Capitalization requirement in Wells Fargo reversed.

In Wells Fargo & Co., 224 F3d 874 (2000), rev'g in part 112 TC 89 (1999), the Eighth Circuit held that a bank is not required to capitalize certain investigatory and due diligence costs and officers' salaries incurred in connection with its acquisition by another corporation.

Davenport Bank and Trust Co. (DBTC) was an Iowa state bank that provided local banking and related services. In 1989, Iowa adopted interstate banking legislation that, for the first time, allowed banking institutions in states contiguous to Iowa to acquire Iowa banks. Concerned about an ability to remain competitive, DBTC began talking with Norwest Corp. (Norwest) about combining their businesses.

In July 1991, DBTC's board of directors approved a transaction by which DBTC and Bettendorf Bank, National Association (BBNA) (a subsidiary of Norwest), would consolidate to form a single national bank that Norwest would wholly own; BBNA's board approved the transaction on the same day. The transaction became effective in January 1992.

Prior to (and in connection with) the transaction, DBTC incurred certain investigatory and due diligence costs. It retained outside advisers to help evaluate the transaction, and several of DBTC's own officers performed services related to the acquisition. The investigatory costs were for legal services rendered before DBTC agreed to participate in the acquisition. A law firm was retained to investigate whether DBTC would strategically fit with Norwest, and whether a reorganization between DBTC and Norwest would be good for the community. The remaining investigatory costs related to services performed by the law firm in investigating whether, after the transaction, Norwest's director and officer liability coverage would protect DBTC's directors and officers for acts and omissions occurring before the transaction.

Some costs were for services performed by the law firm in connection with Norwest's due diligence review. Officers' salaries in question were part of their regular annual salaries and there was no increase in their compensation as a result of their work attributable to the transaction. None of the officers were hired specifically to render services on the transaction, but to conduct the bank's day-to-day business activities. DBTC deducted all of the fees paid to the law firm, as well as the entire amount of the officers' salaries, on its 1991 tax return.

Citing INDOPCO, Inc., 503 US 79 (1992), the Tax Court agreed with the IRS in denying the deductions. The court held that DBTC was not entitled to currently deduct any of the disputed costs it incurred for the acquisition, because they were connected to an event that produced a significant long-term benefit. Although the expenses were incurred before approval of the transaction and were not incurred as direct costs of facilitating the event that produced the long-term benefit, the court held the costs to be essential to the achievement of that benefit.

Appellate Holding

The Eighth Circuit reversed in part the Tax Court's opinion, holding that salaries paid to officers of an acquired subsidiary during the year of acquisition, as well as legal/investigatory expenses incurred before the acquisition, were deductible under Sec. 162.

The appeals court found that the Tax Court erred in its interpretation of INDOPCO. In INDOPCO, the Supreme Court attempted to clarify its previous ruling in Lincoln Savings and Loan Ass'n, 403 US 345 (1971). Lincoln Savings had been interpreted to mean that only expenditures that created or enhanced a distinct asset had to be capitalized, and all other expenditures, regardless of their future benefit, could be deducted. The Supreme Court in INDOPCO clarified that, when determining whether an expenditure must be capitalized or deducted, it is critical to determine whether it resulted in a long-term benefit, and that a separate and distinct asset, while sufficient, is not a requirement.

The Eighth Circuit noted that, unlike the present case, in INDOPCO the expenses required to be capitalized were directly related to the transaction in question. Citing the origin-of-the-claim doctrine, the court found that the officers' salaries in the present case were only indirectly related to the acquisition itself, and were directly related to the employment relationship. There was no increase in their compensation as a result of their work attributable to the transaction, and they would have been paid the salaries in spite of the transaction.

In Rev. Rul. 99-23, the Service determined that investigatory expenses that relate to the questions of "whether to acquire a business" and "which business to acquire" are properly deductible. Similarly, the appellate court found that the legal expenses incurred before DBTC and Norwest approved the transaction were deductible as investigatory costs. The expenses incurred after the date of the final decision on the acquisition were held to facilitate consummation of the acquisition and had to be capitalized.

The IRS had previously conceded that the legal expenses attributable to the investigatory stage of the transaction should have been allowed as a deduction, and that the Tax Court was wrong in requiring capitalization of all of DBTC's legal fees. The proper treatment of the officers' salaries was the only real issue remaining for the appeals court to decide. The Eighth Circuit concluded that the Supreme Court in INDOPCO did not create a new test requiring capitalization whenever an expenditure is incidentally connected with some future benefit. The court also found that the Tax Court misinterpreted the holding of INDOPCO in finding that a cost must be capitalized solely because it was incidentally connected with a long-term benefit.

Discussion

The Eighth Circuit's Wells Fargo decision is important for all taxpayers involved in acquisitions, reorganizations or other capital transactions that provide future benefits, as well as those involved in other projects that may be subject to capitalization (such as enterprise resource planning implementation and Website design). The decision supports deductibility of compensation paid to individuals who indirectly participate in projects that may result in a long-term benefit. Unless the compensation paid increases incrementally as a result of a transaction or project, to the extent the liability is directly related to the employment contract and not the project itself, that compensation would be indirect; hence, it almost always will be deductible.

Wells Fargo is significant because it represents the second favorable appellate court decision in recent months dealing with the capitalization of expenditures that have historically been treated as deductible. In May 2000, the Third Circuit in PNC Bancorp Inc., 5/19/00, reversed a Tax Court decision and concluded that banks are not required to capitalize loan origination costs under Sec. 263. In PNC, the Tax Court had also relied on INDOPCO to require loan origination fees to be capitalized. It was the Third Circuit's opinion that (contrary to the Service's position) not everything associated with a long-term benefit required capitalization. The uncertainty arose in a transaction that resulted in a long-term benefit, but one in which no specific asset was created. The court implied that, when dealing with costs that do not relate to a specific asset, only the direct or incremental costs (and not the allocable indirect costs) of a transaction should be capitalized.

The decision in Wells Fargo should help clarify some of the uncertainties about capitalization policies. Since the Supreme Court's decision in INDOPCO, the IRS has been working to extend the reach of that decision to treat previously deductible expenditures as capital expenses. The Eighth Circuit's decision may curb the Service's growing tendency to require capitalization for otherwise ordinary and necessary expenditures.

FROM KEN BECK, B.S., AND GLENN MACKLES, J.D., WASHINGTON, DC