Deducting success-based financial advisory fees.

• Author: O'Connell, Frank J., Jr.

The deduction of success-based financial advisory fees related to business transactions has been, and continues to be, an area of significant taxpayer uncertainty. While the context of the issue has historically centered on the overall deductibility of these fees, the debate has shifted in recent years to the adequacy of the underlying documentation supporting the deduction. The subjective nature of the documentation often used to support these deductions creates uncertainty. However, there have been recent favorable developments in this area from the IRS National Office. Taxpayers must be aware of these developments and the documentation requirements provided by regulation if they wish to minimize the uncertainty surrounding these deductions.

Background

It is well established through judicial precedent that success-based financial advisory fees are deductible to the extent the taxpayer can demonstrate that a portion of the services provided under the fee arrangement relate to deductible activities. The leading case directly applicable to success-based financial advisory fees is A.E. Staley Mfg. Co., 119 F.3d 482 (7th Cir. 1997). In this case, the court relied on the origin of claim doctrine to conclude that the nature of the services provided under a financial advisory engagement determines their deductibility, not the relationship of the fee to the successful closing of a particular transaction.

In 2003, Treasury issued final regulations under Regs. Sec. 1.263(a)-5 regarding the deductibility of costs related to a variety of business transactions, including asset acquisitions, stock or other equity acquisitions, restructurings, recapitalizations, reorganizations, stock issuances, and borrowing transactions. These regulations provide a general blueprint (described below) for determining which costs facilitate a transaction and which costs do not. Facilitative costs must be capitalized, and nonfacilitative costs can be deducted under Sec. 162 (or amortized under Sec. 195 if the taxpayer is entering a new trade or business).

For acquisitive transactions (where one taxpayer acquires another), a bright-line date is used to segregate facilitative and nonfacilitative costs. The bright-line date is the earlier of:

* 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

* 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, in the case of a taxpayer that is not a corporation, the date on which the material terms of the transaction are authorized or approved by the appropriate governing officials of the taxpayer.

Transaction costs incurred for services provided on or after the bright-line date are presumed to be facilitative and must be capitalized. Costs incurred for services provided before the bright-line...