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Possible impact of INDOPCO decision on business start-up expenditures.

The amortization of start-up expenditures under Sec. 195 may be adversely affected by a recent Supreme Court decision, INDOPCO (formerly National Starch), 2/26/92, aff'g 918 F2d 426 (3d Cir. 1990). The Supreme Court unanimously held that investment banking, legal fees and related expenses incurred by a taxpayer to evaluate a friendly takeover by another corporation were not deductible as current business expenses, but rather had to be capitalized.

The Supreme Court dismissed the taxpayer's argument that a separate and distinct asset must be created for an amount to be classified as a capital expenditure. In doing so, the Court rejected a line of circuit court cases that generally held otherwise. (See NCNB Corp., 684 F2d 285 (4th Cir. 1982); Briarcliff Candy Corp., 475 F2d 775 (2d Cir. 1973); Central Texas Savings & Loan Ass'n, 731 F2d 1181 (5th Cir. 1984).)Instead, the Supreme Court stated that "the creation of a separate and distinct asset well may be a sufficient but not a necessary condition to classification as a capital expenditure."

Justice Blaekmun stated that "the mere presence of an incidental future benefit... may not warrant capitalization." However, a "taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization."

In applying this reasoning to the expenditures at issue in INDOPCO, the Supreme Court concluded that the takeover expenses produced significant benefits to the taxpayer beyond the tax year in question by enabling the taxpayer to have access to the considerable resources of the acquiror.

The potentially broad-reaching significance of this decision is that it establishes that the determination of whether an expenditure is capital or deductible is dependent on the existence of a benefit beyond the current tax year, not the creation of a separate and distinct asset. As a result, it is possible the IRS will aggressively apply this decision's rationale to areas beyond the merger and acquisition arena.

The Service may assert that if an expenditure produces a future benefit that is more than just incidental, it should be capitalized. Such a position may directly undermine the operation of Sec. 195, which is premised on the fact that start-up expenditures (eligible for amortization over 60 months or more) include only those items that would be currently deductible if incurred in an existing active trade or business in the same field (Sec. 195(c)(1)(B)). By denying a current deduction for expenses that produce more than an incidental future benefit, the types of expenses amortizable under Sec. 195 would be limited.

For example, an existing active trade or business incurs significant expenses to develop and implement a customer-specific sales promotion program. Under a literal reading of the Supreme Court's decision in INDOPCO, such costs might be required to be capitalized because of the presence of a significant future benefit (i.e., retention of current customers) beyond the tax year in which the expenditure was incurred. If this argument is successfully made, a start-up entity incurring similar costs would not be able to amortize such expenses under Sec. 195.

The Fourth Circuit recognized this potential problem well before the INDOPCO decision. In NCNB Corp., the court initially held costs incurred by the taxpayer to explore the expansion of its banking business (feasibility studies, long-range planning reports and regulatory applications) could not be currently deducted because such expenditures created a future benefit. The court reasoned that to deduct such expenses when incurred would violate the matching principle and not clearly reflect income.

On rehearing, however, the full Court of Appeals reversed. It decided to follow Briarcliff Candy (which INDOPCO now rejects) and held that such expansion costs were currently deductible because they did not create or enhance a separate and distinct asset.

In support of its holding, the Fourth Circuit noted that, under Sec. 195 as originally enacted, start-up expenditures included only those amounts that would be deductible "if paid or incurred in connection with the expansion of an existing trade or business." (Emphasis added.)However, the Deficit Reduction Act of 1984 amended Sec. 195 to broaden the definition of start-up expenditures to include expenses that would be deductible "if paid or incurred in connection with the operation as well as the expansion of an existing trade or business." (Emphasis added.) (See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 295-297.) The court in NCNB Corp. inferred from this that "Congress is thus under the impression that expenditures for market studies and feasibility studies, as at issue here, are fully deductible if incurred by an existing business undergoing expansion." To hold otherwise, the court stated, would "render [sections]195 meaningless for it would obliterate the reference point in the statute" of expansion of an existing trade or business.

If NCNB Corp. had been decided after the Supreme Court decision in INDOPCO, the court may well have concluded that the expenditures at issue produced more than an insignificant future benefit and should be capitalized. Hence, the court's warning in NCNB Corp. that Sec. 195 would be rendered "meaningless" if it held otherwise could, to some extent, become reality. If such expenditures are not currently deductible in an existing trade or business, by definition such expenditures would not be amortizable by a start-up entity (Sec. 195(c)( 1 )(B)).

It remains to be seen how aggressively the Service and the courts will apply the INDOPCO decision. If broadly applied, this decision could have far-reaching implications under Sec. 195. From Carl J. Grassi, CPA, Cleveland, Ohio
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Author:Grassi, Carl J.
Publication:The Tax Adviser
Date:Jul 1, 1992
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