An acquired target could not use the success-fee safe harbor

Plain-English summary

An S corporation's shareholders sold all its stock, and the target and buyer elected under section 338(h)(10) to treat the deal as a taxable asset acquisition. The target deducted 70 percent of its success-based transaction fees using Revenue Procedure 2011-29's safe harbor. That safe harbor applies only to covered transactions under Treasury Regulation section 1.263(a)-5(e)(3). For asset acquisitions, the regulation covers a taxable acquisition “by the taxpayer,” which includes the acquirer but not the acquired target. The target therefore could not use the safe harbor and had to capitalize the success-based fees unless contemporaneous documentation established that part of the fees related to activities that did not facilitate the transaction.

Ruling snapshot

• Question: Could the acquired target in a section 338(h)(10) transaction use the Revenue Procedure 2011-29 safe harbor for success-based fees?
• Outcome: Advice given, the target was not eligible for the safe harbor
• Key authorities: IRC §§ 263 and 338(h)(10); Treas. Reg. § 1.263(a)-5; Rev. Proc. 2011-29

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           memorandum
           Number: 201624021
           Release Date: 6/10/2016
           CC:ITA:B01:CWGorham
           POSTF-110322-15

 UILC:     263.00-00, 263.08-04

  date:    July 08, 2015

     to:   Anthony J. Kim
           Senior Counsel (San Francisco, Group 1)
           (Large Business & International)

  from:    Lewis K. Brickates
           Branch Chief, Branch 1
           (Income Tax & Accounting)


subject:   Applicability of Treasury Regulation section 1.263(a)-5(e) to Targets in Asset
           Acquisitions

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

           ISSUE

           When an acquired taxpayer elects to treat a stock sale as an asset sale under section
           338(h)(10) of the Internal Revenue Code (“I.R.C. §”), can the acquired taxpayer elect to
           allocate success-based fees paid in conjunction with the acquisition pursuant to
           Revenue Procedure 2011-29, 2011-18 I.R.B. 746?

           CONCLUSION

           No. The safe harbor election under Rev. Proc. 2011-29 only applies to “covered
           transactions” under Treas. Reg. § 1.263(a)-5(e)(3). With regard to an acquired taxpayer
           in an asset acquisition, the transaction is not a “covered transaction” under Treas. Reg.
           § 1.263(a)-5(e)(3).

           FACTS

           On December 31, 2012, the shareholders of Target Corporation (Target), an S
           Corporation, sold all of their outstanding stock to Acquirer Corporation (Acquirer) for $X
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(“Transaction”). Target and Acquirer jointly elected to treat the Transaction as a taxable
asset acquisition under I.R.C. § 338(h)(10).

Target incurred success-based and non-success based costs leading up to the
Transaction, including:

    1. Success-based costs. Target incurred these costs to create financial models and
      prepare buyer lists. These costs were paid to an investment bank.

    2. Non-success based costs. Target incurred these costs in the general marketing
      to potential buyers. The costs include the costs of drafting information
      memoranda, reviewing contracts, and preparing letters of intent.

On its timely filed original 2012 Form 1120-S, U.S. Income Tax Return for an S
Corporation, Target attached a statement electing the safe-harbor allocation under Rev.
Proc. 2011-29. In the statement, Target identified the Transaction, and stated that it
was capitalizing 30% of its success-based costs. Target claimed a transaction cost
deduction, including 70% of its success-based costs under Rev. Proc. 2011-29.

LAW AND ANALYSIS

A taxpayer must capitalize amounts paid to facilitate certain enumerated business
transactions, regardless of whether the transactions are comprised of a single step or a
series of steps carried out as part of a single plan, and without regard to whether gain or
loss is recognized in the transactions. Treas. Reg. § 1.263(a)-5(a). The list of
enumerated business transactions includes, but is not limited to, “an acquisition of
assets that constitute a trade or business (whether the taxpayer is the acquirer in the
acquisition or the target of the acquisition).” Treas. Reg. § 1.263(a)-5(a)(1)-(10).

A success-based fee is paid to facilitate a transaction described in Treas. Reg. §
1.263(a)-5(a) if the amount is paid in the process of investigating or otherwise pursuing
the transaction. Success-based fees are presumed to facilitate the transaction and,
therefore, must be capitalized. Treas. Reg. § 1.263(a)-5(f). A taxpayer may rebut the
presumption, and deduct the amount of the fees, by maintaining sufficient
documentation to establish that a portion of the success-based fees is allocable to
activities that do not facilitate the transaction. Treas. Reg. § 1.263(a)-5(f).

Rev. Proc. 2011-29 provides a safe-harbor election in which a taxpayer may, in lieu of
maintaining the documentation required in Treas. Reg. § 1.263(a)-5(f), allocate
success-based fees between activities that facilitate a transaction and activities that do
not facilitate a transaction. The safe-harbor election is available only for “covered
transactions,” as defined under Treas. Reg. § 1.263(a)-5(e)(3). See Rev. Proc. 2011-
29, Sec. 4.01. Treas. Reg. § 1.263(a)-5(e)(3) lists three transactions as “covered
transactions:”
POSTF-110322-15                              3

   (1) A taxable acquisition by the taxpayer of assets that constitute a trade or
       business.

   (2) A taxable acquisition of an ownership interest in a business entity (whether the
       taxpayer is the acquirer in the acquisition or the target of the acquisition) if,
       immediately after the acquisition, the acquirer and the target are related within
       the meaning of I.R.C. § 267(b) or 707(b).

   (3) A reorganization described I.R.C. § 368(a)(1)(A), (B), or (C) or a reorganization
       described in section 368(a)(1)(D) in which stock or securities of the corporation to
       which the assets are transferred are distributed in a transaction which qualifies
       under section 354 or 356 (whether the taxpayer is the acquirer or the target in the
       reorganization).

In this case, the Transaction is a deemed asset acquisition because of the I.R.C. §
338(h)(10) election. Target cannot, however, treat the Transaction as a “covered
transaction.” Treas. Reg. § 1.263(a)-5(e)(3)(i) uses the phrase “taxable acquisition by
the taxpayer,” which means that the provision only applies to acquiring taxpayers and
not to acquired taxpayers. Nowhere in Treas. Reg. § 1.263-5(e)(3)(i) is there language
like the parenthetical “(whether the taxpayer is the acquirer in the acquisition or the
target of the acquisition),” which is found in Treas. Reg. § 1.263(a)-5(a). Accordingly,
with regard to an asset acquisition, the term “covered transaction” under Treas. Reg. §
1.263(a)-5(e)(3)(i) only applies to the acquiring taxpayer and not the acquired taxpayer.

The Transaction does not qualify as either of the other “covered transactions” listed in
Treas. Reg. § 1.263-5(e)(3). The Transaction was not a “taxable acquisition of an
ownership interest in a business entity;” Target cannot demonstrate stock ownership
post-acquisition. Additionally, the Transaction is none of the reorganizations listed in
Treas. Reg. § 1.263(a)-5(e)(3)(iii).

Accordingly, Target is not eligible to elect safe-harbor treatment under Rev. Proc. 2011-
29 for its success-based fees paid in 2012. Taxpayer must capitalize the success-
based fees that it claimed as a current expense on its 2012 return, unless it establishes
through documentation that a portion of the costs are allocable to activities that do not
facilitate the transaction. Treas. Reg. § 1.263(a)-5(f).

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