Focus on required documentation for allocation of success-based fees


Authored by RSM US LLP

The IRS Large Business and International (LB&I) division announced a new active campaign to ensure taxpayers comply with the documentation requirement for allocation of success-based fees, where the safe harbor election contained in Rev. Proc. 2011-291 is not made by the entity. 

A fee that is contingent on the successful closing of an M&A transaction is commonly referred to as a success-based fee and is typically paid to the financial advisors (i.e., the investment bankers) or the private equity firm involved in the transaction. Generally, success-based fees paid in connection with a business acquisition or reorganization transaction are presumed to be facilitative and are capitalized under section 263(a).2 However, a taxpayer may treat the success-based fees as non-facilitative if proper documentation to support the amount is maintained.3 Note that whether the non-facilitative amount is deductible or subject to capitalization (e.g., section 195 start-up expenses) is a separate determination from the treatment of the costs as facilitative or non-facilitative. For a more detailed discussion of the rules regarding the documentation requirement and treatment of non-facilitative transaction costs, see our prior article, Merger and acquisition transaction costs 2015 redux: Who gets the benefit?

The documentation required is robust, and Treasury Regulations specifically provide that documentation showing only an allocation between the transaction’s facilitative and non-facilitative activities is insufficient.4 The required documentation consists of supporting records such as itemized invoices and time records showing: (i) the various activities performed by the service provider; (ii) the amount of the fee (or percentage of time) that is allocable to each of the various activities performed; (iii) where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction, the amount of the fee (or percentage of time) that is allocable to the performance of that activity before and after the relevant date; and (iv) the name, business address and business telephone number of the service provider.5

The IRS has shown some flexibility for meeting this requirement, by looking to the totality of the evidence provided, even where time sheets or itemized invoices were not provided.6 Examples of other documentation that may be used to satisfy the requirement include:

  • Taxpayer’s records,
  • Attorneys’ files, 
  • Testimony of witnesses who know the facts, 
  • Board of director minutes,
  • Corporate and service provider meeting minutes,
  • Service provider engagement letters,
  • Flow of funds memo, 
  • Bank records (including wire transfers), 
  • Copies of presentations made by the service provider, and 
  • Spreadsheets allocating percentage of time spent on non-facilitative and facilitative costs when supported by other documentation showing the work product and work performed by the service provider and other parties to the transaction.7

However, this lack of clarity around what documentation was necessary to comply with the requirement led to controversy and uncertainty for taxpayers. To reduce the controversy around this requirement, the IRS issued a safe harbor election under Rev. Proc. 2011-29 for taxpayers to deduct a portion of success-based fees paid in covered transactions.8 Under this safe harbor, instead of maintaining the supporting documentation, a taxpayer may make an irrevocable election to treat 70% of success-based fees as non-facilitative (and therefore, potentially deductible), while the remaining 30% is facilitative and therefore capitalized. Taxpayers choosing not to apply the safe harbor must look to the guidance described above, despite the lack of clarity, and thoroughly document the allocation of success-based fees when seeking to deduct any portion of those expenses. 

There are various possible explanations as to why the IRS now has chosen to turn its focus to taxpayer compliance with the documentation requirement under Reg. section 1.263(a)-(5)(f) for success-based fees. For example, perhaps some taxpayers who have not elected to use the safe harbor under Rev. Proc. 2011-29 have become more inattentive about complying with the documentation requirement in recent years. It may also be that the IRS is anticipating an increase in taxpayers seeking to deduct a larger portion of success-based fees in order to achieve a greater tax benefit under the net operating loss (NOL) five-year carryback provision (as amended by the Coronavirus Aid, Relief, and Economic Security (CARES) Act).9 Regardless of the underlying reason, the IRS is alerting taxpayers that if they do not elect the safe harbor but still intend to deduct success-based fees, then they must comprehensively document the allocation. 

In conclusion, a taxpayer may elect to apply the safe harbor under Rev. Proc. 2011-29 to treat 70% of success-based fees as non-facilitative costs. Alternatively, a taxpayer seeking to allocate a portion of success-based fees as non-facilitative costs and to deduct such fees, without electing to apply the safe harbor, must maintain robust documentation of that allocation. In such cases, taxpayers should consult with their tax advisors regarding appropriate documentation, particularly in light of the LB&I’s announcement of this new active compliance campaign.


12011-18 IRB 746. 

2Reg. section 1.263(a)-(5)(a).

3Reg. section 1.263(a)-(5)(f).

4Id. Additionally, in 2018, the IRS ruled that an allocation letter from an investment banker which provided approximated percentages of time spent on facilitative versus non-facilitative activities was insufficient to meet the documentation requirement under Reg. Section 1.263(a)-5(f). CCA 201830011 (July 27, 2018). 

5Reg. section 1.263(a)-(5)(f)(1)-(4). 

6See e.g., TAM 201002036 (Jan. 15, 2010); PLR 200953014 (Dec. 31, 2009); PLR 200830009 (July 25, 2008). 

7Id. A comment letter submitted by the American Institute of Certified Public Accountants about the documentation requirement under Reg. section 1.263(a)-5(f) provides a similar view on appropriate documentation. AICPA comment letter, Comments on Documentation Requirement Under Reg. Section 1.263(a)-5(f), (Jan. 10, 2007). 

8Under Reg. section 1.263(a)-5(e)(3), covered transactions include, among others, a taxable acquisition of assets that constitute a trade or business and certain reorganizations described under section 368(a)(1). 

9For further information as it relates to NOL carrybacks under the CARES Act, see our prior article, CARES Act delivers five-year NOL carryback to aid corporations