Indopco v. Commissioner: the Supreme Court takes National Starch to the cleaners.

On February 26, 1992, the Supreme Court announced its decision in Indopco, Inc. v. Commissioner. (1) Justice Blackmun, writing for a unanimous court, affirmed the disallowance of deductions claimed by the taxpayer for legal fees and investment banking fees incurred by Indopco's predecessor, National Starch and Chemical Corporation, in connection with the friendly acquisition of National Starch by Unilever United States, Inc.

The Court's decision was anxiously awaited because of its potential impact on a significant segment of corporate America. The 1980s witnessed an extremely high volume, both in number and in dillar value, of corporate mergers, acquisitions, and reorganizations. Many of these transactions occurred in the context of friendly or hostile takeovers or attempted takeovers. The professional fees were commensurate with the size and number of the transactions. Consequently, many corporate taxpayers saw themselves as potentially affected by the decision in Indopco.

More fundamentally, legal fees and investment banker fees are not the only expenditures arguably affected by the Indopco decision. Commencing in the mid-1980s, field agents of the Internal Revenue Service began questioning taxpayers' treatment of a wide variety of expenditures associated with takeover transactions. At the same time, the IRS formed the Leveraged Buyouts Industry Specialization Program to formulate standardized positions on takeover issues and to provide support to agents in the field in connection with audit adjustments related to such transactions. (2)

As Indopco was wending its way through the courts, the scope of adjustments proposed by examining agents in connection with takeover transactions grew. Examples included proposed disallowances of expenditures associated with defending against hostile takeovers; expenditures associated with financing before, during, and after a transaction; expenditures associated with employee compensation, including severance payments and the exercise of options and early retirement; expenditures associated with unsuccessful or abandoned transactions; and expenditures of all types incurred months or years after the transactions were completed. Because Indopco was to be the Supreme Court's first pronouncement directly addressing takeover transactions, there was the potential that the decision would have farreaching implications.

I. OVERVIEW

This article examines the Indopco decision in detail, describes what the decision does and does not address, explains the implications of Indopco in circumstances not covered in the opinion, and suggests some strategic considerations for the future. Specifically, the article concludes:

* The holding of Indopco is deliberately crafted to be confined to the precise facts before the Court.

* Indopco addresses only the disallowance of professional fees incurred by a target company in the course of a friendly takeover.

* Such fees must be capitalized when they result in a significant long-term benefit to the taxpayer.

* Professional fees incurred in connection with restructuring a corporation must be capitalized.

* Indopco clearly rejects the proposition that the creation or enhancement of a separate and distinct asset is a prerequisite for capitalization.

* Indopco does not otherwise establish any new standards for distinguishing between expenditures deductible under section 162 and those that must be capitalized under section 263.

* The implications of Indopco for a friendly takeover that is devoid of resource-related benefits and corporate restructuring are far from clear.

* The analysis in Indopco confirms that hostile takeover defense expenditures are currently deductible.

* Traditional analysis and precedent remains intact for a wide variety of expenditures such as compensation, abandoned transactions, and normal post-transaction corporate operations.

* Indopco suggests that corporate structure-related costs have a useful life equal to the period during which the structure created remains in place.

II. THE OPINION

The opinion of Justice Blackmun, from beginning to end, makes two points very clear. First, the opinion addresses a very narrow set of facts: the proposed disallowance of professional charges incurred by a target company in the context of a friendly takeover. Second, the central holding is equally narrow: such charges must be capitalized when they result in a significant long-term benefit.

The intention to render a decision in a narrow factual context is made unequivocal by the architecture of the opinion. The very first sentence of the opinion describes the factual situation with absolute precision. Parts I, II, and III of the opinion discuss the facts, the law, and the application of the latter to the former, respectively; then, the first sentence of Part IV (the summary) repeats the narrow set of facts within which the legal question is presented. It is as if these two sentences were bookends precisely placed to hold the opinion within closely circumscribed confines.

That the central holding of the case is premised upon the finding of a significant long-term benefit is also evident from start to finish. In Part I of the opinion, there is marked emphasis on the lower courts' reliance on the finding of several long-term benefits. As so stated by the Court, the Tax Court "based its holding primarily on teh long-term benefits that accrued to National Starch," (3) and the Third Circuit "affirmed, upholding the Tax Court's findings that [the acquisition] served the long-term betterment of National Starch." (4)

Part II of the opinion -- a sometimes puzzling discussion the law -- imparts a strong focus on the importance of the duration and extent of the benefits acquired. In describing the difference between expenditures deductible under section 162 and those that must be capitalized under section 263, the Court recounts the central principle of matching expenses and revenues, a concept essential to a long-term benefit analysis. (5) According to the Court, to the extent an expenditure creates a benefit of substantial duration and extent, the tax effect of the expenditure should be spread over time to match the revenues presumably derived from the benefit.

The Court's reference to Justice Cardozo's landmark opinion in Welch v. Helvering (6) echoes this theme. The central issue is that the "decisive distinctions" between deductible expenditures and those that must be capitalized are often distinctions "of degree and not of kind." (7) Once a court determines that the degree of benefit is significantly longterm, the expenditure must be capitalized. Conversely, if the degree of the benefit is not sufficiently long-term, capitalization should not be required.

In the light of the emphasis on long-term benefits, it is not surprising -- and was perhaps inevitable -- that the Court rejected Indopco's argument that Commissioner v. Lincoln Savings & Loan Association, 403 U.S. 345 (1971), established an exclusive, new test -- the creation or enhancement of an asset -- for identifying capital expenditures. According to the Court, Lincoln Savings stands only for the proposition that the "creation of a separate and distinct asset well may be a sufficient but not a necessary condition to classification of a capital expenditure." (8) The Court gives short shrift to the taxpayer's argument that failure to affirm the proffered Lincoln Savings test would leave taxpayers without a "principle basis" for distinguishing business expenses from capital expenditures. Indeed, the argument is dismissed in a footnote. (9)

Part III applies the foregoing legal principles to the facts of the case, with the analysis concentrating almost exclusively on long-term benefits. First, the Court finds ample support in the trecord to affirm the lower courts' findings that the expenditures should be capitalized because they produced "significant benefits" extending "beyond the tax year in question." (10) The Court describes as "resource-related" benefits the availability to National Starch of Unilever's enormous resources and the potential for synergy with the Unilever organization. It then turns to corporate structure- related benefits that National Starch obtained. (11) With respect to the latter, the long-term benefit theme is sounded yet again when the Court describes these expenses as "incurred for the purpose of changing the corporate structure for the benefit of future operations." (12)

Part IV consists of three sentences, the last of which simply states that the judgment of the Third Circuit is affirmed. The other two restate the conclusions found elsewhere in the opinion. Although there is no explicit repetition here of the long-term benefit analysis, the statement that the "acquisition-related expenses bear the indicia of capital expenditures" (13) creates no ambiguity since the entire opinion stands for the proposition that an essential characteristic of a capital expenditure is the production of long-term benefits.

Apart from the central focus of the Court's analysis, there are two other lesser but supporting themes in the opinion: (1) the possibility that, in analyzing whether a claimed deduction must be capitalized, lower courts should generally eschew looking to the language of section 162 but should focus instead on the long-term benefit analysis; and (2) the suggestion that the outcome of this case is attributable to the taxpayer's failure to prove the absence of a benefit.

First, the last paragraph of Part III deserves special mention. While the primary focus is on the corporate structure-related benefits obtained by National Starch, the last two sentences do not appear to be so limited. The penultimate sentence essentially says that although courts have sometimes used a section 162 analysis to deny deductions for corporate structure-related expenses, more frequently courts have found that capitalization is required because the purposes of the expenditures were the operations and betterment of the corporation for a substantial period of time. The last sentence then states: "The rationale behind these decisions applies equally to the professional charges at issue in this case." (14) If the cases referred to in the last sentence are those cases that have favored the long-term benefit analysis, the Court is arguably signaling a preference for this analytical framework.

Second, the suggestion that the result in Indopco may be attributed to the taxpayer's failure of proof arises from the Court's going to some length to recite the familiar rubric that "an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer." (15) This is reinforced by the statement that "we conclude that National Starch has not demonstrated that [the expenditures] are deductible." (16) The importance of Indopco as precedent may be affected by the extent to which it is viewed as a case significantly influenced by burden a proof issues.

III. ANALYSIS

A. Capitalization Issues Addressed

in the Opinion

On its face, Indopco can be read to stand for two tightly-drawn propositions:

1. Professional fees incurred by a target corporation in the context of a friendly acquisition must be capitalized when they result in a significant long-term benefit; and

2. The separate and distinct asset standard is not a necessary condition for capitalization. (17)

The critical analytical question is whether Indopco can or should be read in a broader fashion. To answer this question, it is necessary to examine two issues: (1) the standards for capitalization of an expenditure; and (2) the taxpayer's burden of proof.

1. The Standards for Capitalization

Apart from rejecting the separate and distinct asset test, Indopco arguably adds little or nothing to existing jurisprudence. Virtually every circuit has at one time or another employed a long-term benefit analysis in distinguishing deductible expenses from expenditures that must be capitalized. (18) This rule has long been applied to a wide variety of changes in corporate structure. (19) In other words, the Court's analysis in Indopco does not depart in the slightest from the traditional interpretation of the statutes governing deductibility and capitalization. As Judge Wisdom stated in Ellis Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982), cert. denied, 463 U.S. 1207 (1983):

When an outlay is connected to the acquisition of an asset with an extended life, it would understate current net income to deduct the outlay immediately. To the purchaser, such outlays are part of the cost of acquisition of the asset, and the asset will contribute to the revenues over an extended period. Consequently, the outlays are properly matched with revenues that are recognized later, and to obtain an accurate measure of net income, the taxpayer should deduct the outlays over the period when the revenues are produced.

Id. at 1379; see Commissioner v. Idaho Power Company, 418 U.S. 1, 16 (1974) (section 263 "serves to prevent a taxpayer from utilizing currently a deduction properly attributable, through amortization, to later tax years when the capital asset becomes income producing").

In the context of the Court's focus on a long-term benefit analysis, the question arises whether even the slightest continuing benefit is sufficient to require capitalization. There are two aspects of the opinion that point in this direction. First, the "benefits" relied upon by the lower courts seem tenuous, and the record appears to be devoid of evidence that any of the resource-related benefits were ever realized. (Indeed, at least two of the corporate structure-related "benefits" enumerated by the Supreme Court are illusory: the purported "benefits" from the reduction in authorized shares of preferred and common stock.) Second, the Court's choice of language is disconcerting: "[A]n incidental future benefit -- 'some future aspect' -- may not warrant capitalization." (20) Does this language imply that anything more than an "incidental" benefit will require capitalization?

There are several reasons to conclude that any such reading of Indopco is unwarranted. First, the Court itself describes the benefits to National Starch as "significant." (21) Second, notwithstanding efforts by National Starch to discount the resource-related benefits, the Tax Court -- as the trier-of-fact -- found the cumulative presence of long-term benefits to be controlling. (22) The Third Circuit characterized these as 'at least two inherently permanent benefits to National Starch." (23) Third, even if the resource-related benefits were completely absent, there was a substantial realignment of the corporate structure of National Starch. In the total absence of any allocation of expenditures by the taxpayer, 65 years of solid precedent required capitalization. (24) Fourth, the Court's repeated emphasis on the proper matching of revenues and expenditures is inconsistent with requiring capitalization based on the existence of only a slight continuing benefit. Numerous deductible expenses such as salaries, advertising, and repairs have continuing "benefits." Notwithstanding the potential continuing benefit, these and many other current expenses are more properly matched against current revenues. (25) It would be a gross overreading of Indopco to conclude that such expenditures must now be capitalized.

But even if Indopco is not a case that announces a new substantive standard for distinguishing currently deductible expenses from ones that must be capitalized, the opinion may nonetheless signal an important analytical development, for the Court expresses a marked preference for an analytical framework that focuses on long-term benefits and the matching of expenses and revenues when attempting to make these distinctions. Such a focus should, in the long run, produce results that are more logical and consistent.

In the context of today's business climate where mergers, acquisitions, and various forms of restructuring are quotidian events, an analysis that focuses on the language of section 162 will more often than not be contrived. It will be virtually impossible to give words their ordinary meaning and properly distinguish between deductible expenditures and costs that must be capitalized. Continuing attempts to find answers in words such as "ordinary" and "necessary" and in the phrase "carrying on any trade or business" can only increase confusion and conflict. By contrast, the analytical framework suggested by Indopco, which focuses on long-term benefits and the proper matching of income and expense, is more likely to avoid semantic contortions and produce consistent, predictable results. (26)

2. The Burden of Proof

The Court unequivocally emphasizes the taxpayer's burden of proving entitlement to a deduction and the failure of National Starch to meet that burden. It is, however, virtually impossible to evaluate the significance of those statements in the opinion. The difficulty stems from the fact that, under almost any analysis, the existence of major corporate restructuring would have required the structure-related expenditures to be capitalized. It is tempting, therefore, to conclude that these portions of the opinion are of little or no importance and that a taxpayer involved in a takeover has little likelihood of success in claiming deductions under section 162.

The singular characteristics of Indopco, however, suggest that such a conclusion would be ill-advised. First, it appears that National Starch made no effort to negate the existence of the required nexus between specific expenditures and a specific benefit in a capital transaction. (Negation of such a nexus would have permitted a deduction.) Second, National Starch apparently made no effort to allocate any of the expenditures in question to separate undertakings that might not have required capitalization. (Any expenditures that could have been allocated away from the "benefits" would, presumably, have been deductible.) Third, no attempt was made to deduct any of the legal fees until after the case was in litigation. (Such an implicit admission against interest could not have been lost on the various courts.) Finally, although the taxpayer argued that the "benefits," especially the resource-related benefits, were insignificant, it is not clear that a serious evidentiary effort was directed toward proving this point in the Tax Court. (It may be that any such effort would have been futile.) (27)

Cumulatively, the unusual aspects of the case are difficult to ignore. Perhaps an effort by National Starch to raise the arguments or develop additional facts on any or all of these issues would have had absolutely no impact on the outcome. But, apart from the requirement that corporate structure-related expenditures must be capitalized, nothing in Indopco suggests that expenditures incurred during a takeover transaction are never deductible. For any other taxpayer, all of these evidentiary avenues and legal arguments continue to be available. Certainly, the question will be an open one if a taxpayer can demonstrate the total absence of resource-related benefits and no changes in corporate structure. (28) Similarly, the Indopco opinion appears to contain no negative implications for expenditures incurred in defending against a hostile takeover.

In sum, although the facts of Indopco render an objective evaluation of the burden of proof issue impossible, there is nothing in the opinion to suggest that a taxpayer can never carry the burden of demonstrating the deductibility of takeover-related expenses under section 162.

B. Capitalization Issues Not Addressed

Wholly apart from the specific facts and issues discussed in the opinion, the implications of the Indopco opinion are relatively narrow because the parties did not raise, and the Court did not address, two critical issues. First, there must be some connection or nexus -- far more than an incidental association between an expenditure and a capital transaction -- in order for that expenditure to be treated as part of the transaction. Second, where a lump-sum expenditure is connected with both business expenses and capital expenditures, courts have allowed allocation of the expenditure between section 162 and section 263.

1. Nexus

As a matter of both ordinary sense and precedent, there must be a nexus between a capital transaction and a specific expenditure before the capitalization requirement of section 263 applies. General principles of tax law affirm this requirement, and cases on severance payments and abandoned capital efforts graphically demonstrate the importance of a nexus analysis in connection with capital transactions. When judged in the light of the authorities, it is not at all clear that all teh expenditures had sufficient nexus with the Unilever acquisition to require capitalization.

a. General Principles and the Need for Nexus. The court have uniformly required some connection between an expenditure and a capital transaction before the expenditure is subject to section 263 treatment. The mere presence of a capital transaction does not require that all expenses incurred contemporaneously with the transaction be capitalized as part of it. See Commissioner v. Idaho Power Co., 418 U.S. 1, 9 (1974) (capitalization required only for those expenditures "in connection with the construction or acquisition of a capital asset"). In presenting the case to the Supreme Court, however, neither party in Indopco argued, and the Supreme Court apparently did not consider, whether there existed a sufficient nexus between the capital transaction and the expenditures at issue. The Tax Court, the Third Circuit, and the Supreme Court simply assumed that the legal fees and investment banking fees should be capitalized because they were incurred contemporaneously with the capital transaction. The Supreme Court clearly focused on the benefits of the transaction as a whole in determining the benefits from the expenditures. (29)

Courts have consistently carved expenditures out of a capital transaction and allowed a current deduction for them where they were "more closely related to" general business expenses. See Ellis Banking, 688 F.2d at 1380 n.7. Similarly, courts have not required capitalization if an expenditure merely enhances a taxpayer's "overall ability to make capital acquisitions" but is "not related to a specific capital asset." Campbell Taggart, Inc. v. United States, 744 F.2d 442, 455 (5th Cir. 1984); see El Paso Co. v. United States, 694 F.2d 703, 712 (Fed. Cir.1982) (expenses must be "closely related" to capital transaction).

This requirement for a nexus between a capital transaction and an otherwise deductible expense was expressly recognized in the Consolidated Omnibus Reconciliation Act of 1985, where Congress amended section 162 to deny a deduction for stock redemption expenses. Pub. Law No. 99-272, 99th Cong., 2d Sess. $S 10001(c). The Conference Report states:

the provision is not intended to deny a deduction for otherwise deductible amounts paid in a transaction that has no nexus with a redemption other than being proximate in time or arising out of the same general circumstances. For example, if a corporation redeems a departing employee's stock and makes a payment to the employee in discharge of the corporation's obligations under an employment contract, the payment and discharge of the corporation's contractual obligation is not subject to the disallowance under this provision. Payments in discharge of other types of contractual obligations, in settlement of litigation, or pursuant to other actual or potential legal obligations or rights, may also be outside the intended scope of the provision to the extent it is clearly established that the payment does not represent consideration for the stock or expenses related to its acquisition . . . .

H.R. Rep. No. 841, 99th Cong., 2d Sess. 168-69 (part II) (emphasis added).

The need for a nexus in the determination of "distinctions of degree" between section 162 and section 263 is clear in an Eighth Circuit case where the IRS argued that an otherwise deductible expenditure was part of a capital acquisition and therefore had to be capitalized. In Aboussie v. United States, 779 F.2d 424 (8th Cir. 1985), the taxpayer made expenditures for mortgage insurance to obtain a housing loan which in turn ultimately financed construction. The Eighth Circuit found that the payment was related "only incidentally" to the construction and the "attenuated connection" did not trigger capitalization of the insurance premium. Id. at 428; see El Paso Co. v. United States, 694 F.2d 703 (Fed. Cir. 1982); Transamerica Corp. v. United States, 392 F.2d 522, 523 (9th Cir. 1968).

b. Severance Payments or Exercise of Stock Options. Nowhere is the requirement for a nexus more clearly illustrated than in the jurisprudence for a nexus more clearly illustrated than in the jurisprudence on severance payments and employee stock options. Often in a friendly or hostile acquisition, the change in ownership of the target company will trigger severance payments to key employees. The higher prevailing stock prices may also encourage managers to exercise their stock options. (30) Yet both the courts and the IRS have consistently held for over 25 years that although such payments may be undertaken in connection with a capital transaction, triggered by a capital transaction, or even made as a critical condition of a capital transaction, the payments are properly deductible under section 162 because they are more closely related to compensation than the capital transaction itself. (31)

The IRS has long recognized the deductibility of severance and option payments. These payments do not lose their deductibility simply because they are made in connection with a capital transaction. For example, in Rev. Rul. 67-408, 1967-2 C.B. 84, two railroads merged, and the resulting company reduced its workforce by making severance payments and displacement or supplemental allowances pursuant to an agreement negotiated as part of the merger. The IRS held that the severance payments constituted "other compensation" within the meaning of section 162(a)(1) and were therefore deductible in the year of payment. See also Rev. Rul. 73-146, 1973-1 C.B. 61; Rev. Rul. 60-330, 1960-2 C.B. 46 (supplemental unemployment benefits intended to promote the welfare of employees laid off and employer's obligations arise directly in connection with, and relate proximately to, the carrying out of its trade or business).

Courts have also consistently held that severance or option payments are more closely related to compensation than the capital transaction that may trigger them. In Bagley v. Commissioner, 85 T.C. 663 (1985), aff'd, 806 F.2d 169 (8th Cir. 1986), the taxpayer had granted one of its employees an option to buy shares of the employer's common stock. When the taxpayer corporation was later acquired in a tender offer, the employee exercised his option at the high price set by the tender offer. The Tax Court rejected the employee's argument that the payment was connected with the tender offer rather than his employment and instead looked to the "purposes" of granting the options in the first instance, which were compensatory. See Rank v. United States, 345 F.2d 337, 339 (5th Cir. 1965).

c. Post-Acquisition Expenditures. Often an acquiring company will undertake additional expenditures after the acquisition ("Post-Acquisition Expenses"). Such Post-Acquisition Expenses could include such expenditures as reduction in the workforce or plant shut-downs. Such actions might even be required by the lenders as a condition of financing. In some pending audits, the IRS is arguing that such Post-Acquisition Expenses -- even if otherwise deductible -- are an integral part of the target's acquisition and must be capitalized. The cases require a sufficient nexus between the expenditure and the earlier, capital transaction. Absent such nexus, the expenditures are deductible.

One of the earliest cases illustrating the need for a strong connection between the acquisition and the expenditure is Osage Steamship Co. v. Commissioner, 3 B.T.A. 141 (1925), acq., 1926-1 C.B. 4. In Osage, the taxpayer had acquired a steamship and began loading her for her first voyage. Although the vessel was seaworthy and repairs were not required, during the loading the taxpayer decided to make substantial repairs and hired ironworkers to undertake a variety of jobs including "straightening [the] crankshaft, truing up journals, adjusting air pumps, tightening up various connections, reseating valves, and other similar work in the engine room." Id. at 141.

The Commissioner, while admitting that under ordinary circumstances the cost of repairs would be deductible as a business expense, argued that the repairs were part of the purchase of the vessel because they were intertwined with the sale itself:

[W]hen property which has been acquired is very shortly thereafter extensively repaired, the expenditures should be considered as a capital investment, even though they might be considered as ordinary and necessary expenses if the repairs had not been made immediately after acquisition of the property. Id. at 143. The Board of Tax Appeals rejected this interpretation and held instead that the expenditures must be judged standing on their own: "Repairs which are admittedly ordinary and necessary in the operation of a vessel are not required to be added to the capital investment merely because they were made soon after the acquisition thereof." Id.; see H.S. Crocker, Inc. v. Commissioner, 15 B.T.A. 175 (1929) (deduction allowed for post-acquisition repairs to building), acq., 1928-1 C.B. 36.

The Commissioner acquiesced in Osage and the principle is now longstanding. In the context of Indopco, the Osage holding is instructive because it clarifies that if Post-Acquistiion Expenditures are otherwise deductible, they should not be classified as capital expenses simply because they were made contemporaneously with or close in time to the acquisition.

d. The Nexus of a Fairness Opinion. If the question were squarely presented to a court, it is not clear that a court would find sufficient nexus between a capital transaction and a fairness opinion to require capitalization. Delaware imposes no specific obligation upon the directors to obtain a fairness opinion. Smith v. Van Gorkom, 488 A.2d 858, 881 (Del. 1985). The fairness opinion evidences that the directors have met their fiduciary opinion evidences that vis-a-vis all shareholders. See Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983). The transaction can proceed without a fairness opinion. If the directors proceeded without a fairness opinion, the cost of defending the directors in any subsequent legal action would be a business expense. (32) Similarly, the directors could purchase additional insurance from a carrier to cover them against claims brought by shareholders. Again, that expenditure is a business expense. The deductibility of expenses incurred by a corporation to protect its directors should not depend on the choice of prophylaxis. The fairness opinion serves as additional directors' "insurance," which is a business expense. It helps the directors fulfill their fiduciary obligation to the shareholders, which is an integral aspect of the job of being a director. In sum, the nexus between a fairness opinion and a capital transaction seems, at best, only an attenuated connection and instead is more related to helping the directors fulfill their fiduciary duty, like insurance or defensive litigation. Similar remedies should be treated similarly, and the deductibility of the payment becomes clear when one "look[s] at the economic realities of the situation in order to determine the appropriate tax consequences." Eastern Service Corp., v. Commissioner, 650 F.2d 379, 383 (2d Cir. 1981).

2. Allocation Issues

The allocation of a lump-sum expenditure between a currently deductible business expense and a capital expenditure is a critical issue in determining the degree of capitalization required for otherwise deductible expenditures. Neither of the parties in Indopco appears to have raised this issue, (33) and the Supreme Court did not address it in its decision. Nevertheless, it is clear that allocation is permissible under unchallenged case law. Such an allocation may be of critical importance in a later case where, for example, a lump-sum professional fee could be allocated between providing normal business advice and restructuring the corporation.

For 60 years courts have allowed taxpayers to allocate professional fees among various parts of a capital transaction and amortize or deduct currently according to that allocation. (34) In W.P. Brown & Sons Lumber Co. v. Commissioner, 26 B.T.A. 1192 (1932), the corporate taxpayer incurred various expenditures incident to incorporation, a bond issue, and the construction of a hotel. The company paid its attorney a lump sum for his work in connection with all of these activities. The Board of Tax Appeals held that this payment could be apportioned among the cost of legal services incident to the construction of the building (and made a part of the cost of the building), to the corporate organization (and capitalized in the basis of the stock), and to the loan (and spread over the 20-year life of the loan). Id. at 1197; see James Petroleum Corp. v. Commissioner, 24 T.C. 509, 519-20 (1955) (taxpayer could allocate legal fees between business expenses and capital expenditures in suit for both an accounting of profit and clear and free title to oil properties), aff'd, 238 F.2d 678 (2d Cir. 1956), cert. denied, 353 U.S. 910 (1957), acq., 1956-1 C.B. 4.

Such an allocation would be especially useful for taxpayers who paid lump-sum professional fees that cover, for example, services related to the issuance of both debt (where the cost may be amortized over the life of the debt) and equity (a non-amortizable capital expenditure). In the absence of additional evidence, courts and the IRS have often allocated pro rata based on the proceeds.

In Mallinckrodt v. Commissioner, 2 T.C. 1128 (1943), aff'd, 146 F.2d 1, cert. denied, 324 U.S. 781 (1945), acq., 1944 C.B. 18, for example, the taxpayer incurred expenses for financial advice and services in earning both taxable and non-taxable income. The Tax Court held that absent evidence of a more reasonable method, it would allocate lump-sum expenses to exempt and non-exempt income in the proportion that each bears to total income. Id. at 1148. Similarly, in Ellis v. Commissioner, 6 T.C.M. (CCH) 662 (1947), the Tax Court allocated expenses of attorneys fees between taxable and non-taxable income: "[I]n the absence of evidence establishing a portion of the expenditure allocable to non-taxable income, and in the absence of evidence indicating what would constitute a more reasonable basis for such allocation, the expenditure would be allocated to taxable and non-taxable income." Id. at 666; see Jamison v. Commissioner, 8 T.C. 173, 183 (1947) (allocation of office expenses in producing both taxable and non-taxable income based on amounts of income), acq., 1947-1 C.B. 2; E.I. du Pont de Nemours & Co. v. United States, 432 F.2d 1052 (3d Cir. 1970) (allocation possible, but failed for lack of proof).

An allocation between debt and equity in a typical leveraged buyout could result in a substantial portion of such legal fees being allocated to debt, with the opportunity for amortization. Although Indopco did not address the issues of nexus and allocation, the foregoing demonstrates that these inquiries can be critical in establishing the deductibility of expenditures undertaken contemporaneously with a capital transaction. The authorities on nexus and allocation continue to be good law after Indopco, and taxpayers should not confine themselves to arguments regarding the existence (or non-existence) of significant long-term benefits.

C. Application to Other Factual Situations

The Court not only confined the Indopco opinion to the legal issue of long-term benefit, but also carefully limited its holdings to the facts of Unilever's friendly acquisition of National Starch. It is therefore interesting to undertake a post-Indopco analysis of two situations not addressed in the Court's opinion: defensive expenditures to ward off a hostile takeover (without a white knight) (35) and abandoned merger plans. In both instances, the traditional precedential analysis (suggesting such expenditures are deductible) is consistent with the results from an application of the analysis in Indopco.

1. Defense Against Hostile Takeovers

A persistent concern of the Justices at oral argument -- and one that the opinion des not address -- is the tax treatment of expenditures made to defeat a hostile takeover. (36) Instead, the opinion emphasizes its narrow scope by repeated references to Unilever's "friendly" acquisition. Under the long-term benefit analysis of Indopco, however, hostile defense fees would not constitute capital expenditures. No aspect of defense enhances the value of the corporation or constitutes a betterment as compared with the status of the company before the hostile takeover. The defensive measures enable the corporation to continue its operations as before. The overarching goal of the defensive expenditures is to preserve the status quo. (37) (In one sense, these expenditures arguably have even lessened the value of the company in the short term by diverting resources from normal business operations.) Because there is no continuing benefit, and because the expenditures are otherwise deductible, under the Indopco analysis the expenditures would be currently deductible.

This treatment of defense fees is confirmed by a long line of precedent, including opinions from the Supreme Court, although the cases do not focus specifically on long-term or continuing benefit. Under this precedent, expenditures are currently deductible when undertaken to defend the company "against attack." These opinions, of course, are applicable whether the outside attack is a lawsuit against the business or a hostile tender offer.

In Commissioner v. Heininger, 320 U.S. 467 (1943), the taxpayer incurred litigation expenses to defend against charges of mail fraud that ultimately were adjuged to be true. The charges and remedial action sought the government "meant destruction of respondent's business." Id. at 409. The Court upheld the deduction for all of the defensive expenditures:

For respondent to employ a lawyer to defend his business from threatened destruction was 'normal'; it was the response ordinarily to be expected. ... [The taxpayer] was placed in a position in which not only his selling methods but also the continued existence of his lawful business were threatened with complete destruction. . . . Therefore he did not voluntarily abandon the business but defended it by all available legal means. To say that this course of conduct and the expenses which it involved were extraordinary or unnecessary would be to ignore the ways of conduct and the forms of speech prevailing in the business world. Surely the expenses were no less ordinary or necessary than expenses resulting from the defense of a damage suit based on malpractice, or fraud, or breach of fiduciary duty.

Id. at 471-72. Similarly, in Commissioner v. Tellier, 383 U.S. 687, 690 (1966), the Supreme Court allowed the taxpayer to deduct the cost of an unsuccessful defense against criminal securities fraud arising out of his business.

The expenses qualify as business expenses even where the event occurs only once in the life of the business:

[A] lawsuit effecting 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 . . . are the common and accepted means of defense against attack.

Welch v. Helvering, 290 U.S. 111, 114 (1933).

In addition, other courts have held that expenses of a company's defense against the attempts of a minority shareholder to seize control are currently deductible. Such efforts by a minority shareholder to obtain control of a corporation through a proxy fight are analytically indistinguishable from a hostile tender offer: in both instances a shareholder or potential shareholder inimicable to management seeks to acquire voting control of the corporation in order to direct its affairs. The courts have uniformly allowed such outlays as currently deductible expenses.

In Locke Manufacturing Cos. v. United States, 237 F. Supp. 80 (D. Conn. 1964), acq., Rev. Rul. 67-1, 1967-1 C.B. 28, a minority shareholder challenged several aspects of corporate policy. To unseat the current directors he instituted a lawsuit to inspect the shareholder lists and began an extensive proxy contest. After an extended conflict, the company prevailed in the proxy contest. The District Court allowed the deduction for all expenses of the proxy fight because the expenses "were incurred for the benefit of all stockholders in the good faith belief on the part of management that it was in the best interests of all stockholders successfully to resist Belknap's attempt to unseat the incumbent Board and to replace it with Belknap's slate." Id. at 85. In language equally applicable to hostile takeovers, the District Court noted:

A proxy contest has become a part of the corporate way of life; and the economic life of a corporation in all its fullness is the backdrop against which expenses incurred in a proxy contest must be analyzed to find the answer to the riddle whether they are ordinary and necessary from the revenue standpoint.

Id. at 87.

In Central Foundry Co. v. Commissioner, 49 T.C. 234 (1967), acq., 1968-2 C.B. 2, the Tax Court held that expenses of both the successful insurgents and the ousted management were deductible under section 162. The court held that such expenses were deductible when concerned with "a change in corporate policy" or actions undertaken "for the benefit of the corporation." Id. at 251. (38)

The holdings in these cases are consistent with Indopco. Moreover, Indopco made no suggestion that either the holdings or the approach of any of these cases is open to question. It therefore appears that defensive expenditures continue to be currently deductible under section 162(a).

2. Abandoned Efforts

Under the "long-term benefit test" of Indopco, outlays for abandoned efforts are not capital expenditures. The corporation derives no long-term benefit from abandoned plans. Such plans do not provide more than "an incidental future benefit" to the corporation. (39) Accordingly, such expenses would be currently deductible. In fact, courts have so held for over 55 years.

In Doernbecher Manufacturing Co. v. Commissoner, 30 B.T.A. 973 (1934), acq., 1934-2 C.B. 6, an Oregon furniture manufacturer joined a group of furniture companies on the West Coast to investigate a merger. The companies appointed a committee, which in turn appraised assets and investigated various matters, including the companies' finances. The committee subsequently advised the taxpayer that the proposed merger had been abandoned. The taxpayer was permitted to deduct the amount of its committee expenses. Id. at 982.

Similarly, in Portland Furniture Manufacturing Co. v. Commissioner, 30 B.T.A. 878 (1934), non-acq., 1934-2 C.B. 33, the taxpayer sought a merger. When the investment bankers stated that the merge was not possible, the taxpayer abandoned its plans and paid its investigatory expenses. One year later, other companies acquired all of the taxpyer's assets and liabilities. The Board of Tax Appeals allowed a business expense deduction for the investigatory expenses in the earlier year. Id. at 881.

Tax Court cases, expanding on the Board's holdings, have allowed an apportionment of and deduction for costs related to the abandoned parts of a multiple-choice proposal. In Sibley, Lindsay & Curr Co. v. Commissioner, 15 T.C. 106 (1950), acq., 1951-1 C.B. 3, the taxpayer employed Goldman Sachs to study its capital structure and render a report. After several months, Goldman submitted a report recommending three proposals, two of which were subsequently abandoned for legal and financial reasons. The IRS argued that the fees of the investment bankers and attorneys must be capitalized for all three plans because the taxpayer "did select and act in accordance with one of the plans presented to it." Id. at 110. The Tax Court, howver, held that the three proposals were separate and distinct suggestions, and two-thirds of the fees paid were attributable to the rejected proposals. Id.

As with the hostile defense cases, it appears that the approach and holding of these abandonment cases is not called into question by Indopco.

IV. ADDITIONAL STRATEGIES

Based on the foregoing analysis of Indopco's long-term benefit approach, the Court's emphasis on the taxpayer's burden of proof, the requirement of a nexus between an expenditure and a capital transaction before capitalization is required, and the possibilities for allocation of lump-sum expenditures, there are several strategies that the taxpayer may wish to consider:

1. The emphasis in the opinion on the taxpayer's burden of proof clearly demonstrates the importance of building a complete factual record to document where a transaction did (and did not) produce long-term benefits.

2. Taxpayers should explore carefully the possibility that some of their expenditures may not have sufficient nexus with the proposed capital transaction. They could thereby separate deductible from non-deductible expenditures.

3. Many lump-sum payments could be allocated between deductible and capitalizable expenditures, or could be allocated among capitalizable expenditures with different amortization schedules.

4. To the extent that an altered capital structure per se creates long-term benefits, further alterations to the capital structure may terminate this benefit, thereby enabling the taxpayer to take a deduction for the expenditures. For example, if Indopco were to go public again, it would lose the presumed benefits of a single, non-public shareholder, and the expenses associated with that capital change should be deductible.

V. CONCLUSION

The Supreme Courts' decision in Indopco eliminates any confusion about the separate and distinct asset test by holding that the creation of a separate and distinct asset was not a requirement for capitalization. It is, however, in all other respects a narrow opinion. The effect of its "long-term benefit" analysis on tax law will likely be quite small. Indopco, arguably, merely reiterates the well-settled rule that expenditures creating a continuing benefit to the corporation must be capitalized. Nevertheless, Indopco provides taxpayers with an important lesson about the approach court can be expected to take in assessing the deductibility of expenditures incurred in connection with mergers, acquisitions, and hostile takeovers. With that lesson in mind, taxpayers can develop effective responses to the increasingly aggressive positions by the IRS.

(1) Citations to page numbers in the Indopco opinion are to the official print of the opinion obtained from the Reporter of Decisions (hereinafter "Slip Op."). The Third Circuit's opinion is reported as National Starch & Chemical Corp. v. Commissioner, 918 F.2d 426 (2d Cir. 1990), and the Tax Court's as National Starch & Chemical Corp. v. Commissioner, 93 T.C. 67 (1989).

(2) In 1991 the charter of this Industry Specialization Program group was expanded to include general mergers and acquisitions. The group is now called the Leveraged Buyout/Merger and Acquisitions ISP.

(3) Slip Op. at 3.

(4) Id. at 3-4.

(5) "Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes." Id. at 5 (citations omitted).

(6) 290 U.S. 111 (1933).

(7) Id. at 114.

(8) Slip Op. at 8.

(9) Id. at 7 n.6.

(10) Id. at 9.

(11) Id. at 9-10. As to corporate structure-related benefits, the Court noted that National Starch was transformed from a public to a private company and that subtantial shareholder-relations expenses would be eliminated including reporting and disclosure obligations, proxy battles and derivative suits; it also noted the reduction in number of authorized but unissued shares of preferred stock and the reduction of the number of authorized shares of common stock.

(12) Id. at 10.

(13) Id. at 12.

(14) Id. at 11 (emphasis added).

(15) Id. at 5 (citations omitted).

(16) Id. at 9.

(170 The Supreme Court took the case to resolve a perceived conflict on this issue among the circuits. Compare Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775, 782-84 (2d Cir. 1973) (Lincoln Savings brought about a "radical shift in emphasis," making capitalization dependent on whether the expenditure creates or enhances a separate and distinct additional asset), and NCNB Corp. v. United States, 684 F.2d 285, 293-94 (4th Cir. 1982) (bank expenditures for expansion-related planning reports, feasibility studies, and regulatory applications did not "create or enhance separate and identifiable assets," and therefore were ordinary and necessary expenses under section 162(a) with National Starch, 918 F.2d at 431 (lack of separate and distinct asset "does not necessarily mean that an expenditure is ordinary and necessary under section 162(a)).

(18) See, e.g., E.I. du Pont de Nemours & Co. v. United States, 432 F.2d 1052, 1058-59 (3d Cir. 1970); General Bancshares Corp. v. Commissioner, 326 F.2d 712, 715 (8th Cir.), cert. denied, 379 U.S. 832 (1964); Farmers Union Corp. v. Commissioner, 300 F.2d 197, 200 (9th Cir.), cert. denied, 371 U.S. 861 (1962); Mills Estate, Inc. v. Commissioner, 206 F.2d 244, 246 (2d Cir. 1953).

(19) See, e.g., Missouri-Kansas Pipeline Co. v. Commissioner, 148 F.2d 460, 462 (3d Cir. 1945) (distribution to stockholders of warrants to purchase subsidiary's stock); Borg & Beck Co. v. Commissioner 24 B.T.A. 995, 1104 (1931) (change from par value stock to no par value); Holeproof Hosiery Co. v. Commissioner, 11 B.T.A. 547, 555-56 (1928) (increase in authorized capital stock).

(20) Id. at 8 (emphasis in original).

(21) Id. at 9.

(22) 93 T.C. at 75-77.

(23) 918 F.2d at 430.

(24) Indopco's transformation from a publicly-held, free-standing corporation to a corporation with one stockholder freed it from concerns regarding shareholder relations, eliminated the risk of any proxy fights brought by dissatisfied shareholders seeking to change corporate policy, rendered inapplicable state law rules mandating fair treatment of shareholders, freed Indopco from any shareholder's derivative suits, and eliminated the expense of annual filing of Forms 10-K with the Securities and Exchange Commission and of soliciting proxies voting on the Board of Directors and other matters. Because the expenditures effected a "restructuring of the enterprise" and "resulted in a benefit to the taxpayer which could expected to produce returns for many years in the future," E.I. du Pont de Nemours Co., 432 F.2d at 1059, the expenditures were capital in nature.

(25) See, e.g., E. H. Sheldon & Co. v. Commissioner, 214 F.2d 655, 659 (6th Cir. 1954) (advertising expenses); Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 338 (1962) (repairs), nonacq., 1964-2 C.B. 8; Treas. Reg. $S 1.162-5(a)(1) (employee training); id. $S 1.162-1(a) (advertising expenses).

(26) At the same time, the Court's attempt to draw distinctions between sections 161 and 162, on the one hand, and sections 261 and 262, on the other, based on which sections are "specifically enumerated" as opposed to "not exhaustively enumerated" does not appear to be helpful. Slip Op. at 4-5.

(27) The Tax Court opinion makes no reference to testimony on this issue. The Third Circuit's opinion describes certain relevant testimony as "self-interested" and internally inconsistent. 918 F.2d at 432.

(28) See Transamerica Corp. v. United States, 254 F. Supp. 504 (N.D. Cal. 1966), aff'd, 392 F.2d 522 (9th Cir. 1968); United States v. General Banchshares, 388 F.2d 184 (8th Cir. 1968).

(29) Slip Op. at 9 ("the transaction produced significant benefits"; "benefits" accrued from "acquisition"). The blurring of the distinction between the acquisition and all expenses incurred contemporaneously is betrayed in the Tax Court's discussion of the "dominant aspect" of the expenditures.

Petitioner argues that the dominant aspect of its expenditures was the fiduciary duty its directors owed to its shareholders and, accordingly, that its expenditures are deductible because they were incurred incident to that fiduciary duty. The dominant aspect of the transaction was not the fiduciary duty. Instead, the dominant aspect was the transfer of petitioner's stock for the benefit of petitioner and its shareholders.

93 T.C. at 78 (emphasis added).

(30) For the sake of simplicity, the discussion assumes the options in question constitute section 83 property. See I.R.C. $S 83(a).

(31) This analysis would not apply to the extent Congress has altered treatment of parachute payments under section 280G.

(32) International Shoe Co. v. Commissioner, 38 B.T.A. 81 (1938) (corporation may deduct cost of defending directors in suit for breach of fiduciary duty); Vermont Bank & Trust Co. v. United States, 296 F.Supp. 682, 686 (D. Vt. 1969) (deduction allowed for defending directors in legal action brought by dissenting shareholder after conclusion of capital transaction).

(33) The parties may have believed that the expenditures would all stand or fall together. The record reveals that the fee for legal counsel, for example, encompassed services related to advice regarding the director's fiduciary duty, preparation of a tax ruling, participation in negotiations and drafting of documents. 93 T.C. at 72. If a taxpayer were able to assert that there was an insufficient nexus between the director's fiduciary duty and the transaction, the taxpayer could then argue for allocation of such a lump-sum payment.

(34) See Buddy Schoellkopf Products Inc. v. Commissioner, 65 T.C. 640, 647 (1975) (in asset transaction portion of legal fees incurred attributable to trade names must be capitalied and remained currently deducted); see Bugher v. Commissioner, 9 B.T.A. 1155, 1158-59 (1928), acq., 1928-1 C.B. 5 (in suit for income and corpus of trust, settlement costs could be allocated between deductible expenditures relating to income and capital expenditures relating to defense of title).

(35) The use of a white knight in defense of a hostile takeover attempt raises additional issues beyond the defense of a business that cannot be addressed in the space for this article. The white knight strategy may entail changes at the shareholder level (e.g., exchanging many shareholders for one) See Slip Op. at 10 (benefits from "transformation from a publicly held, freestanding corporation into a wholly owned subsidiary". The white knight may also offer potential benefits in other areas, such as availability of resources. See, e.g., id. at 9-10 ("resource-related benefits" from Unilever acquisition). Even if the white knight costs were to be capitalized, costs related more to current defense of the business (or possibly a hostile suitor) should be allocated to the defense and deducted.

(36) See A. Horowitz, The Supreme Court's "Dim" View of the Bright-Line Test in Indopco, 54 Tax Notes 95, 96-97 (Jan. 6, 1992).

(37) An appropriate analogy is deductions for repairs after property, e.g., a building, has been damaged by an outside force. In that situation, the taxpayer is attempting to restore the status quo, just as the target in a hostile takeover is attempting to preserve the status quo. In the realm of expenditures made for repairs, a repair does not constitute an "improvement or betterment" -- and thus yields no "continuing benefit" to the extent it merely restores the status quo. See Plainfield-Union Water Co. v. Commissioner, 39 T.C. at 338 (relevant comparison with status before damage occurs).

(38) The IRS has adopted the foregoing analysis in Letter Ruling No. 90-43-003 (July 9, 1990), holding that expenses related to the defense of a hostile takeover are currently deductible as expenses paid in order to protect the business.

(39) See Slip Op. at 8.

McGEE GRIGSBY practices tax law with Latham & Watkins in Washington, D.C. He is chairman of the firm's D.C. Tax Department. He received his LL.M. from Harvard Law School. Mr. Grigsby specializes in tax controversy practice.

CABELL CHINNIS, JR. practices tax law with Latham & Watkins. He received his J.D. from Yale Law School. Mr. Chinnis has extensive experience in tax issues related to merger and acquisition expenses.