Merger and acquisition transaction costs 2015 redux: Who gets the benefit?

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1 Merger and acquisition transaction costs 2015 redux: Who gets the benefit? With careful planning, merger and acquisition transactions can provide optimal tax treatment to the parties involved. Prepared by: Nick Gruidl, Partner, Washington National Tax, RSM US LLP Amy Kasden, Senior Manager, Boston, RSM US LLP Natalie Tucker, Joint Committee on Taxation, formerly director with McGladrey s Washington National Tax office Reprinted with permission from Business Entities Journal (Thomson Reuters). This article updates our original article published in this journal in and addresses newly issued notices, rulings, and proposed regulations affecting the treatment of merger and acquisition (M&A) transaction costs. Private equity funds, strategic acquirers, and targets incur various costs in M&A transactions. The determination of which party receives the benefit of the expenditures (either current or future deductions) is not always as clear cut as the parties may first believe. 1 Gruidl and Tucker, "Merger and Acquisition Transaction Costs: Who Gets the Benefit?," 12 BET 16 (July/August 2010).

2 Broadly speaking, the two most significant costs incurred in an M&A transaction are compensation-related deductions and professional fees. Compensation-related deductions include items such as option cancellation payments, deferred compensation arrangements, transaction bonuses, and stay bonuses. Certain special rules (e.g., Sections 83 and 404, the next day rule of Reg (b)(1)(ii)(B), etc.) can affect the timing of these deductions, but they are beyond the scope of this article. The focus here is on the treatment of transaction costs associated with professional services, and how recent guidance has changed the way taxpayers and advisors will treat many of these costs. Professional service costs are primarily legal, accounting, and investment banking fees, particularly fees paid only on the successful completion of a transaction (success-based fees), paid to either traditional investment banks or private equity firms or related entities. The primary concern to taxpayers incurring transactions costs in an M&A transaction is the ability of the taxpayer to receive a deduction for the costs. Secondarily, although also significant, taxpayers are concerned about the timing of the deductions. This article focuses on four common transaction structures used in taxable (or partially taxable) M&A transactions: Stock acquisitions (either directly or through the use of a newly created holding company). Asset acquisitions using a newly created corporation or LLC taxed as a partnership. Stock acquisitions with a Section 338(h)(10) election (target is either a Subchapter S corporation or subsidiary of a consolidated group). LLC drop-down transactions (target transfers the business to an LLC and then sells LLC interests to the acquirer). Background Whether transaction costs are deductible or whether they are facilitative costs that are capitalized into the stock or assets acquired (or sold) has been an area of controversy between taxpayers and the IRS for years. Final regulations under Section 263(a), issued in 2003, established rules for the capitalization (or deduction by way of exclusion from regulatory guidance) of transaction costs. Under Section 263(a), a taxpayer generally must capitalize costs incurred to facilitate certain transactions, whether the transaction consists of a single step or multiple steps, and without regard to whether gain or loss is recognized. 2 Facilitative costs are those incurred in the process of investigating or otherwise pursuing a covered transaction. 3 Whether an amount is paid in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances of the case. 4 Reg (a)-5(b)(1) clarifies that an amount paid to determine the value or price of a transaction is an amount paid in the process of investigating or otherwise pursuing that transaction. In applying the facts and circumstances to the costs, a but for transaction analysis is relevant but not determinative. Thus, the fact that a taxpayer would not have incurred a cost if it had not entered into the transaction does not automatically require capitalization of the cost. In addition, a cost paid to acquire tangible or intangible property, including target shareholder stock, is not facilitative of a transaction. Rather, it represents the cost of the property acquired. The capitalization regulations place special rules on certain acquisitive transactions: A taxable acquisition by the taxpayer of assets that constitute a trade or business. A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of Section 267(b) or 707(b). A reorganization described in Section 368(a)(1)(A), (B), or (C) or a reorganization described in Section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Section 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization). 2 Note that asset sales, and sales of an S corporation or consolidated subsidiary in a Section 338(h)(10) transaction are not considered acquisitive transactions available for application of the bright line date and inherently facilitative rules discussed below. This significantly affects the treatment of success-based fees in such transactions, particularly in light of Rev. Proc , 3 discussed further below. Acquisitive transactions are subject to two additional rules, the bright line date rule and an inherently facilitative rule. The regulations, in general, provide separate tax treatment for costs incurred before and after the bright line date, but all inherently facilitative costs are subject to capitalization regardless of when incurred. Interestingly, the regulations are less than clear when it comes to identifying acquisitive transactions in common M&A transactions where a transaction is partially taxable. For example, could a Section 351 transaction be an acquisitive transaction? 4 While not binding, the Service did issue Ltr. Rul providing taxpayer-friendly guidance, ruling that a Section 351 transaction with boot represented a covered acquisitive transaction as defined within Reg (a)-5(e)(3). It is the present authors understanding that the transaction subject to the letter ruling included significant amounts of cash (80% or more of the total consideration). 2 Reg (a)-5(e)(3) IRB A Section 351 transaction could, potentially, be a covered transaction if either boot is present or the transaction is a Section 368(a)(1)(B), (C), or (D) reorganization. 2

3 Bright Line Date. Unless inherently facilitative, costs incurred in investigating or otherwise pursuing an acquisitive transaction are facilitative only if they relate to activities performed on or after the bright line date. 5 The bright line date is the earlier of the letter of intent date or the date on the agreement of material terms. 6 The letter of intent date is the date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target. 7 The agreement of material terms date is the date that the target board of directors, or otherwise authorized personnel, approve or authorize the agreement of the parties, except that where no authorization is required, the material terms date is the date the parties execute a binding written agreement that includes all material terms. 8 The submission of draft agreements and non-binding purchase offers are not considered a triggering event for either the letter of intent date or the material terms date. 9 Inherently Facilitative Costs. Inherently facilitative costs are subject to capitalization irrespective of the fact that the costs may be incurred before the bright line date. Inherently facilitative are costs incurred in: Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction. Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction (e.g., obtaining tax advice on the application of Section 368 ). Preparing and reviewing the documents that effectuate the transaction (e.g., a merger agreement or purchase agreement). Obtaining regulatory approval of the transaction, including preparing and reviewing regulatory filings. Obtaining shareholder approval of the transaction (e.g., proxy costs, solicitation costs, and costs to promote the transaction to shareholders). Conveying property between the parties to the transaction (e.g., transfer taxes and title registration costs). 10 To the extent a taxpayer incurs inherently facilitative costs in an acquisitive transaction, all costs are subject to capitalization. Success-Based Fees. With respect to success-based fees, capitalization is generally required unless the taxpayer retains sufficient documentation to show that a portion of the fee is allocable to activities that do not facilitate the transaction. The documentation 5 Reg (a)-5(e). 6 Id. 7 Reg (a)-5(e)(1)(i). 8 Reg (a)-5(e)(1)(ii). 9 See Reg (a)-5(1), Example Regs (a)-5(e)(2)(i) through (vi) requirement must be satisfied prior to timely filing the tax return for the year in which the taxpayer claims the deduction. Documentation providing only an allocation between facilitative and deductible fees is not sufficient (i.e., a letter or spreadsheet from the investment banker allocating the percentage of the fee or time spent between activities, in and of itself, will not meet this requirement). Rather, the taxpayer must support the allocation with supporting records, such as invoices, time sheets, or other records that identify: The various 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. Where 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. The types of supporting records that constitute sufficient documentation have been an ongoing source of disagreement between taxpayers and exam, and it is anticipated that this standard will be clarified in future guidance. 11 In Ltr. Rul and Ltr. Rul , the IRS favorably noted that time records are not required to support the deductibility of success-based fees (i.e., timesheets are not the exclusive form of acceptable documentation under Reg (a)-5(f) ), but that all evidence should be considered and weighed in determining satisfaction of the documentation requirement. Specifically, in Ltr. Rul , the IRS noted that [a]lthough section 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. Citing case law, Ltr. Rul goes a step further, stating that all available evidence, including the [taxpayer s] records, the files of the 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, should be considered and weighed in determining satisfaction of the documentation requirement (citations omitted). More recently, in TAM , the IRS addressed this issue in detail. The IRS looked at the documentation used by the target of a stock acquisition to support an allocation of success-based fees paid to both a traditional investment banker and an affiliate. Under the facts of the TAM, Target engaged an accounting firm to analyze the transaction costs incurred in connection with Corporation Y s acquisition of its stock. Based on discussions with the investment bankers, the accounting firm prepared spreadsheets detailing the activities performed by the investment bankers. Target was unable to provide time records or itemized invoices from the investment 11 See the Department of the Treasury Priority Guidance Plan, Tax Accounting Project #5. 3

4 bankers to support its allocation of the success-based fees between facilitative and non-facilitative activities, but the accounting firm was able to provide spreadsheets allocating the fees, which were developed through interviews and an analysis of evidence gathered. The IRS determined that the lack of time records did not preclude a deduction, and taken as a whole, all of the taxpayer s documentation met the requirements of Reg (a)-5(f). The IRS added, however, that it is up to the examiners to decide whether, based on all the documentation, the taxpayer made an appropriate allocation, which is a factual question that requires weighing the sufficiency of the evidence. Rev. Proc : 70% Safe Harbor In 2011, as an acknowledgement to the controversy regarding the success-based fee documentation requirement, the IRS issued Rev. Proc , noting that in order to eliminate much of this controversy, it would provide a safe harbor for the allocation of success-based fees between facilitative and non-facilitative costs. Under this safe harbor, in lieu of maintaining sufficient documentation as required by Reg (a)-5(f), a taxpayer may irrevocably elect to treat 70% of the success-based fees paid in a transaction as nonfacilitative under Reg (a)-5. The remaining 30% must be capitalized as a facilitative transaction cost. Note here that the safe harbor does not state that 70% of a success-based fee is deductible under Section 162, but rather that it is not subject to capitalization under Reg (a)-5. Costs may remain subject to capitalization under provisions such as Section 195 as discussed below. Such an election is made by attaching a statement to the original federal income tax return for the tax year in which the success-based fee is paid or incurred. This election is made on a transaction-by-transaction basis and does not represent a change in the taxpayer s method of accounting for such costs. Further, the election applies to all success-based fees paid or incurred in connection with the transaction for which the election is made. Milestone Payments While this safe harbor provided welcome guidance, in the short time since its release taxpayers grappled with whether the safe harbor applied to milestone payments paid or incurred in the course of pursuing a covered transaction for which the taxpayer ultimately incurs a success-based fee. On 4/29/2013, the Large Business and International Division of the IRS (LB&I) issued directive LB&I instructing examiners not to challenge a taxpayer s treatment of eligible milestones (as defined therein) made or incurred in the course of a covered transaction described in Reg (a)-5(e)(3) with respect to which a taxpayer incurs a success-based fee. While seeking to simplify the application of the safe-harbor to milestone payments, that directive ultimately led to more complicated analyses on whether the milestone qualified as an eligible milestone. As a result, on 1/27/2014, LB&I issued an updated directive LB&I that expanded the definition of a milestone. Under LB&I , a milestone means any event, including the passage of time, occurring in the course of a covered transaction, whether the transaction is ultimately completed or not. A milestone payment is defined as a nonrefundable amount that is contingent on the achievement of a milestone and an eligible milestone is a milestone payment made for investment banking services that is creditable against a success-based fee. Thus, where a taxpayer incurs a nonrefundable milestone payment in pursuit of a covered transaction that is creditable against the ultimate successbased fee, LB&I will not challenge the taxpayers application of the safe harbor to the entire success-based fee, including the amount credited for the milestone payment. Despite the simplification provided in the safe harbor and directives, questions remain. One question in particular remains surrounding the application of the success-based fee safe harbor and allocations of fees to debt financing. The use of leverage is common in M&A transactions and in many cases makes up a significant portion of the overall funding. As a result, a portion of the success-based fee, as generally confirmed in the agreement between the service provider and company, may have facilitated the debt financing. In that case, how does the success-based fee safe harbor apply? Should a taxpayer allocate the fee between debt financing and the acquisitive transaction and then apply the safe harbor to the portion attributable to the acquisitive transaction? Should the safe harbor be applied first to the total fee with an allocation of some or all of the 30% subject to capitalization applied to the debt financing? Or, is it possible that by allocating the fee between debt financing and an acquisitive transaction the taxpayer puts their eligibility to apply the safe harbor at risk? We do not believe that this last argument is an appropriate result. Treatment of Transaction Costs in General In brief, transaction costs subject to capitalization are treated differently depending on whether the costs are incurred by the acquirer, the target, or the target s owner. 4

5 Taxable Stock Acquisitions The acquirer in a stock acquisition includes capitalized transaction costs in the stock acquired. 12 With respect to the target corporation in a taxable stock sale, the regulations are reserved. 13 Guidance on the target treatment in a taxable stock acquisition is expected and may include a 15-year amortization safe harbor. 14 Until guidance is issued, the target most likely will either capitalize the costs as a separate intangible or into the outstanding target stock under Indopco, Inc. 15 In any case, the ability to benefit from these costs is limited at best, due to either the application of Section 1032 or the limited events that would allow a corporation to write off a separate asset. If transaction costs are incurred by the target owner, the costs will increase the owner s basis in the stock and reduce gain (or increase the loss) on sale. Taxable Asset and Stock Acquisitions with a Section 338(h)(10) Election The acquirer in an asset acquisition includes capitalized transaction costs in the assets acquired. 16 The result is the same where the acquirer makes a qualified stock purchase with a Section 338(h) (10) election. 17 Meanwhile, the seller in a taxable asset acquisition treats capitalized transaction costs as a reduction in the amount realized on the sale. 18 As with an acquirer in a qualified stock purchase with a Section 338(h)(10) election, the treatment to the seller is the same as in an asset sale. 19 LLC Drop-Down Transactions Under existing authority, an LLC drop-down transaction is treated as the acquisition of the proportionate share of the new LLC s assets followed by a contribution of those assets to an LLC taxed as a partnership. 20 As a result, if the costs are incurred by the acquirer of the LLC units, they will result in additional basis in the assets acquired and subsequently transferred to the partnership. The transaction is also treated as an asset transaction by the target LLC owner, resulting in a reduction in the amount realized on sale. If, however, the costs are incurred by the LLC, the treatment is much less clear. Assuming the costs were incurred (i.e., performance of services) while the LLC was a wholly owned LLC that was disregarded as separate from its owner, the owner may claim that the costs were incurred for the owner s benefit and should reduce the proceeds on the sale. If, on the other hand, the costs are considered pre-formation expenditures or similar costs, the costs would likely be subject to capitalization under Reg (a)-5(a)(5) or as syndication costs under Section 709(a). In either case, the costs generally would result in the creation of a non-amortizable capital asset. In the case of syndications costs, no deduction is allowed either on formation or a subsequent disposition of the LLC business or liquidation of the LLC. 21 Transaction costs not subject to capitalization are also treated differently by the various parties. For the acquirer, the determination is dependent in large part on whether the acquirer was actively conducting business prior to the acquisition and whether the business being acquired was the same or a different business. For the target, the costs will generally result in favorable treatment as immediate deductions. 12 Reg (a)-5(g)(2)(i) 13 Reg (a)-5(g)(2)(ii)(B) 14 See TD 9107, 12/31/03 (the Preamble to Reg (a)-5 states that the IRS intends to issue separate guidance to address the treatment of these amounts and will consider whether they should be eligible for the 15-year safe harbor amortization). See also Notice , IRB 605 (stating that the IRS intends to propose regulations that address the treatment of capitalized costs that facilitate a broad array of transactions, including those covered by the regulations) AFTR 2d US L Ed 2d USTC (1992). See also TAMs and Reg (a)-5(g)(2)(i) 17 See Regs (c)(3) and 1.263(a)-5(g)(2)(i) 18 Reg (a)-5(g)(2)(ii)(A) 19 See Reg (c)(1)(iii) 20 Rev. Rul. 99-5, CB 434, Situation 1 21 Section 709(a). See also Rev. Rul , CB 160 5

6 Taxable Stock Acquisitions and Qualified Stock Purchases with a Section 338(h)(10) Election Where an existing corporation acquires sufficient stock to include the target subsidiary in a consolidated group (e.g., qualified stock purchase), and the parent is either not an operating company or the subsidiary is in a different business, the legislative history of Section 195 supports capitalization and amortization of start-up costs. 22 Rev. Rul further provides that expenditures paid or incurred to determine whether to enter a new business and which business to enter are investigatory costs that are start-up expenditures under Section 195. If an acquirer is in the same line of business as a target corporation, the legislative history supports deduction as Section 162 expansion costs. 24 In general, the primary difference between start-up costs and business expansion costs is the context in which they were incurred (i.e., as part of the start-up of a new business v. the expansion of an existing business). 25 If the acquirer is not a corporation, it is difficult to see where Section 162 expenditures (or Section 195 for that matter) would come into play. Perhaps, if the acquirer were in the trade or business of owning and managing businesses, it could argue that the costs represented expansion of the existing business. But the costs could also be Section 212 expenditures. To the extent the target (seller of assets) incurs costs not subject to capitalization, the costs should also be deductible Section 162 ordinary and necessary expenses. 26 Likewise, in the perhaps unlikely event that the target owner incurred costs not subject to capitalization, it would appear that deductibility under Section 162 or 212 would be the correct conclusion. Taxable Asset Acquisitions Where an existing corporation acquires the assets of a trade or business and the acquiring corporation does not operate a business or the acquired business is a different business than the acquirer operates, Section 195(c)(1) supports capitalization or amortization of the deductions as start-up costs. Where the acquirer is in the same line of business as the acquired business, the legislative history of Section 195, coupled with decision in Wells Fargo & Company and Subsidiaries, 27 supports the immediate deduction of the costs as Section 162 ordinary and necessary expansion costs. As with a stock sale, the target would also incur Section 162 ordinary and necessary expenses to the extent that the costs are not subject to capitalization, and the target owner would incur Sections 162 or 212 expenditures. 22 "However, if in substance, a transaction is the acquisition of the assets of a trade or business, the investigatory expenses are eligible for amortization even though one of the steps of the transaction involved the acquisition of stock, e.g., the acquisition of a corporation which is then liquidated. Further, for example, a corporate taxpayer will be considered to have acquired the trade or business assets of an acquired corporation, rather than having made a portfolio investment in stock, if the acquired corporation becomes a member of an affiliated group that includes the taxpayer incurring the investigatory expenses and a consolidated income tax return is filed for that group." H. Rep't No , 96th Cong., 2nd Sess. 11 (1980) CB In the case of an existing business, eligible startup expenditures do not include deductible ordinary and necessary business expenses paid or incurred in connection with an expansion of the business. As under present law, these expenses will continue to be deductible. "The determination of whether there is an expansion of an existing trade or business or a creation or acquisition of a new trade or business is to be based on the facts and circumstances of each case as under present law." H. Rep't No , 96th Cong., 2nd Sess. 11 (1980). 25 See also, FSA 789, 11/5/93, where the IRS required costs related to an acquisition treated as a partial stock purchase and partial redemption to be allocated between the stock purchase and redemption and ruled that amounts allocated to the redemption were not deductible under Section 162(k). The IRS determined that if the target was not in the same business as the acquirer, then the investigatory and due diligence costs incurred prior to the final decision to acquire target were eligible for amortization under Section 195 to the extent they were allocated to the stock purchase and as long as it was determined that, in substance, the transaction was the acquisition of assets and not merely the stock. It is important to note that often the decision to structure a transaction as a leveraged buy-out and, therefore, have a deemed stock redemption is made at the very end and the costs incurred may not have been in contemplation of a redemption. 26 See Wells Fargo & Company and Subsidiaries, 86 AFTR 2d F3d USTC (CA-8, 2000) (where, citing Rev. Rul , CB 998, the court held that the target in the acquisition could incur investigatory expansion costs even when it is the entity being acquired). See also Playboy Clubs Int'l., 37 AFTR 2d USTC 9560 (DC Ill., 1976) (parent corporation treated as expanding through its subsidiaries); TAM (target corporations could not capitalize otherwise deductible expenses under Section 195 as the targets were not investigating a new business). 27 Id. 6

7 LLC Drop-Down Transactions As discussed above, the acquisition of an LLC interest in the LLC drop down represents an asset acquisition. As a result, if the acquirer is not operating a business or the LLC operates a different business, Section 195(c)(1) supports capitalization or amortization of the deductions as start-up costs by the LLC. Where the acquirer is in the same line of business as the acquired LLC, the Section 195 legislative history supports current deduction as Section 162 ordinary and necessary expansion costs directly related to the acquirer s business. If, however, the costs are incurred by the LLC, the treatment is much less clear. Assuming the costs were incurred while the LLC was a wholly owned LLC disregarded as separate from its owner, the owner may claim that the costs were incurred for its benefit and are, therefore, ordinary and necessary Section 162 deductions to the owner prior to the formation of a tax partnership. 28 If, on the other hand, the costs are considered pre-formation expenditures or similar costs, the costs would likely represent Section 195 costs incurred on behalf of the partnership. 29 The Next-Day Rule with Taxable Stock Acquisitions Where the target incurs deductible expenses in a stock acquisition resulting in the target joining the acquiring group s consolidated tax return, the target and acquiring group need to determine to which tax return the deductions belong (i.e., short period target return or post-transaction consolidated tax return). The current next day rule states: If, on the day of S s change in status as a member, a transaction occurs that is properly allocable to the portion of S s day after the event resulting in the change, S and all persons related to S under section 267(b) immediately after the event must treat the transaction for all Federal income tax purposes as occurring at the beginning of the following day. A determination as to whether a transaction is properly allocable to the portion of S s day after the event will be respected if it is reasonable and consistently applied by all affected persons. 30 An allocation is not reasonable if it is inconsistent with the Code or regulations. 31 Taxpayers have sought to apply the next-day rule to success-based fees and compensation payments (e.g., option cancellation payments and transaction bonuses) that become due and payable upon successful closing of a transaction giving rise to the target joining the group. The IRS addressed the application of the next-day rule in a 2005 technical advice memorandum, where the acquiring group attempted to claim the deductions on the posttransaction consolidated tax return. 32 The IRS ruled that the costs were not eligible for the next-day rule. In coming to this conclusion, the Service looked to the fact that in order for the costs to avoid capitalization, the target had to incur the costs prior to the bright-line date. Because the bright-line date occurred well in advance of the target entering the group, the IRS ruled that it was not reasonable to conclude that the costs were properly allocable to the period after the target entered the group. The IRS followed that with a general legal advice memorandum (GLAM), AM specifying its position that the next-day rule did not apply to, amongst other things, success-based fees and option cancellation payments. Notwithstanding, many practitioners have continued to apply the next-day rule as they felt the TAM and GLAM were not an appropriate interpretation of the regulations. To that end, by applying the next-day rule to success-based fees and certain compensation-related items, the deduction arising from these costs has often been taken in the post-transaction period, a position the IRS felt did not result in a clear reflection of income. As a result, the issue seems to have become a question of what is a reasonable allocation, with the Service and taxpayers on different sides of the issue. In an attempt to eliminate any uncertainty, on 3/5/2015, the IRS issued proposed regulations that, if finalized, will draw a line in the sand on the issue. These proposed regulations establish a new proposed next-day rule that would only apply to an extraordinary item that is the result of a transaction that (1) occurs on the day T joins the group, but after the event resulting in T joining the group, and (2) would be taken into account by T on that day. Specifically, the proposed next-day rule has two very noteworthy changes. First, it would only apply to items arising after the transaction and would not apply to items that arise simultaneously with the events causing T to join the group. Second, this rule would now be mandatory and not elective. 28 By using disregarded entities (e.g., a single-member LLC), costs incurred in expanding an existing business should be currently deductible if the owner of the disregarded entity is presently conducting the business that is being expanded. 29 See, e.g., Bennett Paper Corp., 51 AFTR 2d F2d EBC USTC 9208 (CA-8, 1983) (parent of a consolidated group that formed a wholly owned subsidiary to operate a new marina and yacht club could not deduct the costs it paid for opening a new restaurant via a subsidiary); Specialty Restaurants, TC Memo RIA TC Memo CCH TCM 2759 (parent corporation that operated its restaurant business through subsidiaries could not deduct the costs it paid for opening a new restaurant via a subsidiary). 30 Reg (b)(1)(ii)(B) 31 Reg (b)(1)(ii)(B)(3) 32 TAM

8 To illustrate the rule, the proposed regulations provide a myriad of examples, three of which are worth mentioning: Success-based fees: The liability to pay success-based fees incurred upon closing of a stock acquisition is an extraordinary item that arose simultaneously with the acquisition and, therefore, must be reported under the end-of-day rule and included in the T short-period return. Stock options: The liability to pay employees for the cancellation of stock options that became due as a result of a stock acquisition is an extraordinary item that must be allocated to the date T joins the group. The liability for this item arose simultaneously with the acquisition and, therefore, the proposed next-day rule is inapplicable. Unwanted assets: After the closing of a transaction where T joins a new consolidated group, T sells unwanted assets to an unrelated party. The gain or loss on the sale is an extraordinary item resulting from the transaction that occurs on the day T joins the group, but after the event resulting in T joining the group. Therefore, the gain or loss is reported on the post-transaction consolidated group return. The proposed regulations clarify the current anti-avoidance rule, adding that it may apply to situations in which a person modifies an existing contract or other agreement in anticipation of T joining the group in order to shift an item between the tax years that end and begin as a result of T joining the group if such actions are undertaken with a prohibited purpose. Thus, it appears that taxpayers would not have the ability to negotiate the return to which transaction costs are reported. This determination could have potentially significant repercussions with respect to application of Section 382, the separate return limitation year rule, and net operating loss carryback claims. So Whose Deduction Is It? In general, a business deducts expenses incurred in the normal conduct of its trade or business. 33 When determining which entity receives the deduction, however, the party that arranges for, contracts, or pays the bills is not determinative. Rather, the deduction belongs to the party that benefited from the expenditure. This is the case even where the entity entitled to the deduction does not pay the expenses directly. 34 Reg (a)-5(k) specifically provides that an amount paid by a party includes an amount paid on behalf of that party. On the other hand, voluntary contributions by shareholders to the corporation for any corporate purpose, including the payment of ordinary and necessary business expenses, represent capital contributions. 35 Thus, shareholders who pay their corporation s expenses generally are not entitled to deduct such amounts. 36 In Specialty Restaurants, 37 for example, the Tax Court held that the parent s payment of the start-up costs of a new subsidiary s business constituted a contribution to capital of the new subsidiary and payment of the costs by the subsidiary. 38 Shareholders however, have successfully obtained deductions for amounts paid on behalf of a corporation where the shareholder established that (1) the purpose of the expenditure was to protect or promote its own business (and not the corporation s business), and (2) the expenditure was an ordinary and necessary expense of carrying on its own business (and not the corporation s business). 39 With regard to transaction-related costs, the IRS has issued a pair of rulings that help shed light on which party may lay claim to the deductions. In Ltr. Rul , the IRS ruled on a common leveraged buyout fact pattern involving the proper tax treatment of various transaction-related costs. Under the facts of the ruling, Parent created Intermediate Holdco, a wholly owned subsidiary of Parent, as the direct parent of Merger Sub. The leveraged buyout was accomplished through the merger of Merger Sub with and into Target, with Target surviving the transaction. Various transaction costs for services related to the transaction (e.g., financial advice, legal services, due diligence services, and related costs) were incurred, all of which were either paid or reimbursed by Target at closing or prior to closing. Target requested a ruling confirming that it was entitled to deduct the costs of services arranged for by other parties to the transaction since (1) the services were either rendered to Target or on behalf of Target, and (2) Target either paid for or reimbursed the other parties for the service fees. Based on the taxpayer s representations, the IRS ruled that the transaction costs may be taken into account by Target where Target paid for or reimbursed the other parties for the fees associated with the services. Ltr. Rul was similar to the conclusion previously reached in Ltr. Rul , where the taxpayer requested and the IRS ruled that transaction costs may be allocated based upon the entity to which the services were rendered and/or on whose behalf the services were provided. Ltr. Rul involved the creation of Parent and Intermediate Holdco, a wholly owned subsidiary of Parent and the direct parent of Acquisition Sub. Parent was formed by a group of private equity funds and acquired a portion of the Target for cash and Parent stock in Section 351 transaction. 33 Section See Square D Co., 121 TC 168 (2003) (Target's reimbursement to its acquirer of a commitment fee and direct payment of legal fees related to the financing transaction for its reverse merger into the acquirer were deductible by Target). 35 Reg (a)-2(f) 36 See, e.g., Betson, 58 AFTR 2d F2d USTC USTC 9826 (CA-9, 1986); Madden, TC Memo PH TCM CCH TCM TC Memo RIA TC Memo CCH TCM See also Manor Care, Inc., 46 AFTR 2d F Supp USTC 9547 (DC Md., 1980); Young & Rubicam, 23 AFTR 2d Ct Cl F2d USTC 9404 (Ct. Cl., 1969). 39 See, e.g., Gould, 64 TC 132 (1975); Lohrke, 48 TC 679 (1967). 8

9 The remaining interests in Target were acquired via a reverse merger of Acquisition Sub with and into Target. In allowing the use of an allocation, the IRS noted that the taxpayer argued that due to the many parties involved and the transaction structure, determining who was the proper party incurring the costs may not be easy. In Ltr. Rul the IRS also looked at whether Target could deduct costs related to investigatory pre-decisional due diligence provided by financial advisors, legal counsel, accountants, and other service providers. The IRS, applying the bright-line and covered transaction rules for facilitative costs provided by the regulations, concluded that Target s due diligence costs were deductible if they were (1) incurred in the process of investigating or otherwise pursuing the transaction before the date an exclusivity agreement was executed (i.e., the bright-line date under the facts at issue), and (2) not inherently facilitative costs. Unlike the facts in Ltr. Rul where Target represented it directly and proximately benefited from the services and incurred the economic burden of these services, however, in Ltr. Rul the transaction costs paid by Parent were required to be allocated between Target and Newco, resulting in deductible investigatory costs by Target and capitalized start-up costs by Newco. Since the target in Ltr. Rul represented that all of the investigatory costs were incurred on its behalf, none of the investigatory costs at issue were required to be allocated to Merger Sub and treated as start-up costs subject to 15-year amortization. It is important to note, however, that such a representation is subject to examination on IRS audit. Implications The economics of a deal generally drives which party incurs transaction costs. Under the right set of facts, however, it would appear that pre-transaction planning could allow the parties to structure their professional advisor engagements in a tax-efficient manner. For example, in situations where the acquirer is not a corporation but the target is (e.g., private equity fund, partnership holding company), creation of a merger subsidiary to incur transaction costs may allow some portion of those costs to represent amortizable start-up costs (as in Ltr. Rul ) versus costs that are either capitalized directly into the acquired stock or, perhaps, deductible under Section 212 if they were incurred on behalf of the partnership. Alternatively, consider a target with significant NOLs and a very small Section 382 limit post-acquisition. If the merger sub were to incur the costs rather than the target, the costs could represent amortizable start-up costs amortizable over 15 years rather than increasing a target NOL that, due to limitations, may never be used. Additionally, query whether with the right set of facts, the costs incurred by the acquiring merger sub may truly be on behalf of and for the benefit of the target, such that any non-facilitative costs are Section 162 deductions of the target. In such case, however, those costs would properly accrue pre-transaction and be taken on the targets pre-transaction return, thus requiring the parties negotiate as to who receives the benefit of this tax savings, To determine which party actually incurred the costs, facts beyond who engaged the service provider are necessary, and include: On whose behalf were the services provided? Who were the services rendered to? Who directly benefited from the services? Who paid for the services and which party incurred the economic burden of the services? Was the expense ordinary and necessary to the taxpayer s business? Was debt issued by a party to whom services were provided? Pre-transaction planning to determine who (if economically feasible) should incur the costs for the optimal tax result includes: Have the parties contractually agreed as to who is the beneficiary (e.g., Target company is to receive all tax benefit of transaction costs when used by the Target)? Is the transaction an asset or a stock acquisition? If the acquirer is acquiring assets in a new trade or business with an allocation to goodwill before transaction costs, it does not matter whether the costs are capitalized into goodwill or capitalized and amortized as Section 195 start-up costs. Further, if the transaction is a stock acquisition, capitalized costs by the target corporation results in effectively permanent capitalization. Is the acquisition an expansion of the target or acquirer s business? Is the target company in a current NOL position? Is the target owned by an entity that could incur ordinary deductible expenses on the sale of the target or target business? Is the target a C corporation or a pass-through entity? Due to corporate tax rates, gains on the sale of assets by a C corporation or a Section 338(h)(10) transaction involving a corporate subsidiary are taxed at the same corporate rate, so capitalization and reduction in gain provides the same benefit as ordinary deductions. Conclusion In summary, in determining the proper tax treatment of transaction costs, parties to the transaction should examine who engaged, directed, and paid any third-party service providers, and consider whether any new entities formed will have a trade or business or are simply investment vehicles. The structure of a transaction will not necessarily dictate the deductibility. Rather, the parties must consider all the facts and circumstances surrounding the transaction. Once the transaction costs are analyzed, there are various results that may occur (e.g., deductible under Section 162, amortizable under Section 195, capitalized under Section 263(a), etc.). Because of the opportunities to maximize the value of accounting for transaction costs, careful pre-transaction planning may provide significant tax benefits for the M&A transaction costs incurred. 9

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