On June 21, 2018, the Internal Revenue Service (IRS) issued Chief Counsel Advice (CCA) 2018-30-011, which disallowed a taxpayer’s deduction of a portion of a success-based fee incurred in a corporate transaction because the deduction failed the documentation requirements under Treas. Reg. § 1.263(a)-5(f). In light of the recent increase in merger activity and the IRS’s recent compliance campaign directed at the treatment of certain transaction costs, taxpayers should ensure that when success-based fees, such as investment banking fees, are deducted, these deductions satisfy the substantiation requirements of Treas. Reg. § 1.263(a)-5(f). (See our previous Eversheds Sutherland alert for additional information and analysis regarding the new campaign.)

In this case, the IRS disallowed the deduction altogether, a harsh result for the taxpayer at issue. Moreover, the CCA’s determination is at odds with other rulings that specifically allowed deductions in circumstances seemingly similar to the taxpayers. As such, this recent CCA serves as a reminder that companies should fully substantiate any deduction taken in connection with a success-based fee.

Background

With any corporate transaction, a taxpayer generally may not deduct its costs (e.g., investment banking, legal, accounting, and consulting fees) that facilitate the acquisition of a trade or business.¹ A cost “facilitates” a corporate transaction if it is incurred “in the process of investigating or otherwise pursuing the transaction,” which includes amounts that are designated as “inherently facilitative.”² Except for such “inherently facilitative” activities, an amount paid by a taxpayer in the process of investigating or otherwise pursuing a covered transaction facilitates the transaction only if it relates to activities performed on or after the earlier of the date a letter of intent or similar communication is executed or the date on which the material terms of the transaction are approved (the “bright line date”).³ These rules apply only to the following types of “covered transactions”—taxable acquisitions of assets that constitute a trade or business, taxable acquisitions of an ownership interest in a business entity, and qualifying section 368 reorganizations.⁴

With respect to success-based fees, (e.g., fees that are contingent on the successful completion of a transaction), such amounts generally are considered 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.⁵ Such documentation must be completed on or before the due date of the taxpayer’s timely filed return for the taxable year during which the transaction closes, and must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction.

Furthermore, such documentation must consist of supporting records (e.g., time records, itemized invoices, 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; the date the activity was performed that 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; and the name, business address, and business telephone number of the service provider. To properly substantiate the deduction of any portion of a success-based fee, taxpayers should ensure they obtain as much documentation as possible to demonstrate the nature and scope of services performed, the cost to perform each category of services, and the timing of each category of services. This type of documentation will allow taxpayers to substantiate the non-facilitative portion of the fee.

The IRS regulations seemingly require extensive supporting records to substantiate the deduction of a success-based fee. With respect to certain advisers, for example, investment bankers, the regulations identify items that are not routinely maintained as part of the business relationship (e.g., time records and itemized invoices). Recognizing this limitation, the IRS, in an Exam context and in other IRS pronouncements, regularly accepts other records to support deductions attributable to success-based fees.

For example, notwithstanding the regulatory language, the IRS found that an allocation schedule provided in a spreadsheet was sufficient to satisfy the documentation requirements of Treas. Reg. § 1.263(a)-5(f). In TAM 2010-02-036 (1/15/10). The success-based fee involved investment banking services, and the firm did not provide the taxpayer with time records or itemized invoices. However, the taxpayer provided the IRS with an allocation spreadsheet, which was the product of interviews and the memory of employees regarding activities performed and estimates of time spent on those activities. While Exam argued that the taxpayer failed to satisfy the documentation requirements of Treas. Reg. § 1.263(a)-5(f), the IRS National Office found that under Treas. Reg. § 1.263(a)-5(f) “records other than time records or itemized invoices can qualify as ‘other records’ for purposes of substantiating the non-facilitative portion of a success-based fee . . . and, there are no limitations on the type or source of documents that can qualify as ‘other records.’ Thus, any document, whether or not labeled a ‘time record’ or ‘itemized invoice,’ can serve to establish the deductible portion of a success-based fee.”

Because the term “other records” is not explicitly defined in the regulations, a wide range of documents may be used to substantiate the deductible portion of a success-based fee. In PLR 2009-53-014 (01/04/2010), the IRS similarly acknowledged a variety of “other records” as including the taxpayer’s records, the files of attorneys, the testimony of witnesses who know the facts, and materials such as board meeting minutes and presentations.

Overview of CCA 2018-30-011

In the CCA, the taxpayer engaged an investment banker to explore a potential sale of the taxpayer. An engagement letter memorialized the relationship, including a success-based fee. The investment banker performed due diligence, identified a number of potential buyers, and ultimately, assisted in successfully closing the transaction. Subsequent to closing, the taxpayer asked for, and received, an allocation letter from the investment banker describing the nature and scope of activities rendered during the engagement, whether such activities fell before or after an identified “bright-line date,” and the time allocated among the various activities.

The allocation letter provided by the investment banker indicated that (as is industry practice) the investment banker did not keep detailed time records due to their typical pay structures, but could approximate percentages of time spent on each activity after discussing the transaction with members of the team that worked on the transaction. The letter also caveated that the percentages were merely estimates and should not be relied on by the taxpayer.

On its return, the taxpayer deducted costs incurred in connection with the investment banker in line with the allocation letter, rather than taking the safe harbor provided in Rev. Proc. 2011-29, and substantiated the deductions in Exam by providing the allocation letter and a PowerPoint presentation that the investment banker had given to the taxpayer’s board.

The IRS National Office found that because the taxpayer decided not to take advantage of the safe harbor provided in Rev. Proc. 2011-29, that any deductions taken in connection with the success-based fee at issue must satisfy the documentation requirements of Treas. Reg. § 1.263(a)-5(f) or any deduction of success-based fees would be denied altogether. The CCA concluded that Treas. Reg. § 1.263(a)-5(f) “specifically forbids” such allocation letters, and because the letter was merely an allocation of services, the documentation failed to satisfy the requirements of Treas. Reg. § 1.263(a)-5(f). Therefore, the taxpayer could not deduct any of the success-based fee amount. The CCA concluded by focusing on the fact that Treas. Reg. § 1.263(a)-5(f)(2) does not require supporting records to identify the percentage of time allocable to each activity performed by the investment banker, but rather records that identify the amount of the fee that is allocable to each activity.

More importantly, in denying this deduction, the IRS failed to provide any insight, analysis, or examples of the types of documents that a taxpayer could use to substantiate an allocation of a success-based fee. Rather, the conclusory analysis provided merely states the allocation letter and PowerPoint presentation provided failed to satisfy the requirements of Treas. Reg. § 1.263(a)-5(f).

In light of the recent uptick in merger activity and the IRS compliance campaign focused on corporate transaction costs, taxpayers should take note of this CCA to ensure that deductions attributable to any success-based fees paid in connection with corporate transactions are documented properly, particularly with documentation beyond an allocation letter. The IRS has a long-standing history of accepting a broad array of documents to substantiate deductions, and this CCA serves as an important reminder that taxpayers should document any related allocation with the best available information. Previous experience representing taxpayers before IRS Exam and National Office, has indicated that even without time records, the IRS will allow the deduction of a success-based fee when other records are provided that substantiate the scope and timing of services that were rendered. Nonetheless, this CCA is an important reminder to obtain adequate documentation for significant deductions.

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¹ Treas. Reg. § 1.263(a)-5(a).

² Treas. Reg. §§ 1.263(a)-5(b)(1); -5(e)(2) (such as costs incurred to secure an appraisal or fairness opinion related to the transaction, structure the transaction (including negotiating the structure and obtaining tax advice on the structure of the transaction), preparing and reviewing the documents that effectuate the transaction, obtaining regulatory approval of the transaction, obtaining shareholder approval of the transaction, or conveying property between the parties to the transaction).

³ Treas. Reg. § 1.263(a)-5(e)(1).

⁴ Treas. Reg. § 1.263(a)-5(e)(3).

⁵ Treas. Reg. § 1.263(a)-5(f).

⁶See Cohan v. Commissioner, 39 F.2d 540 (2nd Cir. 1930) (in which the court held that when the evidence shows that the taxpayer incurred a deductible expense, but the taxpayer does not have the evidence of the exact amount, a court can allow an approximate amount).

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