When taxpayers pay fees contingent on the successful closing of certain “covered transactions,” including, for example, taxable acquisitions of assets that constitute a trade or business, such “success-based fees” must be capitalized to the extent such fees are treated as facilitating the transaction. By contrast, any portion of such fees treated as non-facilitative may be currently deductible, depending on the situation. Accordingly, to the extent possible, taxpayers generally prefer success-based fees to be treated as non-facilitative. However, over the years, the IRS has challenged taxpayers’ allocation of such fees.
Under Revenue Procedure 2011-29, a taxpayer may make a safe harbor election with respect to any covered transaction to treat 70% of any success-based fee in connection with such transaction as non-facilitative (i.e., potentially currently deductible) and 30% of such fee as facilitative (i.e., capitalized). If the safe harbor election is properly made, the IRS will not challenge such an allocation. A taxpayer may make the safe harbor election by attaching a statement to its original federal income tax return for the taxable year the success-based fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction, and stating the success-based fee amounts that are deducted and capitalized.
If a taxpayer does not make the safe harbor election with respect to a success-based fee, then the taxpayer must maintain sufficient documentation to establish that a portion of such fee is allocable to activities that do not facilitate the transaction, otherwise, such fee will be treated as entirely facilitative (i.e., capitalized). The documentation must consist of more than a “mere allocation” between activities that facilitate the transaction and those that do not, and must consist of supporting records (e.g., itemized invoices or other records). In 2020, the IRS launched a new campaign to ensure taxpayer compliance with the documentation requirements regarding success-based fees where no safe harbor election was made; for this reason, it is particularly critical that a taxpayer maintains robust records or properly makes the safe harbor election.
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