Many business owners today are turning to professionals like Clayton Capital Partners to assist in selling their businesses. In doing so, many times the fees will be on a "success based" structure. In other words, some part of the fee may be ongoing consulting, etc., but a certain part of the fee may only be due if the Investment Banker is successful in closing the transaction on their client's behalf.
A Safe Harbor
The payment of this fee has generated considerable controversy in the past with the Internal Revenue Service especially with taxpayers who tried to write off part of the fee as an ordinary expense versus capitalizing this fee. Obviously, an immediate ordinary tax deduction generates improved cash flow and potential larger tax savings than a reduction of a capital gain or amortization deductions spread out over multiple periods.
In 2011, relief came in the form of IRS guidance which provides a clear choice for success based fees incurred or paid by taxpayers for taxable years ending on or after April 8, 2011. This safe harbor approach will now allow success based fees, not milestone payments, after the above-mentioned date to be deducted 70% as an ordinary tax deduction, while the remaining 30% must be capitalized. We believe this safe harbor is overlooked by many taxpayers. Normally, we have seen taxpayers capitalize 100% of these transaction costs!
The same rationale applies with purchases of businesses on a success based fee. Again, we have seen many businesses who have incurred these costs capitalize 100% of them into the purchase price of the new business whereas now if they meet the terms of the IRS guidance they will be allowed to deduct up to 70% as an ordinary tax deduction. The definition of a success based fee for tax purposes is an amount paid that is contingent on the successful closing of a "covered transaction."
• Acquisition of assets constituting a trade or business (whether the taxpayer is the acquirer or the target of the acquisition)
• Acquisition of an ownership interest in a business when the taxpayer and the acquired entity are related parties after the transaction
• Acquisition of an ownership interest in the taxpayer (i.e., the taxpayer is the target of an acquisition)
• Certain business entity restructuring, reorganization, capitalization, and recapitalization transactions
• Formation or organization of a disregarded entity (e.g., an LLC)
• Acquisition of capital, including stock issuances or borrowing issuances or borrowing transactions
• Writing an option
Making the Election
A taxpayer wanting to take advantage of this safe harbor will need to make a proper election in accordance with the existing IRS guidance. This election is due with the tax return in the year in which the transaction occurred and can be made on a timely filed return including extensions of time to file. An amended return will not be effective to elect this provision nor will the late election procedures.
Therefore, it is very important that you understand the opportunity to elect this safe harbor when you file the tax return for the year the transaction fee was incurred or paid!
Tony Smith is a Senior Manager in Mueller Prost PC's Tax Services Department, assisting clients in meeting regulatory compliance issues as well as understanding complex tax and financial issues.