How to Deduct Success-Based Fees Paid to Investment Bankers

Things have gotten better for corporate taxpayers who dole out payments only if a merger succeeds.
Gary Q. MichelAugust 16, 2011

Investment bankers hired in the context of mergers and acquisitions generally get paid only if the deal closes successfully. From an economic perspective, success-based fee structures benefit acquirers and targets. But the nature of the fees has created significant tax uncertainty about whether they can be currently deducted or must be capitalized.


Under current Treasury regulations, taxpayers must generally capitalize amounts paid to “facilitate” certain capital transactions. Before a bright-line date, amounts paid by a taxpayer for certain “covered transactions” are generally not treated as facilitating the transaction and are deductible. (The bright-line date is defined as the date a letter of intent or exclusivity agreement is signed or the date the material terms of the transaction are approved by the taxpayer’s board.) Covered transactions are limited to taxable acquisitions of a trade or business, taxable acquisitions or dispositions of ownership interests in business entities, and certain tax-free reorganizations.

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On the other hand, success-based fees are presumed to facilitate the transaction. The presumption can only be rebutted by completing detailed documentation to establish that a portion of the fees can be allocated to activities that don’t facilitate the transaction. The documentation must include such supporting records as time sheets, itemized invoices, or other documentation that identifies the various activities performed by the investment banker, the fees allocable to such activities, and the date the services were performed.


But investment bankers do not — and simply will not — maintain detailed time sheets in the way attorneys do. That makes completing such documentation a challenging task, especially since it must be completed by the due date of the tax return (including extensions) for the taxable year the transaction closes. Further, there are no extensions of time to meet the documentation requirement.

In other words, the documentation must be contemporaneous, and a taxpayer cannot wait until it is audited to gather the necessary documentation to support its deduction.


These onerous record-keeping requirements have caused significant disputes between the Internal Revenue Service and taxpayers over the years. They also have spawned a great deal of uncertainty about the type and extent of documentation required to support a deduction.


In a 2010 Technical Advice Memorandum, the IRS allowed a taxpayer’s outside accountants to evaluate the investment banker’s services and make the allocation of the success fee between facilitative and nonfacilitative services. The evaluation included an interview with each investment banker who worked on the transaction. Even so, that involved an additional expense and effort to achieve a deduction for only a portion of the success fee.


Fortunately, the IRS recently issued Revenue Procedure 2011-29, which provides a safe-harbor election for taxpayers to allocate success-based fees paid in connection with a covered transaction between a deductible current expense and a nondeductible capital expenditure. Taxpayers can now elect to treat 70% of success-based fees as currently deductible while capitalizing the remaining 30%. The safe-harbor election provides taxpayers with welcome certainty that the IRS will not attack their allocation of success-based fees. Electing the safe harbor eliminates the need to meet the documentation requirements under the former time pressures.


Revenue Procedure 2011-29 highlights the importance of determining whether a transaction qualifies as a covered transaction. For example, the sale of assets (as opposed to the acquisition of assets) doesn’t fall under the definition of a covered transaction, and thus the safe harbor wouldn’t apply.

In our discussions with the IRS national office, representatives confirmed this disparate treatment of the buyer and seller of assets but were unable to explain the rationale for it. As a result, the exception to the general rule of capitalization for amounts incurred before the bright-line date, as well as the new safe harbor of Revenue Procedure 2011-29, would not apply to a seller of assets. But the national office affirmed that amounts incurred by a seller of assets before the bright-line date should generally not be treated as paid to “facilitate” a transaction.


Amounts required to be capitalized would be treated as a reduction in the amount realized on the sale of assets. Thus, with respect to the seller of assets and any other transaction that is not a covered transaction (such as a stock issuance or a borrowing), appropriate documentation should be contemporaneously maintained to substantiate the deductible portion of success-based fees paid.

The importance of such documentation cannot be overly stressed. The stakes can be high — the value of an ordinary deduction versus a “capital” deduction, or worse. Reliance on the recent Technical Advice Memorandum (and incurring the additional accounting fees) may be worthwhile. But there is no reason the taxpayer’s in-house accounting staff couldn’t perform the analysis and prepare the necessary documentation.


The safe-harbor election is available for success-based fees paid or incurred in tax years ending on or after April 8, 2011. But our experience with audits of this issue suggests that taxpayers have been able to receive substantially similar results as if the election were always available. In fact, the IRS recently issued a directive to its large business and international examiners not to challenge an allocation of success fees incurred in covered transactions in taxable years not covered by the safe-harbor election if the taxpayer capitalizes at least 30% of the success fee.


The election is made by attaching a statement to the tax return for the year the success-based fee is paid or incurred. The election applies only to the transaction for which the election is made, and is irrevocable. Overall, things have gotten better for taxpayers who dole out success-based fees to investment bankers.


Gary Q. Michel is a partner at law firm Ervin Cohen & Jessup, in Beverly Hills, California, where he chairs the tax-law practice.