Downsizing costs.

In letter ruling 9721002, a buyer terminated a number of employees two days after it had acquired a company. The employees were entitled to severance payments, and the company deducted those payments. In an earlier ruling (revenue ruling 94-77), the Internal Revenue Service had said severance payments were deductible but had not determined whether they were deductible in connection with an acquisition.

Although a buyer that assumes liabilities generally must capitalize (not deduct) the ensuing payments, the severance payments in letter ruling 9721001 were not considered a liability because the employees were terminated after the acquisition.

Costs "incident to" an acquisition also must be capitalized, but the methods of determining such costs are not based solely on when the costs are incurred. Instead, the nature of a cost can be determined under the "origin of the claim" doctrine. In this case, the severance payments originated with the termination of the employees after the acquisition. Thus, the payments were deductible.

Observation: The severance payments did not have their origin in the acquisition because (1) the severance agreements were in place before the acquisition and (2) the agreements were not mentioned in the stock purchase documents.

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