representatives discussed, consulted, reviewed and approved sale transaction terms sent to Buyer. The IRS highlighted such facts to demonstrate the "nexus between the selling costs and Seller's business activities." Finally, the IRS pointed out that the selling costs and Seller's business activities are connected because Seller "operated as a fund that seeks to profit from the purchase and sale of portfolio company businesses." The IRS stated that the Contingent Fee and other costs of facilitating the sale are directly and proximately related to Seller's business activity. "By contrast, the Contingent Fee was only indirectly and incidentally related to Taxpayer's business activities."

Therefore, the IRS concluded that Treas. Reg. Section 1.263(a)-1(e)(1) and case law prohibit the duplicative tax benefit, and the Contingent Fee paid to the Financial Advisor must be capitalized as a cost paid to facilitate the sale of property. Accordingly, the IRS denied Taxpayer's request to make a late election under Revenue Procedure 2011-29 to deduct 70% and capitalize 30% of the Contingent Fee paid by Seller.

Implications

This ruling demonstrates that the IRS is looking closely at the location of transaction costs (i.e., the proper party to take such costs into account for US federal income tax purposes). Specifically, the ruling seems to imply that sell-side transaction costs should be taken into account by the seller, not the target, in certain circumstances. As such, taxpayers should carefully evaluate their specific facts and circumstances when determining which party to a transaction is the appropriate entity to take transaction costs into account. Most importantly, this determination is critical to making a valid safe harbor election under Revenue Procedure 2011-29 for success-based fees. Taxpayers should also be aware that there are other authorities that would support the target corporation taking the Contingent Fee into account based on the facts in this ruling.

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Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor

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ENDNOTES

¹ Although the PLR is not clear, it can be assumed the wire payment to Financial Advisor occurred on the day of the transaction closing.

² The PLR did not provide any detail on how the election was missed on the original return.