In April 2019, the IRS’s Large Business and International Division (LB&I) issued an LB&I Transaction Unit (LTU) that described potential positions a taxpayer may take to recover previously capitalized transaction costs.¹ In apparent contrast, a recent Technical Advice Memorandum (TAM)² concluded that a taxpayer (a corporation that was the parent of an affiliated group of corporations filing a consolidated tax return) that had previously purchased the stock of a target corporation could not deduct the capitalized costs that the target incurred in the prior acquisition when the taxpayer sold the stock of the target. While the facts of the TAM (stock sale of the target) are not directly addressed by the LTU (distribution of the target under section 355), certain general concepts addressed in the LTU seem to have been irrelevant to the IRS when they concluded in the TAM that no section 165 deduction was allowed.

Revisiting Issue Three in the LTU

In the LTU, the IRS describes a position that taxpayers may take to recover previously capitalized transaction costs when the entity or business that was acquired is distributed in a section 355 transaction. The LTU states that costs incurred to separate two businesses are not deductible, but must be capitalized, unless the separation is required by law, regulatory mandate or court order, or the separation transaction is abandoned. However, facts may support recovery of certain previously capitalized transaction costs as a result of a section 355 distribution if the property was acquired through a transaction in which the previously incurred transaction costs were capitalized and in which the distribution is viewed as an abandonment of the business and/or the stock acquired. If the facts support the section 355 distribution as an abandonment, a section 165 abandonment deduction may be appropriate.

In Issue 3, the LTU asks, "In the year the corporate separation was completed, did the controlled corporation deduct costs it previously capitalized as facilitating the distributing corporation’s acquisition of its stock?" To evaluate whether a section 165 deduction is available, the LTU sets forth several conditions that must be present in order for a controlled corporation to support a section 165 deduction of certain previously capitalized costs incurred by a corporation whose stock or assets were acquired.

The controlled corporation claiming the section 165 deduction must establish that (a) any "synergistic and resource benefits associated with the controlled corporation’s affiliation with the distributing corporation terminated in the corporate separation"³; (b) the separation of the controlled corporation’s affiliation with the distributing corporation caused a "bonafide, uncompensated loss evidenced by closed and completed transactions, and fixed by identifiable events, as required under Treas. Reg. 1.165-1(b)"; and (c) the "controlled corporation has provided sufficient evidence to support that it is entitled to deduct the previously capitalized costs that facilitated the acquisition of its stock."⁴ To take the abandonment position contemplated by the LTU, the previously acquired stock or business assets must be part of the controlled entity or its group of corporations that are being distributed in the section 355 transaction. The LTU cites to a 2005 TAM that prevented a target corporation from deducting its previously capitalized costs when the target corporation liquidated and distributed its assets to another member of its affiliated group, making it clear that an actual distribution must occur.⁵

TAM 202004010 – No Section 165 Deduction for Target’s Previously Capitalized Costs Upon Sale of Target’s Stock Outside Its Affiliated Group

Two questions were addressed by the IRS in the TAM: (1) whether the capitalized fees paid by the target in its acquisition by the taxpayer created or enhanced a separate asset under Treasury Regulations sections 1.263(a)-4(b)(1)(iii) and 1.263(a)-4(b)(3)(i), and (2) whether the taxpayer properly deducted, on behalf of the target, the previously capitalized transaction fees under section 165 when the taxpayer sold all the stock of the target to an unrelated buyer. The IRS concluded that the answer to both of these questions was no.

The taxpayer purchased the stock of the target in year 1 through a reverse merger transaction. The purchase price consisted of cash and assumption of liabilities. In the year 1 transaction, the target incurred professional and administrative expenses that were required to be capitalized under Treasury Regulations section 1.263(a)-5(a). These costs were not treated as an amortizable asset for tax or financial accounting purposes, and the target documented the underlying information related to the fees. After year 1, the taxpayer decided to exit the business that the target conducted because of the business’s poor performance. The taxpayer announced to its investors its intent to divest itself of the target’s business and thereafter sold the target’s stock for cash to an unrelated buyer. On its consolidated tax return for the year of the sale, the taxpayer deducted under section 165, on behalf of the target, the year 1 capitalized costs incurred by the target. The section 165 deduction by the target reduced the tax basis of the target in the hands of the taxpayer. As a result, an ordinary deduction was claimed, and the amount of capital loss recognized by the taxpayer on the sale of the target was reduced.

In denying the treatment of the previously capitalized costs as a separate asset under Treasury Regulations section 1.263(a)-4, the IRS relied on INDOPCO,⁶ General Bancshares Corp.⁷ and Motion Picture Capital Corp.⁸ These cases were cited for the conclusion that costs incurred to acquire a business that is expected to produce long-term benefits to the target business must be capitalized under section 263 until such time as the duration of the target’s business enterprise terminates. Therefore, these costs do not create or enhance a separate asset that is subject to amortization or depreciation under the Code, but instead are associated with the overall business enterprise conducted by a target corporation.

The taxpayer argued that it was entitled to a deduction under section 165 for the capitalized costs incurred by the target in year 1. It contended that the sale of the target’s stock was an identifiable event, as required under section 165, that terminated any long-term benefits to the target’s business that might have been obtained through the year 1 transaction. In denying the section 165 deduction, the IRS determined that the benefits to the target’s business would remain with the target unless and until the target subjectively determined or objectively demonstrated that its business was worthless. The fact that the taxpayer sold the target’s stock after indicating to its investors that the taxpayer was going to divest the target’s business on account of poor performance was not "sufficient to demonstrate evidence of worthlessness or a closed and completed transaction with respect to Target’s business".⁹ Thus, no section 165 deduction was allowed to the taxpayer or the target, and the taxpayer was required to increase its tax basis in the stock of the target prior to the sale, which increased the capital loss recognized upon the sale.

Practice Tips

It can be difficult to support a tax position to recover previously capitalized costs. To claim the deduction, a rigorous factual and legal analysis must be performed. This analysis should include documenting all transaction costs incurred in each transaction, and preserving this information even when assets or stock are moved around a group or mergers occur.

In addition, if the capitalized costs can be allocated to specific items, including the tax basis of the stock or assets that are acquired, or to categories of activities that service providers performed in the transaction, the taxpayer should keep detailed records in the tax files documenting these allocations. For any company acquiring a target company, the acquiring company should determine if the target company has any previously capitalized transaction costs. It should also ensure that this information is "carried over" upon any intercompany restructuring transactions via merger or liquidation into another group member. If the business of the target company is abandoned, becomes part of other discontinued operations, or is subject to distribution under section 355, the taxpayer should review potential abandonment positions for the previously capitalized transaction costs to determine if they can be claimed as outlined in the LTU.¹⁰ However, the significant limitations on taking a section 165 position for the target’s costs, as was at issue in the TAM, must be considered.

Takeaways

The TAM recently issued by the IRS illustrates the challenges for taxpayers that are attempting to recover capitalized transaction costs. While the LTU shows that section 355 distributions may be one avenue for recovering capitalized costs, the analysis and results reached in the TAM demonstrate that the facts that enable taking a section 165 deduction for previously capitalized costs may be very narrow. The results in the TAM illustrate the importance of categorizing transaction costs to specific categories of costs, such as prebright-line investigatory costs, financing costs, integration expenses, employee benefit consulting and ordinary business expenses. To lump most transaction costs into a capitalized category will likely limit the arguments that taxpayers can make to recover these costs.

Endnotes