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Developer Required to Capitalize Real Estate Taxes
The Tax Court recently held, in John J. Reichel, 112 TC No. 2, that a taxpayer was required to capitalize real estate taxes paid on properties he intended to, but did not actually, develop. The court rejected the taxpayer's argument that he was not required to capitalize the costs, because he took no positive steps to begin producing the property.
The taxpayer (a sole proprietor) had been a real estate developer since 1989. His business consisted of buying and developing raw land, including: applying for and obtaining zoning variances, grading plans, street plans, water plans, sewer and storm drain plans, site plans, architectural plans, environmental feasibility studies and development and construction cost estimates. He then subdivided the land and sold it to homebuilders. In 1991, the taxpayer bought two parcels of land with the intention of developing them. However, he never began any "development" activities, citing adverse economic conditions. He continued to hold the parcels for development.
In 1993, the IRS disallowed the taxpayer's deduction of real estate taxes on these parcels of land on Schedule C of his tax return. The Service claimed that the taxpayer was required to capitalize all real estate taxes on the property under Sec. 263A(a)(2)(B), and that the taxpayer was a "producer" with respect to the parcels under Sec. 263A(b)(1). The IRS noted that Sec. 263A(g)(1) specifies the term "produce" to mean, among other things, "develop."
The taxpayer argued that Sec. 263A(a)(2)(B) did not require him to capitalize the real estate taxes until he undertook positive steps to begin developing the parcel, contending that the court's earlier decision in Von-Lusk, 104 TC 207 (1995), established the principle that some activity had to occur for production of the property to begin. Because the taxpayer had not undertaken any development activities on the parcels, he claimed he never began producing them within the meaning of Sec. 263A and, therefore, did not need to capitalize the real estate taxes.
The court responded to the taxpayer's argument by referring to Regs. Sec. 263A-2(a)(3)(ii), which states that, if property is held for future production, taxpayers must capitalize direct and indirect costs allocable to such property, even though production has not begun. If property is not held for future production, indirect costs incurred prior to the production period must be allocated to the property and capitalized if, at the time the costs are incurred, it is "reasonably likely" that production will occur at some future date. Because the taxpayer intended to develop the parcels at some point in the future, he would be required to capitalize the real estate taxes paid.
The court also disagreed with the taxpayer's interpretation of Von-Lusk, and performed a substantial review of the legislative intent behind Sec. 263A. In Von-Lusk, the court did not decide whether capitalization was required for expenses incurred before production began, but decided principally that the taxpayer had already begun development of the land in question and had to capitalize related development costs even though the land had not been physically changed. In the court's review of the legislative history of Sec. 263A, it observed that Congress intended the term "produce" to be broadly construed. Further, Congress expected the uniform capitalization rules to be applied from the acquisition of property, through the time of production, until the time of disposition.
Also, in examination of Sec. 263A(f) (which provides a narrow exception under which a particular category of indirect production costs (namely, interest) does not have to be capitalized until the production period begins), the court strengthened its position, concluding there would be no need for this exception if capitalization were never meant to apply until taxpayers actually started the production process. Therefore, if Congress intended for Sec. 263A to imply that no costs were to be capitalized until the beginning of the production period, the codification of Sec. 263A(f)(1)(A) would have been unnecessary.
The Reichel decision solidifies the IRS's position that developers must capitalize real estate taxes paid on undeveloped land from the date of purchase. It provides additional firepower for existing and future audit-related adjustments to Sec. 263A calculations of developers, as the hazards of litigation are tilted further in the Service's favor, reducing the chance of receiving favorable settlements at the appeals level. The only window of opportunity to expense real estate taxes currently would be if property were not held for production and, at the time the costs are incurred, it was not reasonably likely that production would occur at some future date. Developers should keep the Sec. 263A rules in mind when planning their cash-flows, especially in the early phases when cash is tight.
From Michael R. Schuth, CPA, Oak Brook, IL, and Gregory A. Stump, CPA, Elkhart, IN
IRS Clarifies Applicability of Sec. 195 to Business Acquisitions
The IRS recently issued Rev. Rul. 99-23, in response to a growing debate over the treatment of investigatory costs related to business acquisitions. This ruling offers guidance in determining whether such costs qualify as deductible start-up expenditures under Sec. 195 or are required to be capitalized under Sec. 263. Prior to its issuance, the Service's position had been presented in Letter Rulings (TAMs) 9901004 and 9825005.
Background
Prior to the enactment of Sec. 195, there was no Code provision permitting a deduction for investigatory costs incurred in connection with the creation or acquisition of a new trade or business. While Sec. 162 permits a deduction for most trade or business expenses (including certain costs of expanding an existing business), only those costs incurred in carrying on a trade or business fall within its scope. Any costs incurred to investigate the creation or acquisition of a new trade or business fail to meet the "carrying on" requirement of Sec. 162, because the taxpayer is not otherwise engaged in the business being acquired. Thus, no Sec. 162 deduction is available for these costs.
Sec. 195 was enacted in 1980 to stimulate new business investment by minimizing the disparity between the tax treatment of investigatory costs related to the expansion of an existing business and those related to the creation or acquisition of a new trade or business. This section permits taxpayers to amortize qualifying start-up expenditures over a period of not less than 60 months, beginning with the month in which the active trade or business begins.
Sec. 195(c)(1)(A) defines "start-up expenditure" as, among other things, any amount paid or incurred in connection with investigating the creation or acquisition of an active trade or business. However, under Sec. 195(c)(1)(B), start-up expenditures include only those expenses that would otherwise qualify for deduction if incurred or paid in connection with the operation of an existing trade or business in the same field as the business being acquired. In other words, the expenditure would have to qualify as a deductible business expense under Sec. 162, assuming the taxpayer was already engaged in the trade or business being acquired. Sec. 195 does not permit an amortization deduction for costs subject to capitalization under Sec. 263. The term "start-up expenditure" does not include any amount for which a deduction is allowable under Sec. 163(a) (interest), 164 (taxes) or 174 (research and development).
Rev. Rul. 99-23
The primary focus of Rev. Rul. 99-23 is to distinguish between investigatory costs that qualify for amortization under Sec. 195 and acquisition costs that must be capitalized under Sec. 263. In making this distinction, the IRS examined the legislative history of Sec. 195 and other pertinent documents that helped to shape the definition of qualifying investigatory expenditures.
Rev. Rul. 77-254, in particular, provides the fundamental analysis for determining whether costs qualify as investigatory expenditures or capital acquisition costs. According to Rev. Rul. 77-254, expenses incurred in the course of a general search for, or preliminary investigation of, a trade or business that relate to the decisions of whether to acquire a new business and which new business to acquire represent investigatory expenditures. However, once a decision is made to focus on the acquisition of a specific business, all costs related to the attempt to acquire that business must be capitalized.
According to the legislative history of Sec. 195, it is the point at which the taxpayer reaches a final decision to acquire a specific trade or business that closes the period for which qualified investigatory expenditures can be incurred. However, even costs incurred prior to reaching this decision must be capitalized if they relate to the acquisition of a specific business; see, e.g., Ellis Banking Corp., 688 F2d 1376 (11th Cir. 1982). The point at which the taxpayer becomes legally obligated to complete the transaction is not controlling in determining whether expenses qualify as investigatory expenditures.
Rev. Rul. 99-23 includes three hypothetical situations that illustrate the application of these rules in various acquisition scenarios. In each situation, the taxpayer is acquiring a trade or business unrelated to its existing business.
Example 1: In April 1998, Corporation U hired an investment banker to evaluate the possibility of acquiring a trade or business. The investment banker conducted research on several industries before focusing on one particular industry. Within the targeted industry, the investment banker evaluated several potential acquisition candidates, including V and several of V's competitors. The investment banker then proceeded with a detailed evaluation of V to determine a fair acquisition price for its assets. On Nov. 1, 1998, U entered into an acquisition agreement with V to acquire all of V's assets. Prior to entering into this agreement, U submitted no preliminary agreement or written document evidencing an intent to acquire V's assets.
Based on the facts and circumstances presented above, U incurred both qualified investigatory expenditures and capital acquisition costs in its ultimate pursuit of V's assets. Clearly, the costs incurred to conduct the general investigation of several industries qualify as investigatory costs; they relate to U's decision whether to acquire a business and which business to acquire. Likewise, the costs incurred to evaluate the potential target businesses in the selected industry qualify, provided they relate to the whether and which decisions.
However, the detailed evaluation of V conducted to determine a fair acquisition price for V's assets goes beyond a general search and relates directly to the acquisition of the assets. As a result, the costs associated with this evaluation must be capitalized as part of the purchase price of V's assets. In addition, it could be argued that costs incurred to evaluate V's competitors must also be capitalized as part of the acquisition price, if such costs were incurred after a decision was made to acquire V's assets and the information was used in determining the purchase price.
Example 2: In May 1998, Corporation W began a general search to acquire a trade or business. W hired an investment banker to evaluate three potential businesses; a law firm began drafting the regulatory approval documents necessary to consummate the acquisition of the ultimate target. Eventually, W decided to acquire all of the assets of X and entered into an acquisition agreement on Dec. 1, 1998.
Based on these facts and circumstances, the costs incurred by W to evaluate the three potential businesses qualify as investigatory expenditures, to the extent they relate to W's decision whether to acquire a business and which business to acquire.
However, the legal fees incurred to draft the regulatory approval documents that would ultimately be used to facilitate the acquisition of X's assets must be capitalized. This is so regardless of whether these costs were incurred prior to W's decision to proceed with the acquisition, because they do not relate to W's decision of whether to acquire a business or which business to acquire. The legal fees represent an asset acquisition cost that would not otherwise be deductible if incurred in the expansion of the taxpayer's existing business.
Example 3: In June 1998, Corporation Y hired a law firm and an accounting firm to perform preliminary due diligence services to assist in the potential acquisition of corporation Z. These services included conducting research on Z's industry (including information relating to Z's competitors) and analyzing financial projections for Z. In September 1998, Y instructed the law firm to prepare and submit a letter of intent to acquire Z. The letter stated that a binding commitment for the proposed transaction would result only on execution of an acquisition agreement. After issuing this letter, both firms continued to provide due diligence services, consisting of a detailed review of Z's financial information and preparation of an acquisition agreement. On Oct. 10, 1998, Y entered into an acquisition agreement with Z to acquire all of Z's assets.
Based on these facts and circumstances, the costs incurred to conduct the preliminary due diligence represent qualifying investigatory expenditures. These costs were incurred in determining whether to acquire a new business and which new business to acquire, because the taxpayer had not yet made a decision to acquire any business.
Y made a decision to acquire Z in September 1998, around the time Y instructed the law firm to prepare and submit the letter of intent. As a result, the costs of the due diligence procedures conducted after this decision was made represent capital acquisition costs, because they relate to the acquisition of a specific business.
Conclusion
Each situation in Rev. Rul. 99-23 illustrates the significance of the underlying facts and circumstances in determining the proper treatment of costs related to the acquisition of a new trade or business. Costs that qualify for amortization as eligible start-up expenditures under Sec. 195 are generally those relating to the taxpayer's decision of whether to acquire a new business and which new business to acquire. Costs associated with the acquisition of a specific trade or business must be capitalized under Sec. 263.
From David A. Thornton, CPA, Columbus, OH
