Costs of defending against hostile takeover must be capitalized, if future benefit results.

In 1984, corporation X received an unsolicited tender offer from corporation Z. To assess the impact of this offer, X engaged investment banking, legal, tax and media professionals, who provided X and its board of directors with advice. Relying on this advice, X rejected the tender offer and initiated defensive action. Ultimately, X and Z negotiated a settlement (which included the repurchase of Z's X stock).

X claimed that the costs it incurred were ordinary and necessary expenses to protect X and its shareholders against potential harm. The IRS argued that these costs should instead be capitalized.

Analysis

Sec. 162(a) provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries and other compensation for personal services actually rendered.

Sec. 263(a) provides, generally, that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate, subject to certain exceptions. Regs. Sec. 1.263(a)-2(a) illustrates that a capital expenditure includes the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life beyond the tax year.

X argues that payment for professional fees (legal, accounting, investment banking and securities filing) were incurred as ordinary and necessary business expenses and should therefore be deductible under Sec. 162. In advancing this argument, X asserts that the payments for professional fees were expenses incurred in order to protect the safety of its business and its shareholders. Further, these expenses were both common and well accepted. Therefore, the origin of the expenses is traceable to X's board of directors' fulfillment of its fiduciary duties to defend against inadequate takeover attempts.

Deductibility of expenses under Sec. 162 depends first on whether such expenses were "ordinary and necessary" within the meaning of Sec. 162(a). The term "necessary" means "appropriate and helpful" to the development of the taxpayer's business.

"Ordinary" in this context does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. The situation is unique in the life of the individual affected, but not in the life of the group, the community of which he is a part.

On the other hand, an expenditure must be capitalized if it creates, enhances, or is part of the cost of acquiring or defending a tangible or intangible asset with a useful life greater than one year.

There are situations in which the Service has allowed a current deduction for expenses that provide a benefit beyond the current year. However, there are circumstances in which an expenditure provides a long-term benefit and must be capitalized absent the creation or enhancement of an asset. National Starch & Chemical Corp., 918 F2d 426 (3d Cir. 1990), addressed the issue of whether certain expenditures relating to professional fees incurred in a corporate takeover must be capitalized or could be deducted currently. The Third Circuit affirmed the Tax Court's decision, which required the taxpayer to capitalize certain acquisition expenditures even though they did not result in the creation or betterment of an asset. Specifically, in National Starch, the taxpayer incurred an investment banking fee, legal fees and related expenses in connection with a friendly takeover. The Tax Court determined that National Starch believed that the shift in ownership was in National Starch's long-term interest. Thus, the acquisition expenditures at issue lead to a benefit that could be expected to produce returns for many years in the future. On appeal, the Third Circuit affirmed the Tax Court's use of a long-term benefit analysis, which required National Starch to capitalize the various expenditures at issue. Further, the Third Circuit stated that the common characteristic of expenses that have been found to be capital, in fact the sine qua non of capitalization, is the presence of a not insignificant future benefit that is more than merely incidental.

Based on the foregoing discussion, the nature of a proposed corporate takeover (i.e., whether it is friendly or hostile) is not determinative of the proper tax treatment afforded to expenditures for professional fees. Rather, the proper inquiry to be made with respect to these expenditures is whether the target corporation obtained a long-term benefit as a result of making the expenditures. The burden is on the taxpayer to demonstrate that it did not obtain a long-term benefit. Thus, expenditures for professional fees incurred in a takeover attempt (which ostensibly has been labeled as either hostile or friendly) will not uniformly be classified as either currently deductible under Sec. 162 or capitalizable under Sec. 263. Each case will turn on its own specific set of facts and circumstances.

In the instant case, the following transactions gave rise to expenses for professional fees: (1) professional fees for services rendered in connection with filing administrative and judicial actions by X to enjoin Z's takeover attempt; (2) professional fees for services performed in connection with rendering the fairness opinion; and (3) professional fees for services rendered in connection with X's self-tender offer and the counter tender offer of Z stock, which include steps taken towards obtaining X's loan commitment and valuation estimates of X and Z assets. Once the fees have been allocated, it must be determined whether X will realize significant long-term benefits as a result of the expenditure for those fees. That is, X should be permitted a current deduction under Sec. 162 for the professional fees if it can establish that the fees did not create significant long-term benefits.