Expensing Corporate Activities



One of the most difficult questions a company faces is whether it must capitalize an expenditure or whether it can deduct it. Minor variations in the facts can greatly affect the answer to the question.

American Stores Co., a corporation that filed consolidated tax returns, owned and operated a large number of food and drug stores. The company made a tender offer to acquire 100% of the stock of a competitor, Lucky Stores. It notified the Federal Trade Commission of its intention, as required by law. The FTC required the taxpayer to hold the target company separate until it reached an agreement with the commission on certain divestitures. The parties reached an agreement and the FTC issued a final consent to the Lucky Stores acquisition.

The following month the state of California obtained a temporary restraining order requiring American Stores to continue to hold Lucky Stores separate. American incurred significant legal fees relating to the FTC proceedings. It capitalized these fees on its tax return. American Stores also incurred $1,074,867 in legal fees in 1988 and $2,666,045 in 1989 in connection with the California litigation. The company capitalized these amounts for book purposes but deducted them for tax purposes. The IRS issued a notice of deficiency requiring the company to capitalize the fees.

Result. For the IRS. The government argued the expenditures were capitalizable under Indopco. Specifically, it argued that the expenditures were not ordinary and necessary expenses of carrying on a business. Rather, they were part of the cost of acquiring a capital asset.

American Stores responded that in numerous cases the courts allowed a company to deduct expenditures incurred to defend its business and policies. Since it had received FTC approval for the acquisition, the company felt it was defending its business against a challenge by the state of California. The Tax Court acknowledged that while similar expenses were deductible in some cases, an expediture that was deductible in one context may have to be capitalized in another. Therefore, in making its decision, it looked at the context in which the questioned expenditures arose.

The court applied the origin-of-the-claim doctrine to determine the deductibility of the expenditures. Under this doctrine, an expenditure’s origin and not its purpose determines the tax treatment. In this case, the origin was an antitrust suit to prevent the company from acquiring stock or assets that would lessen competition or create a monopoly. Therefore, the origin of the suit was acquisition of a capital asset. The fact that title had already passed was immaterial. The companies had not yet actually merged. They had been held separate as a consequence of California’s “hold separate” order. That meant the expenditures were not made by a single business to defend its decisions. Because the origin was the acquisition of an asset, the expenditures should have been capitalized for tax purposes and not deducted.

In reciting the facts of the case, the Tax Court noted that the company accounted for the acquisition as a purchase, not a pooling, and capitalized the expenditures for book purposes. It did so because the purchase method of accounting treats the expenditures as liabilities of the target company assumed by the acquiring company. As the court did not mention these facts in the opinion, it’s impossible to know what impact they had on its thinking. However, the accounting treatment’s classification of these expenditures as part of the acquisition and not as ordinary expenses of a unified business may have helped the court reach its decision. In any event, taxpayers need to be able to prove they are entitled to a deduction and not rely on the fact that such expenditures are generally deductible by similar taxpayers.

American Stores Co. v. Commissioner, 114 TC no. 27.

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


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