March 2001
Eighth Circuit Allows Deduction of Acquisition Costs
By Charles E. Price and Leonard G. Weld
In August 2000, the Eighth Circuit reversed a Tax Court decision and allowed a current deduction of costs associated with an acquisition by a bank holding company. In the decision, the court elaborated on the capitalization guidelines presented in both Lincoln Savings and Loan Association [91 S.Ct. 1893 (1971)] and INDOPCO [112 S.Ct. 1039 (1992)]. This decision is the latest in a series of pro-taxpayer rulings that have limited the scope of the INDOPCO decision.
Facts
In Wells Fargo & Company [2000-2 USTC para. 50,697], Norwest, a bank holding company and financial services provider, merged with Davenport bank through the Norwest subsidiary Bettendorf Bank. Norwest and Wells Fargo merged in 1998; Wells Fargo shareholders own about 53% of the stock in the combined company. The case takes the name of the surviving entity.
During 1990, Davenport retained the law firm of Lane & Waterman for initial discussions with Norwest about a merger. On June 10, 1991, Davenport’s board of directors authorized several executive officers to negotiate with Norwest, hire legal counsel, and present a plan of reorganization to the board. The board also appointed a special committee to perform an independent due diligence review, obtain professional advice, and report on the fairness and appropriateness of the proposed transaction to the board. Davenport retained KPMG Peat Marwick and J.P. Morgan & Co. to render opinions on the proposed transaction.
On July 22, 1991, Davenport’s board met to consider the proposal. On that date, Norwest (through its subsidiary Bettendorf Bank) entered into an agreement to acquire the voting shares of Davenport, if the proposal received regulatory approval and qualified for the desired method of merger accounting and therefore as a tax-free reorganization. After signing the merger agreement, Norwest began a due diligence review with the help of Davenport employees and Lane & Waterman. On November 26 the Davenport shareholders formally approved the plan, and on December 19 the Bettendorf shareholders did the same. Final regulatory approval was given on January 19, 1992.
During 1991, Davenport paid Lane & Waterman $474,018 and deducted that amount on its 1991 tax return. During Tax Court proceedings, however, Davenport conceded that only $111,270 was properly deductible for expenses incurred before July 23, 1991. In addition to the $474,018, Davenport deducted $150,000 on the 1991 tax return for officers’ salaries attributable to services performed in connection with the merger. The Tax Court ruled that the $150,000 salary expense and the entire $111,270 must be capitalized.
Capitalize or Deduct?
The issue before the appeals court was whether Davenport was required to capitalize both of these amounts or whether any of the costs were immediately deductible. Quoting Lincoln Savings and Loan Association, the court reviewed the criteria for immediate deduction: The item must be paid or incurred during the taxable year for carrying on a trade or business and must be a necessary and ordinary expense. The court explained that the term “ordinary” is used to distinguish between costs that are immediately deductible and those that must be capitalized. The court said that only the question of whether the costs were ordinary needed to be decided.
Prior Judicial Decisions
Lincoln Savings and Loan Association. The appellate court first reviewed the relevant facts and determination in Lincoln: At issue was whether Lincoln’s special insurance premium payments to the FSLIC (Federal Savings and Loan Insurance Corporation) were currently deductible or required to be capitalized. Because the payments might not have to be used by the FSLIC, they were segregated, held in a special reserve, and could be refunded. Lincoln argued that “the possibility of a future benefit from the expenditure does not serve to make it capital in nature as distinguished from an expense.” The Supreme Court stated that the controlling characteristic was whether or not the payment “serves to create or enhance for Lincoln what is essentially a separate and distinct additional asset.” In this instance, the Court decided that the payments did create a separate and distinct asset and, therefore, required capitalization.
INDOPCO. The second significant U.S. Supreme Court decision on the issue of capitalization of expenditures also arose from a merger transaction. In INDOPCO, the court ruled that expenditures incurred by the target corporation during a friendly takeover must be capitalized. The opinion states that, although the expenditures did not create or enhance a separate asset, the significant future benefit dictates that the expenditures be capitalized. The court explained that the Lincoln decision only dictates that expenditures which create or enhance a separate and distinct asset must be capitalized. That is, the asset test is a “sufficient, but not a necessary, condition to classification as a capital expenditure.” The fact that Lincoln states that the existence of a future benefit was not controlling does not “prohibit reliance on future benefit as a means of distinguishing an ordinary business expense from a capital expenditure.”
The Wells Fargo Conclusion
The Eighth Circuit reviewed what it considered errors in interpretation of Lincoln by five other appellate courts. According to its decision, the “separate and distinct” asset test was misinterpreted by these courts as meaning that only expenditures which created these assets should be capitalized. The future benefit test, which was not controlling in Lincoln, had been totally ignored. The Eighth Circuit decision explains that the two tests are not mutually exclusive and can be reconciled.
To determine whether an expenditure should be capitalized, the first test is the separate and distinct asset test. If an expenditure creates or enhances a separate and distinct asset, then there is no question that the expenditure will have a future benefit. By its very nature the asset is a capital asset that provides future benefits to the business. Therefore, once the court determines that an asset has been created, there is no need to establish separately the existence of benefits.
Not all expenditures, however, may create or enhance a separate asset (e.g., costs related to a merger or acquisition), raising the question arises about future benefits. If the expenditure gives rise to more than an incidental future benefit, then that expenditure must be capitalized; the fact that no distinct asset is created is not controlling. INDOPCO did not create a new rule for capitalization of all expenditures that engender a future benefit. The future benefit must be more than incidental and the expenditure must be directly related to the benefit.
In Wells Fargo, the appellate court stated that the Tax Court erred when it required capitalization of salary expenses. In INDOPCO, the costs in question were directly related to the acquisition. In the current case, the officers’ salaries were only indirectly related to the merger: Davenport’s officers had always received salaries and would have continued to receive salaries even if no merger had taken place (there was no increase in the salaries attributed to the acquisition). Therefore, the primary nature of the salaries stems from the employment relationship and they are only indirectly related to the merger activity, which was not sufficient to justify capitalization.
Of the $111,270 legal and advisory expenses incurred by Davenport in dispute, the IRS commissioner has agreed that $83,450 was incurred before July 23, 1991 (when Davenport’s board approved the merger) and is deductible because the activities are attributable to the investigatory stage of the merger transaction. Classification of the remaining $27,820, paid to Lane & Waterman in late July and August 1991, is still disputed. Part of the payment was for work performed in connection with Norwest’s due diligence review. The balance was paid for services performed to determine whether Norwest’s director and officer liability coverage would protect Davenport’s directors and officers following the merger for acts and omissions occurring beforehand. Both parties relied upon Revenue Ruling 99-23 [IRB 1999-20, April 30, 1999] but arrived at different conclusions.
Applying Revenue Ruling 99-23
This ruling does not deal with merger and acquisition costs, but rather, how to determine which costs of a new business qualify for amortization under IRC section 195. Although section 195 doesn’t apply to Wells Fargo (because the merging entities were in the same “trade or business”), it does provide guidance regarding the determination of the cutoff for investigatory versus acquisition costs. Both parties agreed that Revenue Ruling 99-23 is controlling because the discussion in the ruling distinguishes between deductible business expenses (amortized if not in the same trade or business) and expenditures that must be capitalized.
Only investigatory expenditures qualify for amortization under IRC section 195 (or a current deduction, if in the same trade or business), defined as those costs which answer the questions “whether to acquire a business” and “which business to acquire.” Once those questions have been answered and the final decision has been made to acquire a specific business, any further expenditures facilitate the acquisition and must be capitalized.
The relevant question, therefore, is: When was the final decision to merge with Norwest made?
In this instance, the court held that July 22, 1991, represents the date that the final decision was made by the Davenport board. The court stated, however, that this determination is not to be taken as “bright-line rule”; future determinations should take into account all the relevant facts and circumstances.
Examine the Specifics
The capitalization versus expense issue will not disappear with this decision. The IRS will continue to favor capitalization for any expenditure that shows a future benefit and taxpayers will always prefer to expense. One of the lessons from Wells Fargo is that the history of the specific expenditure may be important. In Wells Fargo, executive salaries were paid at the same level before and after merger talks began. Undoubtedly the executives performed work related to the merger, but no incremental salary was available to be capitalized.
Another lesson is that insignificant future benefits do not lead to capitalization. This precept arose in INDOPCO but has been generally ignored by the IRS, which has sought capitalization for any future benefit. Demonstrating that the future benefit is minimal or nonexistent, as in A.E. Staley [97-2 USTC para. 50,521 (CA-7)], will allow the taxpayer to deduct the costs in the current year. Finally, the guidance in Revenue Ruling 99-23 can be used to deduct (or amortize) investigatory expenditures related to a new business.
Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner
Colson, PhD, CPA
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