Tax News
Safe Harbor Provides for 70% deductibility of Success-Based Fees
April 23, 2011
Administrative Actions
Many private equity and venture capital professionals are aware of the general rule that costs incurred to acquire an asset that has a useful life extending beyond the taxable year of acquisition must be capitalized.  Under Treasury Regulations, this general rule extends to fees paid to professionals to "facilitate" acquisitions of whole businesses, as well as various restructurings and reorganizations, which may not result in the acquisition of an asset, but that nevertheless provide significant long-term benefits.  A common example is a fee payable to the fund's investment banking firm that is contingent on the consummation of the acquisition transaction or restructuring for which the firm was retained.   Generally, such a success-based fee must be capitalized to the extent the fee is attributable to services related to the "investigation" or "pursuit" of a transaction that are provided after the signing of a letter of intent or after the material terms of the transaction have been agreed to.  As between the IRS and taxpayers that aim to deduct all or a portion of these costs, the controversy is typically over what percentage of the success-based fee is attributable either to general services (i.e., services that do not directly relate to the investigation or pursuit of the transaction) or to services incurred prior to the cut-off date (i.e., the letter of intent date, or date when the material terms were agreed to).  In particular, the controversy is often focused on whether the taxpayer has provided the IRS with sufficiently detailed documentation to support its allocation between deductible and capitalized expenses.

With Revenue Procedure 2011-29, the IRS has created a safe harbor that the IRS hopes will alleviate these time-consuming controversies over documentation, and from the IRS's perspective, will free up resources for more fruitful pursuits.  If the taxpayer properly makes the election by attaching a statement to its tax return identifying the transaction and showing the allocation between the deductible and nondeductible portions of the fee, the IRS will allow a deduction for 70% of the success-based fee.  The election is made on a transaction-by-transaction basis and is irrevocable.

In a perfect world, the fund that would pass-through the benefits of a deduction in this context would maintain the documentation required by Treasury Regulations 1.263(a)-5(f) to support its allocation between deductible and nondeductible expenses and the IRS would agree with the taxpayer's allocation.  In this case, the taxpayer could simply pick and choose the transactions to which the safe harbor would apply (i.e., those where the deductible portion of the success-based fee is less than 70% of the total).  However, in the aggregate, this practice may not be worth the effort given the significant risk that the IRS will challenge the allocation and that any deduction at all (and resulting cash-flow) may be denied or significantly delayed.  In sum, it is anticipated that the 70% safe harbor will be utilized by many taxpayers and will benefit both taxpayers and the IRS.
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Tags: facilitative cost, Rev. Proc. 2011-29, section 263, Treas. Reg. 1.263(a)-5(f)