Acquisition-related compensation not capitalized under INDOPCO.

The IRS National Office has concluded in Letter Rulings, (TAMs) 9540003 and 9527005 that certain payments made to employees in connection with a reorganization are not required to be capitalized under INDOPCO, Inc., 503 US 79 (1992), even though the payments were made as a consequence of and were a condition of the reorganization. These rulings reflect the position that not all expenses in the context of a reorganization should be capitalized, and that the Service will allow a current deduction for expenses not directly related to investigating and negotiating the acquisition, if the expenses have their origin in something else (such as the employment relationship). The rationale in these rulings would also appear applicable to other types of acquisition-related expenses (other than those directly related to the acquisition), such as severance payments, training and other types of corporate integration expenses that necessarily follow a reorganization.

Origin of Claim Doctrine Applied

In TAM 9540003, prior to and independent of the reorganization, a target company had adopted "Management Incentive Plans," which entitled key employees to stock options and stock appreciation rights (SARs). In connection with the acquisition of its stock, the target company agreed to cancel the stock option and SAR plans and make all cancellation payments originally required by the plans, and to make additional settlement payments for the Federal income taxes imposed on the recipients. In addition, the acquiring company agreed to make a payment to the target to enable it to make the cancellation payments.

The IRS challenged the target's treatment of the payments as currently deductible compensation. The examining agent argued that the portion of the option cancellation payments representing a premium created by the tender offer and the entire payments for the SAR cancellations were directly attributable to the reorganization and, therefore, were subject to capitalization under INDOPCO.

The IRS National Office concluded that the examining agent's application of INDOPCO was overbroad. The mere fact that a takeover resulted in an expenditure was not enough to render an expense capital in nature Instead, the National Office reasoned that the payments were outside the scope of INDOPCO; they were in satisfaction of a preexisting (rather than a new) obligation generated by the reorganization, and were compensatory in nature. Even though the cancellation payments were made to facilitate the merger, they nevertheless were currently deductible.

In TAM 9527005, the taxpayer made payments called "special bonuses" to some of its current management to facilitate the financing of a leveraged buy-out by its management investors. The special bonus payments were not technically subject to a preexisting contractual obligation, but were calculated in an amount necessary to compensate the taxpayer's management investors for the difference between the current price and exercise price of the options that would not survive the merger.

The IRS National Office again relied on the origin of the claim doctrine to conclude that the payments were currently deductible by the target company. Although the Service acknowledged that the payments would not have been made in the absence of the reorganization, were a condition of the reorganization and facilitated the reorganization, the National Office concluded that they nonetheless had their origin in something outside of the reorganization. In this case, the IRS was not dissuaded by the absence of a definite preexisting contractual obligation, and looked to the fact that the payments were made to compensate the managers for prior employment and to encourage continued employment, thus making them distinguishable from payments such as those in Rev. Rul. 73-580 that compensated for "services performed in connection with a corporate merger."

In light of these two TAMs, there is clearly a need for taxpayers in a proposed acquisition to itemize, analyze and document each category of expense incurred in connection with the reorganization. The possibility of avoiding future controversy and ensuring current deductibility will be enhanced by documentation demonstrating that the expenditures in question originated from something outside the reorganization. Interpreted broadly, the TAMs lead to the conclusion that capitalization should be limited to expenses that directly relate to the acquisition itself (such as investment banking, accounting and legal fees) incurred in evaluating and negotiating the acquisition.

Post-Acquisition Expenses

Subsequent to an acquisition, it is almost always necessary for the survivor in the acquisition to incur significant one-time expenses to integrate the previously distinct businesses of the acquirer and target. Severance and other compensation-related payments, training, advertising, quality programs, reengineering, management and operations consulting, relocation, and contract termination payments are examples of some common post-restructuring business integration expenses.

Prior to the issuance of these TAMs, the Service had determined in Rev. Rul. 94-77 that severance payments generally were not required to be capitalized under INDOPCO, even though they could result in a longterm future benefit to the company. However, Rev. Rul. 94-77 expressly stated that it did not address the treatment of such payments in the corporate acquisition context. The exclusion of acquisition-related severance from Rev. Rul. 94-77 appeared contrary to the Service's position in Letter Ruling (TAM) 9326001, in which certain officer termination payments in connection with a merger were deemed currently deductible.

These recent TAMs confirm that the IRS will continue to allow a current deduction for acquisition-related severance as well, except for taxable acquisitions which present issues beyond the scope of INDOPCO. In addition, the current deductibility of other post-acquisition integration expenses would seem to logically follow.

FROM CAROL CONJURA, CPA, J.D., WASHINGTON, D.C.