Determining how transaction costs should be treated—either as a tax deduction or capitalized cost—isn’t always a straightforward process. All too often, companies assume all transaction costs are deductible for tax purposes only to find out later that they aren’t. Costs associated with facilitating a business acquisition, a change in a business’ capital structure, and other transactions are required to be capitalized. In certain cases, when capitalized, recovering these costs may either be deferred as additional stock basis recovered when disposed or, as a newly created intangible asset, never recovered until the final dissolution of the business.

No matter how the transaction costs are incurred—bankers, attorneys, accountants, or other service providers—these costs are typically significant amounts where deduction versus capitalization can be meaningful to either the buyer or the seller, making transaction cost analyses a critical component to transaction success. However, the complex rules of driving transaction cost analyses can make leveraging this key process overwhelming, time consuming, and confusing.

Increase your understanding of transaction costs analyses, improve deductibility accuracy, and position your company for a smooth and successful transaction with the following transaction costs insights.

Transaction Costs: What Are They?

Transaction costs are those expenses incurred in connection with a transaction. However, the ultimate treatment for Generally Accepted Accounting Principles (GAAP) versus tax can vary significantly depending on the transaction’s structure and the nature of the services rendered.

For GAAP purposes, buy-side transaction costs are generally expensed as incurred or upon the close of the transaction, while sell-side costs may be recorded through the flow-of-funds as an adjustment to sales proceeds. In contrast, for tax purposes, the default is to capitalize all transaction costs subject to further analysis, which generally doesn’t favor the taxpayer.

Make this process more efficient by taking these steps:

• Request detailed, itemized invoices for related services from each service provider involved in the transaction.
• Keep transaction costs segregated in a separate expense account.
• Consult with your tax provider early to correctly understand the structure of the transaction and when considering any agreements between parties related to the allocation or payment of any transaction costs.

What is the Transaction Cost Analysis Process?

Analyzing transaction costs begins with discussing key aspects of the costs incurred and services performed to understand the nature and background of each. It’s critical to understand:

• The timing and purpose of the costs
• What party was contracted for the services
• Who paid the costs
• Which parties benefited from the services

It’s also pertinent to understand if there’s any language included in the purchase agreement as to the allocation of these costs between buyer, seller, and target, as well as recognize what occurred—for example, did the allocation of costs match what was agreed upon in the purchase agreement. Other factors and tax provisions, such as start-up costs, may also dictate how some costs are treated as well.

After an initial discussion occurs to understand the transaction’s foundation and the parties involved, additional work must be completed to determine and report the deductible and nondeductible costs on the tax returns including:

• Mapping to the correct entity
• Considering elections that may be beneficial
• Properly capitalizing the costs to either assets or stock basis
• Amortizing the costs, if available
• Adding required disclosures and statements to the tax returns

What are the Transaction Costs Analyzing Steps?

To properly analyze transaction costs, follow these three steps:

Proper Legal Entity

Determining the appropriate taxpayer to take transaction costs into account is often a question of fact. Generally, the legal entity that incurs a cost takes the cost into account for tax purposes, either as a deduction, or as a capital expenditure. However, it’s common for a transaction cost to be paid by one entity on behalf of another entity, where the non-paying entity benefits from the services.

The IRS views amounts paid on behalf of an entity the same as if that entity made the payment itself—meaning the direct and proximate beneficiary. This requirement prevents the benefit of an expenditure from being assigned to a specific party simply by having that party pay the cost.

Example

Private Equity (PE) A sells the stock of Target to PE B. Target engages a financial advisor to facilitate the sale of its stock. A contingent success-based fee is agreed upon for the advisor’s service, and the sale agreement stipulates that the selling shareholders of PE A will pay the contingent fee from sale proceeds.

Target engaged the advisor and, therefore, since it’s responsible for paying the fee, it seeks to deduct a portion of the fee under the argument that the sale provided it with greater access to capital, directly benefiting its business operations.

A 2023 private letter ruling underscored the IRS’ focus on identifying the appropriate party to account for transaction costs. In the above example, the IRS denied Target the right to a deduction, arguing that the selling shareholders, the PE, were the direct and proximate beneficiaries of the financial advisor’s services, as the PE led the negotiations and ultimate sale of Target, which aligned with its trade or business, meaning investing in companies.

Based on the guidance, if an entity improperly claims it incurred transaction-related costs, the IRS may disallow these deductions upon audit, increasing the entity's taxable income and resulting tax liability including interest and penalties. Further, the entity that should have claimed the deductions may lose the ability to do so in future tax years due to reporting requirements.

Facilitative Costs

Costs incurred in investigating or otherwise pursuing the transaction, known as facilitative costs, without further analysis, must be capitalized. These can be costs such as:

• Appraisals to determine the value of a transaction
• Attorney fees
• Accounting fees
• Investment banker fees

However, facilitative costs can also be deductible immediately, recoverable over time—amortized—or not recoverable until the final dissolution. The transaction’s structure and whether the taxpayer represents the acquirer or the target determines how the facilitative costs are treated.

Covered transactions generally include certain asset acquisitions, acquisitions of significant equity interests of corporations and partnerships or certain tax-free corporate reorganizations.

If a transaction is a covered transaction, a bright-line date is used to delineate between facilitative and non-facilitative costs, with the exception of inherently facilitative costs discussed below.

The bright-line date is the earlier of the following:

• Letter of Intent Date. Date on which representatives of the acquirer and the target execute a letter of intent, exclusivity agreement, term sheet or similar written document—other than a confidentiality agreement—reflecting the terms of the transaction.
• Board Approval Date. Date on which the taxpayer’s board of directors, or its appropriate governing officials—if the taxpayer isn’t a corporation—authorize or approve the material terms of the transaction as agreed to by representatives of the acquirer and the target.

Depending upon the bright-line date, it’s generally determined that those expenses occurring before such date are considered non-facilitative and deductible.

Inherently facilitative costs for certain types of activities to investigate or otherwise pursue the transaction require capitalization regardless of when they are incurred. Some examples of inherently facilitative costs include:

• Appraisals
• Advice and assistance in structuring the transaction
• Preparing and reviewing transaction documents
• Obtaining regulatory approval

Success-based fees, that is, fees that becomes due and payable upon the successful completion of a transaction, are presumed to facilitate the transaction and require capitalization, unless the taxpayer can provide, through contemporaneous documentation, that certain activities do not facilitate the transaction.

If a success-based fee is incurred on a covered transaction, the taxpayer may be eligible to use a safe harbor election, pursuant to a 2011 IRS revenue procedure, to deduct a majority of the success-based fee without the stringent documentation requirement. This safe harbor election is sometimes referred to as the 70/30 rule, reflecting that 70% of the costs are non-facilitative and, therefore, may be deductible, while the remaining 30% of the costs are capitalized.

Treatment of Facilitative Costs

The following highlights examples of the treatment of common transaction facilitative costs.

What About the Treatment of Other Costs?

As the name implies, non-facilitative costs are those costs deemed to not facilitate a transaction.

For example, business integration costs incurred in combining two business after a transaction are considered expenses resulting from a transaction but not necessarily facilitating the transaction. The rules provide simplifying conventions including that compensation—such as transaction bonus—is considered non-facilitative and, therefore, deductible.

Start-up costs may also be a determining factor in the treatment of some costs. Whereas these costs may have been previously considered deductible, a taxpayer without historical operations—such as a new holding company formed to legally acquire target or its assets—may be required to capitalize and amortize these costs over 180 months.

Sometimes a transaction is abandoned creating an opportunity to explore, if previously capitalized, facilitative costs as a loss deduction. The rules limit this opportunity when the abandoned transaction was mutually exclusive to any other transaction that was not abandoned—such as a company may have pursued both transactions without abandoning either transaction.

Like many concepts in a transaction cost analysis, this is a facts and circumstances based analysis in which taxpayers need to develop the timeline and understand events that occurred that resulted in abandoning a transaction(s).

We’re Here to Help

To learn more about transaction cost analyses and how it can impact your business, contact your Moss Adams professional.

Additional Resources

• Transaction Consulting Services
• Tax Services