Management agreement termination fee need not be capitalized

Plain-English summary

A corporation paid its manager a termination fee after ending a management services agreement in connection with an initial public offering. The agreement did not give either party an exclusive right to provide or receive the services, so the payment did not create a termination-related intangible under Treasury Regulation section 1.263(a)-4(d)(7). The fee represented payment for prior services and additional compensation, not services performed to carry out the public offering. Payment was not a condition of the offering, and the manager did not perform the work ordinarily associated with a stock offering. The IRS ruled that the fee was not required to be capitalized under either Treasury Regulation section 1.263(a)-4(d)(7) or section 1.263(a)-5.

Ruling snapshot

• Question: Must the corporation capitalize the management agreement termination fee as the creation of an intangible or as a cost facilitating its public offering?
• Outcome: Approved.
• Key authorities: IRC § 263(a); Treas. Reg. §§ 1.263(a)-4(d)(7) and 1.263(a)-5.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201518012 Third Party Communication: None
Release Date: 5/1/2015 Date of Communication: Not Applicable
Index Number: 263.00-00
Person To Contact:
------------------------- --------------------------, ID No. ------------
----------------------------- Telephone Number:
------------------------------------------------ --------------------
-------------------------------------------------- Refer Reply To:
---------------------------------------- CC:ITA:B01
PLR-134589-14
Date:
January 26, 2015

Legend

Taxpayer = -------------------------
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------------------

LLC 1 = ------------------------
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LLC 2 = -------------------------
---------------------
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Shareholder A = -----------------

Shareholder A
Subsidiary = ----------------------------------------

Shareholder B = ------------------------------

Manager = -------------------------

Predecessor = -------------------------------
-------------------------------------
------------------------

Business A = --------------------------------------------------------

State A = ---------------------
PLR-134589-14 2

State B = ---------------

State C = --------------

Bankruptcy Code = ----------------------------------------------

Bankruptcy Court = ---------------------------------------------------------

Date 1 = ------------------

Date 2 = ------

Date 3 = ------------

Date 4 = ------------

Date 5 = ----------------

Date 6 = -----------

Date 7 = -----------

Date 8 = --------------

Date 9 = --------------

Date 10 = ------------

Date 11 = ---------------

Date 12 = ----------------

Date 13 = ----------------

Date 14 = -------------

a = -----

b = --------------

c = ------------

d = -----------
PLR-134589-14 3

e = -----------

f = ---------

g = --------

h = --------

i = -----

j = ----------

Dear ------------:

This ruling is in response to your letter dated Date 1 and subsequent correspondence
requesting a letter ruling on whether Taxpayer must capitalize a termination payment
under § 1.263(a)-4(d)(7) and § 1.263(a)-5 of the Income Tax Regulations.

FACTS

Prior to the Date 2 Acquisition (defined below), Shareholder A owned all of the stock of
Shareholder A Subsidiary and Shareholder A Subsidiary owned all of the outstanding
interests in LLC 2, a State C limited liability company treated as a corporation for
Federal income tax purposes. At such time, LLC 2 wholly owned LLC 1 and the other
subsidiaries conducting Business A.

On Date 3, Shareholder A and Shareholder B entered into an agreement pursuant to
which Shareholder B would acquire a majority interest in the LLC 2 Group (also known
as the “Taxpayer Group”). Effective the same date, Shareholder B caused its wholly-
owned subsidiary, Predecessor, a newly-formed State A limited liability company, to
purchase from Shareholder A Subsidiary all of the outstanding voting interests in LLC 2
(the “Date 2 Acquisition”) in exchange for a and a b interest in Predecessor.

On Date 4, LLC 2 and its subsidiaries (the “Debtors”) filed voluntary petitions with the
Bankruptcy Court and entered into a pre-packaged reorganization plan (the
“Reorganization”) under the Bankruptcy Code.

Subsequently, on Date 5, Predecessor redeemed Shareholder A’s indirect b ownership
interest in Predecessor such that Shareholder B became the sole member of
Predecessor. Later, on Date 6, Predecessor converted to a corporation pursuant to the
laws of State A and changed its name to Taxpayer.
PLR-134589-14 4

Management Services

In connection with the Date 2 Acquisition and the Reorganization, Taxpayer and an
affiliate of Shareholder B, Manager, entered into the Management Services Agreement
pursuant to which Manager agreed to provide certain services (the “Monitoring
Services”) on a regular basis to help Taxpayer in the governance and oversight of
Business A. The Monitoring Services included, but were not necessarily limited to, the
following: (i) participation of Manager officers and employees as members of the
Taxpayer board of directors (the “Taxpayer Board”) and other governing bodies; (ii)
participation of Manager officers and employees in monthly meetings; (iii) other
assistance to Taxpayer in connection with the development of general corporate
strategy and corporate governance functions; (iv) finance and tax oversight; (v)
oversight and strategic support of Taxpayer’s internal and external legal services; (vi)
periodic high-level managerial and operational oversight; (vii) mergers and acquisitions
advice and support; (viii) facilities advice and support; (ix) sales, marketing, and
customer relations advice and support; and (x) strategic human resources support.
Manager did not provide any services on behalf of the Debtors with regard to the
Reorganization or any other part of the Debtors’ bankruptcy proceedings outside of its
associates’ membership on the Taxpayer Board.
In consideration for Manager’s provision of the Monitoring Services, Taxpayer agreed to
pay a monitoring fee (the “Monitoring Fee”) equal to c per month (or approximately d
per year). The Management Services Agreement executed by the parties on Date 7
was scheduled to terminate on Date 8; however, according to its terms, would renew
annually for an additional e term unless the parties agreed not to renew before the
expiration of the then-current term. In addition to the Monitoring Fee and any fees paid
for certain occasional services, Taxpayer agreed to reimburse Manager for all actual
and reasonable out-of-pocket expenses incurred in connection with the services
provided within f following the presentation of an invoice setting forth such expenses.
Following the expiration of the initial term ending on Date 8, the Management Services
Agreement was renewed for g additional e terms, the last of which expired on Date 9.
Prior to each renewal and throughout the relevant annual e term, the Taxpayer Group,
including Taxpayer management and its advisors or employees, would review invoices
and have informal discussions regarding the Monitoring Services provided. Further,
during the time that the Management Services Agreement was effective, each of
Taxpayer and Manager (as well as its affiliates, such as Shareholder B) was free to
enter into other contracts with different service providers or companies such that the
Management Services Agreement did not provide either party with an exclusive right.
Also in connection with the Date 2 Acquisition, Taxpayer and Shareholder A Subsidiary
entered into a new management services agreement (the “Shareholder A Services
Agreement”), pursuant to which Shareholder A Subsidiary would continue to provide
certain management services until Date 8.
PLR-134589-14 5

Termination of the Management Services Agreement

Based on Taxpayer’s financial growth and rejuvenated business model, both Taxpayer
and Manager agreed to terminate the Management Services Agreement. On Date 10,
Manager and Taxpayer entered into an agreement to terminate the Management
Services Agreement (the “Termination Agreement”). The Termination Agreement
provided that upon the consummation of an underwritten (firm commitment) public
offering that results in the listing or quotation of the stock of Taxpayer on one or more
nationally recognized stock exchange or quotation systems, Taxpayer will pay h (the
“Termination Fee”) to Manager in consideration for all amounts owing under the
Management Services Agreement. However, Manager’s receipt of a payment
equivalent to the Termination Fee was not dependent upon a successful public offering.
In other words, even if the Termination Agreement were to have become void as of
Date 11, the parties were free to continue their relationship under the Management
Services Agreement or renegotiate a termination agreement and terminate the
Management Services Agreement.
The parties arrived at the h figure by reviewing precedential fees from similar
transactions, deriving at a i average and then multiplying that average by a j
management fee which represents an adjusted annual management fee. The adjusted
annual management fee of j represents the Monitoring Fee increased by the amount of
additional services and time spent by Manager starting in Date 12 when the
Shareholder A Services Agreement terminated.
This h amount represents in part what Taxpayer believed would have been reasonable
compensation for the services provided by Manager to a financially sound corporation
because Manager had agreed to receive less than the amounts it would have ordinarily
charged over the course of its services to the Taxpayer Group due to the fact that the
Taxpayer Group had just emerged from bankruptcy. In addition, the h amount also
represents additional compensation to Manager for having successfully turned Business
A into a profitable business. No part of the Termination Fee represented a payment to
terminate an exclusive right for the Taxpayer Group to use, or for Manager to provide,
the Monitoring Services.

Public Offering

On Date 13, Taxpayer completed an initial public offering (the “IPO”). The Taxpayer
Group used a portion of the net proceeds from the IPO to pay the Termination Fee.
However, even if the IPO had not gone forward, Taxpayer had the financial wherewithal
to pay a termination fee to Manager. In determining whether or not to undertake the
IPO, none of the investment bankers, Taxpayer, or Manager required that Taxpayer pay
the Termination Fee as a condition to going forward with the offering (i.e., Taxpayer’s
payment of the Termination Fee was not a prerequisite to the occurrence of the IPO).
PLR-134589-14 6

Manager did not assist with any of the activities generally associated with undertaking a
stock offering – for example, pricing, valuation, preparing roadshow decks and banker
presentations, or creating assumptions and projections – or in complying with any of the
necessary filing requirements attendant to listing a company’s shares of stock on an
exchange. Manager did not have expertise in companies engaging in initial public
offerings.

REPRESENTATIONS

  (a)   The Termination Fee did not exceed the value of the services provided by
        Manager to the Taxpayer Group.

  (b)   Taxpayer treated the Termination Fee as an expense for financial
        accounting purposes.

  (c)   Taxpayer treated the Monitoring Fee as an expense for financial accounting
        purposes and for Federal income tax purposes.

  (d)   Taxpayer was not prohibited from entering into a contract or other
        arrangement with any third-party services provider (other than Manager or
        its affiliates) during the time the Management Services Agreement was in
        effect.

RULINGS REQUESTED

   1.   The Termination Fee is not required to be capitalized under
        § 1.263(a)-4(d)(7).

   2.   The Termination Fee is not required to be capitalized under
        § 1.263(a)-5.

LAW AND ANALYSIS

Section 263(a) of the Internal Revenue Code provides that no deduction shall be
allowed for any amount paid out for new buildings or for permanent improvements or
betterments made to increase the value of any property or estate or any amount
expended in restoring property or in making good the exhaustion thereof for which an
allowance is or has been made.

Section 1.263(a)-4 provides rules for applying § 263 to amounts paid to acquire or
create intangibles. Section 1.263(a)-4(b)(1) provides that except as otherwise provided
in § 1.263(a)-4, a taxpayer must capitalize an amount paid to: (i) acquire an intangible
(see § 1.263(a)-4(c)); (ii) create an intangible described in § 1.263(a)-4(d); (iii) create or
enhance a separate and distinct intangible asset within the meaning of § 1.263(a)-
4(b)(3); (iv) create or enhance a future benefit identified in the Federal Register or the
PLR-134589-14 7

Internal Revenue Bulletin as an intangible for which capitalization is required; and (v)
facilitate (as defined in § 1.263(a)-4(e)(1)) the acquisition or creation of an intangible.

Section 1.263(a)-4(d)(1) provides a general rule that a taxpayer must capitalize
amounts paid to create an intangible described in § 1.263(a)-4(d). Section 1.263(a)-
4(d)(7)(i) provides that a taxpayer must capitalize amounts paid to another party to
terminate certain agreements: (A) a lease of real or tangible personal property between
the taxpayer (as lessor) and that party (as lessee); (B) an agreement that grants that
party the exclusive right to acquire or use the taxpayer’s property or services or to
conduct the taxpayer’s business; or (C) an agreement that prohibits the taxpayer from
competing with that party or from acquiring property or services from a competitor of
that party.

In this case, Taxpayer terminated a Management Services Agreement under which
Manager agreed to provide Monitoring Services on a regular basis to assist Taxpayer
with the governance and oversight of Business A. Because the Management Services
Agreement did not provide either the Taxpayer Group or Manager with an exclusive
right to receive or provide the Monitoring Services, the Termination Fee did not create
new intangible assets under § 1.263(a)-4(d)(7)(i)(B).

Section 1.263(a)-5 provides rules for applying § 263 to amounts paid or incurred to
facilitate certain transactions, including: (i) an acquisition of assets that constitute a
trade or business (whether the taxpayer is the acquirer in the acquisition or the target of
the acquisition); (ii) an acquisition by the taxpayer of an ownership interest in a business
entity if, immediately after the acquisition, the taxpayer and the business entity are
related within the meaning of section 267(b) or 707(b); (iii) an acquisition of an
ownership interest in the taxpayer (other than an acquisition by the taxpayer of an
ownership interest in the taxpayer, whether by redemption or otherwise); (iv) a
restructuring, recapitalization, or reorganization of the capital structure of a business
entity (including reorganizations described in section 368 and distributions of stock by
the taxpayer as described in section 355); (v) a transfer described in section 351 or
section 721 (whether the taxpayer is the transferor or transferee); (vi) a formation or
organization of a disregarded entity; (vii) an acquisition of capital; (viii) a stock issuance;
(ix) a borrowing, and (x) writing an option (each of (i) through (x), a “Capital
Transaction”).

Under Reg. § 1.263(a)-5(b), an amount is paid to “facilitate” a Capital Transaction if the
amount is paid in the process of investigating or otherwise pursuing the transaction.
Whether an amount is paid in the process of investigating or otherwise pursuing the
transaction is determined based on all of the facts and circumstances. One of the facts
relevant to the determination, although not determinative, is whether the amount would
(or would not) have been paid but for the transaction.

Although Taxpayer’s obligation to pay the Termination Fee was in part dependent upon
whether or not a public offering occurred, the Termination Fee was not paid to facilitate
PLR-134589-14 8

the IPO. The Termination Fee represents payment for prior services and additional
compensation. Furthermore, payment of the Termination Fee was not a condition in
order to proceed with the IPO. While a secondary benefit of the Monitoring Services
may have been that the Taxpayer Group was in a better position by Date 14 to
undertake the IPO as a result of certain internal management strategies that had been
initiated by Manager, the Termination Fee was not remitted for services rendered in
connection with undertaking the IPO. As the court ruled in A.E. Staley Manufacturing
Co. v. Commissioner, fees associated with general activities not directly related to the
capital transaction must be treated differently. 119 F.3d 482 (7th Cir. 1997), rev’g 105
T.C. 166 (1995). Accordingly, the Termination Fee should not be required to be
capitalized under § 1.263(a)-5 as facilitative of the IPO.

CONCLUSION

Based solely on the facts and representations submitted and the relevant law and
analysis as set forth above, we conclude that:

1. The Termination Fee is not required to be capitalized under
   § 1.263(a)-4(d)(7).

2. The Termination Fee is not required to be capitalized under
   § 1.263(a)-5.

The ruling contained in this letter is based upon information and representations
submitted by Taxpayer and accompanied by a penalty of perjury statement executed by
an appropriate party. While this office has not verified any of the material submitted in
support of the request for rulings, it is subject to verification on examination.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides that
it may not be used or cited as precedent.

A copy of this ruling should be attached to Taxpayer’s federal tax returns for the tax
years affected. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.
PLR-134589-14 9

In accordance with the provisions of the power of attorney currently on file with this
office, a copy of this letter is being sent to your authorized representative.

                                  Sincerely,



                                  Lewis K Brickates
                                  Chief, Branch 1
                                  Office of Associate Chief Counsel
                                  (Income Tax & Accounting)