Wells Fargo & Co. v. Commissioner IR

United States Court of Appeals
FOR THE EIGHTH CIRCUIT
___________
No. 99-3307
___________
WELLS FARGO & COMPANY )
AND SUBSIDIARIES, )
)
Petitioner-Appellant, )
) Appeal from the United
v. ) States Tax Court.
)
COMMISSIONER OF INTERNAL )
REVENUE, )
Respondent-Appellee. )
___________
Submitted: June 12, 2000
Filed: August 29, 2000
___________
Before LOKEN and BRIGHT, Circuit Judges, and HAND1, District Judge.
___________
HAND, United States District Judge for the Southern District of Alabama, sitting by
designation.
This case is before the Court on appeal from the Tax Court, which determined
that $150,000 worth of salaries paid to Davenport's corporate officers must be
1
The Honorable William Brevard Hand, United States District Judge for the
Southern District of Alabama, sitting by designation.
capitalized, rather than deducted fully during the year in which the salaries were paid.
The Tax Court also held that $111,270 of fees and disbursements paid to Davenport's
attorneys must capitalized. The Tax Court determined that the United States Supreme
Court case, INDOPCO, Inc. v. Commissioner, required capitalization of these
expenses. 503 U.S. 79 (1992). It is this Court's determination that the Tax Court is
due to be REVERSED IN PART.
FACTUAL HISTORY
For the purposes of this decision, the Court hereby adopts most of the facts
found by the Tax Court. The following are the facts, as found by the Tax Court, with
only minor changes (noted in brackets), which are made to facilitate continuity within
this opinion.
1. General Information
Norwest is a bank holding company that was incorporated in 1929.
It is the parent corporation of an affiliated group of corporations (Norwest
consolidated group) that files consolidated Federal income tax returns. Its
affiliates include 79 commercial banks in 12 States and numerous other
corporations which provide financial services. Norwest's stock is traded
on the New York and Midwest Stock Exchanges.
Bettendorf Bank, National Association ([Bettendorf]), is a member
of the Norwest consolidated group. [Bettendorf] is a national banking
association operating under a charter granted by the Office of the
Comptroller of the Currency (OCC). [Bettendorf] conducts a general
banking business from its main office in Bettendorf, Iowa, and from two
branches, one in Bettendorf and the other in Davenport, Iowa.
[Davenport] is an Iowa State bank that was incorporated in 1932.
Before the transaction (defined below), it provided banking and related
services in the four-city area that consists of Davenport, Bettendorf, Rock
Island, Illinois, and Moline, Illinois (Quad Cities area). Its main office
was in Davenport, and it had four branches, three in Davenport and one
in Donahue, Iowa. It filed a consolidated Federal income tax return with
two wholly owned subsidiaries.
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[Davenport]'s only class of stock was thinly traded in the
Davenport over-the-counter market. It had 1.2 million shares outstanding,
and [Davenport]'s founder (V.O. Figge) and his five children (collectively,
the Figges) owned, collectively and beneficially, the following numbers
and percentages of these shares:
Number Percentage
------- ----------
V.O. Figge 41,843 3.5
John K. Figge 61,140 5.1
James K. Figge 63,450 5.3
Thomas K. Figge 71,855 6.0
Ann Figge Brawley 77,890 6.5
Marie Figge Wise 69,655 5.8
------- ----------
385,833 32.2
[Davenport]'s directors and executive officers, other than the Figges,
owned another 69,727 (5.8 percent) of these shares on September 18,
1991.
2. The Transaction
In 1989, Iowa adopted interstate banking legislation that allowed,
for the first time, the acquisition of Iowa banks by banking institutions
located in States which were contiguous with Iowa and which had
enacted reciprocal legislation. [Davenport]'s management expected that
national banking would follow and that many large banks, including some
from outside Iowa, would be competing in the Quad Cities area.
[Davenport]'s management was concerned that banks of [Davenport]'s
size (i.e., larger than the small community banks and smaller than the
large regional banks) would be unable to compete in the future.
During 1990, Norwest began talking to [Davenport] about joining
their businesses, and these discussions intensified in early 1991.
[Davenport] retained the law firm of Lane & Waterman (L & W) to assist
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it in these discussions. L & W investigated whether [Davenport] would
strategically fit with Norwest and its affiliates, and whether a
reorganization between [Davenport] and Norwest would be good for the
community.
On June 10, 1991, [Davenport]'s board of directors met to consider
merging [Davenport] into Norwest. Over V.O. Figge's objection to the
merger, the board authorized John K. Figge, James K. Figge, and Thomas
K. Figge, in their capacities as executive officers, to negotiate with
Norwest and to hire legal and other representatives with the intent to
recommend to [Davenport]'s board a letter of intent between [Davenport]
and Norwest on a plan of reorganization. The board also appointed an ad
hoc committee (special committee) consisting of four outside directors to
perform an independent due diligence review, to obtain professional
advice, and to report to [Davenport]'s board as to the fairness and
appraisal of the proposed transaction. Norwest's board of directors, on the
same day, authorized using up to 10 million shares of Norwest common
stock to effect a transaction with [Davenport].
[Davenport] retained J.P. Morgan & Co., Inc., as its financial
adviser for any transaction with Norwest and to render an opinion as to
the fairness of the consideration that [Davenport]'s shareholders might
receive in the transaction. [Davenport] retained KPMG Peat Marwick to
render opinions primarily on whether the proposed transaction would be
a reorganization for Federal income tax purposes, and whether the
proposed transaction would qualify for a desired method of accounting.
On July 22, 1991, [Davenport]'s board met to consider a
transaction (transaction) whereby [Davenport] and [Bettendorf] would be
consolidated to form a national bank (New Davenport) which would be
wholly owned by Norwest. At the meeting, the special committee
recommended that the transaction be approved, and J.P. Morgan opined
that the transaction was fair to [Davenport]'s shareholders from a financial
point of view. [Davenport]'s board approved the transaction. On the same
day, [Bettendorf]'s board approved the transaction.
Four other events also occurred on July 22, 1991, with respect to
the transaction. First, Norwest, [Bettendorf], and [Davenport] entered into
an agreement (agreement) whereby they agreed to the transaction subject
to regulatory approval, approval of [Davenport]'s and [Bettendorf]'s
shareholders, and the satisfaction of certain conditions which included: (1)
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The receipt of regulatory approvals, including the approval of the OCC,
without any requirement or condition that Norwest would consider unduly
burdensome, and (2) the receipt of Peat Marwick's opinions that the
transaction would qualify for the desired method of accounting and as a
tax-free reorganization.
Second, Norwest entered into voting agreements with certain
[Davenport] shareholders. These shareholders held 24.5 percent of
[Davenport]'s stock and included John Figge, James Figge, Thomas Figge,
and other members of the Figge family. The voting agreements provided
that these shareholders would vote their shares in favor of the transaction
and that they would help Norwest complete the transaction.
Third, [Bettendorf] entered into employment agreements with V.O.
Figge, John Figge, James Figge, Thomas Figge, and Richard R. Horst.
The employment agreements provided that the five listed people would
be employed as officers of New Davenport for 1 year at the same salaries
they were receiving from [Davenport]. The parties to the transaction
contemplated that John Figge, James Figge, and Thomas Figge would
become senior vice presidents of New Davenport and that the members
of [Davenport]'s board would become members of New Davenport's
board. Norwest agreed to cause John Figge to be elected to its board.
Fourth, Norwest issued a press release announcing that it had
agreed with [Davenport] to acquire [Davenport]. The release, quoting
V.O. Figge, stated in part:
After extensive deliberations, the Board [of [Davenport] has
determined that it is in the best interests of Davenport Bank
and its stockholders, customers, employees, and the
community it serves, to become part of a larger and more
diversified financial institution that offers local, national and
international resources through what might be termed a
personal hometown presence * * *
*******
It is for these reasons that the board has given careful
consideration to a merger with an organization that
competes aggressively on a regional and national basis, and
can provide the Quad-Cities with a broader array of banking
products and services.
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Following the signing of the agreement, Norwest commenced a due
diligence review on [Davenport] and on [Davenport]'s business activities.
[Davenport] employees and L & W helped Norwest perform the review,
which lasted throughout August. L & W primarily acted as the contact for
both Norwest and [Davenport].
On or about August 29, 1991, Norwest applied to the OCC for
approval to consolidate [Davenport] and [Bettendorf]. At or about the
same time, a prospectus was filed with the Securities and Exchange
Commission (SEC) for the issuance to [Davenport] shareholders of up to
10 million shares of Norwest common stock upon the consummation of
the transaction. The prospectus also served as the proxy statement for a
special meeting (special meeting) of [Davenport]'s shareholders to be held
on November 26, 1991, for the purpose of voting on the transaction. The
SEC approved the proxy statement, and it became effective on October
23, 1991. On the effective date, [Davenport] notified its shareholders of
the special meeting, advised them that its board recommended voting in
favor of the transaction, and mailed them a copy of the proxy statement.
On November 20, 1991, [Bettendorf]'s board called a special
shareholder meeting for December 19, 1991, for the purpose of voting on
the transaction.
At the special meeting on November 26, 1991, [Davenport]'s
shareholders approved the transaction. Approximately 3 weeks later,
[Bettendorf]'s shareholders approved the transaction.
On or about January 29, 1992, the OCC approved [Davenport]'s
consolidation with [Bettendorf], effective January 19, 1992. Shortly
before the approval, [Davenport] and [Bettendorf] had entered into an
agreement providing that the transaction would be effective as of 12:01
a.m. on the date that it was approved by the OCC. Thus, on January 19,
1992, the transaction became effective. Among other things, (1)
[Davenport] and [Bettendorf] were merged to form a consolidated
national banking association under [Bettendorf]'s charter and under the
name "Davenport Bank and Trust Company" and (2) New Davenport
became a wholly owned subsidiary of Norwest, Norwest exchanging
9,665,713 shares of its common stock for the stock of [Davenport] (other
than fractional shares and shares with respect to which dissenter's
appraisal rights were exercised and for which $33,341 was paid) and then
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receiving all the stock of New Davenport in exchange for the stock of
[Davenport].
Following the transaction, New Davenport carried on a banking
business. New Davenport's main office was the same office as
[Davenport]'s, and New Davenport's branches were at the four locations
at which [Davenport] had formerly operated (not including the main
office) and at each of the three locations at which [Bettendorf] had
formerly operated (including the location that had been [Bettendorf]'s
main office). New Davenport offered a wider array of products and
services than [Davenport] had offered before the transaction and
continued [Davenport]'s tradition of being a charitable and community
leader.
[Davenport]'s board and management anticipated that the
transaction would produce significant long-term benefits for [Davenport]
and its shareholders, among others.
3. Costs Incurred by [Davenport] in 1991
During 1991, [Davenport] paid L & W $474,018 for services
rendered ($460,000) and disbursements made ($14,018) during the year.
[Davenport] deducted the $474,018 on its 1991 Federal income tax
return.
Petitioner concedes that [Davenport]'s $474,018 deduction was
improper, alleging that the deduction should have been $111,270.
[Davenport] paid $83,450 of the $111,270 for services rendered (and
disbursements made) before July 21, 1991, in investigating the products,
services, and reputation of Norwest and [Bettendorf], ascertaining
whether Norwest and [Bettendorf] would be a good business fit for
[Davenport], and ascertaining whether the proposed transaction with
Norwest and [Bettendorf] would be good for the Davenport community.
None of the $83,450 was for fees or disbursements related to services
performed by L & W in negotiating price, working on the fairness
opinion, advising [Davenport]'s board with respect to fiduciary duties, or
satisfying securities law requirements.
Twenty-three thousand, seven hundred dollars of the $111,270
related to services performed (and disbursements made) by L & W in late
July and August 1991 in connection with Norwest's due diligence review.
The remainder of the amount alleged to be deductible ($4,120) related to
services performed (and disbursements made) by L & W in connection
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with investigating whether Norwest's director and officer liability
coverage would protect [Davenport]'s directors and officers following the
transaction, for acts and omissions occurring beforehand. At the time of
the services, [Davenport] had a director and officer policy that was due
to expire on January 23, 1992. Norwest agreed with [Davenport] to
maintain insurance until at least January 18, 1995, that would protect
[Davenport]'s directors and officers against acts and omissions occurring
before January 19, 1992, [. . .]. Norwest eventually bought such a policy.
During 1991, [Davenport] had 9 executives and 73 other officers
(collectively, the officers). John Figge, James Figge, Thomas Figge, and
Richard Horst worked on various aspects of the transaction, as did other
officers. None of the officers were hired specifically to render services on
the transaction; all were hired to conduct [Davenport]'s day-to-day
banking business. [Davenport]'s participation in the transaction had no
effect on the salaries paid to its officers. Of the salaries paid to the
officers in 1991, $150,000 was attributable to services performed in the
transaction. [Davenport] deducted the salaries, including the $150,000, on
its 1991 Federal income tax return. Respondent disallowed the $150,000
deduction; i.e., the portion attributable to the transaction.
Norwest Corp. and Subsidiaries v. Commissioner, 112 T.C. 89 (1999) (footnotes
omitted).2
ISSUES OF LAW
The issue before this Court is twofold: 1) whether the Tax Court erred in holding
that $150,000 of Davenport's officer's salaries must be capitalized and 2) whether the
Tax Court erred in holding that $111,270 of Davenport's legal expenses associated with
its consolidation must be capitalized. These are questions of law which the Court will
review de novo.
2
The caption of this case on Appeal lists "Wells Fargo" as the Petition-Appellant,
rather than Norwest. This is due to another (subsequent) bank merger.
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The Internal Revenue Code allows deductions for "all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business."
I.R.C. §162(a). On the other hand, "§263 of the Code allows no deduction for a capital
expenditure— an 'amount paid out for new buildings or for permanent improvements
or betterments made to increase the value of any property or estate.'" INDOPCO Inc.
v. Commissioner, 503 U.S. 79, 83 (1992) (quoting I.R.C. §263). To qualify for a
deduction, "an item must (1) be 'paid or incurred during the taxable year,' (2) be for
'carrying on any trade or business,' (3) be an 'expense,' (4) be a 'necessary' expense, and
(5) be an 'ordinary' expense." Commissioner v. Lincoln Savings and Loan Assoc., 403
U.S. 345 (1971). The parties to this case agree that the first four requirements are met
here. However, it is disputed whether the expenses in this case can properly be
characterized as "ordinary".
The principle function of the term "ordinary" is to distinguish a deductible
expense from one that is capital. Commissioner v. Tellier, 383 U.S. 687, 689-90
(1966). An ordinary expense may be fully deducted during the taxable year. A capital
expenditure, on the other hand, must be depreciated over the life of the asset with
which the expenditure is associated, or, where no specific asset or useful life can be
ascertained, it is deducted upon dissolution of the enterprise. INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 83-84 (1992). The Tax Court determined that none of the
expenses at issue here were ordinary. Therefore, the Tax Court held that all of the
expenses must be capitalized rather than deducted. For the reasons set forth below, the
Tax Court's decision is due to be REVERSED.
Supreme Court Precedents
The Tax Court erred in its interpretation of the INDOPCO case. In order to most
effectively explain the Tax Court's error in logical reasoning, this Court will first
analyze another Supreme Court case, Lincoln Savings, which spurred similar logical
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fallacies among the Circuit Courts of Appeals. Eventually, the Supreme Court decided
INDOPCO in an attempt to clarify the meaning of Lincoln Savings.
Lincoln Savings
In 1971, the Supreme Court decided the case of Commissioner v. Lincoln
Savings and Loan Assoc., 403 U.S. 345 (1971). In Lincoln Savings, the issue was
whether a Savings and Loan association could deduct an "additional premium" which
it paid to the Federal Savings and Loan Insurance Corporation (FSLIC). Initially
Savings and Loan companies were only required to pay one premium to the FSLIC.
However, beginning January 1, 1962, the insureds were required to pay two premiums.
The first premium funded the Primary Reserve, which was a general insurance fund for
all participants. The "additional premium" funded the Secondary Reserve, of which
Lincoln held a pro rata share. In other words, Lincoln had an actual property interest
in the Secondary Reserve. For reasons more fully explained in the text of the Lincoln
Savings decision, the Supreme Court determined that the "additional premium" paid by
Lincoln created or enhanced a separate and distinct additional asset for Lincoln. One
of the arguments put forth by Lincoln was "that the possibility of a future benefit from
the expenditure does not serve to make it capital in nature as distinguished from an
expense." Id. at 354. Responding to this argument, the Court stated, "the presence of
an ensuing benefit that may have some future aspect is not controlling; many expenses
concededly deductible have prospective effect beyond the taxable year." Id. Justice
Blackmun continued: "What is important and controlling, we feel, is that the [additional
premium] payment serves to create or enhance for Lincoln what is essentially a
separate and distinct additional asset and that, as an inevitable consequence, the
payment is capital in nature and not an expense, let alone an ordinary expense,
deductible under §162(a). . . ." Id.
No less than five of the Federal Circuit Courts of Appeals erroneously
interpreted the above quoted language from Lincoln Savings to mean that the Supreme
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Court had adopted a new test for determining whether an expenditure was currently
deductible or must be capitalized. See e.g. Briarcliff Candy Corp. v. Commissioner,
475 F.2d 775 (2nd Cir. 1973); NCNB Corp. v. United States, 684 f.2d 285 (4th Cir.
1982); Central Texas Savings & Loan Assoc. v. United States, 731 F.2d 1181 (5th Cir.
1984); Colorado Springs National Bank v. United States, 505 F.2d 1185 (10th Cir.
1974); First Security Bank of Idaho v. Commissioner, 592 F.2d 1050 (9th Cir. 1979)
(adopting the 10th Circuit's Colorado Springs decision). Each of these Circuits, in
response to the Lincoln Savings decision, adopted a new "separate and distinct
additional asset" test, or some variation thereof. The new test permitted necessary
business expenditures to be fully deducted during the taxable year unless the
expenditure created or enhanced a separate and distinct additional asset.
The Courts which adopted this new test tended to focus on two assertions made
by Justice Blackmun: 1) the presence of a "future benefit" characteristic is "not
controlling", and 2) it was important and controlling that a separate and distinct asset
had been created by the expenditure. See Briarcliff, 475 F.2d at 782; NCNB Corp.,
684 F.2d at 289, 291; Central Tex. Sav., 731 F.2d at 1184; Colorado Springs, 505 F.2d
at 1192. These Circuits misunderstood Lincoln Savings to hold that only expenditures
which created or enhanced a distinct asset should be capitalized, and all other
expenditures, regardless of their "future benefit" characteristics, should be deducted.
Such a mistake in logic is quite simple and all too common. However, the
impact of such a fallacy is dramatic. "In order to give precision to our ideas and
eliminate the risk of confusion resulting from the somewhat vague meanings attached
to words in ordinary usage, it is sometimes helpful to use arbitrary symbols in place of
words." WADDELL, WARD JR., STRUCTURE OF LAWS: AS REPRESENTED BY SYMBOLIC
METHODS 1 (1961). Therefore, to simplify this analysis we can speak in terms of logic
equations and diagrams, using the following symbols:
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A = physical capital ASSET created or enhanced;
-A3 = NO physical capital ASSET created or enhanced;
B = BENEFIT beyond the taxable year;
-B = NO Benefit beyond the taxable year;
R = the expense is directly Related to B;
-R = the expense is only indirectly Related to B;
C = CAPITALIZE;
-C = do NOT Capitalize =4
D = DEDUCT.
Lincoln Savings, held that if an expenditure creates or enhances a separate and distinct
physical asset, then you must capitalize that expenditure. Lincoln Savings 403 U.S. at
354 (because the payments created or enhanced a capital asset, "as an inevitable
consequence, the payment is capital in nature. . . ." (emphasis added)). In other words,
"if A then C".5 The mistake in logic occurs when courts misread "if A then C" as if it
3
The "squiggly" line (-) is properly known as the "not" symbol. Therefore, -A
is read "not A".
4
We can say that -C is equal to a deduction because we are assuming all other
requirements for deduction are present. If the expense is ordinary, then it will not be
capitalized but will instead be deducted.
5
In fact, this expression is best symbolized as: Aº ºC. See WADDELL, Supra at
4. However, for the ease of readers who are unaccustomed to interpreting many of the
symbols used in logical equations, the body of this opinion will intermix language with
symbols.
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read "only if A then C".6 Clearly, the two statements are different and yield different
results. Another way to misstate the holding of Lincoln Savings is to say "if -A then
-C,"7 but this too is not interchangeable with the actual holding, "if A then C." An
equally poor reading of the term "if A then C", would be "if C then A."8 Unless two
terms are proven to be reflexive of one another, they can not be haphazardly
interchanged. And yet these are the very mistakes in logic that some Circuits were
laboring under while misinterpreting Lincoln Savings. By establishing a "new test"
which would not require capitalization unless a new asset was created, those courts
were reading Lincoln Savings to hold one of the following: 1) "if C then A", 2) "only
if A then C" or 3) "if -A then -C", none of which is equivalent to the true holding, "if
A then C."
Furthermore, in Lincoln Savings, Justice Blackmun wrote, "the presence of an
ensuing benefit that may have some future aspect is not controlling; many expenses
concededly deductible have prospective effect beyond the taxable year." (emphasis
added) Lincoln Savings, 403 U.S. at 354. Using our logic terms, we can re-write this
statement: "B … C." (B does not equal C.) This however, was misunderstood to mean
that B is irrelevant when trying to determine C. This simply is not true. When
determining whether a necessary business expenditure must be capitalized or deducted,
it is of critical importance to determine whether the expenditure resulted in a long term
6
/
Once again the proper symbolic expression is: C A (which is properly read,
"C, if, and only if, A.") Id. For ease of reading, we will simply substitute the phrase
"only if A then C" for the term C /A. Symbolically however, it is clear that (Aº …
ºC)…
(C /A).
7
-Aº
º-C. Id.
8
AºC is not necessarily equivalent CºA.
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benefit (B). INDOPCO, 503 U.S. at 87, 88 (Justice Blackmun once again writing for
the Court).
INDOPCO v. Commissioner
After more than twenty years of confusion and disagreement among the Circuits,
the Supreme Court issued its opinion in INDOPCO, Inc. v. Commissioner, 503 U.S.
79 (1992). Once again writing for the Court, Justice Blackmun attempted to clarify the
holding of Lincoln Savings. "Lincoln Savings stands for the simple proposition that a
taxpayer's expenditure that 'serves to create or enhance. . . a separate and distinct' asset
should be capitalized under §263. It by no means follows, however, that only
expenditures that create or enhance separate and distinct assets are to be capitalized
under §263." Id. at 86, 87. Thus, INDOPCO clearly and unequivocally demonstrates
that statements such as "only if A then C", and "if -A then -C" are false statements.
Justice Blackmun continues his explanation of Lincoln Savings by stating: "In short,
Lincoln Savings holds 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." Id.
at 87. So it appears that the inquiry may end once it is determined that the expenditure
DID create a separate and distinct asset (A). This would be true because, it is "an
inevitable consequence [that] the payment is capital in nature" when it "serves to create
or enhance . . . a separate and distinct additional asset." ("if A then C") Lincoln
Savings, 403 U.S. at 354. On the other hand, the inquiry continues if it is determined
that the expenditure DID NOT create a new capital asset (-A). And this was the point
of the INDOPCO case.
In INDOPCO, the Supreme Court required capitalization of expenses incurred
by the target corporation during a planned friendly takeover by another company. 503
U.S. at 90. To facilitate a friendly takeover, the taxpayer in INDOPCO paid for
investment banking services, legal services, and miscellaneous expenses directly
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related to the takeover.9 Unlike the case at hand, INDOPCO was not a situation
wherein the Commissioner sought to capitalize portions of the taxpayers salary
expenditures. Citing Lincoln Savings as authority, the taxpayer in INDOPCO argued
that although the expenditures at issue were directly related to the takeover, and
provided the taxpayer with long term benefits, they did not create or enhance a separate
and distinct asset and therefore should not be capitalized. (See Pet. Br. in INDOPCO
at 1991 WL 521588). In other words, the taxpayer argued the false proposition "if -A
then -C." As explained above, Justice Blackmun dispelled such a notion. In an effort
to drive home this point, and eliminate the myth that long term benefits (B) are
irrelevant when deciding whether to capitalize or deduct, the Court wrote:
Nor does our statement in Lincoln Savings, that "the presence of an
ensuing benefit that may have some future aspect is not controlling"
prohibit reliance on future benefit as a means of distinguishing an ordinary
business expense from a capital expenditure. Although the mere presence
of an incidental future benefit--"some future aspect"--may not warrant
capitalization, 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.
(citation omitted) (footnote omitted) INDOPCO, 503 U.S. at 87.
This tells the reader that B is "undeniably important in determining whether" D
or C is "the appropriate tax treatment." Id. In fact B is "a prominent, if not
predominant, characteristic of a capital item." Id. at 87, 88. On the other hand, Lincoln
Savings tells the reader that "the presence of [B] is not controlling. . . ." Is it possible
the same Justice wrote both of these apparently contradictory statements without
intending to contradict himself? The answer is "yes". In Lincoln Savings, the issue of
9
This direct relationship becomes important later in the analysis.
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B was not controlling because it became moot once the Court decided that the
expenditure created or enhanced a separate and distinct asset. Such an asset, by its
very nature, is capital, and the associated expenses must therefore be capitalized ("if
A then C"). INDOPCO points out that a prominent characteristic of a capital item is
that it provides B ("if C then B"). Building on the two propositions "if A then C"10 and
"if C then B"11, we can conclude "if A then C then B."12 Put more simply, "if A then
B."13 This conclusion not only follows logically, but it also makes legal sense.
Essentially, we are saying that if an expenditure creates or enhances a separate and
distinct asset, then it is a capital item which (by its very nature) provides long term
benefits and must be capitalized. See e.g. Lincoln Savings 403 U.S. at 354; See e.g.
INDOPCO 503 U.S. at 86-88. This is the holding of Lincoln Savings as explained by
INDOPCO.
According to INDOPCO there are occasions when an expenditure does not
create a new asset (-A), and yet the expense must still be capitalized (C). However,
we also know that there are occasions when -A results in a deduction (D). Thus we
conclude, "if -A then (C or D)." How then do we determine whether capitalization or
deduction is the proper tax treatment when considering an expenditure which does not
create or enhance a separate and distinct asset (-A)? This determination is dependant,
to a certain extent, on the presence of a long term benefit (B) associated with the
expenditure. If there is not a long term benefit (-B) associated with the expenditure,
10
See Lincoln Savings 403 U.S. at 354.
11
See INDOPCO 503 U.S. at 86-88.
12
WADDELL supra at 7.
13
Id.
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then the appropriate tax treatment is current deduction.14 This, of course, is true
because "the [Internal Revenue] 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." INDOPCO 503 U.S. at 84. If
there is no long term benefit, there is no need to postpone the tax benefit into later
years.15
On the other hand, what if the expenditure does not create or enhance a separate
and distinct asset (-A), but does provide a long term benefit (B)? There is no easy
answer for this question. Which is why Justice Blackmun wrote in INDOPCO,
The Court has recognized, however, that the "decisive distinctions"
between current expenses and capital expenditures "are those of degree
and not of kind," Welch v. Helvering, 290 U.S., at 114, 54 S.Ct., at 9,
and that because each case "turns on its special facts," Deputy v. Du
Pont, 308 U.S., at 496, 60 S.Ct., at 367, the cases sometimes appear
difficult to harmonize. See Welch v. Helvering, 290 U.S., at 116, 54
S.Ct., at 9.
INDOPCO 503 U.S. at 86.
Justice Cardozo most appropriately wrote "[o]ne struggles in vain for any verbal
formula that will supply a ready touchstone. The standard set up by the statute is not
14
This concept can be expressed as follows: "if (-A and -B) then D". Or more
precisely: -AC-
C-BººD.
15
Thus, the concepts expressed in the previous footnote can be even more
concisely expressed as follows: "if -B then D"; or in pure symbols: -Bº ºD. In fact,
whether or not B exists ought to be the first question when trying to determine whether
the proper tax consequence is capitalization or current deduction. Because without B
the result will always be D. However, if B is present the analysis continues.
-17-
a rule of law; it is rather a way of life. Life in all its fullness must supply the answer
to the riddle." Welch v. Helvering, 290 U.S. 111, 114 (1933).
The Tax Court's Illogical Reading of INDOPCO
From Lincoln Savings we established that "B … C." And we have established
from INDOPCO, "if C then B." Thus, the statement, "if B then C" is false and not
reflexive with the true statement "if C then B." The veracity of this conclusion is
demonstrated when the Supreme Court writes in INDOPCO that "the mere presence
of an incidental future benefit [B]--'some future aspect'-- may not warrant capitalization
[C]." INDOPCO, 503 U.S. at 87. Likewise, the Court stated in Lincoln Savings that
"many expenses concededly deductible have prospective effect beyond the taxable
year." So it is safe to say that the statement "B … C" is a true statement, while the
statement "if B then C" is a false statement. This brings us to the error made by the
Tax Court in the instant case.
In essence, the Tax Court committed a similar error in logic as was committed
by the Courts of Appeals which improperly interpreted the Lincoln Savings decision.
As explained above, one way to misread the Lincoln Savings holding ("if A then C")
was to read it in the reflexive so that it read "if C then A." Similarly, it would be wrong
to interpret the INDOPCO proposition, "if C then B", as if it read "if B then C." But
this is essentially what the Tax Court did in the instant case.
The Tax Court initially erred when it failed to perform an independent analysis
to determine the fate of Davenport's officers' salaries, and another for the investigatory
costs associated with the acquisition. Instead, the Tax Court lumped the two together
and found that Davenport "incurred the disputed costs before and incidentally with its
acquisition." (emphasis added) Norwest Corp. and Subsidiaries v. Commissioner, 112
T.C. 89, 100 (1999). The Tax Court went on to hold: "In accordance with INDOPCO,
[all] the costs must be capitalized because they are connected to an event (namely, the
-18-
transaction) that produced a significant long-term benefit." Id. at 100. This is a
misinterpretation of INDOPCO. The Tax Court is saying that C must result because
of the presence of B. This is equivalent to "if B then C," which we have previously
proven to be a false statement.16 Herein lies the mistake of the Tax Court. Just as the
Court in Lincoln Savings did not create a new test for determining whether current
deduction or capitalization is the proper tax consequence of an expenditure, it also did
not create a new test in the INDOPCO case. Therefore, it is not proper to decide that
a cost must be capitalized solely because the fact finder determines that the cost is
'incidentally' 'connected' with a long term benefit. This is supported by both Lincoln
Savings and INDOPCO. Lincoln Savings states, "many expenses concededly
deductible have prospective effect beyond the taxable year." 403 U.S. at 354.
Likewise, INDOPCO states, "the mere presence of an incidental future benefit--'some
future aspect'--may not warrant capitalization. . . ." 503 U.S. at 87. Thus, the Court
did not create a new test requiring capitalization whenever an expenditure is
incidentally connected with some future benefit.17 On the contrary, INDOPCO points
out that federal courts have "long" required capitalization of expenses similar to those
at issue in INDOPCO. 503 U.S. at 89.
Therefore, we conclude it was error for the Tax Court to require capitalization
of the expenses at issue simply because they were incidentally connected with a future
benefit. Instead, the Tax Court should have performed an independent and appropriate
16
As a reminder to the reader, it was demonstrated earlier that the holding of
INDOPCO was, "if C then B," and this is not equivalent to the statement, "if B then C."
17
"If one really takes seriously the concept of a capital expenditure as anything
that yields income, actual or imputed, beyond the period (conventionally one year) in
which the expenditure is made, the result will be to force the capitalization of virtually
every business expense. It is a result courts naturally shy away from. . . . The
administrative costs of conceptual rigor are too great." Encyclopaedia Britannica, Inc.
v. Commissioner, 685 F.2d 212, 217 (7th Cir. 1982) (citation omitted).
-19-
legal analysis to determine whether each of the expenditures at issue were 'ordinary'.18
In addition to the previously cited characteristics of an 'ordinary' expense, an additional
qualification is that "the expense must relate to a transaction 'of common or frequent
occurrence in the type of business involved.'" INDOPCO, 503 U.S. at 85, 86 (quoting
Deputy v. Du Pont, 308 U.S. 488, 495 (1940)).
Davenport's Officers' Salaries are a Fully Deductible Expense
Lest one should doubt that paying salaries to corporate officers is a transaction
"of common or frequent occurrence" in the business world, we note that courts have
traditionally permitted current deductions for expenses attributable to salaries similar
to those at issue here. See e.g. Dixie Frosted Foods, Inc. v. Commissioner, 6 T.C.M.
(CCH) 586 (1947); Fort Howard Paper Co. v. Commissioner, 49 T.C. 275 (1967).
However, "INDOPCO, which signaled that the Supreme Court's previously announced
tests for capitalization were not exhaustive, may well have been viewed by the IRS as
a green light to seek capitalization of costs that had previously been considered
deductible in a number of businesses and industries." PNC Bancorp, Inc., v.
Commissioner, 2000 WL 655747, *3 (3rd Cir.).
The Tax Court erred when it so easily dismissed a major distinction between the
instant case and INDOPCO. The INDOPCO case addressed costs which were directly
related to the acquisition, while the instant case involves costs which were only
indirectly related to the acquisition. Norwest Corp. and Subsidiaries v. Commissioner,
112 T.C. 89, 100 (1999). According to cases which explain and apply the "origin of
the claim doctrine", such a distinction effects the outcome of the case. See Woodward
v. Commissioner, 397 U.S. 572 (1970); United States v. Hilton Hotels Corp., 397 U.S.
580 (1970); Deputy v. DuPont, 308 U.S. 488, 494 (1940).
18
It was established above that the expenses at issue here meet the other
requirements for deductibility.
-20-
Although the "origin of the claim doctrine" was originally used to distinguish
personal expenses from business expenses, it has been extended to distinguish capital
business expenses from ordinary business expenses. When used in this context, the
ultimate question is whether the expense is directly related to the transaction which
provides the long term benefit. The IRS has applied this "origin" analysis in a number
of recent private rulings while holding compensation payments to employees are
deductible in the context of acquisitions. See TAM 9540003 (6/30/1995); PLR
9326001 (03/18/1993); TAM 9527005 (03/15/1995); TAM 9721002 (01/24/97); TAM
9731001 (01/31/1997). According to I.R.C. §6110 these private rulings (known as
Technical Advice Memoranda and Private Letter Rulings) have no precedential value,
but they do "reveal the interpretation put upon the statute by the agency charged with
the responsibility of administering the revenue laws" and may provide evidence of the
proper construction of the statute. Hanover Bank v. Commissioner, 369 U.S. 672, 686
(1962); see also Oetting v. United States, 712 F.2d 358, 362 (8th Cir.1983) (Revenue
Ruling, while not controlling authority, was persuasive).
This Court is hesitant to fully incorporate and adopt the private rulings of the
IRS.19 However, we certainly agree that payments made by an employer are deductible
when they are made to employees, are compensatory in nature, and are directly related
to the employment relationship (and only indirectly related to the capital transaction,
19
For instance, although this Court agrees with the "origin of the claim" analysis
performed by the I.R.S. in the cited rulings, we do not agree with statements like,
"[g]enerally, expenditures incident to the alteration of the capital structure of a
corporation for the benefit of future operations constitute non-deductible capital
expenditures under section 263 of the Code." (emphasis added) TAM 9540003
(06/30/1995). This Court does not agree that expenditures which are merely
"incidental to" an acquisition or merger necessarily are non-deductible. This is
particularly true if one understands the phrase "incidental to" to be equivalent with
"indirectly related to".
-21-
which provides the long term benefit).20 See e.g., TAM 9540003 (6/30/1995).
Likewise, it is true that,
a deductible expense is not converted into a capital expenditure solely
because the expense is incurred as part of the terms of a corporate
reorganization. Rather, the important consideration in determining the
nature of an expenditure for tax purposes is the origin and character of the
claim for which the expenditure is incurred. See Woodward v.
Commissioner, 397 U.S. 572, 577 (1970); United States v. Gilmore, 372
U.S. 39, 47 (1963). Under the "origin of the claim doctrine," the
character of a particular expenditure is determined by the transaction or
activity from which the taxable event proximately resulted. Gilmore, 372
U.S. at 47. . . . In the present case, . . . the origin of the payments was not
the acquisition, but rather the employment relationship between the
taxpayer and [its employees].
TAM 9540003 (06/30/1995).
Thus the distinction between the case at hand, and the INDOPCO case lies in the
relationship between the expense at issue and the long term benefit. In INDOPCO, the
expenses in question were directly related to the transaction which produced the long
term benefit. Accordingly, the expenses had to be capitalized. See INDOPCO, 503
U.S. 79. We conclude that if the expense is directly related to the capital transaction
20
Symbolically, this can be generally expressed: (- -ACCB)CC(-- R)ººD, which
states, "if the expense does not create a new asset, but does generate a long term
benefit, and the expense is only indirectly related to the long term benefit, then the
expense is deductible." We do not endeavor to explain exactly how one determines
whether the expense is properly characterized as R or -R. This is one of the questions
which will turn on the particular facts and circumstances of each case. It will suffice
to say that in this case we determine the salary expenses to be directly related to the
employment relationship and only indirectly (or incidentally) related to the acquisition
(which provides B).
-22-
(and therefor, the long term benefit), then it should be capitalized.21 See e.g.
INDOPCO, 503 U.S. 79 (1992). In this case, there is only an indirect relation between
the salaries (which originate from the employment relationship) and the acquisition
(which provides the long term benefit [B]).
Similarly, the instant case is distinguishable from Acer Realty Co. v.
Commissioner22, wherein this Court held that the salaries paid to two officers for
"unusual, nonrecurrent services" had to be capitalized. 132 F.2d 512, 513 (8th Cir.
1942). The taxpayer was a corporation whose only business was leasing real estate to
a related corporation. Its officers were paid no salaries prior to their undertaking a
large building program, at which point the two officers began acting as general
contractors and "performed all the services necessary to the management of the
construction of the buildings." Acer Realty, 132 F.2d at 514. Because the salaries
were clearly and directly related to the capital project, this Court determined that most
of the salaries paid were extraordinary or incremental expenses which had to be
capitalized. Acer Realty Co. v. Commissioner, 132 F.2d 512 (8th Cir. 1942).
The instant case is easily distinguishable from Acer Realty because Davenport's
officers had always received salaries, even before the acquisition was a possibility.
There was no increase in their salaries attributable to the acquisition, and they would
have been paid the salaries whether or not the acquisition took place. Therefore, we
determine that the salary expenses in this case originated from the employment
21
-ACCB)(R)º
Symbolically expressed as: (- ºC, which states, "if the expense does
not create a new asset, but does generate a long term benefit, and the expense is
directly related to the long term benefit, then the expense must be capitalized."
22
Acer Realty is the only case in our Circuit, that we are aware of, which denies
the taxpayer a deduction for salary expenses.
-23-
relationship between the taxpayer and its officers. Indirectly, the payment of these
salaries provided Davenport with a long term benefit.
By comparing the relevant symbolic expressions, one can easily see the
distinction between cases like INDOPCO (which require capitalization) and cases
-ACCB)(R)", and the latter
wherein deduction would be permissible. The former is "(-
-ACCB)(-
is "(- -R)": the only difference being the direct/indirect relationship between the
expense and the long term benefit it provides.
Upon consideration of the facts and circumstances of this case, we determine
that Davenport's salary expenses are directly related to (and arise out of) the
employment relationship, and are only indirectly related to the acquisition itself.
Furthermore, this case more closely parallels those cases and IRS rulings which have
traditionally permitted a current deduction for expenses attributable to employee
compensation. Wherefore, Davenport's officers' salaries are a fully deductible expense.
See Woodward v. Commissioner, 397 U.S. 572 (1970); United States v. Hilton Hotels
Corp., 397 U.S. 580 (1970); Deputy v. DuPont, 308 U.S. 488, 494 (1940); TAM
9540003 (6/30/1995); PLR 9326001 (03/18/1993); TAM 9527005 (03/15/1995); TAM
9721002 (01/24/97); TAM 9731001 (01/31/1997).
Davenport's Legal/Investigatory Expenses
It is undisputed by the parties that the Tax Court erred when it determined that
INDOPCO required capitalization of all of Davenport's legal fees, paid to Lane &
Waterman. The Commissioner now agrees that at least $83,450 of Davenport's legal
expenses may be deducted, because they were attributable to the "investigatory stage"
of the transaction. Thus, the parties only disagree as to whether the remaining $27,820
in fees ought to be characterized as capital expenditures or deductible "investigatory
costs".
-24-
Both parties rely on the IRS's Revenue Ruling 99-23 to argue their respective
positions. Obviously, the Commissioner takes the position that the remaining fees
should be capitalized, and Petitioner argues the fees may be deducted (either fully or
at least partially). Before deciding this matter, the Court will analyze the Revenue
Ruling in question.
The issue under consideration in Revenue Ruling 99-23 was stated as follows:
"When a taxpayer acquires the assets of an active trade or business, which expenditures
will qualify as investigatory costs that are eligible for amortization as start-up
expenditures under §195 of the Internal Revenue Code?" At first blush this Issue may
not seem pertinent to the case at hand, because it deals with "amortization" of "start-up"
costs. However, one requirement for an expense to be eligible for amortization under
§195 is that it be an expense which would be deductible if it were incurred by an
existing business. For this reason, the IRS discussed the differences between
"investigatory" expenses which may be deducted, versus those expenses which must
be capitalized.
The IRS determined that investigatory expenses which are related to the
questions "whether to acquire a business" and "which business to acquire" are properly
deductible. On the other hand, once the "whether" and "which" questions have been
answered, and the "final decision" is made to acquire a particular business, then any
further "investigatory" expenses become expenses attributable to facilitating
consummation of the acquisition. According to the IRS, these facilitating expenses are
not deductible.
Along with the parties, this Court agrees with the IRS that any investigatory
expenses which post-date the "final decision" to acquire a business ought to be
capitalized. The parties in this case disagree, however, as to when the "final decision"
occurred.
-25-
Without adopting all of the IRS's conclusions in Revenue Ruling 99-23, this
Court agrees that:
[t]he nature of the cost must be analyzed based on all the facts and
circumstances of the transaction to determine whether it is an
investigatory cost incurred to facilitate the whether and which decisions,
or an acquisition cost incurred to facilitate consummation of the
acquisition. The label that the parties use to describe the cost and the
point in time at which the cost is incurred do not necessarily determine the
nature of the cost.
Rev. Rul. 99-23.
Based on the facts and circumstances of this case, and after reviewing all pertinent
portions of the record, it is the determination of this Court that Davenport made its
"final decision" regarding acquisition no later than July 22, 1991. On that date,
Davenport and Norwest entered into the Agreement and Plan of Reorganization. Our
determination on this point is not to be construed as a "bright line rule" for determining
when a "final decision" has been made. The facts and circumstances of each case must
be evaluated independently to make a proper finding on that issue.
We are simply holding that, in this case, the final decision regarding this
acquisition was made on July 22, 1991, and all other "due diligence" and/or
"investigatory" expenses incurred after that date, were incurred to facilitate
consummation of the acquisition. Accordingly, these expenses, which amount to
$27,820, must be capitalized. See INDOPCO, 503 U.S. at 89, 90.
CONCLUSION
After a full and proper review of the record, and based on the foregoing legal
analysis, we hold that the Tax Court has misread INDOPCO and is hereby
-26-
REVERSED IN PART. The $150,000 of officers' salaries in dispute is fully
DEDUCTIBLE, as is $83,450 of Davenport's legal/investigatory expenses which were
incurred prior to Davenport's "final decision" regarding the acquisition. The remaining
$27,820 of legal/investigatory expenses were incurred after the "final decision" and
therefore must be capitalized. Inasmuch as the Tax Court's conclusion required the
capitalization of this $27,820, we AFFIRM.23
BRIGHT, Circuit Judge, concurring.
I concur in Judge Hand's fine opinion. I write separately to emphasize that the
record in this case is inadequate to show that the portion of the salaries in question,
$150,000, was directly or substantially related to the acquisition. Moreover, the tax
court's findings of fact on this issue does not address the direct or indirect relationship
of the work of the officers to the acquisition. That finding recited:
During 1991, DBTC had 9 executives and 73 other officers
(collectively, the officers). John Figge, James Figge, Thomas Figge, and
Richard Horst worked on various aspects of the transaction, as did other
officers. None of the offices were hired specifically to render services on
the transaction; all were hired to conduct DBTC's day-to-day banking
business. DBTC's participation in the transaction had no effect on the
salaries paid to its officers. Of the salaries paid to the officers in 1991,
$150,000 was attributable to services performed in the transaction.
DBTC deducted the salaries, including the $150,000, on its 1991 Federal
income tax return. Respondent disallowed the $150,000 deduction; i.e.,
the portion attributable to the transaction.
Add. at 11a-12a.
23
To further assist the reader, the Court has provided an Appendix which
includes a flow chart illustrating the Court's rationale.
-27-
This finding does not address whether some officers at any particular period of
time devoted substantial work to the acquisition or whether the officers during the
period of time in question only incidentally worked on the acquisition while doing
regular banking duties.
In order to determine whether an allocation of officers' salaries to an acquisition-
transaction such as made here qualifies as a deduction from income or should be
capitalized, the taxing authorities should require the taxpayer to show officers' time
devoted to the acquisition as compared to time spent on regular work during a
particular and relevant time period.
The finding made by the tax court here does not justify capitalization of the
officers' salaries.
A true copy.
ATTEST:
CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.
-28-
APPENDIX
To qualify for a deduction, "an item must (1) be 'paid or incurred during the
taxable year,' (2) be for 'carrying on any trade or business,' (3) be an 'expense,' (4) be
a 'necessary' expense, and (5) be an 'ordinary' expense." Commissioner v. Lincoln
Savings and Loan Assoc., 403 U.S. 345 (1971). Assuming the first four requirements
are met, the following flow chart will be helpful when determining the proper tax
consequence of a business expenditure. By answering the "either or" questions in the
flow chart, one can follow the chart to determine whether an expense should be
capitalized or deducted. A legend is provided to assist the reader.
A-1
LEGEND
A = physical capital ASSET created or enhanced;
-A = NO physical capital ASSET created or enhanced;
B = BENEFIT beyond the taxable year;
-B = NO Benefit beyond the taxable year;
R = the expense is directly RELATED to B;
-R = the expense is indirectly related to B;
C = CAPITALIZE;
D = DEDUCT.
B or -B
B -B
A or -A D
A -
No easy answer. Apply facts and
C circumstances of each case to
determine whether there is such a
direct relationship (R) between
the expense and B, that
capitalization is required. Or
is the expense more directly
related to something more
ordinary, and only so indirectly
related (-R) to B that deduction
is appropriate?
R -
C D
A-2