CCA 201436049: Tax Treatment of Transaction Costs

The Internal Revenue Service (IRS) issues internal legal guidance, known as Chief Counsel Advice (CCA), to clarify its position on complex tax matters. While a CCA is not binding law and cannot be cited as precedent, it offers insight into how the IRS might interpret the tax code. One such memorandum addresses how to handle transaction costs, such as investment banking and legal fees, incurred during certain corporate acquisitions. The tax treatment of these costs is a frequent point of contention, and this CCA provides a clearer understanding of the agency’s stance.

The Transactional Framework

The guidance centers on a taxable stock purchase where the buyer and seller jointly make a Section 338(h)(10) election. This election is available when a corporation buys at least 80% of the stock of a target company that is either a subsidiary within a consolidated corporate group or an S corporation. The parties involved are the selling group, the company being sold (“Old Target”), and the purchasing corporation.

The defining feature of this election is a legal fiction it creates for tax purposes. Legally, the purchaser buys the target company’s stock. However, for tax purposes, the transaction is treated as if the Old Target sold all of its own assets to a “New Target” (the same company under new ownership). Following this “deemed” asset sale, the Old Target is treated as having distributed the sale proceeds to its shareholders in a complete liquidation.

This structure allows the buyer to receive a “step-up” in the tax basis of the target’s assets to their current fair market value. This higher basis can generate significant future tax deductions for the buyer through depreciation and amortization. The seller must agree to this treatment, and the election is made jointly by filing Form 8023 with the IRS. Sellers often agree because the buyer may pay a higher purchase price to compensate for these tax benefits.

The Core Issue Addressed by the IRS

The CCA analyzes how the target corporation should treat the transaction costs it pays when a Section 338(h)(10) election is made. Given the transaction’s dual nature, the IRS concluded that costs must be separated and treated differently based on what activity they facilitated. The guidance requires an allocation of expenses between two distinct events: the deemed sale of assets by the Old Target and the actual sale of stock by the selling shareholders.

Costs properly allocated to the deemed asset sale are the responsibility of the Old Target. These costs are capitalized as expenses of the sale, which reduces the overall gain recognized from the deemed asset disposition on the target’s final tax return.

Conversely, costs determined to facilitate the shareholders’ sale of their stock cannot be treated as expenses of the Old Target. Instead, these costs belong to the selling shareholders. For the shareholders, these expenses reduce their “amount realized” from the stock sale, which in turn lowers their individual capital gain or increases their capital loss. This approach prevents selling shareholders from having the target corporation pay for and deduct expenses that are truly related to their personal stock sale.

Categorizing and Allocating Transaction Costs

Applying the IRS guidance requires a detailed analysis of all costs incurred to facilitate the deal, such as fees paid to investment bankers, lawyers, and accountants. The primary task is to allocate these fees between activities that facilitated the Old Target’s deemed asset sale and those that facilitated the shareholders’ stock sale. This process involves scrutinizing invoices and engagement letters to determine the nature of the services provided.

A significant portion of these costs is often structured as “success-based fees,” which are contingent on the successful closing of the transaction. Under Treasury regulations, a success-based fee is presumed to facilitate the transaction and must be capitalized. Taxpayers can overcome this presumption by providing documentation to prove that a portion of the fee was for non-facilitative activities.

To ease the documentation burden, the IRS provides a “simplifying convention” in Revenue Procedure 2011-29. This allows taxpayers to elect to treat 70% of a success-based fee as costs that do not facilitate the transaction and capitalize the remaining 30%. However, this safe harbor is only available for certain “covered transactions,” and the Old Target’s deemed asset sale is not one of them. The target cannot use the 70/30 split and must instead rely on a factual analysis, maintaining detailed records like itemized invoices or time logs from service providers. For example, fees for drafting the asset purchase agreement would be allocated to the Old Target, while fees for negotiating the stock price on behalf of the shareholders would be allocated to them.

Tax Reporting for Involved Parties

The Seller/Old Target

The Old Target addresses its portion of the costs on its final tax return, which is a Form 1120-S for an S corporation or part of a consolidated Form 1120 for a subsidiary. The costs allocated to facilitating the deemed asset sale are treated as capital expenditures. These capitalized costs reduce the amount realized from the asset sale, thereby decreasing the taxable gain or increasing the loss. This gain or loss is calculated on Form 8883, Asset Allocation Statement Under Section 338, which is attached to the final return.

The Selling Shareholders

The selling shareholders are responsible for the costs allocated to the facilitation of their stock sale. These amounts are not deductible on the corporate return. Instead, each shareholder treats their portion of these costs as a selling expense on their individual tax return. This expense reduces the total proceeds they received for their stock, which in turn lowers their calculated capital gain or increases their capital loss. This adjustment is reported on Form 8949, Sales and Other Dispositions of Capital Assets, which flows to Schedule D of their Form 1040.

The Purchaser/New Target

The purchasing corporation has its own set of transaction costs, which are separate from those incurred by the target and sellers. The purchaser must capitalize its costs into the tax basis of the assets it is deemed to have acquired. These costs are added to the total purchase price and allocated among the various acquired assets. This allocation is also reported on Form 8883. The increased basis in the acquired assets allows the New Target to claim larger depreciation and amortization deductions over the following years.