Deducting Success Fees in M&A Sell-Side Transactions: Guidance for Private Equity Portfolio Companies

In a typical sale of a private equity portfolio company, sell-side success fees payable to bankers and financial advisors represent one of the most significant transaction costs. Although most types of success fees are generally required for U.S. federal income tax purposes to be capitalized rather than deducted, the Internal Revenue Service (IRS) has for many years permitted taxpayers to deduct 70% of success fees as long as they meet various requirements. For this reason, purchase agreements commonly provide that the portfolio company will make the 70% safe harbor election, with the intent that the portfolio company will deduct 70% of the success fees.

Private Letter Rulings Said Portfolio Companies Could Not Deduct Success Fees

Contrary to the intended tax treatment described above, the IRS has recently asserted in at least two private letter rulings (PLR 202308010 and PLR 202324001) that success fees were more appropriately viewed for tax purposes as direct expenses of the portfolio company’s private equity sponsor rather than of the portfolio company itself. In both rulings, the portfolio companies missed the deadline to make the 70% safe harbor tax election and were applying to the IRS for relief to make a late election. But based largely on the IRS view that the expenses were more appropriately treated as incurred by the sponsors rather than the portfolio companies, the IRS denied the portfolio companies the right to make the late election and deduct 70% of the success fees.

The IRS appears to have based its view in part on the facts that the success fee reduced the sale proceeds payable to the sellers and the private equity sponsor was a controlling shareholder of the portfolio company.

The question of whether to treat a success fee as an expense of a portfolio company or of the selling stockholders involves a murky area of the law and it is unclear whether the IRS position in the private letter rulings is correct. It is also unclear to what extent the IRS position may represent its intention to more aggressively scrutinize and/or challenge the typical treatment of success fees in M&A transactions.

What Should Private Equity Portfolio Companies Consider Doing?

In light of the IRS position, private equity portfolio companies should take extra precautions to help maximize the ability to deduct sell-side success fees.

For example, portfolio companies should:

• Engage directly with bankers and advisors, specifying in engagement letters that the portfolio company – not its private equity sponsor – will pay advisory fees.
• Document the benefits to the portfolio company of engaging the bankers and advisors, for example, in a corporate board resolution.
• Directly negotiate the banker and advisor engagement letters and the terms of the portfolio company sale.
• Where feasible, pay success fees directly to the bankers and advisors rather than directing buyers to pay the fees as an offset to sale proceeds payable to the sellers.
• Perhaps most importantly – ensure timely filing of the 70% safe harbor election so as to avoid the need to seek late relief from the IRS.