TAX CASE

The deductibility of an expenditure can greatly affect the benefit a taxpayer receives from it. When evaluating the acquisition of another business, the issue becomes not only whether the expenditure is deductible rather than capitalizable but also whether it will reduce taxable income at all. Recently, the Tax Court considered several tax questions associated with a corporate acquisition.

In 1990 Schneider SA, a foreign corporation, began a hostile takeover of Square D Co. To guarantee sufficient funds, Schneider contracted for loans with two foreign banks. They required Schneider to pay a fee to tie up the funds and to agree to reimburse the banks for any legal expenses they incurred. To prevent the hostile takeover, Square D adopted compensation arrangements with its executives that included sizable golden parachute payments. Following an increase in the offer price, Square D agreed to be acquired in a reverse subsidiary merger. After the transaction Square D paid the fees due to the foreign banks. Schneider renegotiated the executives’ employment contracts to include large cash payments so they wouldn’t take the parachute payments. Square D deducted both the bank fees and the compensation payments. The IRS objected to both deductions.

Result. For the taxpayer on the bank fees and for the IRS on the compensation. The government argued the bank fees were not deductible as they were the obligation of the acquirer, not the taxpayer. It did not argue the costs should be capitalized as asset acquisition costs under Indopco and A.E. Staley . In other words it treated the fees as costs incurred on a normal business loan. By not treating the fees as acquisition costs, the government retreated from its former position of looking at all acquisition-related costs as capitalizable and adopted a more fragmented approach. The taxpayer argued it was entitled to the deduction either because it was the successor to the corporation that incurred the costs or because another party incurred the costs for its benefit.

The Tax Court rejected the successor argument but considered Square D’s alternative claim: It considered whether a taxpayer must be legally obligated to make a payment before it can deduct the payment since it did not incur the expenses. Based on its prior decision in Waring Prods. Corp. , the court said that a corporation can deduct an expenditure even if it is not legally obligated to make the payment.

In its finding the court distinguished the current case from Lohrke , the precedent the taxpayer had cited. The Lohrke opinion does not follow the general rule that a taxpayer can deduct expenditures incurred for its benefit. Instead the case held that when a taxpayer pays an obligation a third party is unable to pay to protect or promote its business, it can deduct the expenditure. The facts in Square D did not support a finding that the original obligor could not pay the debt. However, according to the court, based on the specific facts of this case, the company was entitled to a deduction since the costs had been incurred for its benefit and it had paid them. The court’s failure to fully identify the facts that led to this decision, which appears to contradict its analysis of Lohrke , leaves the issue to be resolved in future litigation.

As for the deductibility of the compensation payments, the court said it depends on whether they are prohibited golden parachute payments. Under IRC section 280G, a golden parachute payment is one made to a disqualified individual (executive) contingent on a change in ownership of the business and greater than three times the individual’s base compensation. Even if a payment met this stated test it would still be deductible if the corporation could prove it was reasonable.

The court first had to decide whether the payment was contingent on an ownership change. As a general rule, an employment contract negotiated after the change is automatically not contingent on that change. However, in this case, where the contract replaced one contingent on an ownership change, it met this requirement.

The court next addressed the reasonableness of the compensation. The Square D case is appealable to the Seventh Circuit Court of Appeals, which uses the “independent investor” test rather than the multifactor test in Exacto Spring Corp. (The independent investor test seeks to determine if an independent investor would buy stock in a corporation paying similar compensation. The assumption is the compensation is reasonable if the corporation’s profitability is high enough to justify it.) The Tax Court, based on its reading of the congressional intent behind section 280G, determined that the independent investor test is limited to reasonable compensation issues under IRC section 162 and that the historic multifactor test should apply to section 280G; therefore, it was not bound to use the independent investor test. After reviewing the different factors, the court concluded that part of the compensation was unreasonable and therefore were nondeductible golden parachute payments.

This case raises more questions than it answers. It leaves for another day a determination of when a corporation can deduct items it pays that a shareholder incurred for its benefit. It also leaves open the question of the proper test to determine reasonableness of compensation. The case does clarify that postacquisition employment contracts may generate golden parachute payments.

Square D Co. v. Commissioner, 121 TC no. 11.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama at Tuscaloosa.

TAX CASE

IRC section 61 defines gross income as all income from all sources—unless specifically excluded by law. In general a taxpayer must include in gross income any increase in wealth he or she realizes in the period “realization” occurs. The claim of right doctrine says realization takes place whenever a taxpayer receives an amount without restriction as to how he or she can dispose of it. This happens when the recipient has no definitive obligation to repay the amount. Therefore, compensation for services is income when received—even if the taxpayer later voluntarily returns the payment to the employer.

John M. and Carolyn Merritt resided in Oklahoma City. John was a licensed attorney and sole owner of JMA & Associates, a personal service law corporation, also in Oklahoma City, which specialized in representing victims in personal injury and product liability cases on a contingent fee basis.

The law firm generally entered into two types of contingent fee contracts:

Clients reimbursed the firm for litigation costs it had advanced and then paid the firm a fee equal to 50% of the net recovery remaining.

Clients paid the firm a fee equal to 33 13 % of the gross recovery and then reimbursed it, out of the clients’ remaining 66 23 % share of that recovery, for litigation costs the firm had advanced.

In 1994 and 1995 John received compensation from JMA in the form of wages and independent contractor fees of $703,800 and $299,925, respectively. In December 1994 he returned to JMA $129,000 of independent contractor fees. Initially, the firm’s independent bookkeeper recorded the return as a reduction in the contractor fee expense account. However, in February of 1995, JMA’s bookkeeper reclassified the funds as a reduction in accounts receivable due from John. John and Carolyn Merritt filed their 1994 joint federal individual income tax return on July 10, 1996, and did not include as income the $129,000 independent contractor fee John had returned to the law firm in December of 1994.

For the taxable years ending November 30, 1994 and 1995, JMA advanced litigation costs relating to client contingent fee contracts of $737,652 and $1,069,275, respectively. On August 28, 1995, and October 2, 1996, JMA filed its corporate federal income tax returns for the 1994 and 1995 fiscal years. On those returns the firm deducted as an ordinary and necessary business expense litigation costs of $705,647 and $629,834 it had paid on behalf of contingent fee clients whose matters had not been resolved by yearend. During the years at issue a third party performed all bookkeeping tasks.

A CPA—who also was licensed to practice law—with whom John had a business relationship for more than 20 years prepared the couple’s individual and corporate federal income tax returns.

On July 6, 1998, the IRS determined a deficiency in the Merritts’ 1994 joint federal income tax liability, disallowing exclusion of the $129,000 independent contractor fee John later returned. On audit the IRS also disallowed the law firm’s deduction of the litigation costs associated with unresolved cases. On both the couple’s individual returns and on JMA’s corporate returns the IRS determined additions to tax for failure to timely file and also assessed accuracy-related penalties.

The taxpayers, citing Gregory v. H elvering (35-1 USTC 9043), 293 US 465,469 (1935), argued the $129,000 of compensation John returned to JMA was excludible from gross income because the couple was entitled to structure their transactions to pay the least amount of federal income tax. Further, since JMA did not advance payment of litigation costs based on the probability of recovery from contingent fee clients, such amounts were not loans.

Result. For the IRS. There was no evidence to indicate there were any restrictions on John’s use of the $129,000 independent contractor fee or that he had any obligation to return the money to JMA. Section 61(a)(1) says “gross income” includes “all income from whatever source derived,” including compensation for services and fees. The court held that the $129,000 John received and returned to JMA was not excludible from income.

In Canelo v. Commissioner (Dec. 29,827), 53 TC 217, 225-226 (1969), affd. per curiam (71-2 USTC 9598), the court decided that, generally, litigation costs advanced or paid by lawyers on behalf of their clients based on contingent fee contracts under which the clients are obligated to repay the litigation costs if matters are resolved successfully are treated in the year paid as loans to the client, not as ordinary and necessary business expenses. Upon resolution of the contingent fee matters, if the client does not repay the litigation costs, the firm should deduct them as bad debts.

The taxpayers argued the facts of Canelo were distinguishable from the facts of this case because Canelo carefully screened its contingent fee clients based on the probability of recovery while JMA did not do this and often any recovery was doubtful. Yet the court concluded the firm should treat the litigation costs in dispute as loans in the year the firm advanced them not as ordinary and necessary business expenses.

In addition the court held the taxpayers were liable for the additions to tax for failing to timely file their income tax returns for the years at issue. As a practicing attorney, John Merritt was fully capable of making sure the returns for himself, his wife and his firm were completed and filed on time. The court found his alleged reliance on the CPA for timely filing was not credible.

The court believed, however, the Merritts did reasonably rely on their CPA’s advice on how to handle the issues at hand and therefore had reasonable cause for the deficiency and had acted in good faith. They were not liable for the accuracy-related penalties.

John M. Merritt and Carolyn Merritt v. Commissioner, JMA & Associates, P.C. v. Commissioner, TC Memo 2003-187.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and T ina Quinn, CPA, PhD, associate professor of accountancy, Arkansas State University, Jonesboro.