Merger Undertaken to Qualify for S Election Qualifies as F Reorganization

A district court has stated that a merger undertaken solely to make an S election was nevertheless a reorganization. The court also ruled that accounting fees incurred when the C corporation merged into a newly formed S corporation were not ordinary and necessary business expenses and must be capitalized (United Dairy Farmers, 107 F Supp2d 937 (DC Ohio 2000)).

Background

The IRS has issued several letter rulings approving reorganizations undertaken to make an S election; see Letter Rulings 8806074, 8631058, 8541034, 9104009 and 8942091. However, in each of these rulings, the taxpayer asserted that the transaction was also undertaken to simplify operations or reduce administrative or accounting expenses.

Facts

To change from a C corporation to an S corporation, United Dairy Farmers (UDF) formed an S corporation, Uncle Bud's Fried Dough, Inc. (UBFD). UDF merged into UBFD. After the merger, UBFD changed its name to United Dairy Farmers. The sole purpose of the merger was to make an S election and thereby reduce the individual shareholder's tax liability. (The facts cited by the court do not indicate why the merger was necessary to effect the S election.) The merger did not change UDF's corporate structure, assets or business operations. No facts were presented identifying expenses to be reduced by the merger.

UDF paid $46,300 for accounting fees associated with the merger. UDF deducted that amount on its 1993 corporate tax return, arguing that the fees were tax compliance costs deductible as ordinary and necessary business expenditures. The Service disagreed, claiming the fees were corporate reorganization costs that should have been capitalized because the S election produced benefits extending beyond the tax year.

Holding

On review, the district court ruled that the accounting fees were corporate reorganization expenses that should have been capitalized. Citing INDOPCO, Inc., 503 US 79 (1992), the court noted it is "well-established that expenses incurred for professional fees related to corporate reorganizations must be capitalized."

The court determined that the merger had all the hallmarks of an F reorganization, as established in Davant, 366 F2d 874 (5th Cir. 1966): the shareholders and their interests were identified, the business enterprise continued unimpaired and the new business entity was the alter ego of the old. The court thus concluded that the merger, "even if done only for purposes of making an S election," was an F reorganization.

From Nelson Crouch, Washington, DC