Sale Of Stock + Target’s Capitalized Costs = Creation Of Intangible? Nope

Farrell Fritz, P.C.
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Sale of Stock

Ask a business owner to identify the parties to an agreement for the purchase and sale of the stock of a target corporation, perhaps even their own. After giving you a quizzical look,[i] they will likely reply that, on the one hand, you have the target’s shareholders, who will be selling their shares of target stock; on the other, you have the buyer, who will be purchasing those shares of target stock from the target’s shareholders.

Ask the same question of the target’s tax advisers, and you will likely hear the following: “It depends.” Now it’s your turn to give the quizzical look, to which the adviser will respond with their own questions, among which may be the following: how many shareholders are there, how many shares do they each own, how long have they held them, and what is each shareholder’s basis for their shares; how are the shareholders treated for tax purposes – individuals, trusts, estates, corporations, partnerships; are any of them likely to resist a sale, is there a shareholders’ agreement and, if so, does it include a drag-along provision; how many buyers are there, and what is their status for tax purposes; is the buyer interested in a basis step-up for the target’s assets; what long-term debts does the corporation have; does it own any real property; is the corporation a party to any agreements with change-in-control provisions?[ii]

Your responses to these questions are certain to raise still more questions as the adviser tries to gather all of the relevant facts that are to be introduced in the opening chapter of the unfolding story that is the sale of a business.

What about the Target?

The target corporation is often viewed as a passive character in this story – the object that is being transferred from one party to the other.

Although there is an element of truth in this perception of the target, at least with respect to the actual transfer of its stock, advisers who are experienced in “stock deals” know that the target is, itself, a vital player in the transaction and, as such, will likely incur significant costs throughout the term of the transaction. For example, the well-advised target will retain the services of qualified accounting and legal professionals to assist it in responding to the buyer’s due diligence requests. The target may also become obligated to pay a bonus to certain key employees as a result of the sale of its stock.

The tax treatment of these costs will, in turn, affect the overall economic cost of the acquisition to the sellers, the buyer, and to the target itself. Where these costs may be deducted, they generate an immediate tax benefit for the party that incurred them by offsetting the party’s operating income. Where the costs must be capitalized (for example, added to the basis of the acquired stock), they may reduce the amount of capital gain realized by the seller on the sale of the target,[iii] whereas, in the case of the buyer, they may be recovered on a subsequent sale or liquidation[iv] of the target.

Costs Incurred by the Target

In general, the costs incurred by the target to facilitate the sale of its stock must be capitalized by the target. An amount is paid to “facilitate” a purchase and sale transaction if it is incurred in the process of investigating or otherwise pursuing the transaction. Whether an amount is incurred “in the process of investigating or pursuing the transaction” is determined based on all of the facts and circumstances. In order to simplify the determination of whether certain “routine” costs are incurred to facilitate a transaction, the IRS’s regulations provide that employee compensation and overhead costs are treated as amounts that do not facilitate an acquisition transaction and, thus do not need to be capitalized; instead, they may be deducted against the taxpayer’s operating income in the year they are incurred.

In general, an amount incurred by the taxpayer[v] in the process of investigating or otherwise pursuing the taxable acquisition of a corporation’s stock facilitates the transaction only if the amount relates to activities performed on or after the earlier of: (i) the date on which a letter of intent (“LOI”), exclusivity agreement, or similar written communication is executed by the acquirer and the target; and (ii) the date on which the material terms of the transaction are authorized or approved by the taxpayer’s governing board or officials. This “pre- vs. post-LOI timing rule” provides a helpful bright-line approach to the treatment of many deal expenses. However, the rule does not apply in the case of amounts incurred in the process of investigating or otherwise pursuing an acquisition transaction if they are “inherently facilitative.”[vi] Such amounts must be capitalized by the taxpayer regardless of whether they are incurred for activities performed prior to, or after, the execution of an LOI.

This is all well and good for a seller and for a buyer – one increases its basis for the shares of stock it is selling, while the other increases its basis for the shares of stock it is acquiring. But how does the target corporation – the shares of which are being purchased and sold – capitalize its costs? Do its expenditures create some kind of intangible asset, the cost of which may later be recovered?

This issue was considered by the IRS in a recent technical advice memorandum.[vii]

The Stock Transaction

In Year 1, Taxpayer, which was a corporation engaged in Business, acquired the stock of Target, a manufacturer of Products, in a taxable reverse triangular merger.[viii] Taxpayer and Target stated that the merger was intended to achieve cost synergies that would generate long-term growth and increased efficiencies for both Taxpayer’s and Target’s shareholders, customers, and employees.

Fees Incurred by Target

In connection with the sale of its stock to Taxpayer, Target paid various professional fees and administrative expenses. These included payments to several law firms, investment firms, accounting firms, other professional firms, and regulatory agencies. Target determined the portion of these fees and expenses that was paid in the process of investigating or otherwise pursuing its acquisition by Taxpayer, and therefore, was required to be capitalized as costs of facilitating the acquisition of its trade or business.[ix] Target also determined the amount that represented “success-based fees”[x] and elected to allocate those success-based fees between facilitative costs, which were required to be capitalized, and non-facilitative costs, which were deducted currently as business expenses.[xi]

Capitalized by Target

Taxpayer indicated that Target capitalized the facilitative fees as an intangible asset on its tax books. Taxpayer stated that “since this asset was not acquired as part of the transaction, but rather created by the transaction, neither Taxpayer nor Target recorded an intangible asset for the facilitative fees for financial accounting purposes. What’s more, neither Taxpayer nor Target amortized these fees under any provision of the Code or regulations.

Not long after its acquisition of Target, Taxpayer decided to divest itself of its Products business.[xii] After considering several suitors, Taxpayer sold the Target stock to Buyer. Taxpayer claimed a capital loss from the sale. However, in determining Target’s separate taxable income for the year of the sale, Taxpayer claimed an ordinary loss for Target which was attributable to the above-referenced fees that had been capitalized by Target.

During a subsequent examination of Target’s federal income tax return, the IRS examiner requested technical advice[xiii] from the IRS Office of Chief Counsel (the “OCC”)[xiv] as to the following issue: Whether the professional and administrative fees paid by Target in connection with Taxpayer’s acquisition of Target’s stock created or enhanced a separate and distinct intangible asset?

OCC’s Analysis

The OCC began by noting that IRS regulations generally require taxpayers to capitalize: (i) an amount paid to another party to acquire an intangible from that party in a purchase or similar transaction, (ii) an amount paid to another party to create an intangible, (iii) an amount paid to another party to create or enhance a separate and distinct intangible asset, or (iv) an amount paid to facilitate the acquisition or creation of any of the foregoing intangibles.[xv]

A “separate and distinct intangible asset,” the OCC explained, means a property interest of “ascertainable and measurable value” in money’s worth that is subject to protection under applicable state, federal or foreign law, and the possession and control of which is intrinsically capable of being sold, transferred or pledged separate and apart from a trade or business.[xvi]

The regulations also provide that a taxpayer must capitalize an amount paid to facilitate a business acquisition or reorganization transaction, including, among other transactions, 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).[xvii]

Assuming a facilitative cost is capitalized, the regulations provide rules for the treatment of such costs by the acquirer and target corporations in the context of transactions that involve taxable asset acquisitions. The OCC observed, however, that the regulations expressly reserve on the treatment of a target’s facilitative costs in a taxable stock acquisition.[xviii]

Taxpayer’s Position

The OCC then considered whether certain professional and administrative fees paid by Target in connection with the taxable acquisition of its stock by Taxpayer created or enhanced a separate and distinct intangible asset. The OCC explained that Taxpayer agreed with the IRS that the professional and administrative fees incurred by Target in its acquisition by Taxpayer would not, by themselves, qualify as a separate and distinct intangible asset. Instead, Taxpayer argued that Target paid these amounts to create a separate and distinct intangible asset in the form of the “synergistic benefits” that Target expected to receive from its combination with Taxpayer.

Taxpayer contended that these benefits arose from Target’s access to Taxpayer’s markets, research, quality and innovation platforms, management approaches, and supply chain productivity tools. Under this analysis, Taxpayer argued that the administrative and professional fees paid by Target in connection with Taxpayer’s acquisition of its stock created a separate and distinct intangible asset that was properly capitalized by Target. However, this asset became useless to Target at the termination of its relationship with the Taxpayer; that is, when Taxpayer sold Target’s stock to Buyer.

Taxpayer contended that this conclusion was consistent the U.S. Supreme Court’s analysis in INDOPCO, Inc. v. Commissioner,[xix] which reasoned that professional expenses incurred by a target corporation in the course of a friendly takeover were required to be capitalized, in part, because of the synergistic benefits expected to be generated by the combination of the target and acquirer’s businesses. Taxpayer contended that in Target’s case, these synergistic benefits comprised a separate asset that was properly recoverable at the end of the asset’s useful life, consistent with the premise of INDOPCO. Taxpayer also argued that, by not providing regulations that specifically address the treatment of a target’s capitalized facilitative costs in taxable stock acquisitions, the IRS had implicitly sanctioned alternative treatments, such as “treating such costs as creating a new asset the basis of which may or may not be amortizable.”

OCC’s Response

The OCC, however, agreed with the IRS examiner that the treatment of Target’s professional and administrative costs was addressed by the regulations. As summarized above, the regulations provide rules for determining whether a taxpayer must capitalize (i) amounts paid to acquire an intangible, (ii) amounts paid to create an intangible, or (iii) amounts paid to create or enhance a separate or distinct intangible asset.[xx]

In contrast, the OCC pointed out, the rules for determining whether a taxpayer must capitalize the amounts paid or incurred to facilitate the acquisition of a trade or business provide that a taxpayer must capitalize an amount paid to facilitate an acquisition of an ownership interest in the taxpayer.[xxi]

Both the IRS examiner and the Taxpayer agreed that Target’s professional and administrative fees were incurred by Target in the acquisition of its business by Taxpayer, and that these fees facilitated this acquisition.

Moreover, Taxpayer provided no arguments that these costs were incurred to acquire or create any of the intangible assets described in the regulations. As such, the OCC stated, the professional and administrative fees paid by Target were not amounts incurred to acquire or create a separate and distinct intangible and, so, could not capitalized as such.

Rather, under the applicable rules,[xxii] these fees were properly capitalized by Target as the costs of facilitating an acquisition of Target’s business.

While the regulations are clear that a Target must capitalize the costs of facilitating the acquisition of its trade or business, Taxpayer correctly observed that they specifically reserved, and therefore do not address, the treatment of Target’s costs capitalized in a taxable stock acquisition. Nevertheless, the absence of regulations did not imply, the OCC stated, that any particular treatment was correct. Rather, with regard to Taxpayer’s facts, the OCC believed that longstanding case law, including the Supreme Court’s analysis in INDOPCO, was determinative.

The OCC explained that, in INDOPCO, the Supreme Court addressed a situation that was similar to that of Taxpayer and Target. In that case, the Court decided that certain professional investment, banking, and legal costs incurred by a target corporation in the course of a friendly takeover were required to be treated as capital expenditures. In its analysis, the Court clarified that the creation of a separate and distinct asset may be sufficient, but was not a necessary prerequisite, for determining that a taxpayer must capitalize costs. The Court also determined that a taxpayer’s expectation of significant future benefits from a corporate acquisition or restructuring was another appropriate basis to require capitalization. The Court noted that the target expected to benefit from both the acquiring corporation’s enormous resources and from the cost savings and administrative conveniences stemming from its transformation from a freestanding corporation to a wholly-owned subsidiary. The Court stated that such expenses have long been treated as “incurred for the purpose of changing the corporate structure for the benefit of future operations.”

The Court also pointed out that courts more frequently have characterized an expenditure as capital in nature because the “purpose for which the expenditure is made has to do with the corporation’s operations and betterment, sometimes a continuing capital asset, for the duration of its existence or for the indefinite future or for a time somewhat longer than the current taxable year.” Thus, in INDOPCO, the Court addressed not only the requirement to capitalize costs that produce significant future benefits, but also the nature of professional and administrative costs incurred by a target corporation in the course of its acquisition by another corporation. In its reasoning, the Court made clear that these costs were incurred for the restructuring of the target corporation, its continuing operations and betterment, for the duration of its existence, and not for the acquisition of an intangible asset that was separate and distinct from its ongoing business. In discussing the treatment of capital expenditures, the Court explained that a capital expenditure is usually amortized or depreciated over the life of the relevant asset or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise.

The OCC concluded that Taxpayer’s facts were analogous to the facts in INDOPCO, and that the same analysis and conclusion were warranted. Thus, the professional and administrative fees paid by Target in connection with Target’s acquisition by Taxpayer did not create or enhance a separate and distinct intangible asset but were incurred to facilitate a restructuring of Target’s trade or business. Consistent with INDOPCO, these facilitative costs were characterized as the costs of acquiring significant future benefits for Target’s business and operations, and they would remain capitalized for the life of that business – generally, the duration of Target’s business enterprise.

Therefore, the professional and administrative fees paid by Target in connection with Taxpayer’s acquisition of Target did not create or enhance a separate and distinct intangible asset.

Parting Thoughts

The OCC was right in concluding that Target’s capitalized expenditures neither created, nor added to the value of, a separate and distinct intangible asset.

To the extent any economic benefit resulted from Target’s pre-acquisition outlays, it was manifested in the consideration ultimately exchanged between the Taxpayer and Target’s shareholders.

If there had been a subsequent increase in Target’s value, it would have been attributable to its post-acquisition relationship with Taxpayer, not because of any asset arising from Target’s pre-acquisition expenditures.

That being said, how should the parties to a straight stock sale[xxiii] – i.e., the selling shareholders and the buyer – account for the facilitative and other capitalized costs incurred by the target corporation in connection with the purchase and sale of the target’s stock?

It is not unusual for the buyer to insist that the sellers bear the target’s transactional expenses.[xxiv] Without such a provision, after all, the buyer will indirectly bear such costs once it acquires all of the target’s stock. Alternatively, the parties will sometimes agree to share these costs.

At the end of the day, it’s all about economics and the parties’ leverage relative to one another that will determine which of them will be bear the burden of the target’s outlay of value. Thus, it will behoove each side of the deal to be aware of these target expenditures and to account for them in determining the total consideration and the overall economic effect of the transaction on the seller or the buyer, as the case may be.


[i] Many years ago, a close client said to me, in response to what he thought was a silly question: “Duh? Lou!” Never expecting him to say such a thing, I was in tears from the laughter. We still talk about it.

[ii] There’s a lot to consider. A recalcitrant shareholder who is not interested in selling their stock may necessitate the use of a reverse merger to effectuate the stock sale and compel such shareholder to go along (subject to dissenter’s rights under state law). If an election under IRC Sec. 338(h)(10) or Sec. 336(e) is being considered – which would cause the stock sale to be treated as a sale of assets, followed by the liquidation of the target, for tax purposes – the presence of such a shareholder could be a major stumbling block. These two issues may be anticipated and addressed in a shareholders’ agreement.

[iii] IRC Sec. 1001.

[iv] Other than into an 80-percent parent corporation. IRC Sec. 332 and Sec. 337.

[v] Other than employee compensation and overhead costs.

[vi] An amount is inherently facilitative if the amount is incurred for: (i) Securing an appraisal, formal written evaluation, or fairness opinion related to the transaction; (ii) Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure of the transaction; (iii) Preparing and reviewing the documents that effectuate the transaction (for example, a purchase agreement); (iv) Obtaining regulatory approval of the transaction; (v) Obtaining shareholder approval of the transaction; or (vi) Conveying property between the parties to the transaction (for example, transfer taxes).

[vii] TAM 202004010 (Jan. 24, 2020).

[viii] In which a wholly-owned subsidiary of Taxpayer was merged with and into Target; Taxpayer exchanged shares in its subsidiary for shares of Target; the Target shareholders exchanged their Target shares for cash; Target survived as a subsidiary of Taxpayer.

[ix] Under Reg. Sec. 1.263(a)-5(a). https://www.taxlawforchb.com/2017/04/beyond-purchase-price-the-tax-treatment-of-ma-deal-costs/

[x] Reg. Sec. 1.263(a)-5(f).

[xi] The IRS has provided taxpayers a simplified method for allocating between facilitative and non-facilitative activities any success-based fee paid in a “covered transaction.” Under this safe harbor for allocating a success-based fee, an electing taxpayer may treat 70-percent of the success-based fee as an amount that does not facilitate the transaction; this amount would be currently deductible by the taxpayer. The remaining portion of the fee would be capitalized as an amount that facilitates the transaction. Rev. Proc. 2011-29, 2011-18 I.R.B. 746.

[xii] WTH, right?

[xiii] A technical advice memorandum, or TAM, is guidance furnished by the Office of Chief Counsel upon the request of an IRS director or an area director, appeals, in response to technical question that develops during a proceeding. A request for a TAM generally stems from an examination of a taxpayer’s return. TAMs are issued only on closed transactions and provide the interpretation of proper application of tax laws, regulations, revenue rulings or other precedents. The advice rendered represents a final determination of the position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued.

[xiv] The chief legal advisor to the IRS on all matters pertaining to the interpretation, administration and enforcement of the Internal Revenue Laws.

[xv] Reg. Sec. 1.263(a)-4(b)(1).

[xvi] Reg. Sec. 1.263(a)-4(b)(3)(i). The determination of whether a payment creates a separate and distinct intangible asset is made based on all of the facts and circumstances existing during the taxable year in which the payment is made.

[xvii] Reg. Sec. 1.263(a)-5(a)(3).

An amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction. Whether a payment if made for this purpose is determined based on all of the facts and circumstances. The amount paid by a buyer to the target’s shareholders in exchange for their stock in a stock acquisition is not an amount paid to facilitate the acquisition of the stock. Reg. Sec. 1.263(a)-5(b)(1).

[xviii] Reg. Sec. 1.263(a)-5(g)(2)(ii)(B).

[xix] 503 U.S. 79 (1992).

[xx] Reg. Sec. 1.263(a)-4.

[xxi] Reg. Sec. 1.263(a)-5(a)(3).

[xxii] Reg. Sec. 1.263(a)-5.

[xxiii] No joint election under IRC Sec. 338(h)(10) or seller election under IRC Sec. 336(e).

[xxiv] This may be reflected, for example, in the purchase price or in the working capital adjustment.

[View source.]

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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We reserve the right to change this Privacy Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our Privacy Policy will become effective upon posting of the revised policy on the Website. By continuing to use our Website and Services following such changes, you will be deemed to have agreed to such changes.

Contacting JD Supra

If you have any questions about this Privacy Policy, the practices of this site, your dealings with our Website or Services, or if you would like to change any of the information you have provided to us, please contact us at: privacy@jdsupra.com.

JD Supra Cookie Guide

As with many websites, JD Supra's website (located at www.jdsupra.com) (our "Website") and our services (such as our email article digests)(our "Services") use a standard technology called a "cookie" and other similar technologies (such as, pixels and web beacons), which are small data files that are transferred to your computer when you use our Website and Services. These technologies automatically identify your browser whenever you interact with our Website and Services.

How We Use Cookies and Other Tracking Technologies

We use cookies and other tracking technologies to:

  1. Improve the user experience on our Website and Services;
  2. Store the authorization token that users receive when they login to the private areas of our Website. This token is specific to a user's login session and requires a valid username and password to obtain. It is required to access the user's profile information, subscriptions, and analytics;
  3. Track anonymous site usage; and
  4. Permit connectivity with social media networks to permit content sharing.

There are different types of cookies and other technologies used our Website, notably:

  • "Session cookies" - These cookies only last as long as your online session, and disappear from your computer or device when you close your browser (like Internet Explorer, Google Chrome or Safari).
  • "Persistent cookies" - These cookies stay on your computer or device after your browser has been closed and last for a time specified in the cookie. We use persistent cookies when we need to know who you are for more than one browsing session. For example, we use them to remember your preferences for the next time you visit.
  • "Web Beacons/Pixels" - Some of our web pages and emails may also contain small electronic images known as web beacons, clear GIFs or single-pixel GIFs. These images are placed on a web page or email and typically work in conjunction with cookies to collect data. We use these images to identify our users and user behavior, such as counting the number of users who have visited a web page or acted upon one of our email digests.

JD Supra Cookies. We place our own cookies on your computer to track certain information about you while you are using our Website and Services. For example, we place a session cookie on your computer each time you visit our Website. We use these cookies to allow you to log-in to your subscriber account. In addition, through these cookies we are able to collect information about how you use the Website, including what browser you may be using, your IP address, and the URL address you came from upon visiting our Website and the URL you next visit (even if those URLs are not on our Website). We also utilize email web beacons to monitor whether our emails are being delivered and read. We also use these tools to help deliver reader analytics to our authors to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

Analytics/Performance Cookies. JD Supra also uses the following analytic tools to help us analyze the performance of our Website and Services as well as how visitors use our Website and Services:

  • HubSpot - For more information about HubSpot cookies, please visit legal.hubspot.com/privacy-policy.
  • New Relic - For more information on New Relic cookies, please visit www.newrelic.com/privacy.
  • Google Analytics - For more information on Google Analytics cookies, visit www.google.com/policies. To opt-out of being tracked by Google Analytics across all websites visit http://tools.google.com/dlpage/gaoptout. This will allow you to download and install a Google Analytics cookie-free web browser.

Facebook, Twitter and other Social Network Cookies. Our content pages allow you to share content appearing on our Website and Services to your social media accounts through the "Like," "Tweet," or similar buttons displayed on such pages. To accomplish this Service, we embed code that such third party social networks provide and that we do not control. These buttons know that you are logged in to your social network account and therefore such social networks could also know that you are viewing the JD Supra Website.

Controlling and Deleting Cookies

If you would like to change how a browser uses cookies, including blocking or deleting cookies from the JD Supra Website and Services you can do so by changing the settings in your web browser. To control cookies, most browsers allow you to either accept or reject all cookies, only accept certain types of cookies, or prompt you every time a site wishes to save a cookie. It's also easy to delete cookies that are already saved on your device by a browser.

The processes for controlling and deleting cookies vary depending on which browser you use. To find out how to do so with a particular browser, you can use your browser's "Help" function or alternatively, you can visit http://www.aboutcookies.org which explains, step-by-step, how to control and delete cookies in most browsers.

Updates to This Policy

We may update this cookie policy and our Privacy Policy from time-to-time, particularly as technology changes. You can always check this page for the latest version. We may also notify you of changes to our privacy policy by email.

Contacting JD Supra

If you have any questions about how we use cookies and other tracking technologies, please contact us at: privacy@jdsupra.com.

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This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.