Deducting defense expenses.

In Indopco v. the Commissioner, the Supreme Court ruled that expenses incurred by a target company in a friendly acquisition were nondeductible capital expenditures because the transaction produced significant long-term benefits that extended beyond the close of the year the expenditures were made.

A.E. Stale7 Manufacturing v. the Commissioner applied the Indopco ruling to hostile transactions that lead to an acquisition or a successful defense that uses recapitalization or other capital structure adjustments. Indopco applied even though the offer was unsolicited because the Tax Court ruled the acquisition produced long-term benefits. In fact, the court ruled that expenses incurred in a successful defense that did not feature a capital structure adjustment were not deductible. The court presumed there were long-term benefits because the expenses were not related to the current production of income.

The only way to earn the tax deduction is to demonstrate that a portion of the expenses is related to the development and consideration of separate and distinct proposals that were ultimately abandoned. In this instance, the relevant expenses create a loss deductible under Internal Revenue Code section 165. However, in Stale7, this attempt to deduct expenses was rejected because of the way the fee agreements were structured. Most of the fees were contingent compensation payable when Staley was sold. Therefore, Staley was unable to prove the fees were related to abandoned alternative proposals.

Observation: In the future it is unlikely that defense fees will be structured as success fees. To sustain a tax deduction, fees should be assigned to each proposal explored and, to the extent each is abandoned, a deduction for the allocated fees should be earned.

--Robert Willens, CPA, managing director at Lehman Brothers, New York City.