Salary Expenses Associated with Bank Acquisition Are Deductible

Reversing in part a Tax Court decision, the Eighth Circuit ruled that salary expenses incurred in connection with a business acquisition are deductible, and that investigatory costs incurred after a final decision to acquire a business has been made should be capitalized (Wells Fargo & Co., 224 F3d 874 (2000), rev'g in part Norwest Corp., 112 TC 89 (1999)).

In Norwest, the Tax Court ruled that certain investigatory, due diligence and officer salary expenses associated with a bank acquisition could not be deducted as ordinary and necessary business expenses. The target bank had incurred the costs in evaluating a possible acquisition by Norwest. Although the costs did not directly facilitate the acquisition and were incurred before a formal decision was made about the transaction, the Tax Court ruled the costs must be capitalized because they were "sufficiently related to an event that produced a long-term benefit" to the bank.

On appeal, the Eighth Circuit analyzed the Supreme Court's opinions in Lincoln Savings & Loan Ass'n, 403 US 345 (1971), and INDOPCO, Inc., 503 US 79 (1992). The court interpreted Lincoln Savings as providing that capitalization is required if a cost creates or enhances a separate and distinct asset. The Eight Circuit noted that numerous courts had erroneously interpreted the Supreme Court's opinion as requiring capitalization only if a cost creates or enhances a separate and distinct asset.

According to the court, these erroneous interpretations were rejected by INDOPCO; INDOPCO held that a cost that creates or enhances a separate and distinct asset represents a capital item, which itself has a long-term benefit (i.e., capital items by their nature have long-term benefits). Further, if a cost were not associated with a long-term benefit, it should be deducted. However, the court noted that INDOPCO could not be read to conclude that the presence of a long-term benefit, without the creation or enhancement of a separate and distinct asset, necessarily requires capitalization. Instead, the presence of a long-term benefit was an important consideration, but not a decisive factor in resolving whether to deduct or capitalize the cost.

Under this interpretation, the court found the Tax Court in Norwest erred in requiring capitalization "simply because the expenses were incidentally connected with a future benefit." To properly characterize the costs, the Tax Court should have performed "an independent and appropriate legal analysis to determine whether each of the expenditures at issue were 'ordinary,'" without relying on a generalization that the presence of a future benefit requires capitalization. In particular, the Tax Court failed to distinguish the salary costs at issue from the costs in INDOPCO. The court noted that INDOPCO addressed costs directly related to an acquisition, which produced a future benefit.

While noting a lack of precedential value, the Eighth Circuit pointed out that the Service has used an "origin of the claim" analysis in a number of recent letter rulings to hold that compensation payments made in the context of acquisitions were deductible; see Letter Ruling 9326001and TAMs 9527005, 9721002 and 9731001. While not fully incorporating the letter rulings, the court agreed that "payments made by an employer are deductible when they are made to employees, are compensatory in nature and are directly related to the employment relationship (and only indirectly related to the capital transaction, which provides the long term benefit)...See, e.g., TAM 9540003 (6/30/95)."

In this case, the Eighth Circuit reasoned that the salary payments originated from an employment relationship; the officers had received salaries since a time before the acquisition was a possibility, the salaries were not increased due to the acquisition and the salaries would have been paid regardless of whether the acquisition occurred. Thus, the court concluded that the salary payments were distinguishable from the costs in INDOPCO because they were directly related to an employment relationship and only indirectly related to the acquisition itself.

The court then addressed the acquisition-related legal and investigatory costs incurred after the taxpayer had completed its investigatory stage. (Note: in its brief to the Eighth Circuit in Norwest, the Department of Justice conceded that costs incurred during the investigatory phase of that transaction were deductible.) For the remaining costs, the court cited Rev. Rul. 99-23, noting that "any investigatory expenses which post-date the 'final decision' to acquire a business ought to be capitalized." The court analyzed the facts and circumstances of the case and determined that the final decision was made no later than the date on which the parties entered into an agreement and plan of reorganization. Any other due diligence or investigatory costs incurred after that date were incurred to "facilitate consummation of the acquisition" and thus should be capitalized.

The Eighth Circuit cautioned that it did not establish a "bright line" rule for determining when a final decision on an acquisition has been made. Instead, each case must be evaluated on its own facts and circumstances to make that determination.

From Diane Herndon, Washington, DC