Business/Industry:

Deducting Your Hostile Takeover Battles

A ccording to the Tax Court in A. E. Staley Manufacturing Co. v. Commissioner, no. 96-1940 (CA-7, July 2, 1997), the investment advisory fees a company pays to fend off a hostile takeover are deductible, while those it pays to facilitate the ultimate merger must be capitalized. Staley paid $13 million to investment bankers (and other vendors) to evaluate an unsolicited tender offer. The advisers determined the offer was below the true value of the stock and recommended alternatives. A sweetened cash bid was accepted.

The Internal Revenue Service disallowed the deduction Staley claimed for the investment banking fees. The IRS asserted that the expense must be capitalized in accordance with Indopco Inc. v. Commissioner, 503 US 79 (1992). In Indopco, the U.S. Supreme Court required the target company to capitalize investment banking fees incurred in connection with a friendly takeover.

Reversing and remanding the Staley decision, the Seventh Circuit Court distinguished Staley from Indopco on the grounds that Staley was engaged in defending its business, while the taxpayer in Indopco spent money to produce a significant future benefit. The court did find that a small portion of the fees was paid for activities that facilitated the ultimate merger and should be capitalized.

Observation: Staley serves as the other bookend to Indopco. The Supreme Court is sure to be asked to resolve the question of whether fees incurred in a hostile takeover should be given different tax treatment from those incurred in a friendly takeover. The opportunity this presents the court to narrow (or widen) the Indopco precedent should affect IRS efforts to support capitalization of a wide variety of expenses. For now, many taxpayers will relish Staleys victory.

—Tracy Hollingsworth, Esq., staff director of tax councils at Manufacturers Alliance, Arlington, Virginia.

Independent Contractors and Employee Benefit Programs

R ecent conflicting court rulings make it unclear whether companies should include freelancers—independent contractors—in their benefit programs when they classify employees for tax purposes.

Basically, two issues have triggered the inclusions:

• In some cases, when the Internal Revenue Service changed the status of some independent contractors, the courts said that, due to the reclassification, freelancers were eligible to be included.
• In other cases, the courts ruled that the benefit plans wording and intentions determine inclusion.

Observation: Because of the additional financial burden of including reclassified independent contractors in their benefit programs, small business owners should

1. Be sure the independent contractors they engage meet the required tax criteria for that status.

2. Review their benefit programs with the plans administrators and/or professional advisers to ensure the plan uses the proper exclusion wording.

Small businesses that rewrite their plans to exclude independent contractors also may be faced with a problem—the plans may not comply with the top-heavy rules. In addition, small businesses that lease employees may find themselves in the same trap.

—Stanley Person, CPA, partner of Person & Co., New York City.

Deductibility of Limited Partners Legal Fees

I n private letter ruling no. 9728002, the Internal Revenue Service ruled that legal and accounting fees resulting from a lawsuit filed by limited partners against a companys general partners could be deducted only as a miscellaneous itemized deduction.

The taxpayers, who were involved in the real estate business on a full-time basis, were limited partners in a partnership that owned and operated a shopping center. When the limited partners purchased the partnership interest, the general partners had agreed to purchase all unsold limited partnership interests and to fund any negative cash flows. However, the partnership was unable to sell all its limited partner shares, and the general partners failed to perform as promised. As a result, the partnership did not have sufficient capital to operate and filed for bankruptcy.

The next year the partnership filed its final tax return after its lender foreclosed on all its operating assets. Consequently, with their negative capital accounts increased to zero, the taxpayers recognized a phantom gain for that year.

The limited partners sued the general partners for failing to fulfill their agreement. A settlement was reached and the taxpayers sought to deduct their legal and accounting fees as ordinary and necessary business expenses under Internal Revenue Code section 162.

According to the letter ruling, the IRS said the settlement proceeds were payments solely for the limited partners investment losses. The lawsuit had no relation to the operation of the shopping center. Therefore, the related legal and accounting fees were deductible only under Internal Revenue Code section 212 as nonbusiness expenses.

Expenses allowed under section 212 generally are classified as miscellaneous itemized deductions. However, section 62(a)(4) allows an above-the-line deduction to arrive at adjusted gross income if the expenses relate to property held for the production of rents or royalties. The IRS ruled the partnership (not the limited partners) held property for the production and collection of rents. Therefore, because the legal and accounting fees did not relate to the partnership rental property, the IRS ruled the expenses were allowed only as miscellaneous itemized deductions.

Observation: Expenses incurred to manage investments generally are not deductible under section 162 as business expenses. However, according to Kornhaucer v. United States (276 US 145, 1928), in the case of a general partner who participates in and is responsible for the active management of the partnerships business, such legal and accounting fees can be considered legitimate business expenses.

—Michael Lynch, CPA, Esq., associate professor of accounting at Bryant College, Smithfield, Rhode Island.