Due Diligence Costs: Expense or Capitalize, and If the Deal Dies

Do I expense due diligence costs or add them to the purchase price?

For federal tax, fees paid to buy a business are added to what the buyer paid for it (its tax cost, or basis), not deducted in the year paid. Legal, accounting, broker, banker and valuation fees can all be covered: any amount paid in the course of investigating or pursuing the purchase, judged on all the facts, and work that sets the value or price counts (26 CFR 1.263(a)-5(a) and (b)). The rule applies to any buyer, including a sole proprietor or a single-member LLC; the examples use a corporation.

In the most common deals (buying a business's assets, or buying an ownership interest that leaves buyer and target related), a date test carves out early investigation: work before the earlier of a signed letter of intent and approval of the terms, called the trigger date here, is not capitalized under this rule. The table shows the result in those deals, called covered deals below.

These facts make a case harder than the table suggests:

• One invoice mixes work from before and after the trigger date.
• A banker is paid only if the deal closes.
• The deal died, or another deal replaced it.
• The buyer is a new entity, or buyer and target are related.
• The books expensed the costs and the return must capitalize them.
• A filed return already deducted deal costs.

What to gather:

• Engagement letters, which show what each adviser was hired to do.
• Invoices itemized by date and task, not one lump sum.
• The signed letter of intent or exclusivity agreement, with its date.
• Board minutes or a written consent approving the deal's terms.
• Any success-fee agreement.
• The closing statement, or the letter or notice that ended the deal.
• Prior-year returns and the ledger, if any deal costs were expensed.

Which date turns due diligence costs from expensed to capitalized?

In a covered deal, diligence costs are capitalized only for work done on or after the earlier of two dates, called the trigger date here. The first is when representatives of both sides sign a letter of intent, exclusivity agreement or similar written communication; a confidentiality agreement does not count. The second is when the buyer's board, or the equivalent governing officials of a buyer that is not a corporation, approves the material terms tentatively agreed. If the deal needs no such approval, the second date is when both sides sign a binding written contract (26 CFR 1.263(a)-5(e)(1)).

A covered deal is a taxable purchase of assets that make up a business, a taxable purchase of an ownership interest after which buyer and target are related under section 267(b) or 707(b), or certain reorganizations (26 CFR 1.263(a)-5(e)(3)). Related mostly means more than half owned, directly or indirectly, but sections 267(b) and 707(b) also reach other links, such as family members and a common-control group (section 267; section 707).

An ownership-interest purchase that leaves buyer and target unrelated has no date shortcut. Its costs are capitalized when paid in the course of investigating or pursuing the purchase, judged on all the facts (26 CFR 1.263(a)-4(e)(1)).

Work before the trigger date is not capitalized under this rule, but that does not by itself make it deductible. The IRS has described the cost of investigating an expansion of an existing business as generally deductible under section 162 when the other requirements are met, and whether a purchase is an expansion or a new business depends on the facts (Rev. Rul. 99-23). Investigating a new business, or one in a different field from the buyer's own, is generally a start-up cost, deducted only once the business begins; see the last section.

An invoice that spans both periods has to be split by date. Ask each adviser for itemized invoices or time records while the people who did the work remember it.

Which deal costs are capitalized whatever the date?

In a covered deal, six kinds of cost are capitalized even when the work came before the trigger date (26 CFR 1.263(a)-5(e)(2)):

• An appraisal, formal written evaluation or fairness opinion about the deal.
• Structuring the deal, including negotiating its structure and getting tax advice on it.
• Preparing and reviewing the documents that carry out the deal, such as the purchase agreement.
• Getting regulatory approval, including the filings.
• Getting shareholder approval, such as proxy and solicitation costs.
• Conveying property between the parties, such as transfer taxes and title registration costs.

A label does not settle it. A bill called "due diligence" that is really valuation or structuring work belongs on this list. In a ruling on start-up costs, the IRS said the label the parties use, and the timing, do not by themselves decide what a cost is (Rev. Rul. 99-23).

Do small amounts, employee pay and overhead count as deal costs?

Not unless the buyer elects to capitalize them. The regulation treats employee compensation, overhead and de minimis costs as not facilitating the deal (26 CFR 1.263(a)-5(d)).

• Employee pay. Salary, bonus and commission paid to the buyer's own employees, and a partner's guaranteed payment.
• De minimis costs. All other costs of pursuing the deal, if together they do not exceed $5,000 (or a greater amount set in published guidance). If the total is over the limit, even by a dollar, none of the amounts is de minimis. A commission never is.

A buyer may elect, deal by deal, to capitalize employee pay, overhead or de minimis costs. It does so by treating them as deal costs on its timely filed original return for the year paid, extensions included. A partnership or S corporation makes the election itself, not its owners, and revoking it for a year takes IRS consent. For a stake purchase the same rules sit in 26 CFR 1.263(a)-4(e)(4).

What happens to a banker's success fee?

A fee payable only if the deal closes is treated as a deal cost, unless the buyer's records show that part of it paid for work that did not facilitate the deal (26 CFR 1.263(a)-5(f)). Two routes exist.

The presumption applies to deals under the acquisition regulation, and the safe harbor only to covered deals. An ownership-interest purchase that leaves buyer and target unrelated falls under the intangibles regulation, which has no success-fee rule, so its fee is judged on all the facts (26 CFR 1.263(a)-4(e)(1)). A bare split between facilitative and other work is not enough; the regulation asks for supporting records such as time records or itemized invoices. The election is irrevocable, covers every success-based fee in that deal, and is not a change in accounting method (Rev. Proc. 2011-29, section 4).

If the deal closes, do capitalized costs go to asset basis or stock basis?

Capitalized deal costs go to the basis of what the buyer acquired, in a taxable deal: the assets in an asset purchase, the shares in a stock purchase (26 CFR 1.263(a)-5(g)(2)(i)). For a tax-free reorganization the regulation leaves the rule reserved (paragraph (g)(1)), so that case needs a professional's read of the facts.

• Asset purchase. The costs raise the cost of the assets. That cost is split among them by class, with goodwill and going concern value last, and the buyer and seller each report the split on Form 8594 when the assets make up a business to which goodwill could attach (Form 8594 instructions). Basis is what the buyer uses for depreciation and for gain or loss on a later sale (Publication 551). Cost allocated to goodwill and similar intangibles is generally amortized over 15 years (section 197); cost allocated to depreciable assets follows their depreciation.
• Stock purchase. The costs raise the basis of the shares, which is used to figure gain or loss when the shares are sold (Publication 551).

A stock purchase that is treated as an asset purchase for tax follows the asset rule. Buying a business explains when that happens.

If the deal falls through, can I deduct the costs I capitalized?

Generally yes, as a loss in the year the buyer abandons the deal, if the facts support it. The regulation's examples say a buyer may recover the capitalized costs of an abandoned deal under section 165, in the year it abandons the deal (Examples 3 and 4). Section 165 allows a deduction for a loss sustained during the year (section 165(a)). The loss must come from a closed and completed transaction fixed by identifiable events in that year, and it cannot exceed the basis, here the capitalized costs (26 CFR 1.165-1).

So the abandonment date, and proof of it, generally decide the year. Keep the document that ends the deal: a termination letter, a board minute or written notice to the other side. A deal that just goes quiet is harder to date.

Reimbursement can change both the amount and the year. Reduce the loss by any compensation received. If the contract gives a claim to recover the costs and there is a reasonable prospect of recovery, the part that may be reimbursed is not sustained until it is reasonably certain whether it will be paid (26 CFR 1.165-1(c)(4) and (d)(2)). Keep the reimbursement terms, and any settlement or release, with the termination records.

Four things can change the result:

• Another deal replaced it. If the buyer's two deals could not both happen, the dropped deal's capitalized costs (inherently facilitative work, and diligence from the trigger date on) are added to the costs of the deal that closes, not taken as a loss; earlier diligence stays outside the rule (26 CFR 1.263(a)-5(c)(8), Example 13, which shows it from the target's side).
• A break-up or termination fee. If the deals were mutually exclusive, a fee paid to end the first is capitalized with the deal that closes (Example 13). If the buyer could have done both, the regulation does not require capitalizing it (Example 14); whether and when it is deductible turns on other rules and the facts. How a buyer treats money it receives when a deal dies is not answered by the regulation and depends on the contract.
• Several targets were studied. If the buyer could have bought any or all of them, valuation work on a target it drops is capitalized and can be recovered in the year it abandons that target (Example 4).
• The loss's character is not settled by the examples. They say "may recover"; they do not say whether the loss is ordinary or capital, and capital losses are allowed only as sections 1211 and 1212 permit (section 165(f)). That turns on the facts. Section 1234A can make the loss capital when the right or obligation that ended concerned property that would be a capital asset for the buyer, such as shares. A partnership's loss passes to its partners.

What is the accounting treatment of due diligence costs, and how does it differ from the return?

A buyer whose books follow U.S. GAAP expenses these costs in a business combination, while its tax return capitalizes them. In that case the buyer's finder's fees, advisory, legal, accounting, valuation and other professional fees, and general administrative costs are expensed as incurred. Costs to issue debt or equity securities are the exception and follow other GAAP (FASB Statement No. 141(R), paragraph 59, the 2007 text, now carried in FASB Topic 805 as the Federal Reserve's reporting instructions describe it). The standard does not apply to buying assets that are not a business (paragraph 2); for those, the same Statement has the buyer record the assets at cost, which generally includes transaction costs (paragraphs D4 and D5), so books and return both capitalize. Whether a purchase is a business can differ between GAAP and tax. Books kept on the tax basis follow the return instead.

The gap is a book-tax difference. To keep it straight:

1. Keep one schedule per deal, with every invoice coded by work date and type: before the trigger date, after it, always capitalized, success fee, financing, integration.
2. Record each cost on the books' own basis. GAAP books expense the deal costs of a business combination as incurred, and the schedule tracks what the return must capitalize. Tax-basis books carry only the costs that must be capitalized in a balance-sheet account such as "Deal costs in progress", carried forward at each year end. At closing, move it into the cost of the assets bought or the investment in the shares; if the deal is abandoned, assess the loss in the year of abandonment. Track financing, integration and start-up costs separately.
3. Each year, reconcile books to return. Add back only book expenses the return does not yet deduct, and subtract tax deductions missing from book income, such as depreciation or amortization of the capitalized cost and an abandonment loss. Use Schedule M-1 of Form 1120 or Form 1065, or Schedule M-3 where it is required instead (Form 1120 instructions; Form 1065 instructions).

For a buyer on the accrual method, a cost is paid for this rule when the liability is incurred, never before the year it is incurred (26 CFR 1.263(a)-5(h)).

If a return already filed deducted costs that this rule capitalizes, the fix may be an amended return or a change in accounting method. The IRS treats the way a success-based fee is split as a method of accounting (Rev. Proc. 2011-29, section 2.04), and in most instances a method is not established for an item without consistent treatment (26 CFR 1.446-1(e)(2)(ii)(a)). Which applies depends on the facts.

How are the costs of raising money treated?

Costs to borrow are capitalized under their own rule and are not deal costs, even when the loan pays for the purchase (26 CFR 1.263(a)-5(c)(1) and Example 2). Costs to issue stock must also be capitalized, but the regulation has no matching carve-out and leaves their treatment reserved, so whether stock issued to fund or pay for a purchase also counts as a deal cost depends on the facts (26 CFR 1.263(a)-5(a)(8) and (g)(3)). Debt issuance costs, when deductible, are deducted over the loan's term as if they lowered its issue price (26 CFR 1.446-5). For legal fees on an equity round, see recording a priced round.

The seller's own deal costs follow separate rules; see selling your business.

Who pays the due diligence fee?

Whoever signed the engagement letter owes the invoice unless the purchase agreement moves it to the other side; tax law does not set who pays. The regulation treats an amount paid on behalf of a party as that party's payment (26 CFR 1.263(a)-5(k)), so an invoice the buyer pays for the seller or the target is treated, for this rule, as the other side's cost. It does not follow that the buyer may deduct it: the payment can instead be part of what the buyer paid for the business, as with seller-owed amounts a buyer agrees to pay in a property purchase (Publication 551), and the agreement and the facts decide. Write down who owes each invoice before it is paid.

What if I have no business yet?

A buyer with no active business, or one buying a business in a different field from its own, generally treats the cost of deciding whether and which business to buy as start-up costs, deducted or spread out only once the business begins; an acquired business begins when the buyer acquires it (section 195). The amounts and the election are in startup costs before launch.

Costs of the attempt to buy a specific business are different: valuation, diligence after the decision to buy, and drafting the agreement are capital acquisition costs, not start-up costs (Rev. Rul. 99-23). For a covered deal, the later regulation sets the line. Costs it requires to be capitalized cannot be start-up costs; costs it does not require to be capitalized, such as ordinary diligence before the trigger date, may be if section 195's other conditions are met (T.D. 9107 preamble). The 1999 ruling predates the regulation, and deciding to pursue a particular target does not move the trigger date.

If no business is ever acquired, section 195 gives no deduction by its terms, because the deduction arrives with the business. Capitalized costs of an abandoned specific deal follow the loss rules above, on the same facts. Whether a failed search produces any deduction depends on the facts; for search funds, see the search fund guide.

Example

These examples are illustrative; all amounts are in US dollars.

Asset purchase with a mixed diligence bill

A corporation buys a business's assets in a taxable deal. Assume March 1 is the earliest trigger date: no exclusivity agreement or similar written communication came before it, and no board approved the terms before it. Its advisers bill $50,000: $25,000 of general investigation before the letter of intent is signed on March 1, $15,000 of legal diligence after it, and $10,000 to draft the purchase agreement. The $15,000 is capitalized because the work came after the trigger date, and the $10,000 whatever its date. That makes $25,000 added to the purchase price, split across the assets bought and reported on Form 8594. The early investigation is not capitalized under the regulation; the buyer then asks whether it is an ordinary expense of an existing business or a start-up cost. A single $50,000 invoice with no split by date would leave the buyer unable to show which is which.

A banker's success fee

A banker is paid $200,000 when a $5,000,000 covered deal closes. With the Rev. Proc. 2011-29 election, the buyer treats 70% ($140,000) as not facilitating the deal and capitalizes 30% ($60,000), and attaches the statement to the original return for the year the fee is paid or incurred. Without the election, the whole $200,000 is capitalized unless the banker's records, finished by the return's due date, support a non-facilitative part.

A deal that dies

A buyer whose books follow GAAP plans a business combination, so its books expense the deal costs as incurred. It pays $40,000 in Year 1 and $20,000 in Year 2 for work that facilitates the deal, and abandons the deal in November of Year 2.

The books show $60,000 of expense across the two years. The return shows none in Year 1 and a $60,000 loss in Year 2, if the loss is allowed and ordinary. Had the buyer ended the deal in January of Year 3 instead, the loss would fall in Year 3, if allowed, so the date on the termination letter matters.

Different for you?

• One invoice mixes work from before and after the letter of intent, a banker or broker is paid only on closing, or the buyer or the target is a new or related entity: the split, the records and the date test decide what is capitalized, and the documentation has a deadline. Get corporate tax help before the return is filed.
• A deal died and large fees sit on the books, or a break-up fee was paid or received: the year of the loss turns on when the deal was abandoned, its character depends on the facts, and the books and return must be lined up. Get corporate tax help before deciding whether and when to take the loss.
• A filed return already deducted deal costs, or the books expensed them and the return must capitalize them: the way to correct it depends on how the treatment repeated, and the ledger needs a deal account and a schedule that carries to the return. See bookkeeping help for the books, and corporate tax help before amending.
• You are choosing between buying assets and buying the company: see buying a business.
• You are checking the seller's numbers: see checking a seller's books before you buy.
• A buyer or investor wants your records: see the records investors ask for in due diligence.
• You want to know what a quality of earnings review costs: see quality of earnings report cost.
• You have no business yet, or run a search fund: see startup costs before launch and the search fund guide.
• You are a Canadian buying a US business, or a US buyer purchasing a Canadian one: see buying a US business as a Canadian and an American buying a Canadian business.
• You are the seller: see selling your business.