Sec. 162 demutualization payment deductible, but not until paid.
Under the origin-of-the-claim doctrine, a transaction's nature, not a taxpayer's motive for or possible consequences of making the payment, governs whether an item is nondeductible, currently deductible or a capital expenditure.
In Gilmore, 372 US 39 (1963), the taxpayer deducted legal fees incurred in his divorce. He argued that if his spouse were successful in her suit against him, he would have lost his controlling stock interest in three companies, as well as his employment as president of those companies. Thus, the taxpayer asserted that he could deduct the legal fees as expenses for the conservation of property held for the production of income. The Court held that the origin of the claim was the taxpayer's marriage, and therefore personal in nature.
In the TAM, the taxpayer was originally incorporated as a nonstock, non-profit corporation. It was the successor to organizations originally formed as hospital service plans and medical service plans, providing prepaid hospitalization and medical services. At the time of the IRS audit, the taxpayer was in the health insurance business. Over time, it has been subjected to a series of changing regulatory regimes, and was classified at one time under applicable state law as a "health services plan," rather than as an insurance company. At some point, after concluding that its status as a health services plan placed it at a competitive disadvantage compared to commercial insurance companies, the taxpayer converted to a mutual insurance company.
Some time later, the taxpayer concluded that it needed better access to equity markets, from which it was excluded because of its mutual status. It sought access primarily in response to the rapid changes in the health insurance industry that required large investments for system development and expansion. The taxpayer began exploring the possibility of demutualizing, by which it would become a stock insurance company.
Following extensive negotiations with various state authorities, the taxpayer filed demutualization applications. These actions ultimately culminated in state legislation that set the payment amount the taxpayer had to make to apply for approval of the proposed demutualization. The taxpayer deducted the amount of the payment in year 14, and made the payment in year 15 (it effectuated the demutualization during year 15).
The taxpayer believed the demutualization payment was deductible, and qualified for the Sec. 461(h)(3) recurring-item exception, deductible in year 14 rather than year 15 (the year in which it made the payment).
The examining revenue agent rejected the taxpayer's position and proposed capitalization of the payment. Ultimately, the IRS National Office ruled that even though the payment was deductible under Sec. 162, it did not qualify for the recurring-item exception, making the payment deductible in the year paid.
Citing duPont, 308 US 488 (1940), the National Office pointed out that the payment's character depended on the facts and circumstances. It then moved on to the key issue--the application of the origin-of-the-claim doctrine.
After determining that the origin-of-the-claim doctrine applied, the National Office examined the nature of the payment's origin. Was it the demutualization (requiring capitalization) or the taxpayer's status as a non-profit, tax-exempt corporation (permitting a deduction)?
Although the National Office stated that the taxpayer had to capitalize costs incurred to demutualize, it pointed out that the taxpayer had capitalized certain costs directly connected with the demutualization. It went on to clarify that an otherwise deductible expenditure does not become a capital expenditure merely because of some temporal or circumstantial relationship to a capital transaction; see Connecticut Light and Power Co., 299 F2d 259 (Ct. Cl. 1962), and Rev. Ruls. 73-146 and 67-408.
The National Office noted that the claims in Rev. Ruls. 73-146 and 67-408 arose from a taxpayer's ordinary course of business, and existed independently of capital transactions. The fact that the taxpayers might not have made payments if the capital transactions had not occurred did not affect the payments' character as deductible ordinary and necessary business expenses. The taxpayer's payment in the case at hand was similar to the payments in question in the revenue rulings.
The taxpayer argued that the origin of its underlying obligation to make the payment originated from its status as a nonprofit, tax-exempt organization. It asserted that this status gave rise to certain claims or obligations that the state can assert against it under the cy pres doctrine, the constructive-trust doctrine or a similar doctrine for the public benefit. A state official supported these assertions, stating that the taxpayer's status as a nonprofit, tax-exempt corporation prior to the demutualization placed an obligation on the taxpayer to dedicate some or all of its assets to the public benefit. As a consequence, the taxpayer might be subject to claims by the state; some of its cash surplus had been derived from its tax-exempt and tax-advantaged status, as well as from the nonprofit status the taxpayer had enjoyed since its formation. In addition, the official asserted these positions throughout the demutualization process, further demonstrating that the underlying claims against the taxpayer existed prior to (and independent of) the demutualization.
These facts contradicted the revenue agent's argument that the taxpayer had no pre-existing legal obligation to make the payment. In light of the facts and circumstances, the National Office agreed with the taxpayer, stating that even though the taxpayer did not have to make the payment prior to the demutualization, the payment's origin was in the ordinary course of the taxpayer's business, not the demutualization.
The National Office also rejected the argument that the payment constituted a charge for the right to demutualize and thus provided the taxpayer with significant long-term benefits in keeping with INDOPCO, Inc., 503 US 79 (1992). Although applicable legislation arguably imposes such a charge to demutualize, the National Office had already concluded that the origin of the obligation was that which the taxpayer stated previously, and was incurred to extinguish existing liabilities.
Having disposed of the origin-of-the-claim issue, the National Office then explained why the payment was an "ordinary" and "necessary" business expense.
Because the National Office concluded that the payment was deductible under Sec. 162, it simply stated that it did not need to address whether the payment was deductible under Sec. 164.
Year of Deduction
Finally, the National Office addressed the tax year of deduction. The taxpayer argued that the payment was incurred in year 14 under Sec. 461 and the regulations. In other words, the taxpayer asserted that as of the end of year 14, under Kegs. Sec. 1.461-1(a)(2): (1) all events had occurred that established the fact of the liability, (2) it had been able to determine the amount of the liability with reasonable accuracy and (3) economic performance had occurred for the liability (subject to the recurring-item exception under Sec. 461(h)(3)).
The National Office agreed with the taxpayer on the first and second points, but rejected the taxpayer's position on the point of economic performance. Despite the fact that the National Office did consider the recurring-item exception, it still concluded that the taxpayer failed to satisfy the third point. The National Office reasoned that the payment did not qualify for the recurring-item exception because it was not a rebate or refund. As a result, the payment was deemed to have fallen under the rules for "other" payment liabilities under Regs. Sec. 1.461-4(g)(7), making it ineligible for the recurring-item exception.
The TAM clearly demonstrates that the revenue agent relied heavily on INDOPCO, arguing that the taxpayer received significant long-term benefits from the demutualization. However, the National Office distinguished between a situation in which a payment extinguished a pre-existing liability and yet remained deductible (even though it was a prerequisite for demutualization approval), and a situation in which the payment originated in the actual demutualization.
Given the IRS's frequent use of INDOPCO, TAM 200126008 provides an opportunity for taxpayers to demonstrate the inherent intricacies in any deduction-versus-capitalization debate, and the necessity for rigorous, fact-specific analysis before agreeing to unfavorable settlements with the IRS.
FROM ANDREW GANTMAN, CPA, MBT, WASHINGTON, DC
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|Publication:||The Tax Adviser|
|Date:||Jun 1, 2002|
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