IRS allows deduction for severance payments after Sec. 338 election.

In Letter Ruling (TAM) 9721002, the IRS analyzed the question of whether severance payments made by a new target corporation are required to be capitalized in the basis of the assets acquired from an old target corporation as a result of a Sec. 338 election.

B acquired the stock of T, a wholly owned subsidiary of P, in a qualified stock purchase, and the parties filed a timely election under Sec. 338(g) and (h) (10). Two days after the purchase, B issued termination notices to certain T employees, who were entitled to severance pay pursuant to contracts previously entered into with T and T's personnel policy. B deducted these payments on its consolidated income tax return as ordinary and necessary business expenses.

The Service first analyzed the issue of whether these payments by "New" T resulted from "Old" T liabilities, either fixed or contingent, that New T may be considered to have assumed. In such a situation, the payments would have to be capitalized. In holding that these obligations were not liabilities of Old T, the IRS held that the events most critical to the creation of the liability (in this case, the actual termination of the employees) took place after the purchase, even though the amount of the severance payments was based on employment status and length of service with Old T.

The Service then discussed whether New T may deduct these payments currently, or whether they were capitalizable as a cost', of acquiring Old T. Generally, costs incurred incident to the acquisition of another entity should be capitalized. However, the fact that an expense is incurred in a corporate acquisition does not convert an otherwise deductible expense into a capital expenditure. Under the "origin of the claim doctrine," established by the Supreme Court in Gilmore, 372 US 39 (1963), the origin and character of a claim determine the deductibility of the related expense. Here, B wished to terminate the employees to consolidate operations in a cost-saving effort. The severance payments were merely coincidental with the acquisition of T. "While the acquisition may have been the catalyst for the employees' receipt of the severance payments, the acquisition was not itself the basis for the payments." It was therefore held that the payments were not capitalizable as part of B's basis in T stock.

The IRS finally concluded that the payments were not to be included in "adjusted grossed-up basis" (AGUB) under Sec. 338. B's AGUB included T's liabilities as of the beginning of the day after the acquisition date (other than liabilities that were neither liabilities of Old T nor liabilities to which Old T's assets were subject). Because the severance payments were not liabilities of Old T, the Service concluded that the payments were not includible in the AGUB of the New T assets.

Although taxpayers and their advisers have been unsure as to the IRS's treatment of otherwise deductible expenses in light of INDOPCQ Inc., 503 US 79 (1992), this ruling, while not precedential, indicates that deductible expenses that have their origins outside of an otherwise capitalizable event win continue to be deductible even if close in time to that event. Taxpayers and their advisers in such a situation should review any tax years still open to determine whether refund claims should be filed.