United States: Tax Treatment of Reorganization Costs

Last Updated: January 22 2004
Article by Mark J. Silverman and Andrew J. Weinstein

Practising Law Institute Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations and Restructurings 2003

By Mark J. Silverman and Andrew J. Weinstein

Originally published June, 2003. To read this article in full, please go to the bottom of this page.

OVERVIEW

PART ONE - THE PRESENT LAW

I. COSTS FOR UNCONTESTED ACQUISITIONS
A. Costs Incurred by Target Corporations: National Starch and INDOPCO
B. Costs Incurred by Acquiring Corporations
C. Costs Incurred by Shareholders
D. Public Comments on INDOPCO

II. ABANDONED TRANSACTIONS

III. COSTS FOR CONTESTED ACQUISITIONS: HOSTILE TAKEOVER
A. Resisting Unwanted Acquirers
B. Redemptions of Stock

IV. COSTS INCURRED IN DIVISIVE REORGANIZATIONS
A. General Rule
B. Divestiture Required by Law
C. Future Benefits and the Application of INDOPCO
D. Summary

V. COSTS ATTRIBUTABLE TO PROXY FIGHTS

VI. EXAMPLES
A. Example 1
B. Example 2
C. Example 3

PART TWO - THE PROPOSED SECTION 263(a) REGULATIONS

I. BACKGROUND TO THE PROPOSED SECTION 263(a) REGULATIONS
A. Public Comments on INDOPCO
B. The Advanced Notice of Proposed Rulemaking (the "Advanced Notice")
C. The Proposed Section 263(a) Regulations (the "Proposed Regulations")

II. GENERAL DISCUSSION OF THE PROPOSED REGULATIONS - PROP. TREAS. REG. § 1.263(A)-4
A. Organization of the Proposed Regulations
B. Capitalization of Acquisition Costs - Prop. Treas. Reg Prop. Treas. Reg. § 1.263(a)-4(c)
C. Capitalization of Creation or Enhancement Costs - Prop. Treas. Reg. § 1.263(a)-4(d)

III. CAPITALIZATION OF TRANSACTION COSTS – PROP. TREAS. REG. § 1.263(a)-4(e)
A. General Rule for Transaction Costs
B. "Transaction" Defined
C. "Restructuring" and "Reorganization" Defined
D. "Facilitate" Defined
E. Treatment of Capitalized Transaction Costs – Prop. Treas. Reg. § 1.263(a)(-4(g)
F. Post Proposed Regulations Developments

IV. EXAMPLES
A. Example 1 - Costs that Facilitate an Issuance of Stock
B. Example 2 - Costs that Facilitate a Borrowing
C. Example 3 - Costs that Facilitate a Corporate Acquisition
D. Example 4 - Employee Compensation
E. Example 5 – Integration Costs
F. Example 6 – Compensation to Target’s Employees
G. Example 7 – Corporate Acquisition; Retainer
H. Example 8 – Corporate Acquisition; Antitrust Defense Costs
I. Example 9 – Corporate Acquisition; Hostile Defense Costs
J. Example 10 – Corporate Acquisition; Break Up Fees
K. Example 11 – Corporate Acquisition; Break Up Fees to White Knight

OVERVIEW1

I. Deduction vs. Capitalization

A. Section 162(a) of the Internal Revenue Code allows a deduction for all "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. . . ."2

B. Section 263, however, prohibits deductions for amounts "paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." Such items must be capitalized.

C. The line between what items may be deducted and what items must be capitalized has long been a question for debate in the tax field. See Thompson v. Commissioner, 9 B.T.A. 1342 (1928) (holding that expenditures for surveys, geological opinions, legal opinions, settlements of suits involving title to lands, and abstracts of title are not deductible as ordinary and necessary expenses, but are capital expenditures to be added to cost of property).

II. In INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), the Supreme Court held that expenditures incurred by a target corporation in the course of a friendly takeover are nondeductible capital expenditures.

III. Although INDOPCO clarified the law as it pertains to target corporations in successful friendly takeovers, issues still remain regarding the deductibility of expenses related to the investigation of an acquisition, expenses related to failed or abandoned transactions, expenses related to fighting hostile takeovers, expenses related to searching for white knights, expenses related to divisive reorganizations, expenses related to proxy fights, and costs of obtaining financing to redeem shares to prevent a hostile takeover, among others. This outline addresses those issues.

IV. This outline also addresses recently issued proposed regulations under section 263(a) (the "Proposed Regulations"), Reg. 125638-1 (December 19, 2002), which, among other things, are intended to clarify and simplify many of these issues, and which, when finalized, should diminish the applicability of much of the case law and IRS authorities discussed in this outline. See generally Prop. Treas. Reg. § 1.263(a)-4.

A. The Proposed Regulations provide bright-line rules that govern taxpayers’ treatment of three different types of costs, including:

1. The direct costs of acquiring, creating, or enhancing intangible assets;

2. The indirect costs of acquiring, creating, or enhancing intangible assets; and

3. The transaction costs associated with certain restructurings, reorganizations, and transactions involving the acquisition of capital.

B. This outline primarily concerns the third-type of cost -- transaction costs incurred with respect to reorganizations, restructurings, and transactions involving the acquisition of capital. However, for the sake of clarity and completeness, this outline also will briefly discuss the Proposed Regulations that govern the direct and indirect costs of acquiring, creating, or enhancing intangible assets (i.e., the first and second type of cost).

V. Accordingly, PART ONE of this outline discusses the present law (i.e., statutes, case law, and relevant IRS authorities) applicable to the determination of the treatment of reorganization costs. PART TWO of this outline discusses the Proposed Regulations as they relate to this determination.

PART ONE -- THE PRESENT LAW

I. COSTS FOR UNCONTESTED ACQUISITIONS

A. Costs Incurred by Target Corporations: National Starch and INDOPCO

1. Early Revenue Rulings

a. In Rev. Rul. 67-125, 1967-1 C.B. 31, the Internal Revenue Service ("Service") held that legal fees for advice as to the tax significance of a potential reorganization must be capitalized.

(i) The Service noted first that legal fees incurred for services performed in drafting a merger agreement must clearly be capitalized as incident to a reorganization, since the merger changes the capital structure of the corporation. Rev. Rul. 67-125, supra.

(ii) The Service went on to explain that legal fees for advice as to the tax ramifications of such reorganization are "just as necessary in effecting a reorganization as those for the actual drafting of the reorganization agreement." Id.

b. In Rev. Rul. 73-580, 1973-2 C.B. 86, the Service held that compensation paid for services performed by employees relating to reorganizations should be treated the same as fees paid for similar services performed by outsiders. Thus, under the analysis set forth in Rev. Rul. 67-125, supra, the portion of compensation paid to employees in connection with services relating to a reorganization must be capitalized.

2. National Starch

a. In National Starch and Chemical Corp. v. Commissioner, 918 F.2d 426 (3rd Cir. 1990), aff'g 93 T.C. 67 (1989), aff'd INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), the Third Circuit, in affirming a Tax Court decision, held that a corporation must capitalize consulting fees, legal fees and other expenses incurred in deciding whether to accept a friendly takeover bid.

(i) Unilever, the acquirer, was a United States company that was owned by a foreign company. Wanting to increase its United States revenues relative to its overall revenues, the foreign company directed Unilever to approach National Starch, one of Unilever's suppliers, to find out if National Starch would be interested in being the target of a friendly takeover. Unilever made it clear that they were only interested in a friendly takeover.

(ii) To accommodate the principal shareholders of National Starch, the transaction was consummated in two steps.

(a) In step one, shareholders of National Starch were given the opportunity to exchange each share of National Starch common stock for one share of nonvoting preferred stock of a newly formed subsidiary of Unilever. This transaction was intended to be tax free under section 351.3

(b) In step two, a transitory subsidiary of the Unilever subsidiary was merged into National Starch, and any National Starch common not exchanged under step one was converted into cash (a "reverse subsidiary cash merger").

(iii) National Starch hired independent investment bankers and attorneys to assist in valuations and to make sure the board of directors did not breach any fiduciary duties. In addition, National Starch incurred miscellaneous fees such as accounting, printing, proxy solicitation, and SEC fees in connection with the transaction. National Starch deducted these fees, but the Service argued that they should be capitalized.

b. National Starch argued that the Supreme Court's holding in Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971) established a rule that an expense is only a capital expense if a separate and distinct additional asset has been created or enhanced due to the expense.

(i) Since there was no separate asset created under the merger, National Starch argued, the fees should not be capitalized. Thus, the corporation should be allowed to deduct the expenses under section 162(a).

(ii) Furthermore, National Starch argued that Lincoln Savings specifically rejected looking to the presence of a future benefit to determine whether expenditures were ordinary and necessary.

c. The Tax Court and Third Circuit in National Starch, however, disagreed with these arguments. The Third Circuit noted that Lincoln Savings did not establish a "separate and distinct asset" test, and that it is possible for an expense to be a capital expense, even though there is no separate and distinct asset.

(i) Although the court stated that no one factor controls the deduction/capitalization distinction, the Third Circuit seemed to adopt a "future benefits" test.

(ii) Under this test, an expense must be capitalized if such expense would produce benefits for the future. Whether or not an expense will produce a future benefit is a question of fact.

(iii) Note: The future benefits test is not a new one. Courts have recognized in the past that expenses like those above "'incurred for the purpose of changing the corporate structure for the benefit of future operations are not ordinary and necessary business expenses."' General Bancshares Corp. v. Commissioner, 326 F.2d 712 (8th Cir. 1964) (quoting Farmers Union Corp. v. Commissioner, 300 F.2d 197 (9th Cir. 1962). See Mid-State Products Co. v. Commissioner, 21 T.C. 696 (1954) (disallowing deductions for attorneys fees because reorganization expenses result in continuing benefit to successor corporation).

3. INDOPCO

a. The Supreme Court in INDOPCO, Inc. v. Commissioner affirmed the Third Circuit's decision in National Starch.4 The Court held that the fees noted above "produced significant benefits to National Starch that extended beyond the tax year in question . . . ." INDOPCO, at 88. Thus, they must be capitalized.

(i) The Court held that the fact that the fees do not create or enhance a separate and distinct additional asset under Lincoln Savings "is not controlling." INDOPCO, at 90. Lincoln Savings did not hold that only expenditures that create or enhance separate and distinct assets are to be capitalized, just that those that do must be capitalized. The INDOPCO court concluded that investment banker fees, legal fees, proxy costs, and S.E.C. fees incurred by a target corporation in a friendly takeover must be capitalized if the takeover produces significant future benefits.

(ii) Regarding the future benefits test, the Court stated that "although the mere presence of an incidental future benefit . . . may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important" in determining whether the costs must be capitalized. INDOPCO, at 87.

(iii) Thus, it appears that the Supreme Court did not literally establish a future benefits test. Rather, they provided only that such a benefit is "undeniably important" in determining whether an expenditure must be capitalized. Subsequent cases, however, use future benefits as the benchmark in determining whether an expense may be deducted. See, e.g., Victory Markets, Inc. v. Commissioner, 99 T.C. 648 (1992); A.E. Staley Mfg. Co. v. Commissioner, 105 T.C. 166 (1995), rev'd 119 F.3d 482 (7th Cir. 1997).

(iv) Note: The Southern District of Ohio in In re Federated Dep't Stores, Inc., 171 Bankr. 603, 94-2 U.S.T.C. ¶ 50,430 (S.D. Ohio 1994), concluded that INDOPCO does not stand for the proposition that any expenditure "that merely preserves the existing corporate structure or policy must be capitalized." As a threshold issue, costs must be incurred in connection with the reorganization for the rules under INDOPCO to apply. See United States v. Gilmore, 372 U.S. 39 (1963). See also Pope & Talbot, Inc. v. Commissioner, 162 F.3d 1236 (9th Cir. 1999), aff’g 73 T.C.M. 2229 (1997) (holding that fees paid for business planning and advice as to potential corporate acquisitions were deductible because no acquisition or takeover was ever threatened or attempted); Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000) (holding that costs incurred in the investigation of whether to be acquired are deductible if such costs are incurred prior to a final decision regarding the approval of the transaction for submission to the shareholders).

(a) Thus, in TAM 9402004 (Sep. 10, 1993), the Service ruled that costs incurred by a target corporation related to acquiring five years of liability insurance for claims against the target's officers and directors, which insurance was required by the acquirer prior to purchase, were immediately deductible. Although the target's normal business practice was to purchase insurance on a yearly basis, the Service argued that such insurance costs would have been incurred by the target eventually, whether the merger went through or not.

(b) Furthermore, in TAM 9641001 (May 31, 1996), the Service concluded that premiums paid to debt holders in repurchasing their debt, in order to obtain the shareholders' consent to a merger, were not a capital expenditure. The Service reasoned that the early retirement of the debt was not an integral part of the merger, but payment on an already existing debt. The corporation was not required to purchase the debt as part of the merger. However, the Service ruled that consent solicitation payments to the shareholders must be capitalized, as such payments had their origin in the merger.

b. The Service has stated that it believes that the decision in INDOPCO "did not change the fundamental legal principles for determining whether a particular expenditure may be deducted or must be capitalized." See Notice 96-7, 1996-1 C.B. 359. Furthermore, the Service has ruled that INDOPCO did not alter the deductibility of advertising costs (Rev. Rul 92-80, 1992-2 C.B. 57), incidental repair costs (Rev. Rul. 94-12, 1994-1 C.B. 36), severance payments (Rev. Rul. 94-77, 1994-2 C.B. 19), training costs (Rev. Rul. 96-62, 1996-2 C.B. 9; PLR 199918013 (training costs associated with building a workforce for a new division are deductible)), or voluntary certification costs (Rev. Rul. 2000-4, 2000-1 C.B. 331).

(i) All of the above are generally deductible under section 162, even though they may have some future effect on business activities. See RJR Nabisco Inc. v. Commissioner, 76 T.C.M. (CCH) 71 (1998) (holding that there is no distinction between the costs of developing advertising campaigns and the costs of executing those campaigns, and thus the former are deductible, regardless of the fact that expenditures for the development of advertising campaigns give rise only to long-term benefits). However, in certain circumstances such costs must be capitalized. For example, if advertising is directed towards obtaining future benefits "significantly beyond those traditionally associated with ordinary product advertising," a taxpayer must capitalize the advertising costs. Rev. Rul. 92-80, supra; In re Hillsborough Holdings Corp., No. 91-313 (Bankr. M.D. Fla. 3/30/2000) (denying deduction for advertising and printing expenses in connection with the offers to purchase the target); PLR 199952069 (denying deduction for travel costs associated with the solicitation of new business).

(ii) At least one Circuit Court has affirmed the Service’s position that INDOPCO maintains the fundamental legal principles for determining whether an expenditure may be deducted or must be capitalized. See PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822 (3rd Cir. 2000), rev’g 110 T.C. 27 (1998). In PNC Bancorp, Inc., the Third Circuit concluded that the INDOPCO holding does not require costs that have been historically deductible, such as loan origination fees, to be capitalized. On appeal from the Tax Court, the Service argued that the Tax Court was correct in requiring the capitalization of loan origination fees as they created a separate and distinct asset under Lincoln Savings. The Third Circuit, however, determined that "the Tax Court took too broad a reading of what Lincoln Savings meant by separate and distinct" and held that loan origination fees were deductible under section 162 because such expenses were ordinary and "geared toward income production" rather than "betterment[s] into the indefinite future." But see Lychuk v. Commissioner, 116 T.C. 27 (2001) (disagreeing with the Third Circuit’s holding in PNC Bancorp, Inc. with respect to the deductibility of loan origination fees); FSA 200109001 (Mar. 3, 2001) (disagreeing with the holding expressed in PNC Bancorp, Inc. and stating that a corporation is required to capitalize the costs of acquiring loans).

4. Payments to Employees Terminating Unexercised Stock Options

a. Corporations that are acquired in reorganizations often must make payments to employees holding unexercised stock options, in order to facilitate the transaction.

b. In Rev. Rul. 73-146, 1973-1 C.B. 61, the Service held that payments to target employees to terminate unexercised stock options, as a condition of a reorganization, are compensation to the employees, and deductible by the corporation.

(i) The Service ruled that the cancellation of the options was not in satisfaction of a new obligation generated by the reorganization, but in satisfaction of a pre-existing obligation of a compensatory nature.

(ii) Thus, payment to employees was deductible as an ordinary and necessary business expense under section 162. See TAM 9438001 (Apr. 21, 1994) (acquiring corporation purchases stock options from target employees indistinguishable from Rev. Rul. 73-146).

c. Another issue arises as to amounts paid to employees to terminate unexercised stock options that are in excess of amounts that would have been paid to the employees had a pending takeover not influenced the stock price.

(i) In TAM 9540003 (June 30, 1995), the Service addressed this issue in the context of both stock options and stock appreciation rights.

(ii) The Service held that such payments "are substantially the same as the payments that were analyzed by the Service in Rev. Rul. 73-146."

(iii) Although the agent contended that the excess amount over the amount that would have been paid to employees barring the pending takeover should be capitalized, the Service stated that such a distinction is not controlling.

(a) The Service noted that such a premium may have been present in Rev. Rul. 73-146, supra.

(b) In addition, the premium was merely the fair market value of the stock at that time, and compensation to the employee would rise along with the fair market value.

(c) The Service also noted that a deductible expense is not converted to a capital expenditure solely because the expense is incurred as part of a reorganization.

(iv) In FSA 199201244, 99 ARD 195-1 (Jan. 24, 1992), the taxpayer corporation made payments pursuant to employee phantom stock plans. Although the value of the stock was influenced by a pending takeover and a self-tender offer, the Service held the payments to be compensatory in nature and, therefore, deductible.

d. As opposed to the above rulings, in Jim Walter Corp. v. United States, 498 F.2d 631 (5th Cir. 1974), the Fifth Circuit held that a corporation could not deduct an amount paid to repurchase warrants.

(i) The exercise of a warrant entitled the holder to one share of common stock and two $25, 9% subordinated bonds.

(ii) The corporation in Jim Walter wanted to repurchase the warrants because they were conducting a separate public offering of securities, and the underwriters of the offering feared that the warrants might be exercised, thus causing the issuance of substantial debt obligations and shares of common stock, resulting in large interest payments and a serious dilution of shareholder equity and earnings per share.

(iii) The Jim Walter court stated that the repurchase of warrants was a recapitalization expense associated with the public offering, and held that expenses incurred in connection with the acquisition or issuance of corporate stock are nondeductible capital expenditures.

(iv) The court implied that it might reach a different result if the repurchase of the warrants were necessary for the corporation's survival.

(v) Although the Jim Walter decision seems contrary to Rev. Rul. 73-146, supra, taxpayers presumably should be allowed to follow the Service's guidance and deduct costs related to payments to employees to terminate unexercised stock options and warrants.

5. Pre-Acquisition Investigatory Costs

a. In Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000), rev’g in part Norwest Corporation and Subsidiaries v. Commissioner,5 112 T.C. 89 (1999), the Eighth Circuit held that INDOPCO does not require capitalization of pre-acquisition investigatory and due diligence costs that are ordinary, related to the carrying on of an existing trade or business, and incidentally connected with a future benefit.

(i) In Wells Fargo, the target bank hired both a financial consulting firm and a law firm in order to determine whether a merger with another bank would benefit the company and the community. The target also directed that board members and several high ranking officers devote time to considering the merits of the transaction. On July 22, 1991, the Board voted to recommend the transaction to the shareholders. The target bank deducted expenses incurred both before and after the date of the Board’s approval of a recommendation to submit the transaction to the shareholders.

(ii) The Eighth Circuit held that the portion of officers’ salaries attributable to services performed in the transaction was fully deductible, reasoning that the payments for services arose out of, and were directly related to, an employment relationship and were only indirectly related to the acquisition. The court found that expenses attributable to employee compensation are traditionally deductible and held that "paying salaries to corporate officers is a transaction of common or frequent occurrence in the business world." 224 F.3d at 886 (internal quotations omitted).

(iii) The Court also held that costs properly attributable to the investigatory stage of a transaction are only indirectly related to the future benefits derived from the consummation of the transaction and, therefore, currently deductible.

(a) The Court held that the investigatory stage of the transaction ended, and a "final decision" regarding the transaction was reached, when the parties entered into an Agreement and Plan of Reorganization.

(b) However, the Court also held that "[o]ur determination on this point is not to be construed as a ‘bright line rule’ for determining when a ‘final decision’ has been made. The facts and circumstances of each case must be evaluated independently to make a proper finding on that issue."

b. Prior to the Wells Fargo decision, the Service acquiesced to the deductibility of a portion of the investigatory costs conceding that Rev. Rul. 99-23, 1999-1 C.B. 998, (discussed below) mandated such a result. Accordingly, The Government’s Response Brief stated that "such costs are deductible where, as here, the cost is incurred by a taxpayer already actively engaged in an existing trade or business in the same field as the trade or business with respect to which the investigatory costs are incurred." Government’s Response Brief, 224 F.3d 874 (8th Cir. 2000) (No. 99-3307); See also Salem & Shaw, Deducting Business Expansion Costs: IRS Opens a Window on the INDOPCO Door, Mergers & Acquisitions Vol. 1, No. 2, at 23 (June 2000) (summarizing the appellate pleadings in Norwest) (hereinafter Deducting Business Expansion Costs.)

(i) In Rev. Rul. 99-23, which technically applies only to start up costs incurred by an acquiring corporation under section 195, the Service defined investigatory costs as the costs incurred in determining whether to acquire a business and which business to acquire. Under Rev. Rul. 99-23, once these decisions have been made, all further expenses are properly attributable to facilitating the consummation of that acquisition rather than investigating the acquisition. Pre-decision expenses are amortizable under section 195 whereas post-decision expenses must be capitalized under section 263.

(ii) Rev. Rul. 99-23 and the Wells Fargo holding suggest that the dividing line between "investigating" and "carrying out" an acquisition is a "final decision" to go forward with the transaction: pre-final decision expenses may be deductible (or amortizable in the case of start-up expenses), post-decision expenses may not be deductible. The final decision is made once the acquiring corporation has determined whether to acquire a trade or business and which trade or business to acquire. Further, the determination of when a decision has become final is based upon an evaluation of the independent facts and circumstances of each case.

6. Summary

Fees incurred by a target corporation in a friendly takeover must generally be capitalized, as such takeovers usually produce significant long-term benefits. While the INDOPCO court did not explicitly adopt a "future benefits" test, most courts have used such a test in determining whether a taxpayer must capitalize costs incurred in reorganizations. Pre-transaction investigatory costs are generally deductible if the costs are properly attributable to the determination of whether to acquire a new business and which business to acquire. In addition, payments to employees terminating unexercised stock options in order to facilitate a reorganization are generally deductible under section 162.

B. Costs Incurred by Acquiring Corporations

1. Although INDOPCO technically only applied to costs of a target corporation pursuant to a reorganization, the principles of the case apply to the acquisition costs of acquirers. See In re Hillsborough Holdings Corp., supra (relying, inter alia, on INDOPCO to disallow the acquirer’s acquisition-related fees and costs).

2. In United States v. Hilton Hotels Corp., 397 U.S. 580 (1970), the Supreme Court held that litigation expenses incurred by an acquirer in connection with the valuation of stock due to a hotel merger were capital expenditures rather than business deductions.

a. In Hilton, the acquirer hired a consulting firm to prepare a merger study to determine a fair rate of exchange of stock. However, the target's dissenting shareholders disagreed with the consulting firm's result, and began appraisal proceedings following the merger. The acquirer deducted fees paid to the consulting firm for the merger study, and the cost of legal and professional services arising out of the appraisal proceeding.

b. The Court reasoned that expenses of litigation arising out of the acquisition of a capital asset are capital expenses. They further stated that the primary purpose of the transaction is not relevant to such determination.

(i) In Woodward v. Commissioner, 397 U.S. 572 (1970), a companion decision to Hilton, the Court noted that a test based upon the taxpayer's purpose in undertaking litigation "would encourage resort to formalisms and artificial distinctions." See also Jim Walter, supra (agreeing with the court's reasoning in Woodward).

(ii) Thus, if litigation expenses are directly related to the purchase of stock, such expenses must be capitalized.

3. Litigation expenses incurred to defend shareholder objections to a merger must be capitalized. Berry Petroleum v. Commissioner, 98-1 U.S.T.C. ¶ 50,398 (9th Cir. 1998) (unpublished opinion), aff’g 104 T.C. 584 (1995). In Berry Petroleum, a corporation acquired the stock of a target, and the minority shareholders of the target brought a lawsuit against the acquirer alleging that the merger caused the target minority shareholders irreparable damage. The acquirer attempted to deduct the litigation expenses associated with the suit as ordinary and necessary business expenses. The Ninth Circuit affirmed the Tax Court’s ruling that the suit had its origins in the corporation’s acquisition of stock, and the costs to defend that suit are not deductible as ordinary and necessary business expenses.

a. The "origin and character" test for determining whether litigation expenses can be deducted was recently applied in In re Hillsborough Holdings Corp., supra. At issue in In re Hillsborough Holdings Corp. was a leveraged buyout which a group of shareholders sought to enjoin. The court directed its inquiry to "the ascertainment of the kind of transaction out of which the litigation arose." Because the origin of the litigation was the disposition of the target stock, the expenses of settling the litigation were nondeductible.

4. Retainer fees paid annually to a law firm to ensure that such firm would not represent hostile companies are not deductible to the extent such fees are offset against fees for legal services associated with a capital transaction. Dana Corporation v. United States, 174 F.3d 1344 (Fed. Cir. 1999), rev’g 38 Fed. Cl. 356 (1997). The origin of the retainer is determined by the services provided during the year it was paid.

5. Legal fees incurred defending against a state antitrust suit which arose from the acquisition of a company are not deductible. American Stores Co., et al. v. Commissioner, 114 T.C. 27 (2000). In American Stores, an affiliated group of retail food and drug corporations purchased a chain of grocery stores. Even though the merger was approved by the FTC, the state of California objected and filed an antitrust suit to block the merger. While the suit was pending, the companies were prevented from combining their business operations. Citing INDOPCO, the court concluded that the legal services at issue were "performed in the process of effecting a change in corporate structure for the benefit of future operations," and not in the process of defending existing operations. For this reason, the costs of creating the new corporate structure, including the legal fees, had to be capitalized.

6. Accounting fees paid by an acquiring company to investigate the financial condition of a target, incurred in connection with the acquisition of such target's stock, also must be capitalized. Ellis Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982). The Ellis Banking court held that "expenses of investigating a capital investment are properly allocable to that investment and must therefore be capitalized." Id., at 1382. See also In re Hillsborough Holdings Corp., supra (holding that fees and costs incurred to evaluate offers to purchase target stock, as well as fees paid in connection with analyzing the target’s potential environmental liability are nondeductible). But see Wells Fargo, supra (implying that such fees are deductible if incurred prior to determining whether and/or which target to acquire).

7. Advertising expenditures incurred for the predominant purpose of facilitating the acquisition of a capital asset are not deductible. See Rev. Rul. 92-80, supra; In re Hillsborough Holdings Corp., supra (denying deduction for advertising and printing expenses in connection with the offers to purchase the target).

8. In TAM 9825005 (Mar. 9, 1998), the Service ruled that a bank holding company's expenditures in investigating the acquisition of a bank must be capitalized and are not eligible for amortization under section 195. The Service reasoned that the expenditures were not start-up costs, but acquisition costs. But see Rev. Rul. 99-23, supra (discussed below).

9. Although many of the above authorities indicate that all expenditures related to a reorganization must be capitalized, courts and the Service have permitted the deduction of reorganization-related expenses under certain circumstances.

a. In Rev. Rul. 99-23, supra, the Service clarified that investigatory expenditures incurred by a taxpayer in the course of a general search for, or investigation of, an unrelated active trade or business (in order to determine whether to enter a new business or which existing business to acquire) qualify as start-up costs amortizable under section 195.

(i) For example, costs incurred to conduct industry research and review public financial information about a trade or business that is unrelated to the trade or business of the acquiring company are amortizable under section 195 because they are related to a general investigation of the acquisition of a new trade or business. See Rev. Rul. 99- 23, Situation 1. Legal fees related to the "preliminary due diligence" services prior to the time the acquirer makes the decision to acquire the target involved in an unrelated trade or business are also amortizable under section 195. Id., Situation 3. Costs incurred to evaluate the target and the target’s competitors also may be amortizable investigatory costs, but only to the extent they were incurred to assist the acquirer in determining whether to acquire an unrelated business and which unrelated business to acquire. Id., Situation 1.

(ii) By contrast, costs incurred in an attempt to acquire a specific unrelated trade or business are capital in nature and, thus, are not characterized as start-up expenditures. For example, costs incurred to draft regulatory approval documents for a target are not amortizable even if incurred prior to the time the acquirer makes a final decision to acquire the target, because the purpose of such costs is to facilitate the acquisition. See Rev. Rul. 99-23, Situation 2. Due diligence costs incurred after the decision to acquire a specific business must be capitalized. Id., Situation 3.

b. In Wells Fargo, supra, which technically applies to a target’s costs, the Eighth Circuit applied and extended the Service’s conclusions in Rev. Rul. 99-23, holding that investigatory costs ("whether" and "which" expenses) were deductible under section 162. The court further held that employee salaries associated with the potential acquisition of a related trade or business were deductible because they were ordinary and only indirectly related to the long term benefits derived from the acquisition.

c. In Rev. Rul. 67-408, 1967-2 C.B. 841, an acquirer became obligated to pay severance payments to employees of a target who were terminated due to the merger. The acquirer was obligated to pay such amounts due to agreements with railroad unions, in order to facilitate the merger. The Service ruled that the satisfaction of the acquirer's obligation constituted ordinary and necessary business expenses that are deductible under section 162. The payments would not have been made but for the prior employment relationship between the target and the employees.

d. In TAM 9326001 (March 18, 1993), a target had severance payment provisions in contracts with officers that provided payments to such officers in the event the officers were terminated as a result of a merger.

(i) Following a merger, the acquiring corporation entered into new agreements with the officers that had approximately the same provisions as in the old agreements. The officers were then terminated prior to the expiration of the new agreements, and the acquirer paid the amounts designated in the new agreements.

(ii) The Service ruled that the acquirer could deduct the amounts paid to the officers, because the payments related to the employment relationship, not the reorganization. The payments were merely coincidental to the reorganization, as they "had their basis in the longstanding employment relationship with [the target], not the reorganization itself." TAM 9326001 (Mar. 18, 1993).

e. See also PLR 9527005 (Mar. 15, 1995) (ruling that amounts paid as "bonuses" to make up for terminated stock options are deductible, as such amounts arise in the employment relationship); PLR 9721002 (Jan. 24, 1997) (ruling that severance payments made following a section 338 acquisition are deductible); PLR 9731001 (Jan. 31, 1997) (ruling that severance payments made under an agreement of merger that are more than payments normally required under a pre-merger plan are deductible as such payments are coincidental to the merger).

f. Expenditures for goodwill associated with the acquisition of a business may be deducted provided that the expenditures reflect "economic reality." In C.H. Robinson v. Commissioner, T.C. Memo 1998-430, a corporation acquired the assets of another corporation, including a covenant not to compete and the employment services of a key officer. The purchase price consisted of a $300,000 cash payment, $1.3 million for a three-year covenant not to compete, a $250,000 per year bonus payment to a key officer, and $292,000 per year as additional payments under the covenant not to compete. The corporation claimed the payments for the covenant and the salary bonuses were ordinary and necessary business expenses. The Tax Court ruled that the $300,000 cash payment and the $1.3 million payment for the covenant were payments for the company’s assets, and therefore not deductible. The court reasoned that these payments resembled the original terms of the agreement to purchase the assets. The additional payments of $292,000 associated with the covenant not to compete were allowed as deductions because they "reflected economic reality" in that a threat of competition was feasible. The Tax Court also held that the bonus payments were deductible because they constituted reasonable compensation.

g. In Metrocorp, Inc. v. Commissioner, 116 T.C. 211 (2001), the Tax Court allowed a bank to deduct fees paid to FDIC insurance funds upon acquisition of a failed savings association because the fees were regular business costs and produced no significant future benefit to the bank that would require capitalization, and the Service did not argue that the fees were incurred in connection with the acquisition of a business.

10. Summary

Expenses incurred by an acquirer pursuant to a friendly takeover must generally be capitalized. However, such expenses may be deducted if they relate to the pre-final decision investigation of whether to acquire a business and which business to acquire, are incurred due to a prior employment relationship.

Footnotes

1 The authors would like to thank Ryan Hotchkiss for his contribution to this outline.

2 All Code sections refer to the Internal Revenue Code of 1986, as amended, and the regulations thereunder, unless otherwise noted.

3 In the transaction, 179 of National Starch's shareholders, holding approximately 21% of National Starch's common stock, exchanged their shares for shares in the Unilever subsidiary.

4 Prior to the Supreme Court's decision, National Starch and Chemical Corporation changed its name to INDOPCO, Inc.

5 Norwest was acquired by Wells Fargo prior to the Eighth Circuit’s decision in Wells Fargo.

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