|
Executive Overview The Importance of Documentation to Support Deduction of a Portion of a Success-Based Fee On January 5, 2004, regulations addressing the federa income tax treatment of certain transaction costs were published in the Federal Register [T.D. 9107, 69 FR 446, Jan. 5, 2004]. These regulations confirm that certain costs incurred for services in connection with a potential corporate transaction can be properly deducted as ordinary and necessary expenses under Section 162 of the Internal Revenue Code, if documentation is provided that demonstrates that such services are not facilitative of the transaction. Thus, if a success-based fee, such as an investment banking fee, is to be bifurcated and a portion deducted as an ordinary and necessary expense, the taxpayer must provide detailed records describing the specific services that were not facilitative of the transaction. When a Tax Opinion May Not Protect Against Penalties On December 29, 2003, Treasury and the Service issued proposed revisions to Circular 230 governing tax shelter opinions. These revisions are proposed to increase the standards for due diligence required by practitioners issuing tax opinions with a "more likely than not" level of assurance, as well as mandating the disclosure of a tax advisor’s referral agreement or financial interest in the promotion of the shelter. In the process of notifying IRS agents of the proposed changes to Circular 230, the Commissioner stated that the IRS will not accept reliance on an opinion from a non-independent tax-advisor as proof of reasonable cause and good faith on the part of the taxpayer. Thus, this policy statement may allow the IRS to assess penalties, such as an accuracy-related penalty, to a taxpayer that receives an opinion on the federal income tax treatment of a tax shelter. |
Deductibility of Transaction Costs
A longstanding concept in federal income taxation is that a deduction is allowed to a taxpayer under Section 162(a) for ordinary and necessary expenses incurred in carrying on a trade or business. Recently published regulations address the circumstances in which certain transaction costs may be deducted as ordinary and necessary. Treas. Regs. Section 1.263(a)-5 [T.D. 9107, 69 FR 446, Jan. 5, 2004]. In addition, these new regulations provide for the deductibility of certain costs incurred in the pursuit of transactions that are ultimately abandoned under Section 165(a). See Treas. Reg. Section 1.263(a)-5(l), Example 2 (iii).
The Regulations divide up the universe of transactions into two categories, (a) listed transactions, and (b) covered transactions. A higher level of documentation is required for deductibility of costs incurred during transactions found in the first category.
Listed Transactions
Listed Transactions include (a) Asset acquisitions (non-taxable), (b) Entity acquisitions (non-taxable and non-Section 368 reorganizations), (c) Stock repurchases, (d) Section 355 and Section 368(a)(1)(E) corporate restructurings, (e) Section 351 transactions, (f) LLC formations, (g) Raising cash, (h) Stock issuance, (i) Borrowing and debt issuance, and (j) Option writing. If a taxpayer is seeking to deduct transaction costs that are success-based and incurred while pursuing a listed transaction (presumably focused on investment banking fees), detailed documentation must be completed indicating the specific activities that were performed by the taxpayer’s service providers during the pendancy of the transaction demonstrating that these activities were not facilitative of the transaction. The documentation must be done "on or before the due date of the taxpayer’s timely filed original federal income tax return (including extensions) for the taxable year during which the transaction closes." Treas. Reg. Section 1.263(a)-5(f).
Covered Transactions
The second group of transactions includes (a) Taxable asset acquisitions, (b) Taxable stock acquisitions where a controlling interest is acquired, and (c) Tax-free reorganizations under Sections 368(a)(1)(A), (B), (C), and (D) (only applies to non-divisive D’s). Treas. Reg. Section 1.263(a)-5(e). Transaction costs incurred in the investigatory process of a covered transaction can be deducted if they occur prior to, and relate to, the pre-decisional phase of the transaction.
The regulations are effective for amounts paid or incurred on or after December 31, 2003. Treas. Reg. Section 1.263(a)-5(m).
GCD Comments:
For taxpayers entering into transactions in 2004 (or transactions that began in 2003 which have not been closed), it is now very important to keep detailed records of the services provided in the course of evaluating and pursuing a corporate transaction, in order to be able to support a deduction for certain transaction costs.
IRS Proposes Changes to Circular 230 Standards for Issuing Tax Shelter Opinions
On December 29, 2003, the Treasury and IRS issued proposed changes to the rules that govern the provision of tax advice by practitioners [Reg-122379-02. TD 9108; TD 9109, Dec. 29, 2001]. These changes focus on raising the standards of analysis and due diligence that is required from practitioners and their firms when preparing tax opinions. The proposed changes also require that new disclosures must be included in tax shelter opinions that reach a "more likely than not" level of assurance. These rules are proposed to be effective when final rules are published in the Federal Register.
Although the changes in these rules target practitioners and their firms, the proposed rules’ impact may extend to the taxpayers that receive certain tax opinion letters. In an internal memorandum also dated December 29, 2003 ["IRS Commissioner Mark Everson Memo for LMSB, Small Business/Self-Employed Commissioner on IRS Penalty Policies," dated December 29, 2003], the IRS Commissioner notified the Commissioners of the Large and Mid-Size Business Division and Small Business/Self-Employed Divisions of the proposed rule changes indicating that the IRS will question the reasonableness and good faith of taxpayers who know, or have reason to know, of the non-independence of the tax advisor issuing the tax shelter opinion.
GCD Comments:
Because the proposed regulations do not specifically define "a tax shelter", once they become effective, the IRS will have broad ability to challenge a taxpayer’s reliance on either marketed or non-marketed opinions on transactions and other events deemed to be tax shelters. Thus, consideration should be given to obtaining a tax opinion on these transactions from independent counsel.
Copyright 2004 Gardner Carton & Douglas
This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.