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.