Beyond Purchase Price: The Tax Treatment of M&A Deal Costs
April 24, 2017
Recovering Transaction Costs
It is a basic tax principle that the more a seller pays in taxes on the sale of its business, the lower will be the economic benefit realized on the sale; similarly, the more slowly that a buyer recovers the costs it incurs in acquiring a business, the lower will be the return on its investment.
In most cases, these “truths” are only considered in the context of allocating the consideration paid and received for the purchase and sale of a business among the assets comprising the business. An allocation of consideration to the goodwill of the business, for example, will generate capital gain for the seller, and will be recoverable by the buyer over a 15-year amortization period; an allocation to the tangible personal property used in the business may generate significant ordinary income for the seller (in the form of depreciation recapture), though it will be depreciable by the buyer over a relatively shorter period.
There is another element in every transaction, however, that needs to be considered in determining the tax consequences of the purchase and sale, but that is often overlooked until after the transaction has been completed and the parties are preparing the tax returns on which the tax consequences of the transaction are to be reported.
I am referring to the tax treatment of the various costs that are incurred by the buyer and the seller in investigating the acquisition or disposition of a business, in conducting the associated due diligence, in preparing the necessary purchase and sale agreements and related documents and, then, in completing the transaction. 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, thereby reducing the economic cost of the transaction. Where the costs must be capitalized (i.e., added to the basis of the acquired property), they may reduce the amount of capital gain realized by the seller on the sale, whereas, in the case of the buyer, they may be recovered over the applicable recovery periods for the assets acquired (up to 39 years, in the case of nonresidential real property), thereby making the deal more expensive.
According to the IRS
Under regulations promulgated by the IRS, a purchaser must generally capitalize any amounts incurred to “facilitate” the acquisition of a business from a target company or the acquisition of ownership interests from the target’s owners; a similar rule applies as to costs incurred by the target or its owners to facilitate the sale.
Examples of Facilitative Expenses
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.
The fact that an expense would not have been incurred but for the transaction is relevant, but it is not determinative of whether it was incurred to facilitate a transaction.
On the other hand, an amount incurred to determine the value of a transaction is treated as an amount incurred in the process of investigating or otherwise pursuing the transaction.
However, an amount paid to another party in exchange for property is not treated as an amount incurred to facilitate the exchange. For example, the purchase price paid to a target in exchange for its assets is not an amount paid to facilitate the acquisition. Similarly, the amount paid by an acquirer to the target’s owners in exchange for their ownership interests is not an amount incurred to facilitate the acquisition of the ownership interests. (Of course, the amount paid by a taxpayer to another party to acquire the assets of a business or an ownership interest in the business must be capitalized; specifically, it must be added to the taxpayer’s cost basis for the business assets or the ownership interest, as the case may be.)
An amount incurred by a taxpayer to facilitate acquisition financing does not facilitate the acquisition for which the borrowing is incurred.
An amount paid by a target to facilitate a sale of its assets does not facilitate another transaction (other than the sale); for example, where a target corporation, in preparation for a merger with an acquiring corporation, sells assets that are not desired by the acquiring corporation, amounts incurred by the target to facilitate the sale of the unwanted assets are not required to be capitalized as amounts incurred to facilitate the merger.
An amount incurred to integrate the business operations of the taxpayer with the business operations of another does not facilitate an acquisition transaction, regardless of when the integration activities occur.
However, an amount paid to terminate an agreement to enter into an acquisition transaction will constitute an amount paid to facilitate a second acquisition transaction only if the transactions are mutually exclusive.
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.
The term “employee compensation” means compensation (including salary, bonuses and commissions) paid to an employee of the taxpayer. For this purpose, a guaranteed payment to a partner in a partnership is treated as employee compensation, as is the annual compensation paid to a director of a corporation. However, an amount paid to the director for attendance at a special meeting of the board of directors is not treated as employee compensation. An amount paid to a person that is not an employee of the taxpayer (including the employer of the individual who performs the services) is generally treated as employee compensation only if the amount is paid for administrative support services.
Election to Capitalize
A taxpayer may elect to treat otherwise deductible employee compensation or overhead costs paid in the process of investigating or otherwise pursuing an acquisition as amounts that facilitate the transaction and, thus, must be capitalized. For example, a taxpayer may elect to treat overhead costs, but not employee compensation, as amounts that facilitate the transaction.
In general, an amount incurred by the taxpayer in the process of investigating or otherwise pursuing a “covered transaction” (other than employee compensation and overhead costs) facilitates the transaction only if the amount relates to activities performed on or after the earlier of:
The date on which a letter of intent, exclusivity agreement, or similar written communication is executed by the acquirer and the target (an “LOI”); or
- The date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the taxpayer’s board of directors or, in the case of a taxpayer that is not a corporation, the date on which the material terms of the transaction (as tentatively agreed to by the acquirer and the target) are authorized or approved by the appropriate governing officials of the taxpayer.
The term “covered transaction” means the following transactions:
- A taxable acquisition by the taxpayer of a target’s assets that constitute a trade or business; and
- A taxable acquisition of a significant ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition).
Inherently Facilitative Costs
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.” 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.
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).
An amount incurred by a taxpayer with respect to a service provider that is contingent on the successful closing of an acquisition transaction is presumed to be an amount incurred to facilitate the transaction and, thus, must be capitalized, though a taxpayer may rebut the presumption by maintaining sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction.
In lieu of maintaining this documentation, however, 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.
Capitalized Costs: Basis & Reduction of Gain
In the case of an acquisition that is not treated as a tax-free reorganization, any amount that is required to be capitalized by the acquirer under the preceding rules is added to the basis of the acquired assets (in the case of a transaction that is treated as an acquisition of the assets of the target for tax purposes) or to the basis of the acquired stock (in the case of a transaction that is treated as an acquisition of the stock of the target for tax purposes).
Any amount required to be capitalized by the target is treated as a reduction of the target’s amount realized on the disposition of its assets.
It is important for taxpayers that are contemplating the acquisition or disposition of a business that they not overlook the tax benefits that may be realized from the expenses they incur in connection with such acquisition or disposition.
For that reason, a brief summary of the principles set forth above is in order:
- Any non-facilitative fees may be deducted by the taxpayer regardless of when incurred in the acquisition process.
- Employee compensation and overhead costs may be treated as deductible, non-facilitative costs.
- Any facilitative costs that are incurred prior to the execution of an LOI may also be deducted, provided they are not inherently facilitative.
- Inherently facilitative fees must be capitalized regardless of when incurred in the acquisition process.
- Success-based fees may be treated as partially facilitative and partially not facilitative.
Armed with this knowledge, an acquiring or selling taxpayer will be in a better position to gauge the true costs of certain expenditures, and should therefore be in a better position to negotiate the true economics of a deal.