June 28, 2023 IRS denies taxpayer's 9100 relief request to make a late safe harbor election to deduct 70% of a success-based fee under Revenue Procedure 2011-29
In PLR 202324001, the IRS has denied the taxpayer's (Taxpayer) request to make a late safe harbor election under Revenue Procedure 2011-29 (the Safe Harbor) to deduct 70% and capitalize 30% of a success-based fee paid to an investment banker because Taxpayer did not act reasonably and in good faith. Taxpayer filed the request under Treas. Reg. Sections 301.9100-1 and -3 (9100 relief request) for an extension of time to elect the Safe Harbor after the IRS fully disallowed a greater-than-70% deduction for failure to meet the substantiation requirements under Treas. Reg. Section 1.263(a)-5(f). The IRS concluded (i) Taxpayer was informed of the election and its consequences in all material aspects but chose not to make the election; (ii) Taxpayer had the benefit of hindsight; and (iii) Taxpayer may have been ineligible to make the election. Background Treas. Reg. Section 1.263(a)-5 contains rules requiring taxpayers to capitalize amounts paid to "facilitate" (within the meaning of Treas. Reg. Section 1.263(a)-5(b)), 10 specifically identified transactions.1 An amount is paid to facilitate a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction.2 Under Treas. 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 [tax] year during which the transaction closes." Additionally, the required documentation [M]ust 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: Success-based fees are often the most significant fees paid in a transaction, and their treatment has been one of the more contentious issues between taxpayers and the IRS. The difficulty posed by success-based fees is allocating the fee between nonfacilitative and facilitative services and substantiating the allocation, especially when a success-based fee is paid to advisors who do not keep time records. In an effort to avoid 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. This guidance creates 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. Facts Taxpayer, a C corporation, uses an accrual method of accounting and the calendar year as its tax year. Taxpayer entered into an agreement with an investment bank whereby the investment bank agreed to act as Taxpayer's financial advisor in connection with Taxpayer's sale. In exchange for the investment bank's services related to the sale, Taxpayer agreed to pay the investment bank a contingency fee, which would be a percentage of the consideration received from the sale (the Success-Based Fee), and to reimburse the investment bank for its expenses. A buyer acquired Taxpayer in a merger, and Taxpayer continued as a separate entity. The investment bank invoiced Taxpayer for the Success-Based Fee. Taxpayer and the buyer each transferred a certain amount to the investment bank, the total of which equaled the Success-Based Fee and expense reimbursement. Taxpayer's former shareholders were interrelated private equity (PE) funds that owned Taxpayer before the sale. The former shareholders received proceeds from the sale, which were reduced by the Success-Based Fee and other items. For the year in which the sale closed, Taxpayer hired a tax return preparer (Preparer) to prepare Form 1120 (US Corporate Income Tax Return). Under the agreement between Taxpayer and Preparer, Preparer was also tasked with identifying and documenting the federal income tax consequences associated with the Success-Based Fee and including a Revenue Procedure 2011-29 election statement. Preparer explained that Taxpayer could deduct 70% of the Success-Based Fee under the Revenue Procedure 2011-29 Safe Harbor and would receive some audit protection. If Taxpayer chose not to make the Safe Harbor election, Preparer noted that Taxpayer could possibly deduct more than 70% of the Success-Based Fee. Preparer assisted the investment bank with drafting a letter that allocated the fees and expenses as (i) investigatory and due diligence services rendered before the sale approval; and (ii) services facilitating the sale. Preparer showed Taxpayer a numerical comparison of the Safe Harbor election (70% deduction) versus the investment bank allocation letter (greater-than-70% deduction). Preparer told Taxpayer that the allocation letter and Preparer's workpapers were sufficient documentation to support Taxpayer's greater-than-70% deduction of the Success-Based Fee in accordance with Treas. Reg. 1.263(a)-5(f), but informed Taxpayer that it could be examined by the IRS. Taxpayer chose not to make the Safe Harbor election, and took the larger deduction based on the investment bank allocation letter on its return. Taxpayer's officer, a certified public accountant, communicated with Preparer on Taxpayer's behalf, including on how the Success-Based Fee was reported. The officer was an expert in corporate finance, but not in federal income taxation. Three months before Taxpayer filed Form 1120, it hired an expert in federal income taxation to review the Form 1120. Taxpayer, however, did not inform the expert about the Success-Based Fee reporting and did not give the expert all the documents to review the Success-Based Fee reporting before Taxpayer filed Form 1120. The IRS examined Taxpayer's Form 1120 and issued a Letter 950-Z (offering Taxpayer its right to Appeals consideration) in which it proposed fully disallowing the Success-Based Fee deduction because the investment bank allocation letter did not meet the Treas. Reg. Section 1.263(a)-5(f) substantiation requirements. The IRS extended the date for Taxpayer to respond to Letter 950-Z, and Taxpayer filed a protest requesting an appeal, which is still pending. In light of the IRS's challenge to Taxpayer's position under Treas. Reg. Section 1.263(a)-5(f), Taxpayer sought the protection of the Safe Harbor. As the due date for electing the Safe Harbor had passed, Taxpayer had to request an extension of time under Treas. Reg. Section 301.9100-1 et seq. (i.e., 9100 relief). In its request for 9100 relief, Taxpayer asserted the following:
Analysis The IRS denied Taxpayer's 9100 relief request for an extension of time to file the Safe Harbor election for three primary reasons: Taxpayer was informed of the Safe Harbor election and its consequences in all material aspects but chose not to make the election Treas. Reg. Section 301.9100-3(b)(3)(ii) deems that a taxpayer will not have acted reasonably and in good faith if it "was informed in all material respects of the required election and related tax consequences, but chose not to file the election." The IRS determined that Preparer informed Taxpayer about the material aspects of the Safe Harbor election and the tax consequences, but Taxpayer chose not to make the election. The IRS noted that Preparer not only discussed the Safe Harbor with Taxpayer, but also showed a numerical comparison of making the election versus not making it. Rejecting Taxpayer's argument that Preparer did not explain that the IRS could challenge the claimed deduction, the IRS pointed out that "the potential exists for any claimed deduction and its underlying substantiation to be challenged on examination." The IRS also concluded that Taxpayer should have known that the audit risks from not making the Safe Harbor election were greater than the risks from making the election. The IRS stated, "[Treas. Reg.] Section 301.9100-3(b)(3)(ii) speaks to Election's material aspects and tax consequences and not to the likelihood of success upon an examination," and noted that "all deductions must be substantiated, and IRS examination and disallowance of deduction is always a risk." Additionally, the IRS pointed out that Preparer explained that Taxpayer could be examined, and it would receive some audit protection if it made the Safe Harbor election. Additionally, the IRS reasoned that Taxpayer's claim that Preparer incorrectly advised it that the investment bank allocation letter sufficiently substantiated the deduction "is irrelevant and self-contradictory because Taxpayer does not concede that such substantiation (by itself or combined with other documents that Taxpayer may have) is insufficient … " "Preparer did not advise Taxpayer that the substantiation could not be challenged, only that they believed it to be sufficient. Therefore, Taxpayer's request fails under [Treas. Reg. Section] 301.9100-3(b)(3)(ii)." Taxpayer had the benefit of hindsight in light of policies behind Revenue Procedure 2011-29 Treas. Reg. Section 301.9100-3(b)(3)(iii) deems that a taxpayer will not have acted reasonably and in good faith if "it uses hindsight in requesting relief." Citing Vines v. Commissioner, 126 T.C. 279, 293 and Estate of Clemons v. Commissioner, T.C. Memo. 2022-95, the IRS concluded that Taxpayer had the benefit of hindsight because it is "attempting to make [the Safe Harbor election] after its deduction was disallowed in an examination for not meeting the substantiation requirements under [Treas. Reg. Section] 1.263(a)-5(f)." The IRS also noted "[h]indsight is a concern here also because Taxpayer claimed an amount greater than the 70% allowed under [the Safe Harbor election], and seeks to elect the [Safe Harbor] only due the unfavorable result in the audit." Finally, noting that the purpose of the Safe Harbor was to eliminate much of the controversy regarding the type and extent of documentation required, the IRS determined "the goal of avoiding controversy has been frustrated in Taxpayer's case" because Taxpayer waited months after receiving the adverse Letter 950-Z and years after the Safe Harbor election was due to apply for an extension of time to make the late Safe Harbor election. Quoting from a treatise by Martin D. Ginsburg, Jack S. Levin & Donald E. Rocap, Mergers, Acquisitions, and Buyouts ¶402.3.3.3 (2021), the IRS concluded Taxpayer's 9100 relief request failed under Treas. Reg. Section 301.9100-3(b)(3)(iii) because a "'taxpayer cannot first seek to deduct' an amount of success-based fee greater than 70% 'without making the 70% election, while seeking to invoke the 70% safe harbor as a 'protective' fall back measure on audit if it cannot meet the documentation requirements." Taxpayer likely is not eligible to make the Safe Harbor election Noting that the IRS has discretion to deny a 9100 relief request to make an election for which the taxpayer fails to qualify, the IRS expressed doubts about Taxpayer's eligibility for the Safe Harbor election. Without concluding whether Taxpayer was eligible for the Safe Harbor Election, the IRS speculated that the Success-Based Fee "likely was not Taxpayer's expense … " Instead, the IRS questioned whether the Success-Based Fee should have been taken into account by Taxpayer's former shareholders as a selling cost and treated as an offset to the amount realized under Treas. Reg. Section 1.263-1(e)(1). Accordingly, the IRS ruled Taxpayer did not act reasonably and in good faith and denied Taxpayer's 9100 relief request to make a late Safe Harbor election under Revenue Procedure 2011-29 to deduct 70% and capitalize 30% of the contingent fee. Implications There are several implications arising from PLR 202324001. 9100 relief requirements The outcome of the ruling serves as a helpful reminder to taxpayers about the requirements to have "acted reasonably and in good faith" to be eligible for 9100 relief. Specifically, failure to appreciate that tax positions may be challenged by the IRS does not prevent taxpayers from being "informed" under Treas. Reg. Section 301.9100-3(b)(3)(ii). Additionally, pursuing the late election only after having previously chosen to forgo the election (and being informed of the tax consequences), and having that position denied by the IRS during an examination, in this instance, is seen as "hindsight" under Treas. Reg. Section 301.9100-3(b)(3)(iii) (see, e.g., TAM 200447037). Treas. Reg. 1.263(a)-5(f) documentation requirements On exam, the IRS fully disallowed the deduction based on the investment banker allocation letter, concluding the letter did not meet the substantiation requirements under Treas. Reg. Section 1.263(a)-5(f). Treas. Reg. 1.263(a)-5(f) requires supporting documentation to "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." Here, the investment banker allocation letter provided an allocation percentage for services attributable to facilitative and non-facilitative activities. The IRS's conclusion that this mere allocation is insufficient without further supporting documentation is consistent with prior IRS guidance (see CCA 201830011 and Tax Alert 2018-1543). While Taxpayer also offered "Preparer's workpapers" as supporting documentation, it is unclear what those workpapers consisted of and why they were deemed insufficient by the IRS. In prior guidance, 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, presentations, calendar entries, service provider documents produced for the client, transaction documents and assorted other documents (See PLR 20083009, PLR 200953014 and TAM 201002036). Taxpayer eligibility for the Safe Harbor election Notably, the IRS stated that the Success-Based Fee "likely was not Taxpayer's expense." The brief explanation provided by the IRS on this point was that the Success-Based Fee directly and proximately related to Taxpayer's former shareholders' generation of sales proceeds from the sale of Taxpayer, a portfolio company in which interrelated PE funds invested. As such, the IRS questioned whether the Success-Based Fee should have been taken into account by the former shareholders (not Taxpayer) and treated as an offset to the amount realized from the sale. A similar rationale was recently articulated by the IRS in PLR 202308010, in which the IRS denied a taxpayer's request to make a late Safe Harbor election 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. Consequently, the taxpayer (i.e., target) could not make the election (See Tax Alert 2023-0572). In PLR 202308010, the IRS's focus on the seller as a PE fund in the business of buying and selling companies suggests that it viewed the banker services as benefiting the PE seller. Similarly, this PLR involved a transaction with PE sellers. However, taxpayers should be aware that there are other authorities that would support the target taking contingent fees into account. Other considerations The ability to deduct success-based fees can have significant financial ramifications for taxpayers, as those 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. Depending on the existing underlying substantiation generated around success-based fees, taxpayers should seriously 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, 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 obtain sufficient documentation to support the deductibility of success-based fees should they forgo the Safe Harbor. ———————————————
Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor ——————————————— 1 Transactions falling within the ambit of Treas. Reg. Section 1.263(a)-5 include: (1) an acquisition of assets that constitutes 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 under 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 Treas. Reg. Section 1.263(a)-5(b). | ||||||||||||||||||
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