Employee compensation attributable to acquisitions.

On Jan. 17, 2002, the IRS issued an advance notice of proposed rulemaking (REG-125638-01) to provide guidance "regarding expenditures incurred in acquiring, creating, or enhancing intangible assets." Taxpayers expect the proposed regulations to identify several categories of expenditures requiring capitalization under Sec. 263 or, alternatively, appropriately expensing items in the year incurred.

One of the expenditure categories the proposed regulations will address is transaction costs. This category includes certain costs incurred in transactions that facilitate the acquisition, creation, reorganization or structuring of a business entity, as well as Sec. 1060 asset acquisitions.

Generally, employers can deduct employees' salaries (including corporate officers) under Sec. 162, subject to the reasonableness standard of Sec. 162 (a) (1) and, for publicly held companies, Sec. 162(m). Generally, businesses must capitalize costs that they incur as a direct result of a merger or acquisition (such as investment banking and attorney fees) (INDOPCO, Inc., 503 US 79 (1992)). Often at issue in the context of an employer's merger or acquisition is whether the employer must capitalize the salaries and bonuses of existing employees allocable to the time they spent on the transaction.

The controlling cases in this area are Lincoln Savings & Loan Ass'n, 403 US 345 (1971), INDOPCO and Wells Fargo & Co., 224 F3d 874 (8th Cir. 2000). In Lincoln, the Supreme Court required capitalization of insurance premiums when such expenditures created or enhanced a separate and distinct asset (an insurance reserve). The primary criteria for capitalization in Lincoln focused on asset creation or enhancement. Nevertheless, expenditures remained deductible despite the existence of a "future benefit." In INDOPCO, the Court narrowed the prior deduction-friendly environment it had established under Lincoln. Not only did INDOPCO reiterate the standard set forth in Lincoln (that creation or enhancement of a separate and distinct asset requires capitalization), it further added a capitalization requirement for costs that result in a future benefit for a business. While providing ready material for discussion, INDOPCO further complicated the lives of those responsible for characterizing expenditures incurred during the course of a merger or acquisition due to the subjectivity of the so-called future-benefit standard.

In Wells Fargo, the issue was the treatment of the salaries of bank executive officers during the period in which they were evaluating a merger transaction. Did the services of the bank executives result in a future benefit? The Tax Court, in Norwest Corp., 112 TC 89 (1999) (the lower court decision of Wells Fargo), had held that the executives' salaries were sufficiently connected to the merger transaction, which enabled the bank to achieve a significant long-term benefit. On appeal, the Eighth Circuit interpreted the INDOPCO standard to require the bank to capitalize only costs directly related to an acquisition, contrasting expenditures incidentally connected thereto. Put simply, given that the employees' salaries arose out of (and were directly related to) an ongoing employment relationship and were only indirectly related to the merger, the court allowed the deduction treatment.

Wells Fargo raises as many questions as it answers. Would the court have decided differently if the level of involvement of the corporate executives had been greater? Further, how might the court have treated the executives' bonuses if they had been awarded for services associated with the merger transaction?

In its proposed regulations, the Service will probably state that employee compensation and "fixed" overhead costs will not require capitalization, which follows the treatment in Wells Fargo. However, businesses will be required to capitalize bonuses and commissions that they pay as a direct result of an acquisition. However, the IRS is considering "alternative approaches" to "minimize uncertainty and to ease the administrative burden of accounting for transaction costs." Such approaches may require that taxpayers conform the tax treatment of transaction costs to their financial or regulatory accounting treatment.

Given the prescription that the Service will soon issue, only time will tell whether the "side effects" of the cure will be better or worse than the disease for which they are intended. The IRS indeed has a challenging task to prescribe a rule(s) that captures the broad standards that have been evolving through the courts for the past 30 years.

FROM MARK D. PUCKETT, CPA, MEMPHIS, TN

Pamela Packard, CPA
Vice Chairman
Tax Services
BDO Seidman LLP
New York, NY