IRS Signals Increased Scrutiny of Deductibility of Success-Based Fees in M&A Transactions

Alston & Bird

Our Tax Group sheds light on recent IRS rulings that disallow deductions involving success-based fees in M&A transactions.

  • Contrary to common practice, the IRS recently ruled target companies could not deduct success-based fees in certain situations
  • The IRS denied target company deductions when the target was sold by controlling private equity shareholders
  • Taxpayers should take precautions to ensure target companies can deduct success-based fees

In M&A transactions, target companies and sellers often engage investment banks to assist in consummating a sale. The fees payable to investment banks are typically contingent on the sale of the target company and may equal a percentage of the ultimate sale price. When stock of the target is acquired from its shareholders, there is a practical question of who will pay the fee. Sometimes, parties to M&A transactions reduce the purchase price payable to the sellers by certain costs and expenses of the target company, including success-based investment banking fees payable by the target company, which are paid at closing.

Revenue Procedure 2011-29 allows the target company in a transaction described in Treasury Regulations Section 1.263(a)-5(e)(3) to deduct 70% of success-based fees incurred by the target company, and it is also common for parties to contractually agree to such treatment. This result must be elected, and making the election can be highly important.

The IRS has recently issued private letter rulings (PLRs) taking the position (contrary to common practice) that, in certain circumstances, success-based fees should be treated as incurred by the selling shareholders, not the target company, and therefore are not deductible by the target company. So not only did the target company not get the deduction but none of the fee was a deductible Section 162 expense.

Recent PLRs on Success-Based Fees

In PLR 202308010, a private equity fund (as controlling shareholder) along with minority shareholders (together, “Sellers”) owned 100% of the stock of Parent. Parent was the common parent of a group of corporations filing a consolidated tax return, which included Corporation X. Corporation X contracted with a financial advisor to provide services for the sale of Corporation X (as the transaction evolved, the financial advisor provided services for the sale of Parent stock). Corporation X agreed to pay the financial advisor a success-based fee.

Sellers agreed to sell Parent’s stock to Buyer pursuant to a stock purchase agreement. Pursuant to the terms of the stock purchase agreement, certain expenses of Corporation X, including the success-based fee, were to be paid out of the proceeds payable to Sellers.

After executing the stock purchase agreement, the financial advisor issued an invoice to Corporation X. However, Buyer transferred the gross sale proceeds to Sellers, who used the funds to satisfy the success-based fee payable to the financial advisor. Corporation X’s tax position was that the amount of the success-based fee should be a deemed capital contribution to Parent, and then presumably a deemed contribution by Parent to Corporation X, which then satisfied its obligation to make the payment.

Corporation X requested relief to file a late election to deduct 70% of the success-based fee, which was denied by the IRS. The taxpayer contended that Corporation X should be able to deduct 70% of the success-based fee because it entered into the contract and primarily benefitted from the financial advisor’s services.

Treasury Regulations Section 1.263(a)-5(a)(3) recognizes that a target corporation can incur a deductible expense to facilitate the acquisition of its stock from its shareholders, even though that might seem to be paying for a benefit to shareholders and hence a dividend: “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).” But the IRS said that regulation never applied because under the general capitalization rule, the expense was an expense of the shareholders under more general principles.

The IRS ruled that the success-based fee was properly allocable to Sellers because the success-based fee was directly and proximately related to Sellers’ (presumably, only the private equity fund’s) activity of buying and selling portfolio companies and only indirectly and incidentally related to Corporation X’s business. Corporation X was merely the object of the sale. To support its argument, the IRS highlighted that the success-based fee was contingent upon a sale and the amount of sale proceeds (and not any operational performance metric or activity of Corporation X) and that Sellers’ representatives reviewed and approved the sale transaction terms. The IRS concluded that the success-based fee was paid to facilitate a sale generating profits for Sellers, and therefore, the success-based fee was an expense of Sellers and not Corporation X.

The IRS issued other comparable rulings in 2023 on similar fact patterns. In PLR 202324001, the IRS concluded the success-based fee was properly allocable to the interrelated private equity fund sellers rather than the target corporation. However, in PLR 202335013 and PLR 202349003, the IRS allowed the success-based fee to be deducted by the target corporation, which although private, was widely held without a controlling shareholder.

Thoughts and Implications

The location and deductibility of success-based fees should be flagged as an issue to consider for buy-side and sell-side advisors. If the target company is to pay the fee and the parties intend for it to be a Treasury Regulations Section 1.263(a)-5(a)(3) transaction and a 70% deduction election be made, the parties should take steps to document that the intended party is getting the economic benefit of the deductions in the intended taxable period.

These recent PLRs indicate the IRS is focusing on the location of success-based fees, particularly in the context of private equity fund sellers. The rulings indicate that if a controlling shareholder (such as a private equity fund) sells a target company in connection with the controlling shareholder’s business and economically bears the cost of any success-based fees incurred in the sale (i.e., through reduction of purchase price payable to the seller), the success-based fees are properly allocable to the seller.

It is important to note that these PLRs are not governing law. Therefore, taxpayers are permitted to take positions supported by applicable law that may be contrary the IRS’s implied current position based on these rulings. Nevertheless, taxpayers should take some precautionary steps to strengthen their position on the intended deductibility of success-based fees by target companies.

Primarily, taxpayers should timely make any election to deduct 70% of success-based fees. It is best practice to include language requiring these elections in purchase agreements and to flag the requirements for the tax preparers so that compliance can be properly handled. If the election is timely and properly made, then the taxpayer will not have to request late election relief from the IRS.

Further, parties should consider the impact of the flow of funds and the identity of the counterparties to the agreement with the bankers.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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