Proposed IRS Regulations Likely to Eliminate Flexibility in Allocation of M&A Costs
January 08, 2015
PitchBook Dealmakers Column
Recent statements from the IRS could spell bad news for common private equity treatment of M&A costs. In most transactions, a target corporation will incur significant transaction costs. Often the largest of those are success-based fees paid to an investment banker or PE management company and compensation deductions (e.g., option cancellation payments and transaction bonuses). In general, the majority of these costs are deductible to the target, providing a significant tax shield that is either carried back to obtain a refund of prior taxes or carried forward to offset future income.
If the target is acquired by another corporation and joins in a consolidated tax filing, the parties often agree to apply the “next-day rule” to those transaction deductions, thereby pushing those deductions to the post-transaction tax period, which often is more beneficial from a federal income tax perspective. The next-day rule is a rule in the consolidated tax return regulations that allows the parties to agree to allocate costs to the day after the transaction if the parties agree to report the item consistently and the costs are reasonably allocated to the portion of the day after the transaction. Unfortunately, the IRS appears to oppose this application of the next-day rule and most recently has stated that it intends to issue regulations that will eliminate much of the electivity taxpayers have historically utilized in applying the next-day rule.
While it’s unlikely that any regulations issued would be retroactive, PE firms should fully understand the IRS view on the application of the next-day rule to success-based fees and compensation deductions for future transactions and should consult their tax advisors when determining the treatment of these costs.