Settlement payment held deductible under sec. 162(a).

In Chief Industries, Inc., TC Memo 2004-45, the Tax Court recently held that a taxpayer's settlement payment to its former chief executive officer (CEO) to terminate an employment agreement and other business-related claims, concurrently with the redemption of the CEO's outstanding shares, was deductible under Sec. 162(a). The court found that the settlement payment and the redemption payment should be regarded separately. While the years at issue preceded the effective date of the new regulations under Sec. 263(a) (TD 9107), the decision provides an interesting and not uncommon fact pattern involving Sees. 162(a) and (k), and 263(a).

Background

In 1993, the taxpayer's board of directors voted to replace the principal founder of the company as chairman of the board and CEO; shortly after this vote, the founder and the taxpayer entered into an employment agreement, under which the founder could use the title "chairman of the board emeritus" but could not exercise managerial authority. Subsequently, the founder and the board engaged in a prolonged series of disputes--including litigation--to control the taxpayer. Because of the substantial risk, time and expense revolved in the litigation against its founder, the board pursued settlement negotiations, beginning in 1995. In 1996, the parties reached an agreement under which the taxpayer, and the new chairman and CEO, purchased all of the founder's stock in the taxpayer for $37,223,114; the taxpayer also transferred to the founder a value of $3,082,710 in settlement of existing and potential disputes and in relinquishment of the founder's rights under the employment agreement.

The taxpayer deducted $3,082,710 as an ordinary and necessary business expense, reflecting the payment as "lawsuit settlement cost" on its return. The IRS disallowed the deduction, asserting that the payment was capital or, alternatively, that it was connected with the taxpayer's reacquisition of its stock.

Tax Court's Analysis

The court first examined the amount in dispute under Sec. 162(a), citing Lincoln Savings & Loan Ass'n, 403 US 345 (1971) and other authorities for the premise that an item, to be deductible under that provision, must be (1) paid or incurred during the tax year, (2) for carrying on any trade or business, (3) an expense, (4) a necessary expense and (5) an ordinary expense. The Service argued that the settlement payment was made in connection with acquiring a capital asset (i.e., the stock reacquisition), as well as to ensure that the former CEO did not attempt to regain control of the taxpayer, thus increasing the company's value. The taxpayer argued that the settlement payments were made partially to defend against attacks on its business practices and partially in cancellation of an employment agreement.

The court turned to the three-pronged test enunciated in Lychuk, 116 TC 374 (2001), which calls for capitalizing an expenditure if it (1) creates or enhances a separate and distinct asset, (2) produces a significant future benefit or (3) is incurred in connection with acquiring a capital asset. The IRS did not raise the second prong (i.e., significant future benefit), so the court did not address it. For the third prong, the court rejected the assertion that the expenditure was incurred in connection with acquiring a capital asset, and deferred detailed discussion until its analysis under Sec. 162(k).

Separate and distinct asset: The court next focused on the IRS's argument that the settlement payment created or enhanced a separate and distinct asset (the test's first prong). Citing the settlement agreement's substantive language, it found that the payment was made partially to settle all claims that the former CEO had or could have against the taxpayer and its directors, officers, employees and agents, as well as the employee stock option plan committee and trustee, and partially for the former CEO's resignation as a director, officer and employee, as well as a release of the taxpayer from its obligations under the employment agreement. Citing various authorities, the court noted that payments made to settle litigation are deductible if they have a business origin and are otherwise deductible under Sec. 162(a), and that payments made to discharge outstanding obligations under an employment agreement qualify for deductibility if they otherwise meet that section's requirements.

Citing Old Town Corp., 37TC 845 (1962), the court found that the portion of the payment made to settle litigation had a business origin, because (1) the board members lacked confidence that the taxpayer would prevail in the underlying litigation, (2) the taxpayer made the payment to avoid damages or liability it could have incurred absent the settlement and (3) the board members were justified in taking the former CEO's claims seriously and acted reasonably in attempting to settle all litigation so as to reduce time and cost.

The court found that both portions of the settlement payment met the five-pronged criteria for Sec. 162(a) deductibility, as set forth in Lincoln Savings. Accordingly, the entire settlement payment made to the former CEO was held deductible under Sec. 162(a).

Turning to Sec. 162(k) to address the Service's alternative argument for nondeductibility, the Tax Court first noted that the statute disallows an otherwise allowable deduction for amounts paid or incurred by a corporation in connection with the reacquisition of its stock. The court reasoned that the change was to determine whether the settlement payments fell under Sec. 162(k) as incurred in connection with a stock reacquisition; it explained that, although the phrase "in connection with" has a broad meaning, legislative history indicates that it is not intended to deny a deduction for an otherwise deductible amount simply because the payment is proximate in time to or arises out of the same circumstances as a redemption. In fact, a specific example in the legislative history appears to mirror the facts in Chief Industries; see H. Conf. Rep't No. 99-841 (Vol. II) at II-168 to II-169, 1986-3 CB (Vol. 4) 1, p. 168-169. The court rejected the Service's reading of the phrase "in connection with" and held that Sec. 162(k) did not apply to the settlement payment, as the redemption and settlement were not associated or related, except insofar as they were executed and negotiated by the same parties at the same time.

Conclusion

The new final regulations on capitalizing intangibles clearly would not apply to the years at issue in Chief Industries; see Regs. Sec. 1.263(a)-4(o). However, the regulations seem to suggest an answer consistent with the Tax Court's decision. First, they do not appear to directly affect Sec. 162(k); thus, that portion of the court's decision has ongoing vitality. The preamble to prior Prop. Regs. Sec. 1.263(a)-4 (REG-125638-01, 12/19/02), in discussing transactions subject to its provisions, stated, "[w]hile the term [reorganization] is broad enough to encompass stock redemptions, the treatment of costs incurred in connection with a stock redemption is specifically prescribed by section 162(k)"; see also Regs. Sec. 1.263(a)-5(a)(3) (excluding a taxpayer's acquisition of an ownership interest in itself from the types of transactions subject to Regs. Sec. 1.263(a)-5, presumably because of Sec. 162(k)). Although the regulations address other capital acquisition transactions, there was no other business acquisition at issue in Chief Industries. (For a discussion, see Braverman and Geracimos, Tax Clinic, "Final Regs. on Capitalizing Transaction Costs," p. 339, this issue.)

As to the IRS's argument that the payment to the former CEO created or enhanced a separate and distinct asset, Regs. Sec. 1.263(a)-4(b)(3)(i) provides:

The term separate and distinct intangible asset means a property interest of ascertainable and measurable value in money's worth that is subject to protection under applicable State, Federal or foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business.

The resolution of the employment agreement and other business claims between Chief Industries and its former CEO seems neither of measurable or ascertainable value nor capable of being sold, transferred or pledged. Because the above provision appears to exclude the settlement payment from the definition of a "separate and distinct intangible asset," and because no other provision in the final regulations appears to require its capitalization, a similar payment ought to be deductible. Thus, assuming arguendo that the new regulations were applicable to Chief Industries, it would seem unlikely that the IRS would raise this argument or that the court would reach a result different than under prior law.

David Madden, J.D., LL.M.

Principal

Washington National Tax Service

KPMG LLP 

Washington, DC

FROM FRENCH L.TAYLOR, II, CPA, AND SCOTT W. VANCE, J.D., LL.M., WASHINGTON, DC