Deal Costs, Generally
Every purchase and sale of a business, whether from the perspective of the seller or the buyer, is about economics, and few items will impact the economics of the transaction more certainly or immediately than taxes. The transaction involves the transfer and receipt of value, with each party striving to maximize its economic return. The more taxes that a selling party pays as a result of the deal structure, the lower is that party’s economic return. The more slowly that a purchasing party recovers its investment, the more expensive the deal becomes.[i]
In many cases, these “truths” are only considered in the context of allocating the consideration[ii] actually or constructively paid or received in exchange for the business.[iii]
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 expenses incurred by the buyer and seller in considering, preparing for, and closing an “M&A” transaction.[iv] It is important for taxpayers contemplating the acquisition or disposition of a business that they do not overlook the tax benefits and costs that may be realized from the expenses they incur in connection with such an acquisition or disposition. For that reason, a brief (and oversimplified) summary of the applicable rules[v] may be helpful:
- Any “non-facilitative” costs may be deducted by the taxpayer regardless of when incurred in the acquisition process.
- Employee compensation and overhead costs generally may be treated as deductible, non-facilitative costs.
- Any “facilitative” costs that are incurred prior to the execution of an LOI[vi] may also be deducted, provided they are not inherently facilitative.
- If such a cost is incurred after the execution of an LOI, it must be capitalized.
- “Inherently facilitative” costs must be capitalized regardless of when incurred in the acquisition process.[vii]
Success-based fees may be treated as partially facilitative and partially not facilitative.[viii]
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, they may reduce the amount of 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.[ix]
But what happens if the transaction is not consummated?
Both the buyer and the seller may have retained their own bankers, accountants, attorneys, appraisers, and other advisers to assist them with investigating the deal and putting it together. These professionals can be relatively expensive.[x]
Any non-facilitative expenses incurred by either party should be deductible as business expenses regardless of whether the transaction is consummated.
But what about the parties’ facilitative costs? And what about termination fees[xi] that become payable in connection with the failure to close a transaction?
Many buyers will seek to protect themselves, for example, from a target that may suffer from the jitters, or that may get a better offer, by requiring that the target pay a termination fee in the event the transaction fails to close under certain circumstances.
The target will recognize the logic in this, at least from the buyer’s perspective, and will have to take such a fee into account in determining whether to walk away from the deal.[xii]
However, the target itself may insist that a buyer pay a “reverse termination fee”[xiii] as protection, for example, against a buyer that walks away from a deal, that fails to secure financing or regulatory approval for the deal, or that fails to close the deal by a so-called “drop dead” date.
Whether the amount of this fee will succeed in deterring a party from walking away from a deal, or whether it will sufficiently “compensate” the other party for its expenditure of funds, effort, and lost opportunity will depend, in no small part, upon how the fee, together with the facilitative costs incurred by the party, will be treated for tax purposes.
An amount paid to terminate an agreement relating to the acquisition of a business constitutes an amount paid to facilitate another similar transaction – with respect to which the termination payment must be capitalized – only if the transactions are mutually exclusive.[xiv] Where no other transaction is completed, the termination fee should be deductible in the year the agreement is terminated.[xv]
Similarly, an amount paid to facilitate the acquisition of a business is treated as an amount paid to facilitate another transaction (assuming the abandonment of the first) only if the transactions are mutually exclusive. In the absence of another transaction, these facilitative amounts should also be deductible.
The IRS Office of Chief Counsel recently considered the tax treatment of certain termination fees paid by Taxpayer.[xvi] The issue presented was whether the fees should be treated as capital losses (which may offset capital gains) or as business expense deductions (which may offset ordinary operating income).
“Double” the Fees
Taxpayer was party to an agreement to acquire Target. If the acquisition was not consummated by a specified date, Taxpayer was required to pay Target a termination fee.
Taxpayer was also party to an agreement pursuant to which Buyer would acquire Taxpayer, but this transaction was contingent upon Taxpayer’s acquisition of Target. Thus, if Taxpayer failed to acquire Target, Taxpayer’s agreement with Buyer would terminate, and Taxpayer would be obligated to pay a termination fee to Buyer.
Due to what was described as the “impracticability” of proceeding with their transaction, Taxpayer and Target agreed to terminate their agreement and Taxpayer paid the first termination fee to Target.[xvii]
When Taxpayer and Target terminated their agreement, Taxpayer and Buyer executed a termination agreement by which Taxpayer agreed to pay Buyer the second termination fee.
Just when Taxpayer must have thought that things couldn’t get worse, . . .
Tax Return and Audit
Taxpayer reported its payment of the two termination fees (the “Termination Fees”) as ordinary business expenses for which it claimed deductions[xviii] on its federal income tax return[xix] for the tax year in which the payments were made. By doing so, Taxpayer sought to reduce the income tax liability arising from its regular operations.
On the subsequent audit of Taxpayer’s tax return, the IRS examiner sought to disallow the ordinary business expense deductions claimed by Taxpayer and to recharacterize all or part of the Termination Fees as capital losses.[xx]
The examiner requested guidance from the IRS Chief Counsel’s Office on whether the Termination Fees paid in connection with the termination of the two related agreements (the “Agreements”) should be treated as capital losses under Section 1234A of the Code,[xxi] or whether Taxpayer properly claimed them as business expense deductions under Section 162 of the Code.[xxii]
In response, the Office issued Chief Counsel Advice (“CCA”) 202224011.[xxiii]
According to Section 1234A, the CCA began, the loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer[xxiv] should be treated as a loss from the sale of a capital asset.[xxv]
The plain language of this provision, the CCA continued, sets forth the following requirements in determining whether a transaction is subject to Section 1234A:
- There was a loss that was attributable to an extinguishing event (i.e., a cancellation, lapse, expiration, or other termination; a “termination event”);
- That event extinguished a contractual right or obligation;
- The extinguished contractual right or obligation concerned an underlying property that was a capital asset in the hands of the taxpayer (or that would have been a capital asset if the property had been acquired by the taxpayer); and
- There was a “with respect to” nexus or connection between the extinguished right or obligation and the underlying capital asset.
According to the CCA, Section 1234A creates the requisite deemed “sale of a capital asset” from which a loss attributable to a termination event would arise.
In support of its position, the CCA looked to the regulations issued under Section 263(a) of the Code,[xxvi] which require that the “facilitative” costs of acquisitions or dispositions of a trade or business be capitalized. For this purpose, the CCA stated, an amount is paid to facilitate one of the specified transactions “if the amount is paid in the process of investigating or otherwise pursuing the transaction.”[xxvii]
The CCA explained that, under these regulations,[xxviii] the costs required to be so capitalized will be recovered as losses under Section 165 of the Code[xxix] when the transactions are terminated or abandoned.[xxx]
Section 165(a) of the Code provides that a deduction shall be allowed for “any loss sustained during the taxable year that is not compensated for by insurance or otherwise.” However, the deduction of losses from sales or exchanges of capital assets may be limited. For example, in the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges.[xxxi] Moreover, if a corporation has a net (or excess) capital loss for any taxable year, the amount thereof shall be a capital loss carryback to each of the three taxable years preceding the loss year, and a capital loss carryover to each of the five taxable years succeeding the loss year; thus, in the absence of capital gains, the loss may expire without being used.[xxxii]
The CCA then considered the legislative history of Sec. 1234A, which, the CCA stated, reflected Congress’s understanding that terminations of contracts with respect to capital assets were dispositions of the contracts, which would generate loss for purposes of applying Section 1234A. Congress enacted section 1234A, the CCA continued, to “deem” certain non-sale or exchange dispositions to be sales or exchanges to ensure that loss from such dispositions had the same character as a loss from selling the contract.
Applying Sec. 1234A to Taxpayer
With respect to the first two requirements under Section 1234A, the CCA acknowledged that the Agreements created contractual rights and obligations that were extinguished by the termination of the Agreements. The termination of the Agreements, in turn, resulted in the payment of the Termination Fees. Thus, the tax consequences of such payments were attributable to the terminating events described earlier.
The CCA then explained that the payment of the Termination Fees upon the termination of each Agreement constituted a disposition of property that gave rise to a loss to which Section 1234A would apply to the extent the terminated Agreement involved the acquisition of a capital asset. In that case, the CCA continued, Taxpayer was able to recover the Termination Fee, as well as the capitalized facilitative costs,[xxxiii] as losses under Section 165 of the Code.
With that, the CCA next considered the remaining requirements of Section 1234A, including whether the rights and obligations embodied in the terminated Agreements were with respect to property that either was a capital asset in Taxpayer’s hands or would have been a capital asset in Taxpayer’s hands if Taxpayer had acquired the property.
If the Agreement with Target had been consummated in accordance with its terms, it would have resulted in the acquisition of Target stock by Taxpayer. That transaction, viewed in isolation, would have given Taxpayer rights and obligations with respect to Target stock—a capital asset in Taxpayer’s hands, if Taxpayer had acquired it. The CCA explained, however, that immediately after the acquisition of its stock, Target would have been merged with and into an LLC that was wholly owned by Taxpayer (a disregarded entity). Under step transaction principles, because the merger was a step in an integrated plan that included the stock acquisition, the transactions would have been treated as an asset acquisition by the Taxpayer; thus, the Agreement with Target provided Taxpayer with rights and obligations with respect to Target’s assets.
The CCA determined that Taxpayer’s Section 165 loss resulting from the termination of the Agreement with Target should be treated as a capital loss under Section 1234A to the extent the loss was attributable to the property of Target that would have been capital assets in Taxpayer’s hands if Taxpayer had acquired it. Similarly, Taxpayer’s loss resulting from the termination of the Agreement with Buyer was treated as capital under Section 1234A to the extent that loss was attributable to capital assets of Taxpayer that Taxpayer would have sold to Buyer if that transaction had been consummated.
Based on the foregoing, the CCA concluded that the termination of the two Agreements resulted in dispositions by Taxpayer that gave rise to losses under Section 165 of the Code[xxxiv] in an amount equal to the sum of the otherwise capitalizable facilitative costs plus the Termination Fees, and that Section 1234A of the Code applied to characterize the resulting Section 165 losses as capital losses to the extent those losses were attributable to the termination of rights or obligations with respect to capital assets.
In other words, it appears this loss must be bifurcated between the portion related to capital assets, to which Section 1234A capital loss treatment would apply, and the portion related to other assets, for which ordinary loss treatment would apply.
Is That Right?
As indicated earlier, non-facilitative expenses incurred by either party to a purchase and sale transaction should be deductible as ordinary business expenses regardless of whether or not the transaction is consummated.
What about the facilitative costs that otherwise would have been capitalized but for the abandonment of the transaction, and in the absence of a subsequently completed mutually exclusive alternative transaction, as in the case of Taxpayer?
What about the termination fee?
In neither case has there been an actual sale or exchange. However, according to the CCA, Section 1234A deems such a disposition to have occurred upon the termination of an agreement to acquire stock or assets.
Does it matter that a CCA is not precedential? Probably not. In fact, the CCA in question is only the latest of several comparable pronouncements by the IRS.
How then may a taxpayer avoid the adverse outcome – capital loss treatment – resulting from the application of Section 1234A of the Code to the taxpayer’s capitalized costs, and to its payment of a termination fee, upon the abandonment of an M&A transaction?
Is it significant that the scenario addressed by the CCA involved executed agreements?
What if the termination had occurred before the parties had completed negotiating and documenting the terms of the transaction? Would it be reasonable in that case to assert that Section 1234A is inapplicable to the termination fee because there is no termination of a “right or obligation” with respect to a capital asset? Would the delay in documenting what ultimately turned out to be a failed transaction maximize the amount of non-inherently facilitative costs that may be deducted?
Hopefully, we’ll have answers to these questions sooner rather than later.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] The allocation of risk between the two parties is the other side of the same coin. In general, that’s where the representations and warranties, indemnity, holdback/escrow, and transactional insurance provisions come into play. Indemnity payments are usually treated as an adjustment to the purchase price, at least for tax purposes.
[ii] As well as certain costs that will likely differ between the buyer and the seller. For example, a buyer’s cost for the acquired business may differ from the total amount allocated under the purchase and sale agreement because it will reflect in its total cost certain items (such as capitalized acquisition costs) not included in the amount so allocated. Similarly, the amount realized by a seller may differ from the total amount allocated under the agreement to reflect transaction costs that reduce the amount realized for income tax purposes.
[iii] IRC Sec. 1060; IRS Form 8594.
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.
[iv] I am assuming for purposes of this post that we are dealing with “friendly” (as opposed to “hostile”) acquisitions. We’re practicing “happy law.”
[v] Reg. Sec. 1.263(a)-5.
[vi] Actually, an amount paid by the taxpayer in the process of investigating or otherwise pursuing a transaction facilitates the transaction only if the amount relates to activities performed on or after the earlier of (1) The date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target; or (2) The date on which the material terms of the transaction (as tentatively agreed to by representatives of the acquirer and the target) are authorized or approved by the taxpayer’s board of directors (or committee of the 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 representatives of the acquirer and the target) are authorized or approved by the appropriate governing officials of the taxpayer. In the case of a transaction that does not require authorization or approval of the taxpayer’s board of directors (or appropriate governing officials in the case of a taxpayer that is not a corporation) the date determined is the date on which the acquirer and the target execute a binding written contract reflecting the terms of the transaction. Reg. Sec. 1.263(a)-5(e)(1).
[vii] Including, for example, the amount paid for an appraisal, for negotiating the deal structure, for tax advice (yep), and for preparing the purchase and sale agreement. Reg. Sec. 1.263(a)-5(e)(2).
[viii] See the elective treatment of success-based fees under Rev. Proc. 2011-29’s generous safe harbor.
[ix] Reg. Sec. 1.263(a)-5(g).
[x] Sometimes, they are even paid what they are worth.
[xi] Or “breakup fees.” After Musk announced last Friday that he was terminating his merger agreement with Twitter, the latter’s board responded that it would seek to enforce the deal or seek to collect the agreement’s $1 billion breakup fee.
[xii] This additional cost would be borne by the target or its new suitor.
[xiii] Many times, the seller will insist upon a good faith deposit that will be forfeited if the deal does not close.
[xiv] Reg. Sec. 1.263(a)-5(c)(8).
[xv] Rev. Rul. 73-580. The deduction would be claimed under IRC Sec. 165. See also Reg. Sec. 1.263(a)-5(l), Ex. 14.
[xvi] CCA 202224011.
[xvii] Because Taxpayer was the acquirer in the proposed transaction, the Termination Fee paid by Taxpayer is commonly known as a “reverse” termination fee.
[xviii] Under IRC Sec. 162.
[xix] IRS Form 1120, U.S. Corporation Income Tax Return.
[xx] Which, generally, may only be used to offset capital gains.
[xxiii] In general, Chief Counsel Advice (CCA) is written advice prepared by the Office of Chief Counsel and issued to field or service center employees of the IRS. It is intended to convey a legal interpretation of a revenue provision, such as the Code. It is not intended to be precedential or relied upon for any future analysis.
[xxiv] IRC Sec. 1221. https://www.law.cornell.edu/uscode/text/26/1221.
Thus, Sec. 1231 property is not covered by IRC Sec. 1234A. https://www.law.cornell.edu/uscode/text/26/1231.
[xxv] IRC Sec. 1234A applies to gains and losses. Because the CCA considered the treatment of a loss, the post refers only to losses.
[xxvi] Reg. Sec. 1.263(a)-5(a). Specifically, Reg. Sec. 1.263(a)-5(a)(2) requires capitalization of costs in transactions involving the acquisition by a taxpayer of an ownership interest in a business entity, while Reg. Sec. 1.263(a)-5(a)(1) requires capitalization in cases involving an acquisition of assets that constitute a trade or business (whether the taxpayer is the acquirer or the target of the acquisition).
[xxvii] See Reg. Sec. 1.263(a)-5(b)(1).
Amounts paid are “inherently facilitative” (as defined in Reg. Sec. 1.263(a)-5(e)(2)) if paid in the process of investigating or otherwise pursuing the reorganization be capitalized, regardless of whether the amount is paid for activities performed prior to the date determined under Treas. Reg. § 1.263(a)-5(e)(1) , i.e., the date described in the regulations after which amounts paid in the process of investigating or otherwise pursuing a covered acquisition (or reorganization) are deemed to facilitate the transaction. See Treas. Reg. § 1.263(a)-5(e)(2).
[xxviii] Reg. Sec. 1.263(a)-5.
[xxix] Treas. Reg. § 1.165-1(b) provides that “a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year.”
Deductions for abandonment losses are not specified in IRC Sec. 165. Reg. Sec. 1.165-2(a), however, allows a deduction under Sec. 165(a) for a loss incurred in a business (or in a transaction entered into for profit) and arising from the sudden termination of the usefulness in such business (or transaction) of any non-depreciable property, in a case where such business (or transaction) is discontinued or where such property is permanently discarded from use therein.
Accordingly, merger and acquisition costs, otherwise capitalizable, are deductible losses under Sec. 165 when the transaction is abandoned.
[xxx] Reg. Sec. 1.263(a)-5(l), Example 3 provides that costs associated with evaluating “an acquisition by Z of a competitor, and an acquisition of Z by a competitor” must be capitalized and are recoverable by Z as losses under IRC Sec. 165 when Z abandons the acquisition transactions. Reg. Sec. 1.263(a)-5(l), Example 4 requires that appraisal costs incurred in investigating the acquisition of certain targets be capitalized and are recovered as Sec. 165 losses in the year the planned acquisitions are abandoned.
[xxxi] In the case of a taxpayer other than a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges, plus (if such losses exceed such gains) the lower of $3,000, or the excess of such losses over such gains. IRC Sec. 165(f) and IRC Sec. 1211.
[xxxii] IRC Sec. 1212(a). By contrast, a non-corporate taxpayer generally may carry such losses forward indefinitely.
[xxxiii] Under Reg. Sec. 1.263(a)-5(a). According to the CCA, Taxpayer capitalized facilitative transaction costs. The losses resulting from the termination of the Agreements were determined by taking into account the Termination Fees paid to terminate the transactions and the Taxpayer’s properly capitalized facilitative transaction costs of those transactions.
[xxxiv] Rather than business expenses under IRC Sec. 162.