Transaction costs: Capitalization vs. deduction
Historically, the determination of whether transaction costs should be capitalized or deducted has been a contentious issue with the IRS. Generally, costs must be capitalized if they are facilitative of an acquisition, which is a facts and circumstances determination.
An amount is considered paid to facilitate a transaction if the amount is paid in the process of investigating or otherwise pursuing the transaction.
Generally speaking, costs incurred after the execution of the letter of intent are considered costs to facilitate an acquisition. However, certain activities, regardless of the date incurred, are considered inherently facilitative and are subject to capitalization. Inherently facilitative activities include:
- Securing an appraisal, a formal written evaluation, or fairness opinion
- Structuring the transaction, including negotiating the structure of the transaction and obtaining tax advice on the structure
- Preparing and reviewing the documents that effectuate the transaction
- Obtaining regulatory approval of the transaction, including preparing and reviewing regulatory filings
- Obtaining shareholder approval of the transaction
- Conveying property between the parties to the transaction (i.e., transfer taxes and title registration costs)
Capitalized costs must generally be capitalized with the purchase price for the transaction. If the transaction is a stock transaction, they must be capitalized in the basis of the stock that is purchased. If the transaction is structured as an asset transaction, the costs are generally capitalized with the underlying assets. This generally results in an additional purchase price being allocated to intangibles if the purchase price has already been allocated to this asset class.
Success-based transaction fees
A safe-harbor election exists for certain transaction fees that are contingent on the successful closing of a transaction. This election generally permits taxpayers to treat 70 percent of the total success-based fees as an amount that does not facilitate the transaction. The remaining 30 percent of the fee must be capitalized as an amount that facilitates the transaction. The 70 percent that is not facilitative of the transaction still might be capitalized under other tax provisions, such as start-up expenditures, if these tax provisions apply to the transaction.
The transactions for which the safe-harbor election is available include:
- The taxable acquisition of assets constituting a trade or business (acquirer only)
- The taxable acquisition of more than 50 percent an ownership interest in a business entity, whether the taxpayer is the acquirer or target
- Certain reorganizations involving corporations, whether the taxpayer is the acquirer or target
- The use of the safe-harbor election will also reduce the amount of documentation required to deduct costs.
Generally, costs must be capitalized if they are facilitative of an acquisition, which is a facts and circumstances determination.
Start-up expenditures include amounts incurred in connection with investigating the creation or acquisition of an active trade or business. Generally investigatory costs are currently deductible only when they relate to the expansion of a business that is pre-existing. If the costs are incurred to investigate a business in which the taxpayer does not currently operate, they must be capitalized and amortized over a 180-month period as start-up expenditures. The amortization of the start-up expenditures begins in the month in which the active trade or business begins.
In the case where an acquisition company acquires the assets or stock of a company, the amounts paid to acquire the business are often required to be capitalized as start-up expenditures since the acquisition company has not previously conducted a trade or business. On the other hand, if a pre-existing entity acquires assets of a company, it is more likely that transaction costs, such as the 70 percent of the success-based fees, can be deducted if the business is in a similar trade or business to the pre-existing entity. As a result of the various rules, it is important to consider the type of entity that is purchasing the target and incurring costs that might possibly be capitalized under the start-up expenditures.