The topics of how to properly classify M&A transaction costs and under which circumstances these expenditures are considered tax deductible have been a source of great debate.
Transaction costs can significantly increase the cost of any acquisition. With so much at stake, the discussion of how transaction costs are classified by the Internal Revenue Service has spanned more than a decade.
Plagued by uncertainty, taxpayers historically relied more on speculation than fact when determining which costs qualified for deduction. Recently, IRS tax regulations finally defined the deductibility rules for these expenditures and outlined the importance of proper documentation.
Evolution of the law
The transformation from ambiguity to clarity, while welcomed, was not easy. The evolution of transaction costs law began in 1992, when INDOPCO Inc. v. Commissioner first established the precedent that expenses incurred as part of an acquisition should be capitalized if they produce long-term benefits. The IRS attempted to soften its translation of this U.S. Supreme Court decision, issuing an explicatory ruling, which differentiated deductible investigatory costs and nondeductible capital expenditures.
This clarification stipulated that deductible costs existed if the expense was incurred prior to the “final decision” date and was “investigatory” in nature. Investigatory was defined using a “whether or which” test.
This guideline considered fees instrumental in determining whether to acquire a business and which business to acquire as deductible. While this interpretation and a later bank acquisition court case calmed many issues surrounding the categorization of the transaction costs, it created a new topic of debate — the decision date.
A clear translation
Finally, in December 2003, the IRS established clear regulations that outlined when and how a cost was considered deductible. The ruling defined specific “facilitative” costs that demanded capitalization and others that did not regardless of when they were incurred.
This explanation also introduced the “bright line” test. This bright line established consistent guidelines to follow when figuring the key decision date.
The analysis defined the decision date as the first of two dates. The first is the date a letter of intent, exclusivity agreement or other similar papers (with the exception of a confidentiality agreement) is implemented by an agent acting on behalf of the acquirer or target.
The second, the date the taxpayer’s board of directors (or a committee representing them) approved the transaction’s material terms, or if a board’s approval wasn’t necessary, the date the parties signed a binding written contract.
Proving your point
While this clarification simply defined the criteria needed to classify transaction costs, taxpayers were still strongly encouraged to provide documentation that supported their classifications. In the case of acquisition fees paid to investment bankers — known as success-based fees — the IRS instituted special documentation requirements.
In fact, the IRS went as far as to define the requirement stating supporting documents “must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not.”
Any success-based fee not substantiated with the proper contemporaneous documentation was automatically judged facilitative and accordingly, not tax deductible. In addition, the IRS attached a deadline requiring that taxpayers complete all necessary paperwork by the return due date for the year in which the transaction closed. The requirements may seem strict.
Success-based fees are commonly the largest source of expense incurred after the acquisition process. Moreover, investment bankers’ billing methods make qualifying the exact time of their service difficult.
As a result, documenting the percentage of fees incurred prior to the decision date is easier said than done. But despite the obligatory paperwork, wise taxpayers wanting the maximum possible deduction welcome the guidance these new regulations bring.
PAUL AILSLIEGER, JD, LLM, is a senior manager, and LOU MILLER, CPA, is an executive with Crowe Chizek and Company LLC. Ailslieger is in Iraq to serve his country’s call to duty. For more information about transactions cost, contact Miller at (574) 236-8661 or [email protected].
