If your business has been through a merger, you may have experienced a termination fee. Such fees, sometimes referred to as “break fees,” are usually charged by the target business as security that the buyer is serious and as compensation for lost time. If you’re part of a failed merger and have to pay this kind of fee, the fee is tax deductible. However recent IRS guidance points out that your business can’t generally use this deduction from ordinary income.
In a merger the buyer is acquiring a target’s assets by giving them either cash or shares of the new company. The IRS views this as an investing transaction, a related termination fee should therefore be characterized as a capital loss. Capital losses generally can only be deducted from capital gains. There are exceptions for individual tax payers who can deduct excess capital loss up to $3,000 per year against their ordinary income. However corporate tax payers do not get the $3,000 reprieve and are strictly limited to deducting capital losses against capital gains. Individual tax payers can carry forward unused capital losses indefinitely, while corporate taxpayers can carry losses back three years and then forward only five years. Thus a corporate taxpayer can run out of opportunities to deduct capital losses if there aren’t enough gains in the carry back or carry forward periods. Being limited on the deduction, may for practical purposes, increase the after tax cost of a merger termination fee.