Tax consequences of transaction costs.

• Author: Witner, Larry

When dealing with property, a taxpayer may incur transaction costs, sometimes called indirect costs. Such costs facilitate a transaction, and they include such things as commissions, advertising fees, appraisal fees, transfer fees (e.g., transfer taxes), meals, travel, and professional fees (e.g., accounting and legal).This article discusses the tax consequences of transaction costs in four settings: in general, when acquiring or producing tangible assets, when acquiring or creating intangible assets, and when acquiring a business. As authority, the article often cites the proposed regulations regarding deduction and capitalization of property. (1) While such regulations are not definitive, they reveal IRS thinking, may be enough to avoid penalties, and portend the future.

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Transaction Costs--Sales of Property

In general, transaction costs have the following tax consequences:

1. If a taxpayer incurs transaction costs while selling dealer property (inventory), they are ordinary and necessary business expenses, otherwise known as selling expenses. (2) As such, they are deductible.

2. If a taxpayer incurs transaction costs while selling or disposing of property other than inventory, transaction costs are capitalized. Under the general rule, capitalized transaction costs are (1) in the year of sale, subtracted in arriving at the amount realized, or (2) in the year the sale is abandoned, deducted as a loss under Sec. 165, if permissible. (3) Under an alternate rule, taxpayers add capitalized transaction costs to adjusted basis in situations involving securities, like-kind exchanges, and installment sales.

   Example 1: When taxpayer T sells securities (adjusted basis = $70,000; FMV = $100,000) for their fair market value (FMV), T pays a commission of $1,000. The commission is a transaction cost on disposition. Under the general rule, the commission is subtracted in arriving at the amount realized of $99,000: $100,000 (selling price) - $1,000. Under the alternate rule, the commission is added in arriving at an adjusted basis of $71,000: $70,000 + $1,000. As Exhibit 1 reveals, both treatments produce the same result.

   Exhibit 1: General rule versus alternate rule, from Example 1 Rule General Alternate Amount realized $99,000 $100,000 Adjusted basis (70,000) (71,000) Realized gain $29,000 $29,000 Example 2: T owns a truck that is business or income-producing property. In late year 1, T decides to sell the truck and pays $500 for an appraisal to determine a reasonable asking price. In early year 2, T sells the truck for $20,000. In year 1 T capitalizes $500 and in year 2 subtracts $500 in arriving at the amount realized of $19,500 ($20,000 - $500). (4)

   Example 3: The facts are the same as in Example 2, except in early year 2 T decides not to sell the truck. In year 1, T capitalizes $500, and in year 2, when the sale is abandoned, T deducts a loss of $500 under Sec. 165. (5)

   Example 4: The facts are the same as in Example 3, except the truck is personal-use property, not business or income-producing property. T abandons the sale in year 2 but cannot deduct a loss of $500 because the truck is not business or income-producing property. (6)

   Transaction Costs--Acquisitions of Property

   In general, taxpayers must capitalize costs to acquire or produce tangible property that is a unit of property, is not materials or supplies, and is not de minimis. (7) In addition, taxpayers, with certain exceptions, must capitalize transaction costs. (8)

   De Minimis Item Exception

   Taxpayers capitalize amounts paid or incurred to acquire or produce property. There is a de minimis item exception to this general rule. According to this exception, items are deductible, provided the taxpayer: (9)

1. Maintains applicable financial statements; (10)

2. Has a written financial accounting procedure for expensing items costing less than a certain dollar amount;

3. Treats this amount as an expense on its financial statements in accordance with its written financial accounting procedure; and

4. The total amount paid for de minimis items not capitalized does not distort the taxpayer's income.

   Taxpayers may elect to capitalize amounts that would otherwise be de minimis items. (11) Thus, if the amounts are used in business or income-producing endeavors, they would be deductible over time through depreciation, not...