Merger and acquisition (M&A) agreements commonly contain a provision under which one party is obligated to pay a breakup fee to the other party if it backs out of the deal. The amount of this fee is often expressed in terms of a percentage of the sales price, normally in the 1%-3% range. For big transactions, the breakup fee can run in the millions of dollars and, thus, the tax treatment of breakup fees can be a significant issue for the parties to an M&A agreement. In recently issued guidance, the IRS has changed its longstanding position on the tax treatment of breakup fees.
In the past, the IRS generally treated the character of breakup fees as ordinary in nature. For example, in TAM 200438038 and PLR 200823012 the IRS used similar reasoning in advising that the party that receives a breakup fee must treat the fee as ordinary income. The primary purpose of a breakup fee, according to the IRS, is to provide the recipient with damages for the benefits it expected to receive under the agreement. The IRS advised that such “expectation damages” are the equivalent of lost profits and that there is ample authority for the position that a recovery for lost profits is treated as ordinary income. Consistent with this IRS guidance treating breakup fees as ordinary in nature for taxpayers receiving such fees, taxpayers paying breakup fees have normally taken an ordinary deduction for the amount of breakup fees paid.
During 2016, the IRS changed course in its treatment of breakup fees with two new pieces of guidance, FAA 20163701F and CCA 201642035. In FAA 20163701F, the IRS advised that a taxpayer paying a breakup fee must treat the amount of the fee paid as a capital loss. The IRS based this conclusion on its determination that §1234A applies to breakup fees. Under §1234A, any gain or loss attributable to the termination of a right or obligation with respect to property that would be a capital asset in the hands of the taxpayer is treated as a capital gain or loss. The IRS essentially determined that (i) a taxpayer that is a party to an M&A agreement has rights and obligations with respect to property – the property being the stock that would be acquired under the agreement, (ii) the stock that would be acquired under the agreement is property that would be a capital asset in the hands of the taxpayer, (iii) the breakup fee is paid as a result of the termination of the right or obligation to acquire the stock, and (iv) the gain or loss the taxpayer recognizes with respect to the breakup fee is gain or loss attributable to the termination of the taxpayer’s right or obligation to acquire the stock. Thus, according to the IRS, the gain or loss a taxpayer recognizes with respect to a breakup fee must be treated as a capital gain or loss.
The IRS position in FAA 20163701F is contrary to its earlier position in PLR 200823012, where it stated without explanation that §1234A does not apply to breakup fees. With the IRS now taking the position that §1234A applies to breakup fees, it has made clear its position that taxpayers paying breakup fees may no longer treat the fees as ordinary deductions, but must instead treat them as capital losses.
CCA 201642035 addresses the tax treatment of breakup fees from a different perspective – the perspective of taxpayers receiving breakup fees. In its analysis of this issue, the IRS took the same position it took in FAA 20163701F – that §1234A applies to breakup fees. Thus, according to the IRS, taxpayers receiving breakup fees must treat the fees received as capital gains. This position is contrary to the guidance the IRS previously provided in TAM 200438038 and PLR 200823012, where it advised that taxpayers receiving breakup fees must treat the fees received as ordinary income.
The IRS about-face on breakup fees and the application of §1234A has the most significance for taxpayers paying breakup fees. It effectively eliminates the ability of some taxpayers to deduct breakup fees. As discussed above, taxpayers paying breakup fees must now treat the fees as capital losses instead of ordinary deductions. Because capital losses are deductible only to the extent of capital gains, taxpayers with little or no capital gains will not be able to deduct large breakup fees.
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