Copyright (c) 1991 Tax Analysts

Tax Notes

 

OCTOBER 28, 1991

 

LENGTH: 17669 words 

 

DEPARTMENT: Special Report (SPR) 

 

CITE: 53 Tax Notes 463 

 

HEADLINE: 53 Tax Notes 463 - THE EXPENDITURES INCURRED BY THE TARGET CORPORATION IN AN ACQUISITIVE REORGANIZATION ARE DIVIDENDS TO THE SHAREHOLDERS: (PSSST, DON'T TELL THE SUPREME COURT) (Section 351 -- Transfer to Controlled Firm) 

 

AUTHOR: Johnson, Calvin H.

 University of Texas 

 

CODE: Section 351 -- Transfer to Controlled Firm 

 

SUMMARY:

 

   Calvin H. Johnson is professor of law at the University of Texas and graduated in 1971 from Stanford Law School. Professor Johnson has no financial interest in the outcome of Indopco directly or through clients. The article arises out of his academic interest in healthy tax law. The author wishes to thank his colleagues Doug Laycock and Tom Evans for insightful criticisms of an earlier draft. 

 

   In a case to be decided this term, the Supreme Court will decide the tax treatment of $2.7 million in professional fees paid by the target company when its stock was acquired in a tax-free reorganization. Professor Johnson argues that the fees are dividends, which create neither corporate deductions nor basis. Corporate payments that give their primary benefit to shareholders are dividends. The fees are dividends, under the primary-benefit test, because they relate to a change of corporate ownership rather than a change of operations of the corporation. The fees were paid to get the best price for sale of the shares and a quite favorable tax treatment of that price. They are shareholder-level costs of selling stock, properly included in shareholder income and then added to basis so as to reduce recognized gain. Fees incurred by the target corporation in a tax-free reorganization, Professor Johnson goes on to argue, are always dividends to the target shareholders as a matter of law. 

 

   If the costs were primarily related to the corporate level, then they would be capital expenditures. The best explanation of why the target's costs are capitalized is that reorganizations are deferred gain transactions and the costs must be matched with the deferred gain. Taxpayer's argument that investments may not be capitalized unless they create a separate and distinct asset is without merit in accounting or legal theory. These costs have none of the hallmarks of corporate capital expenditures, however, because they are dividends, but dividend characteristics are not reasons to allow an immediate deduction. The Court must dispose of the prior dividend issue before it can reach the question of capital expenditure argued by the 

 

TEXT:

 

   In a case to be decided this term, the Supreme Court is being asked to choose whether a target corporation's costs, paid by the corporation when its stock was acquired in a tax-free reorganization, are current expenses or capital expenditures. /1/ In 1978, Unilever Corporation acquired all of the stock of National Starch and Chemical Corporation for $483 million with a combination of cash and Unilever stock. In connection with the acquisition, the target corporation, National Starch, paid $2.7 million to its lawyers and investment bankers. The Commissioner, who won below, argues that the $2.7 million fees are capital expenditures because they were expected to improve the corporate structure for the indefinite, possibly infinite future. /2/ The taxpayer argued that the fees did not create a 'separate and distinct asset,' so that the fees are deductible currently. 

 

   The secret of the case, which neither side will argue, is that payment of the fees was a dividend, which created neither basis nor current expense to the corporation that paid for them. /3/ The $2.7 million fees are related overwhelmingly to shareholder-level purposes rather than to corporate-level purposes. The fees were incurred so that the shareholders could sell their shares at the best after-tax price. They are like the stock brokers fees that are incurred in a sale of shares on the stock market. The fees bear no relationship to any current or future income from operation of the business, the taxpayer itself argued; they are shareholder expenses paid by the corporation. The economics of the transaction and the motivations of the parties are comprehensible only by understanding that the fees were a dividend. 

 

   When a corporation pays shareholder expenses, or incurs expenses primarily to benefit shareholders in their individual capacity, the payments are a dividend. For expenses driven by ownership issues, rather than by the operation of the business, the benefits at the owner level  outweigh the benefits at the business level. Expenses of selling the shares and expenses incurred to reduce shareholder tax are per se shareholder-level benefits. A target's costs in an acquisitive reorganization, in fact, are always dividends. When National Starch picked up the $2.7 million legal and investment banker fees, its shareholders had a $2.7 million dividend and the corporation had no deduction. 

 

   The function of the tax accounting on this issue is to describe the transaction without subsidy or favor. /4/ Congress has, in recent years, shown itself to be very willing to impose significant tax 'impediments' on corporate acquisitions, /5/ but in the absence of specific legislation, no penalty should be implied here. On the other hand, given a tax climate with some noticeable hostility to corporate takeovers, the courts should also not subsidize the takeovers, for instance, by ignoring the dividend element in shareholder-level benefits. 

 

   Because the fees were dividends, the transactions created neither current deductions nor basis to National Starch. The parties before the court in Indopco are battling it out on a nonissue-- whether the fees are an intangible asset or a current business expense of the corporation. Both parties are right that the other side is wrong, and both are wrong that they themselves are right. The expenses are not a capital expenditure because they in fact give no future benefits to the corporation, but they are not related to current income either. Nothing that the parties say about the quintessential nature of expenses or capital expenditures can have any relevance to the facts at hand. 

 

   With neither party giving any aid or assistance to the Supreme Court, however, the Court is going to have trouble finding the right result. The Court may well say something helpful or silly about the extraordinarily important tax law of capitalization in a case, which, on its facts, has nothing to do with corporate capital expenditures. Good law needs 'singing reason,' however; that is, the doctrinal rules need to be coherent within a wider theoretical framework and to describe the facts and give legal results appropriate to those facts. /6/ The Court is going to have trouble finding singing reason in a case so badly served by the arguments of the parties themselves. When all its work is done on this case, the Court is all too likely to be found to have played the fool. /7/ 

 

   Parts IA&B describe the facts and law of Indopco (formerly National Starch) and concludes that the fees were a dividend, for both National Starch and its shareholders. A corporation can neither deduct nor capitalize dividends. Shareholders include dividends in income, IC concludes, but then add the amount of the dividend to their basis to reduce the amount of recognized gain. Part ID concludes, moving beyond the facts of Indopco, that the target's costs of changing the ownership of the enterprise in a tax-free reorganization are always dividends to the shareholders. 

 

   Part IIA deals with capitalization issues, on the assumption (untrue in Indopco) that the costs were related primarily to corporate-level operations, and concludes that the target's expenses are matched with deferred gain. To match the costs with the deferred gain, the costs create basis for the successor corporation, best viewed as basis in the goodwill of the ongoing enterprise. Part IIB examines and rejects the Indopco argument that investments can be deducted when made, so long as the investment is not a separate and distinct asset. The fees are not corporate capital expenditures, part IIC concludes, only because the facts show the fees are dividends. Part IIC then discusses how the Court might dispose of the case and concludes that the Court needs to invite briefs on the dividend question before it can reach the capital expenditure issue.

 

 

 

 

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                        I. THE FACTS AND LAW OF INDOPCO

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 A. The Story of the Fees 

 

   The facts of the case are not in dispute, although obviously the parties disagree about what legal characterization should be applied to the facts. /8/ The $2.7 million fees consist of legal fees of $490,000 that went to the law firm of Debevoise, Plimpton in New York and fees of $2.2 million that went to the investment banking firm of Morgan Stanley. The fees themselves tell a story that settles internally how the fees should be treated for tax.  

 

   The Debevoise fees went to pay the billable hours needed to solve the legal puzzles, especially the tax puzzles, involved in the acquisition. Unilever first approached the board of directors of National Starch in 1977 with an offer to acquire all of the shares of National Starch. Frank Greenwall was the largest shareholder of National Starch, holding 14-1/2 percent of the shares, and he was also the chairman of the executive committee of the board of directors. Mr. Greenwall had a problem -- the prospect of paying tax. Given his position, his problems got close attention. Greenwall was 81 years old and his wife was 79 and they had big taxable gains built into their shares. If they sold their shares in a taxable sale, they would recognize the gain. But if they could avoid a recognition event before their death, under section 1014 of the code, their heirs would get a step up in basis to the fair-market value of the shares on their death. Section 1014 accomplishes a tax indulgence on death and expunges all prior taxable gain. /9/ The Greenwalls needed to have the acquisition qualify as a tax-free exchange at least to them. 

 

   Most of the other 3,700 National Starch shareholders wanted cash, even if that meant paying capital gains tax. For those with shares that had been turned over recently, their basis was high enough that the taxable gain was not much of a factor. Cash, moreover, has a certain convenience to it. As it turned out, shareholders who wanted to avoid taxable cash were given nonvoting, nonmarketable preferred stock of a subsidiary Unilever controlled; cash might well look good by comparison. 

 

   Cash for the 85.5 percent of the shares of National Starch that the Greenwalls did not hold was, however, far too much cash for the transaction to qualify for nonrecognition as an acquisitive reorganization, even for shareholders like Greenwall who would receive no cash. /10/ Transactions with so much cash that they predominantly resemble sales overall are treated as taxable sales. Under the 'continuity of interest' doctrine, nonrecognition of taxable gain is reserved for reorganizations that better represent a pooling of interests by two groups of shareholders who join together, maintaining a 'continuity of interest' in their prior businesses in modified corporate form. /11/ Thus, under the reorganization rules, the Greenwalls would recognize gain upon receipt of Unilever stock because the other National Starch stockholders wanted cash. It looked like the acquisition could satisfy either the shareholders who wanted cash, or the shareholders who wanted tax-free treatment, but not both. 

 

   Debevoise, however, in combination with the Unilever attorneys, figured out how to satisfy both cash and recognition-avoiding shareholders. By an accident of history, section 368, governing acquisitive reorganizations, has a tax sibling, section 351, which allows tax-free formation of a new corporation, /12/ without however expressly limiting the percentage of transferors who may be cashed out. The National Starch acquisition took the form of the formation of a new subsidiary, to be controlled by Unilever. Unilever contributed cash to the subsidiary in return for all of the corporation's voting stock. Those National Starch shareholders who wanted cash (79 percent) contributed their National Starch shares and got $380 million cash from the subsidiary. Those National Starch shareholders who wanted to avoid tax recognition (21 percent) got $97 million of nonvoting, nonmarketable preferred stock of the subsidiary. 

 

   The Service was willing to rule for National Starch, that the continuity of interest doctrine did not apply to section 351 to limit what percentage of transferors are cashed out. /13/ The National Starch ruling is one of the most important developments in law of corporate acquisitions of the last 50 years. The Service might have ruled  the other way /14/ -- sections 351 and section 368 are children of the same parents and nursed by the same rationale. /15/ The rule taxing shareholders who in fact received stock in the surviving corporation had, however, been criticized at the highest academic levels, even to reorganizations, /16/ so the ruling might be defended as a limitation on the scope of a bad rule. The ruling, in any event, opened up a whole new galaxy of ways to merge two corporations while avoiding the traditional doctrines restricting access to section 368 acquisitive reorganizations. /17/ Debevoise earned its fees in part, the old fashion way, with routine hard work in segments of 0.1 billable hours. But there was extra time spent and undoubtedly a well-deserved premium because of the successful and innovative effort to satisfy the chairman's tax needs, given the disparate needs of two very different groups of shareholders. The distinctive (and famous) character of the Debevoise fees is that they saved shareholder tax. 

 

   Investment bankers do not do billable hours; they get cuts from large streams of stock and money as it changes hands. Morgan Stanley charged $2.2 million for its services, over four times the Debevoise fees. Out-of-pocket costs (including, for instance, dinners and xeroxing) roughly track work done, and since Debevoise had twice the out-of-pocket costs, it plausibly did twice as much work for its one- quarter fee. /18/ The Morgan Stanley work was quite routine appraisal work assessing what the company was worth; the work was not a candidate for a most important innovation of the last 50 years in its field. 

 

   But Morgan Stanley earned every cent of its fee for National Starch shareholders if it is even partly responsible for the increase in Unilever's offer. Morgan Stanley was willing to certify that Unilever's initial price was fair, but it also conveyed (and possibly legitimated) National Starch's request that Unilever up the bid per share. Unilever's initial offer was for $65-$70 a share. When National Starch, through Morgan Stanley, asked for $80 a share, Unilever upped the bidding to the final $73.50 per share. Advice to ask for more money in the middle of the haggling may not be original, but it was valuable advice. An extra $8.50 extended to the 6,563,000 outstanding National Starch shares means $56 million more for the shareholders. An extra $3.50 per share means $22,980,000 more for the shareholders. Morgan Stanley's $2.2 million fee might have been just a 10-percent cut of the extra sale price that they had something to do with. In a $487 million stock acquisition, in any event, a $2.2 million fee can get lost. But the Morgan Stanley fee, in any real game, can be understood only as a cost of the sale price that the National Starch shareholders got for their shares. As with the Debevoise fee, the target corporation paid the fee, but the shareholders got the benefit.

 

 B. The Law of Dividends: Do Expenses Benefit Primarily Ownership or Operations? 

 

   Expenses paid by a corporation that give their primary benefit to shareholders rather than to the corporation are dividends. /19/ It is not necessary that the dividend be formally declared, or that the payment be termed a dividend, or that the payment be made to all the shareholders. /20/ Payments that primarily benefit shareholders in their individual capacity as a matter of economics are dividends even if not intended to be dividends. It is not the intent of the parties that governs the characterization of the distribution, but rather the economic and consequent legal effect of their actions.21 Dividends are not deductible by the corporation. 

 

   The primary-benefit test for a dividend trumps the question of whether an expense is an ordinary and necessary business expense. Corporations are entitled to deduct expenses that only minimally relate to their business; the requirement that expenses be 'ordinary and necessary' under section 162 is construed to mean 'appropriate and helpful' for the development of the taxpayer's business. /22/ There is sometimes a kind of a business judgment rule, under which the courts assume that the officers know their business better than judges so the courts should defer to the officers and assume that the expenses were wise if the officers spent them. /23/ When benefit to shareholders is implicated, however, the issue switches from a minimal-justification test at the corporate level to a weighing test in which the courts measure the relative benefit to corporation and shareholders. Wise officers, it turns out, pay out dividends as well as they incur operating expenses, so that there is nothing in their wisdom that negates the dividend nature of the expenditure. 

 

   In Sammons v. Commissioner, /24/ for instance, the corporate taxpayer argued that the corporation needed only to have a sufficient business justification at the corporate level for a deduction to be allowed. The court responded that the primary benefit at the corporation level was required:

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          It is true that '(t)he line between shareholder benefit and

     corporate benefit is not always clear . . .' [b]ut this does not

     mean that where the primary or dominant motivation for a

     distribution was to benefit the stockholder rather than the

     corporation that the articulation of a concededly subordinate

     business justification should cause the entire transaction to be

     recharacterized for tax purposes. To permit such a swallowing up

     of the greater by the lesser would require us to espouse a rule

     of law which both ignores the substance of corporate

     transactions and sharply departs from the recent trend of

     cases.... We decline to so rule. /25/

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   The courts can get pretty hard-nosed about weighing the shareholder and corporate-level benefits under the primary benefit test. They have found that even desperate corporate needs are outweighed by the shareholder-level benefit. In Jack's Maintenance Contractors, Inc. v. Commissioner, /26/ for example, the sole shareholder of the corporation was indicted for tax fraud and his corporation paid the legal fees of the ultimately successful effort to avoid conviction. The corporation contended that the expenditure was a business expense rather than a dividend. It argued that it, not the shareholder, was the primary beneficiary of the expense because it needed the continued presence of its shareholder chief operating officer to stay in business. The court weighed the relative benefits to corporation and shareholder:

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          While it is difficult to quantify the relative benefits to

     an individual of avoiding imprisonment and fine and to a

     corporation of staying in business, we have no hesitation in

     holding that the former outweigh the latter. The payment was

     thus dividend to [the shareholder] and consequently not

     deductible by the corporation. /27/

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   Application of the primary-benefits test in National Starch's case is, by contrast, a piece of cake because the ownership-level benefits so predominate. 

 

   The $2.7 million fees benefited the National Starch shareholders in their personal or ownership capacity. Fees paid by shareholders for investment advice in connection with an acquisition of their corporation are shareholder-level expenditures 'made for personal, rather than corporate purposes.' /28/ The shareholders' decisions to readjust what stock they hold are personal investment decisions. /29/ Shareholders' costs incurred in selling their stock for cash or other stock are shareholder capital expenditures, offset against their proceeds of sale /30/ or added to the basis of the shares they receive in exchange. /31/ The fees are stock sales costs matched with the shareholders' gain, not costs of corporate operations. The $2.2 million Morgan Stanley fees are especially closely related to haggling over the price paid for the stock and the Debevoise fees are especially closely related to the tax treatment to be accorded to that price. The fees caused the shareholders' sale of their National Starch stock for a fair price. To match the costs to the related sales proceeds, the costs must first become dividends to the shareholders. 

 

   In Revenue Ruling 75-421, /32/ the Service ruled that professional fees the target corporation paid in a B reorganization were dividends. The fees incurred were for the services of an accountant and a financial consultant for the purposes of ascertaining the value of the stock so that it could be sold for the maximum price. The ruling governs here and is clearly correct under general tax principles. Both a 'B' reorganization and the transfer to a new corporation effected here are sales of stock, as a matter of state law, and the costs related to the sale. Sale of stock was an ownership issue, rather than an issue related to corporate level operations or taxable income. 

 

   The transaction also related to the Greenwalls' personal estate planning. The chairman of the board of National Starch testified that the Unilever offer was a 'particular opportunity' to solve 'the 'estates problems' concerning the Greenwalls[, which] were 'overhanging the market' and represented a 'question mark -- for National Starch Corporation for the future.'' /33/ But estate planning is a shareholder-level concern and does not  constitute a corporate-level 'business purpose' to justify a corporation's spinning off a subsidiary. /34/ Solving estate problems was a shareholder-level benefit. 

 

   The fee paid to the Debevoise tax department was a shareholder- level benefit for the additional reason that the fees related to shareholder tax. Shareholder tax is, per se, a shareholder-level issue. A corporation's payment of shareholder taxes is a nondeductible dividend to the shareholder. /35/ A corporation's payment of the legal expenses of defending against a tax fraud charge against the shareholder is a dividend to the shareholder, even though the payment protected the very heart of the corporation's ability to continue in business. /36/ 

 

   Obviously shareholders benefit from legitimate business expenses incurred by a corporation in its operations. Operating expenses usually generate corporate profit on net, which improves the value of the shares. But benefits that come to the shareholder only through enhancement of the value of her shares are corporate-level expenses and not expenses of the shareholder level. /37/ Under tax law, the world of corporate stock is rigidly separated from the operations of the corporation. /38/ A shareholder cannot use the business of its corporation to justify its own deductions and a corporation cannot use the business of its shareholder to justify its deductions. /39/ 

 

   Corporations are entitled to have basis or deductions for costs, related to the shareholder or ownership level, only if the corporation primarily benefits. In Indopco, the taxpayer argued that the fees were deductible by National Starch under the district court case of Locke Manufacturing Co. v. United States. /40/ In Locke, the court allowed a corporation to deduct the costs of a proxy fight with one of its shareholders. The deduction was allowed, however, in Locke only because of the finding of fact that the 'expenditures were primarily concerned with questions of corporate policy.' /41/ 

 

   In the world of law in action, corporations undoubtedly get sloppy in their accounting and in fact deduct shareholder-world expenses. We should not be fighting, moreover, over de minimis shareholder-related expenses that are too small to be worth the cost of the accounting. /42/ The Debevoise and Morgan Stanley fees are, however, big enough to account for and simple to disallow in full. Expenditures of primary benefit to shareholders or related primarily to ownership or the owner's world are dividends as a matter of principle and not deductible by the corporation. 

 

   The acquisition of National Starch by Unilever in 1978 was a question related to ownership of the stock of National Starch and not to the operations of the corporation. An acquisitive reorganization may occasion added costs related to operations. A reorganization is a commercial marriage between two corporations and marriages, whether of the traditional kind or commercial ones, mandate some readjustments of old habits. If these fees had related to corporate operations, they would have been deductible currently or in the future periods in which they generate their taxable income, even if the expenditures were occasioned by the reorganization. But, the fees to Debevoise and Morgan Stanley related to the ownership of National Starch and not to its operations. The fees were paid to get the best price for the shares and to acquire quite favorable tax treatment of that price. The target's interest in the acquisition arose and was driven forward only because of shareholder-level concerns. As found by the Tax Court, these fees were spent 'to shift ownership of the corporate stock.' /43/ 

 

   For nontax financial accounting purposes, a qualified reorganization is 'in substance a transaction between the combining stockholder groups and does not involve the corporate entities. The transaction therefore neither acquires nor justifies establishing new basis of accountability for the assets of the combined corporation.' /44/ Accountants define a qualified reorganization more narrowly than tax law does. The accounting term, moreover, is 'pooling of interest accounting method' rather than 'reorganization.' Still, under accounting theory, a corporation  need recognize no gain in a reorganization only because, under the accounting theory explanation of the transaction, there is no corporate involvement. That theory sings, especially as applied to the facts of this case. 

 

   The relative-benefit test in this case is also made easier by the taxpayer's own argument that there was no corporate-level benefit. The taxpayer was trying its best to convince the court below that National Starch had no asset with continuing value on the corporation level. A National Starch officer testified it viewed the transaction as 'swapping approximately 3,500 shareholders for one.' /45/ A Unilever officer testified that there was no synergism 'in the classical sense' between National Starch and Unilever. /46/ As the petitioner stated in its petition for certiorari:

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          After the transaction, National Starch's management (its

     directors and officers) remained in place, its key employees

     entered into employment contracts with the company, and its

     business (adhesives, starches and specialty chemical products)

     continued in the same way as before. Unilever did not make any

     changes in National Starch's operations, did not provide

     National Starch with any significant technological or financial

     assistance or legal, administrative or accounting services, and

     did not materially increase its purchases of National Starch

     products.' /47/

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   According to the taxpayer, the Unilever-National Starch reorganization had no connection to any corporate operations.

 

   The taxpayer marshalled all this evidence to show that there was no significant future benefit to the corporation to avoid capitalizing the cost. /48/ But, there is no more benefit or taxable income currently, in the short taxable year in which the taxpayer took the deductions. As found by the Tax Court, '[t]here is no evidence of an immediate benefit from the affiliation.' /49/ Any benefits to the corporation would have to be in the future. The costs relate no better to current profit of the corporation than to future profit. In testifying that the costs gave the corporation no benefit, the taxpayer was denying current as well as future benefit. 

 

   The taxpayer's arguments, in fact, raise doubts about corporate deductibility ever, even if the dividend character of the expenses were not implicated. The costs were voluntarily incurred, so that they cannot be fairly called business 'losses.' /50/ In order for an expense to be deducted as a business expense under section 162, the expense must be related to the taxable income of the taxpayer. Expenses not motivated by the attempt to acquire pretax accounting income are not profit-related expenses and may not be deducted. /51/ As noted, the shareholders' and corporation's worlds are rigidly separated and a corporation may not use facts of the shareholder's world to justify its deductions. /52/ Current expenses, moreover, are just those capital expenditures that happen to relate to current rather than future income; current and capitalized costs are not different in metaphysics or kind. Having denied that the acquisition created any future benefits on the corporate level, the taxpayer seals the case against any current year benefits as well. /53/ The payment 'must be a dividend, for if it does not benefit the corporation, it must benefit the shareholders.' /54/ 

 

   The taxpayer has undoubtedly gone overboard in its own argument. The taxpayer could have probably found some incidental future benefits to the corporation from the Unilever acquisition had it allowed a creative litigator to search the files. But incidental benefits are not decisive in application of the primary benefits test. /55/ Also, there is a rich, ironic justice in hoisting litigators on their own petard.

 

 C. Tax-Free Reorganization Expenses Are Always Dividends 

 

   Moving beyond the current case, the target corporation's costs incurred in effecting a tax-free reorganization are always properly considered dividends to the target shareholders, as a matter of law. As dividends, the expenditures are not deductible by the target corporation nor do they create corporate-level basis. A reorganization  changes the ownership of stock, not the operations of the enterprise. Under the primary benefit test of a dividend, ownership changes primarily benefit shareholders as a matter of law. 

 

   Costs of changing ownership always relate primarily to ownership, even when they affect operations. Operations, as noted, are commonly affected by the change of ownership. The corporation was once single, but now it is part of a corporate marriage and the change to corporate matrimony may require the corporation to change its habits in important ways. The corporations may pay fees to management consultants to integrate its operations with those of the acquirer. UCC bulk-sale notification to creditors is required upon the transfer of assets in some reorganizations. /56/ If we view the transfer of assets as separate from the modification of the corporate structure that goes on in a reorganization, the (rather small) costs of bulk-sale notification might be treated as cost of sale of the assets, added to the basis of those assets to offset the deferred gain from the asset. /57/ But, the investment bankers and the tax and corporate lawyers' fees to effect the modification of the corporate structure that occurs in a tax-free corporate acquisition are not related to corporate-level operations but to the shareholder world. Those fees are related to the manner in which ownership will be changed and to the price to be paid for the ownership interest. Ownership changes may benefit the corporation or affect its operations indirectly. But before a change of ownership can affect the corporation, indirectly and secondarily, it must affect the shareholder first and primarily. 

 

   The target's costs of an acquisitive reorganization are dividends to its shareholders, no matter what form the reorganization takes. In all acquisitive reorganizations, the shareholders of the target give up their shares and in return they get shares of the acquiring corporation. In all reorganizations, the acquiring corporation owns the target enterprise after the transaction. Sometimes the target is merged into the acquirer, /58/ sometimes the target gives up its assets in exchange for acquirer stock and then distributes the stock of the acquirer to its shareholders, /59/ and sometimes the target shareholders exchange their stock directly for acquirer stock. /60/ What letter of the alphabet is used, however, does not make much difference. After any reorganization, the acquirer owns the target operations and the former owners own stock in the acquirer. The sole defining function of every acquisitive reorganization is to effect a change of ownership of the target enterprise. 

 

   Tax law needs bright line rules because tax law is enforced on a tax return. Tax advisers may tell their client taxpayers to take a position on a tax return for which there is some realistic possibility of success, even though the taxpayer is considerably more likely than not to lose on the position. /61/ The IRS audits less than two percent of all individual returns. /62/ In the face of uncertainty, the law as reported will be extraordinarily protaxpayer, without regard to what the law was meant to be. Subtle decisions, ambiguous law or facts and circumstances tests are a wonderful self- indulgence for a judge, but they have no impact on taxpayers in the overwhelming percentage of cases. In our self-assessing tax system, moreover, we believe that taxpayers should voluntarily pay tax in accordance with clear rules set out in advance. Taxpayers are not supposed to have to go to court just to find out how to report their tax. The Court must thus decide tax issues with bright line doctrinal rules--e.g., reorganization expenses are dividends--that can be enforced on a tax return. 

 

   If we were writing reorganization law afresh, many of the costs incurred in a tax-free reorganization might be considered costs of the purchase and sale of assets, on the enterprise level, rather than merely dealings among shareholders. As a matter of economics, the reorganization is often best understood as an endeavor by the acquiring corporation to buy the assets or the going concern enterprise of the target. Proponents of the purchase method of accounting, for instance, argue that every reorganization could be viewed as the purchase and sale of enterprise assets:

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          Proponents of purchase accounting hold that a business

     combination is a significant economic event which results from

     bargaining between independent parties. Each party bargains on

     the basis of his assessment of the current status and future

     prospects of each constituent as a separate enterprise and as a

     contributor to the proposed combined enterprise. The agreed

     terms of the combination recognize primarily the bargained

     values. /63/

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   If acquisitive reorganizations were a purchase and sale of assets, then it would be appropriate to add the costs of the reorganization to the basis of the assets of the enterprise on the corporate level. /64/ 

 

   The purchase method of accounting applied to tax, however, would treat every reorganization as a taxable  sale of assets. Gain would have to be recognized by the selling corporation in every event. In an acquisition where the 'pooling of interest' method applies (that is, in an acquisition that is the accounting analogue of a tax-free reorganization) the acquisition is 'in substance a transaction between the combining stockholder groups and does not involve the corporate entities.' /65/ The reorganization is tax-free and basis is carried over, precisely because the corporation is not involved. /66/ 

 

   It is too late then to argue that tax-free reorganizations should be treated in some other way because their true underlying economics are really a purchase and sale. The tax law characterization of the transaction as a tax-free reorganization grabs the transaction, without regard to its economics, and makes the corporation a nonparty as a matter of law. When the corporation is not involved as a matter of law, shareholder benefits predominate, as a matter of law, and the costs become per se a dividend. 

 

   Treating the target's costs as dividends would be in lieu of the indefinite-life corporate asset, i.e., improved corporate structure, that is said to arise in corporate reorganizations. Under current law, expenses incurred in a corporate reorganization are capital expenditures rather than current deductions. /67/ Among the rationales given for that result is that expenses related to a reorganization are considered to be made to better the corporate structure. The improved corporate structure is an asset expected to contribute to the corporate operations for the indefinite future. /68/ The asset is nondepreciable and remains nondeductible until the acquiring corporation liquidates and ceases to need a corporate structure. /69/ 

 

   That model may be plausible for some expenditures on the acquirer's side, but it does not describe National Starch or any other target corporation very well. /70/ In a reorganization, the target corporation either remains intact as a subsidiary with its corporate structure unaffected, as did National Starch in the Unilever acquisition, or the target corporation disappears in the reorganization, as happens for instance in merger ('A' reorganization) /71/ or assets for stock ('C') reorganizations. /72/ The target corporation's structure is unmodified or is gone. The acquiring corporation may not kindly view the idea that the target's costs, spent in getting more money out of the acquirer or in trying to beat the takeover as a whole, are giving it the asset of improved corporate structure, with an infinite useful life. /73/ The target's costs of an acquisitive reorganization truly relate to corporate ownership, not corporate structure. They benefit the shareholders, and hence are dividends, and do not plausibly give any benefit current or deferred, to the corporate-level enterprise. The target's costs of tax-free acquisitive reorganizations are always dividends to its shareholders. 

 

   In any event, whatever the proper way to treat a target's costs as a matter of law in the general case, the target's fees in Indopco are dividends on the facts of this case.

 

 D. Treatment of the Shareholders

 

   Dividends are taxable income to the shareholders, as well as nondeductible to the corporation. The IRS did not assess income against the National Starch shareholders and the statute of limitations has long since passed on a 1978 acquisition. The failure to tax shareholders does not imply, however, that the corporation has not paid a dividend. In former years, Bittker and Eustice inform us, the Service was often content to disallow deduction of constructive dividends at the corporate level without coupling the disallowance with an assessment against the  shareholders. /74/ While the shareholders are not before the Court, however, discussion of the shareholders makes the dividend a complete and consistent story. /75/ 

 

   Allocation of the Dividend. In the absence of anything to the contrary, ownership costs borne by the corporation should be allocated pro rata, taxable to each shareholder according to the shareholder's fractional interest in the corporation. The shares acquired by Unilever were fungible and all of the shares of National Starch were acquired by Unilever. The Morgan Stanley fee seems primarily related to price negotiations and every shareholder got the benefit of the price increase. 

 

   For the Debevoise tax work, however, the fees seem best allocated as a dividend entirely to the Greenwalls and the other shareholders (seven percent) who joined them in taking stock rather than cash. Debevoise did not have to spend much billable time planning the tax effects of a cash sale -- the tax principles for taxing cash gain are straightforward. The time and creativity were expended to give the shareholders the opportunity to exchange for Unilever stock free of tax. The shareholders who got the tax-free treatment received the benefit and should receive the dividend from the Debevoise tax fees. 

 

   To the extent that the shareholder reported a taxable dividend, the shareholder should receive tax recognition for the fees, as if they had received the constructive dividend directly in cash and then paid the fees themselves. /76/ Shareholder-paid costs of sales are consistently netted against the proceeds of the sale and are tax- recognized symmetrically as an offset to whatever tax treatment is accorded to the sales proceeds. For the shareholders who sold their National Starch stock for cash, the selling shareholders would be treated as if the shareholders had received less cash by the amount of the fees. /77/ The fees would thus reduce the capital gain (or increase the capital loss) reported on the sale. An ordinary deduction for the costs of sale would by contrast mismatch an ordinary deduction and the capital gain that the costs caused. 

 

   For those shareholders who exchanged their National Starch stock for the Unilever subsidiary stock, their attributable share of the fees is added to the basis of the Unilever shares they receive as if the fees were part of the purchase price for the Unilever shares. /78/ Shareholders are not entitled to recognize loss in the course of a reorganization exchange. /79/ An improper interpretation of the rule that costs of sales offset the proceeds /80/ would be to treat the costs as just a reduction in value of the stock received. That interpretation would make the costs disappear without tax recognition, because the value of the stock received has no effect on either the shareholder's gain or resulting basis, and would misdescribe the taxpayer's position over the full transaction. /81/ Adding the costs to the shareholder's basis for Unilever shares received, however, means the costs are recognized for tax when the gain built into the National Stock shares is recognized for tax purposes, if and when the Unilever stock is sold. A reorganization is a deferred-gain sale of the stock and adding the costs to the shareholder's basis for Unilever stock matches the costs with the deferred gain. /82/ If the gain is never recognized, /83/ then the basis would appropriately go unrecognized. 

 

   Boot. A target's payment of shareholder expenses, although dividends, are not boot that would destroy the qualification of the reorganization as a whole. In a 'B' reorganization, the stock of the target must be acquired 'solely for the voting stock' of the acquirer. A dollar of cash or other property ('boot') paid to the target shareholders by the acquirer will destroy the tax-free qualification of the reorganization. /84/ In a reverse subsidiary merger, a dollar of boot will not destroy the transaction, but 80 percent of the target stock must be acquired for voting stock. /85/ The dividend that comes from target payment of the costs of the acquisition would not, however, disqualify either kind of reorganization, although the dividends would be taxed. The 'solely for voting stock' requirement limits the kind of consideration which the acquirer can give out in the acquisition, but it does not limit the distributions which a target gives to its own shareholders, even in connection with the acquisition. /86/

 

 

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                           II. CAPITAL EXPENDITURES:

                             THE MISSPOTTED ISSUE

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 A. Capitalization of the Target's Reorganization Costs 

 

   In Indopco, the target's costs in effecting the reorganization are dividends to its shareholders that never give the corporation any tax benefit. But if we assume, counterfactually, that the costs were primarily related to corporate operations or if a court ignores the primary-benefit dividend test, then the costs would be capital expenditures for the corporation. Capital expenditures create basis for the enterprise and are not currently deductible. It is the 'well- established rule' that the costs incurred, on either side of the table, to affect a corporate reorganization are not deductible in the year paid and create basis instead. /87/ The reasons given for denying deductibility, however, vary from case to case. /88/ 

 

   Matching with Deferred Gain. If we continue the funny assumption that the target-side costs of a reorganization are primarily related to the corporate level, then the strongest explanation why target- side costs are capitalized is matching. The target's costs in a reorganization, if recognized at all, are properly matched with the enterprise's deferred gain. Reorganizations are deferred-gain sales for both the target corporation and its shareholders. In a reorganization, neither corporate nor shareholder gain is recognized immediately, /89/ but the property held at the end of the reorganization gets a carryover basis so that the gain not recognized in the reorganization is taxed upon the ultimate sale of the property. /90/ By adding the target corporation's costs of the sale to the basis of the ongoing enterprise, the costs of the sale are matched with the gain the enterprise ultimately recognizes. 

 

   Expenses have no inherent character for tax purposes; they are sponges that acquire their personality as subtractions from the income to which they relate. /91/ The process of tax accounting, like the process of accounting generally, has matching as a fundamental, even constitutional, principle. /92/ The tax character of expenses is determined by the receipts that the expenses cause or create. Mismatching is a sin of tax accounting, as much as it is in financial accounting. Tax law cannot allow current, ordinary deductions, for instance, for costs that cause sales that are not current income. 

 

   Costs of selling assets are treated as offsets to the proceeds of the sale. /93/ As noted in the discussion of shareholder costs, that offset rule, properly understood, should mean that the costs in a reorganization should be added to the basis of assets extant at the end of the reorganization. /94/ To the target corporation, a reorganization is a transfer of appreciated assets in which the tax recognition of the gain is deferred. An acquisitive reorganizaton is a bargained exchange between two adverse parties and the gain is realized and could be reported as a matter of good accounting. /95/ Recognition of the gain is deferred by the tax reorganization provisions, however, until a later cash sale or other event in which the corporation uses its basis in the assets. To match the costs of transferring the assets with the deferred gain from the assets, the costs must be added to the basis for the corporate assets.

 

     Under the Internal Revenue Code, corporate costs are not recognized in a reorganization. Section 361(b)(2) of the code, which provides that a target corporation cannot recognize a loss in a reorganization, is broad enough to prevent deduction of the costs of the reorganization. /96/ The rule disallowing tax recognition of costs is a rule of symmetry arising from the nonrecognition accorded to the corporation's gain in the reorganization. The corporation's past and current costs are very real, but the costs are deferred as a part of basis of the enterprise's assets. 

 

   Section 265(a)(1) of the code, moreover, overrides tax deductions otherwise allowable /97/ and provides that the cost of tax-exempt gain is offset against the income. For gain that is permanently tax-exempt, section 265(a) (1) means permanent disallowance, but for gain that is merely tax-deferred, as reorganization gain is, section 265(a)(1) means that the costs are merely tax-deferred, through the basis account, until the gain on the assets is realized. 

 

   Beyond the statutory language, whether construed narrowly or broadly, there is the common sense and common law rule that expenses are offset against the related income and draw their character from that income. Costs attributable to tax-nonrecognition corporate sales are, for instance, not deductible because they are offset against the unrecognized gain. Old section 337 of the code (repealed in 1986) once provided that no gain was recognized by a corporation in a sale made in the course of its liquidation. Corporations claimed current and ordinary deductions for the costs of such nonrecognition sales, but all of the courts of appeals considering the issue uniformly came to the conclusion that corporate expenses related to tax nonrecognition sales and were not cognizable by tax because they offset tax exempt income. /98/ In some cases, the consensus to match the costs to related income required the courts explicitly to reverse themselves on the issue. /99/ 

 

   The nonrecognition accorded the target in a reorganization is like the nonrecognition accorded under old section 337. A 'C' reorganization /100/ is explicitly a sale of assets for stock of the acquirer and under section 361, the target realizes but does not 'recognize' gain, just as under old section 337. Even in an 'A' reorganization, /101/ the target transfers its assets in return for valuable consideration, although in an 'A' the stock consideration goes directly to the shareholders without expressly passing through the corporation. Absent the reorganization sections, a corporation would be taxed on a sale of its assets with consideration going directly to its shareholders. /102/ Mergers are market transactions in which gain can be realized and assets written up for accounting purposes, /103/ but the gains are not recognized under the reorganization provisions. /104/ The war for good matching, so hard won as to section 337 costs, should not lightly be discarded in reorganizations. The target, which has no recognition in the reorganization, is exactly like the corporation with gain not recognized by the old section 337 liquidating sale provisions. /105/ 

 

   The tax accounting theory that the fees are matched to tax- deferred gain means that there is no proper distinction between friendly and unfriendly takeovers. The Service has private rulings that treat defense against an unfriendly takeover as deductible costs whereas costs of friendly takeovers have to be capitalized. /106/ Such a distinction, if it survives, would create some pretty strong incentives for the parties to snarl at each other, like professional wrestlers, for the benefit of the camera. In a case pending before the Tax Court, for instance, the taxpayer tries to interpret the haggling over price as proof that the takeover was hostile. /107/ In friendly, semi-friendly and hostile takeovers alike, however, the targets are getting tax- deferred gain. The targets' costs of abandoned acquisitions, however, would be properly deductible under any theory of basis, at least if the costs are not part of a larger transaction that is ultimately consummated /108/ and of course under the continuing counterfactual assumption that they were not dividends. 

 

   There are sufficient other reasons to capitalize the corporate costs of a reorganization, as if matching were not enough. The target's costs create basis not current deductions because they originate in a capital transaction /109/ and because they have value substantially beyond the end of the taxable year. /110/ Expenses related to a reorganization are considered to be made to better the corporate structure, and corporate structure is an asset expected to contribute to the corporate operations for the indefinite future. /111/ The various reasons given for capitalization may have different implications as to when the enterprise will recover the basis, but any and all of the reasons are sufficient to prevent the target from deducting its costs currently. 

 

   Basis is the Successor's. Costs that are not deducted by the target corporation immediately before the reorganization are carried over to the acquiring corporation. /112/ In a 'B' reorganization, nothing happens to the target corporation, so that its basis accounts and methods of accounting remain intact. But the asset accounts also remain intact in a merger (an 'A' reorganization) or an asset sale ('C') reorganization. In both an 'A' reorganization (merger) and a 'C' reorganization (asset transfer), the target corporation in fact disappears, but as a matter of law the disappearance is not treated as a liquidation. The surviving corporation is considered to be the continuation of the business enterprise under a modified corporate structure. /113/ 'In a dissolution, the privileges, powers, rights and duties of the corporation come to an end, [but] [i]n a merger, these attributes of corporate life are transferred to the surviving corporation and are there continued and preserved.' /114/ The acquiring corporation is the continuing alter ego of the target after a reorganization. It steps into the shoes of the disappearing target corporation and takes over its basis for corporate assets and other tax accounts. /115/ Thus, recovery of the target's basis must be recovery by the acquiring corporation.

 

   The target's cost of the acquisition carry over to the successor even in a 'C' reorganization (transfer of assets). In a 'C' reorganization, the target corporation usually liquidates after exchanging away its operating assets, as a matter of state law, disgorging the stock of the acquiring corporation to its shareholders. Liquidation of a corporation is usually the event for a corporation to write off its prior 'corporate structure' asset accounts that have not been written off before, as a tax loss under section 165, because the corporate structure is presumably worthless when the corporate is liquidated. /116/ In 1984, Congress required the target corporation in a 'C' always had to liquidate in substance. /117/ In the eyes of the Tax Code, however, the 'C' reorganization is no more a liquidation than is a merger. /118/ After the liquidation of the target, the end product of the 'C' is exactly the same as the end product of a merger: the enterprise assets are held by the acquiring corporation and the old target shareholders hold acquiring corporation stock. A 'C' reorganization is, in substance, just a practical merger. In a 'C' reorganization, as in a merger, the wine of the old corporation has been fully decanted into a new bottle;  i.e., the acquiring corporation. The expenses of the target in both a merger and a 'C' reorganization are not losses, or expired costs or worthless when made, but rather basis that carries over the successor corporation. /119/ 

 

   Recovery of the Basis. The matching rationale, which seems the most satisfying of the reasons for capitalization, seems to imply that basis arising from the target's costs should be allocated among all of the enterprise's assets and not just to a separate and distinct asset. /120/ Under the matching rationale, basis is created for the costs so that they can be used against gain that is recognized. /121/ As the gain on the assets is recognized, accordingly, the basis should be used. 

 

   In taxable sales, the acquirer's total basis is allocated among the purchased enterprise assets. When a corporation buys an enterprise by acquiring stock and elects to treat the transaction as if it had purchased assets, /122/ the acquirer's cost of the stock is allocated among the assets of the enterprise under the 'residual method.' /123/ Basis is allocated, first to cash and cash equivalents, second, to marketable securities (and among them according to their fair-market value), third, to other assets not listed on an established market, and finally to the infinite-life intangible assets, such as goodwill and going-concern value. The residual method allocates the basis as much as possible to assets that are relatively easy to value. The method also prevents overallocation to cash and short recovery assets and prevents any allocation to goodwill, unless the price paid exceeds the fair-market value of all specific assets. 

 

   In a tax-free acquisition of assets, however, the residual method for allocating acquisition costs will maximize unrealized appreciation and minimize the enterprise's adjusted basis at any point. Because the reorganization was not an event upon which gain was recognized, by choice of the parties, there will be a great deal of unrealized gain in the specific assets of the enterprise, especially in those assets benefiting from rapid depreciation or immediate write-offs. Under the residual method, the assets with short write-off schedules will absorb all of the costs, although no gain was recognized on those assets, and the costs will be written off again quickly. Thus the residual method of allocating basis, applied to carryover basis situations, seems to maximize the quick deduction of costs and maximize the difference between the enterprise's aggregate adjusted basis and its value.

 

   An alternative that is only slightly better would be to allocate the costs among the enterprise assets according to how much unrealized appreciation is in the assets. /124/ That allocation, while minimizing unrealized appreciation initially, will also allocate a great deal of gain to assets near the end of their depreciation life, where the unrealized gain is likely to be especially high and where the basis will be written off again quite shortly. Again the method seems to maximize the difference between an enterprise's worth as an investment and the adjusted basis it has in its assets. 

 

   Under an ideal income tax, the adjusted basis of an investment giving normal fair-market value returns should equal the fair-market value of that investment. /125/ In an income tax, investments are made and continued with hard money, that is, post-tax, undeducted amounts, rather than with pre-tax, deducted, soft money amounts. /126/ Deducting investments that still have continuing value reduces the effective rate of tax on the investment to below the congressionally provided statutory tax rate. /127/ An enterprise as a whole is an investment, no different from any others. The fairest allocation method would be to allocate basis so as to make the adjusted basis of the enterprise come closest to fair-investment value of the enterprise. 

 

   The fairest allocation of the target's-costs basis, consistent with the norms of the income tax, would be to allocate the costs of the reorganization to goodwill of the enterprise, if any. Goodwill is defined as the excess by which the value of the firm as a whole exceeds the value of its assets. Allocating the costs entirely to goodwill at the time of purchase, if any, would make the adjusted basis of the firm most closely approximate the value of the firm as an investment. Goodwill is a nondepreciable asset with an indefinite, possibly infinite life, /128/ but that seems reasonable in the usual case. So long as the target enterprise continues, the value of the enterprise as a going concern will be greater than the sum of the value of its parts. The goodwill value is a permanent  investment, much like corporate stock, that continues to generate income so long as the enterprise continues. 

 

   Goodwill costs would, however, be deductible if the acquirer ever abandons the enterprise of the target or breaks up the target assets so they are no longer a going concern. /129/ In McCrory Corporation v. United States, /130/ the second circuit held that a merger could be viewed at least in part as the acquisition of the target's business, so that acquirer could deduct its reorganization costs when it abandoned the target enterprise. The acquirer did not have to abandon its entire 'improved corporate structure' to recognize its costs. /131/ 

 

   Allocation of the corporate-level-justified costs of the reorganization to goodwill in the target enterprise, as McCrory suggests, seems an ideal solution. It describes the acquirer as buying an ongoing enterprise that has a great deal of appreciation and it allocates the costs of the acquisition first to that appreciation. While allocating the target's basis to goodwill seems an optimal solution, any of several allocations would be reasonable enough to justify capitalization of the reorganization costs /132/ if again they were considered primarily for corporate benefit in the first place.

 

 B. The Separate and Distinct Asset Test 

 

   The taxpayer in Indopco argues that the Debevoise and Morgan Stanley fees cannot be capitalized because they did not create a 'separate and distinct asset.' The taxpayer argues that the separate and distinct asset requirement was promulgated by the Supreme Court in 1971 in Commissioner v. Lincoln Savings and Loan Association. /133/ The taxpayer argues that the separate and distinct test has replaced prior tests, under which the court looked to whether the costs generated substantial future value. /134/ While there is indeed authority to the effect that Lincoln Savings created such a rule, /135/ the more accurate and charitable view is that the language in Lincoln Savings made a separate and distinct test a sufficient reason for capitalization, but not a necessary one. /136/ Whether or not the requirement is new, however, if the taxpayer succeeds in its argument in Indopco, a finding that there is a 'separate and distinct asset' will be a prerequisite for capitalization. 

 

   It is hardly clear that proponents of the rule know what an 'asset' is, in theory or in practice, but the argument is made assuming that the 'separate and distinct asset' test would allow deduction of at least some costs that are investments, as a matter of economics, generating future income. The test seems also intended to overrule the 'well-established rule' /137/ that costs of reorganizations are capitalized. /138/ 

 

   The taxpayer's argument that a 'clear and distinct asset' test should replace a significant-future-value test is babbling nonsense in accounting theory. For accounting purposes, an 'asset' is the account on the balance sheet which carries costs from the current year over to future years. 'Assets' are simply costs, warehoused on  the balance sheet, waiting to be written off against future income. Capital expenditures are nothing but tax-deferred expenses, held in suspense in the wings offstage, and waiting to gain tax recognition on some future tax return. Accountants debit costs to 'asset' accounts rather than to current 'expense' accounts, because the costs generate future income. /139/ Because the costs cause future income, the costs are properly matched against that future income. For an accountant, calling a cost an 'asset' is not a statement that you can touch or feel something out there in the real world, but rather a statement that the firm's recognition of the costs is deferred. A 'separate and distinct asset' test thus does not rebut or override a 'future benefit' test for capital expenditure, because costs that have future benefit are properly accounting assets. 'Future benefit' and 'asset' are not opposites; under good usage, they are synomyms. 

 

   Strictly speaking, moreover, to call something an 'asset' is an accounting conclusion and not a datum from the real world at all. The nontax accounting term, 'asset' is the accounting analogue of the tax term, 'basis,' and both mean that the taxpayer has costs not yet recognized, which will need to be recognized at some future point. An 'asset' test would literally be circular, analogous to testing whether costs should be capitalized by looking to see whether the costs are deductible or instead create 'basis.' If you need basis, then make basis and if that is all that is required, then any costs can be capitalized under the separate and distinct asset test. 

 

   It is certainly possible to find or create a separate and distinct asset in Indopco. If the target corporation's costs were related to corporate-level income, it would be good and natural accounting to collect those costs in single separate asset account called goodwill or corporate structure or whatever. The acquiring corporation would then take over that asset account, most probably with an indefinite tax life. If a court needs an 'asset' to find capitalization, then, all it needs to say is 'Poof, there is an asset.' It is indeed that simple. /140/

 

   A strong law of capitalization is extraordinarily important to an income tax. Under the norms of an income tax, costs that constitute investments, generating future income for the taxpayer, are capitalized and may not be deducted so long as the costs continue to generate income. Investments in an income tax are normally made and continued only with 'hard-money,' that is, with amounts that have been already subjected to tax. The opposite, or 'soft-money' investing, is the opportunity to make or continue investments with costs that have been excluded or deducted from tax. Soft-money investing is a privilege that is ordinarily as valuable as not having to pay tax on the subsequent return from the investment. The thesis that expensing an investment, that is, deducting it immediately, is equivalent to exempting the subsequent income from the investment from tax, is one of the bulwarks of modern tax economics, but it is not generally known or appreciated within the tax law community. Too many capitalization decisions have been rendered under ways of looking at the issue as if expensing of investments were a normal thing to do rather than an extraordinary privilege. /141/ 

 

   Congress has directed the courts toward a comprehensive tax, from whatever source derived, /142/ and maintaining investment costs as hard money costs is a necessary part of taxing income. In adopting a comprehensive income tax, Congress intended that all investments should be capitalized, absent quite explicit orders to the contrary. /143/ In the absence of congressionally mandated subsidy, the courts need to enforce capitalization with enthusiasm. 

 

   There are lots of investments, properly capitalized, that are highly intangible. More and more wealth now and in the future will be in intangible form. In the future more and more investments will be found 'out there' only in electronic blips. It can indeed be hard work to identify and capitalize business intangibles, /144/ but that work needs to go forward without a 'separate and distinct asset' barrier. Under the norms of an income tax, even intangible business investments need to be made with hard-money nondeductible amounts. Within an income tax system that generally requires investments to be made with post-tax hard money, allowing corporate acquisitions to occur with untaxed soft money would be an extraordinary subsidy that corporate takeovers do not deserve. 

 

   The best explanation of why the target's costs are properly added to basis, in any event, has little to do with whether they are investments. Reorganizations are deferred-gain transactions if they are corporate related at all and the costs of the transaction need to be matched with the deferred gain from the transaction. /145/ Apparently the 'separate and distinct asset' test would prevent good tax accounting by setting up a barrier to good matching. In Hillsboro National Bank v. Commissioner, /146/ the Court recently threw out a narrow doctrinal barrier (the 'recovery' requirement) to good tax accounting. The Court should not reinsert one here. 

 

   The taxpayer's 'separate and distinct asset' test would also apparently reverse a number of the Court's sound precedents. Costs of sales could no longer be capitalized to be offset against the sales proceeds, /147/ because once something is sold, there is no continuing asset. The capital character of a cost could no longer be ascertained by looking to the tax character of the transaction out of which the transaction arose. /148/ Character could no longer be ascertained by looking to the origin of the claim. /149/ The origin of the claim test has been an especially satisfying rule, inducing the courts to reverse a number of bad accounting deductions where an ordinary deduction was a bad mismatch. /150/ A holding for the taxpayer in Indopco on the issue of capital expenditures, in sum, would rip apart the framework of existing law, just so that some dividends in a corporate takeover could be deducted.

 

 C. Posture of Indopco 

 

   Before the Supreme Court, Indopco will be argued as a capitalization case rather than as a dividend case. The IRS argued before the Tax Court that the Debevoise and Morgan Stanley fees were dividends. The Tax Court did not reach the dividend issue because it ruled in favor of the IRS on its alternative argument that the fees were capital expenditures and it is the later argument that went up on appeal. 

 

   The Tax Court should have ruled on the dividend question. Dividends and capital expenditures are not alternative arguments, although they both deny deductions in the current tax year, because capital expenditures create corporate basis, usable at some point, and dividends do not. A responsible court should in its theory make clear the consequence of its decisions in future years. /151/ Dividends are also taxable to shareholders whereas capital expenditures are not. The dividend question, moreover, is prior to the capitalization question because if the costs are dividends, as they are here, they are neither capital expenditure nor an expense to the corporation. 

 

   The posture of the case as a capital expenditure case makes it difficult for the court to say anything that sings for the facts presented. These fees, it should be important to note, are not on their facts corporate-level capital expenditures. They are not corporate investments because they do not give future value nor generate future taxable income for the corporation. They are plausibly not costs of deferred-gain sales because National Starch, under a not-terrible way of looking at the facts, did not sell any assets. /152/ They are not costs of improving National Starch's corporate structure or operations because the National Starch corporate structure and operations did not change. What did change was ownership. These fees are owner-level costs related to haggling over price and change of ownership. The fees benefited the shareholders, not the corporation. They are not even capital expenditures, they are dividends. But of course the fact that these fees are dividends on the facts is a truly silly reason to give the corporation a current deduction for them. 

 

   The facts as found by the Tax Court are rich enough for the Supreme Court to find that these fees are dividends, under the primary-benefit test, as a matter of law. The parties, however, have not argued the dividend issue  since the trial level, and they would undoubtedly enjoy the opportunity to influence the shape of the law. The Court could 'dig' the case, that is, dismiss [certiorari] as improvidently granted, sweeping all the problems under a rug. That would leave Indopco with a basis account of some kind, and Indopco could sue next year, and perhaps serially for many years, to see what kind of basis it has and if any of the years are years in which it can recover all or part of a basis it should not have. The Supreme Court might better remand to the Tax Court to find whether the fees are dividends as a matter of fact under the primary benefit test, except that the Tax Court has already found enough primary facts to preclude anything but a dividend. The Court thus would best invite briefs from the parties as to whether the fees are dividends as a matter of law on these facts. The dividend question is prior. Without a decision on the dividend question, there is no capitalization question fairly before the Court. Since the Debevoise, Plimpton fees and the Morgan Stanley fees were in fact dividends, the taxpayer has neither a capital expenditure nor a current expense.

 

 

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                                   FOOTNOTES

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   /1/ Indopco, Inc. v. Commissioner, 59 U.S.L.W. 3764 (1991) accepting certiorari sub nom in National Starch and Chemical Corp. v. Commissioner, 918 F.2d 426 (3d Cir. 1990) aff'g 93 T.C.67 (1989). 

 

   /2/ 918 F.2d at 428, 434. 

 

   /3/ Before the Tax Court, the IRS argued both that the fees were dividends and that they had to be capitalized. 93 T.C. at 73. The Tax Court disposed of the deduction for the year by capitalizing the fees. On appeal and certiorari the IRS merely defends on the ground on which it won below. The court might hold that the fees do not create a capital expenditure, but as a matter of logic, the court cannot rule in favor of the taxpayer without first disposing of the dividend question. 

 

   /4/ The language 'reflects an attempt to measure economic income--not an effort to use the tax law to serve ancillary purposes.' Portland Golf Club v. Commissioner, 110 U.S. 2780, Slip Opinion No. 89-530 at 15 (June 21, 1990) 

 

   /5/ Congress has enacted at least five major tax penalties on corporate acquisitions in the last years: (1) IRC section 5881 (anti- 'greenmail' provisions), added in 1987, imposes a 50-percent penalty that prevents a corporate raider from making his profit by selling back a fractional interest in the target corporation to the target. See, Ginsburg & Levin, 4 Mergers, Acquisitions and Leveraged Buyouts para. 1317 (1991); (2) IRC section 163(e)(5)&(i), added in 1989, defers and then disallows accrued but unpaid interest in a leveraged buyout if the interest rate is above threshold rates. (See, Sheppard, 'Conference Committee Goes After the Junk Bond Junkies,' 45 Tax Notes, 1042 (Nov. 27, 1989); (3) IRC sections 280G, 4999 (anti-golden parachute provisions), added in 1984, penalize management that pays itself a large severance payment that might induce it to go along with an acquisition; (4) IRC section 172(b)(1)(E)&(h), added in 1989, prevents interest incurred in a leveraged buyout from providing Net Operating Loss carrybacks; and (5) IRC section 279 (acquisition indebtedness) is a holdover from a prior generation (enacted in 1969), but it still prevents the deduction of interest incurred to acquire another corporation. 

 

   The IRS has shown itself to be quite partial to the defense in corporate takeovers by allowing potential targets to issue 'poison pills' without tax. Poison pills are bargain stock options issued to existing shareholders, contingent on a takeover threat, which dilute the raider's interest. Rev. Rul. 90-11, 1990-1 C.B. 10. 

 

   /6/ K. Llewellyn, The Common Law Tradition: Deciding Appeals 183 (1960). 

 

   /7/ See, e.g., Wolfman, 'The Supreme Court in the Lyon's Den: A Failure of Judicial Process,' 66 Corn. L. Rev. 1075 (1981) (arguing that the Supreme Court was ill-served by the adversary process in the tax leasing case of Frank Lyon Co. v. United States). The General Utilities doctrine, repealed in 1986 after a generation of tax reform agitation (See, Bittker & Eustice, Federal Income Taxation of Corps. & Shareholders para. 7.20 (5th ed. 1987), arose originally from the government's failure to raise the telling arguments below. See, General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). 

 

   /8/ The facts are drawn from the Tax Court findings, 93 T.C. 67 (1989). 

 

   /9/ In aggregate, according to Lindsey (Harvard Economics department) and Gravelle (Library of Congress), 76 percent of capital gains disappears into the black hole of section 1014. Gravelle and Lindsey, 'Capital Gains,' 38 Tax Notes 397, 400 (1988). Section 1014 might absorb an even higher percentage of economic gain, if Kotlikoff and Summers are right that 80 percent of all wealth is transferred to the next generation. Kotlikoff, 'Intergenerational Transfers and Savings,' 2 J. of Econ. Persp. 41, 43 (Spring 1988). 

 

   /10/ Kass v. Commissioner, 60 T.C. 218, 227 aff'd without opinion, 491 F.2d 749 (3d Cir. 1974) (84 percent of shares cashed out, 16 percent of shares exchanged as stock was not 'tantalizingly' close to qualifying as reorganization); Yoc Heating Corp. v. Commissioner, 61 T.C. 168 (1973) (85 percent cash is too much). The Service will rule that continuity of interest requirements are satisfied if half of the stock of the target is exchanged for stock in the successor, even though the other half of shares are cashed out. Rev. Proc. 77-37, 1977-2 C.B. 568, 569. 

 

   /11/ The genesis cases for the continuity of interest doctrine are Cortland Specialty Co. v. Commissioner, 60 F.2d 937 (2d Cir. 1932); Pinellas Ice & Cold Storage Co. v. Commissioner, 57 F.2d 188 (5th Cir. 1932). The language describing a qualified reorganization as a pooling of interest comes from the Financial Accounting Standards describing the same basic idea. Accounting Principles Board Opinion No. 16, Business Combinations (1970). 

 

   /12/ Both sections 368 and 351 were carried in birth by the same subsection (Revenue Act of 1921, Pub. L. No. 98, 67th Cong., 1st Sess. section 202(c)(2) (reorganizations) & (c)(3) (transfers to controlled corporation)) and both were wet nursed by the same justification that the stock received in the exchange represents a continuation of the taxpayer's same investment with a modification of the corporate form that is not worth recognizing in tax. Bittker & Eustice, supra note 7, para. 3.01 at 3-3 (section 351), para. 14.01 at 14-3 (section 368). 

 

   /13/ Private Letter Ruling No. 78839060, June 23, 1978. Rev. Rul. 84-71, 1984-1 C.B. 106 confirms the result in public. 

 

   /14/ In Rev. Rul. 80-284, 1980-2 C.B. 117; Rev. Rul. 80-285, 1980-2 C.B. 119 revoked by Rev. Rul. 84-71, supra note 13, the Service would have applied continuity of interest principles to section 351 if the formation of the new corporation was part of a larger transaction that was really a corporate acquisition. 

 

   /15/ See, supra, note 12. 

 

   /16/ See, e.g., discussion in Wolfman, 57 'Continuity of Interest' and the American Law Institute, 57 Taxes 840, 842 (1979). 

 

   /17/ The rich planning use of the National Starch ruling is described, e.g., in Ginsburg & Levin, supra note 5, vol. 2, ch. 9 (1991).

 

   /18/ The Debevoise out-of-pocket expenses were $15,069. The Morgan Stanley out-of-pocket expenses were $7,586. 93 T.C. at 72. 

 

   /19/ Jack's Maintenance Contractors, Inc. v. Commissioner, 703 F.2d 154, 156 (5th Cir. 1983) (legal fees to keep CEO out of jail); Sammons v. Commissioner, 472 F.2d 449, 452 (5th Cir. 1972) (contributions reducing shareholder guarantees); Loftin and Woodard, Inc. v. United States, 577 F.2d 1206, 1215 (5th Cir. 1978). 

 

   /20/ See, e.g., Sachs v. Commissioner, 277 F.2d 879, 882 (8th Cir. 1960), cert. denied, 364 U.S. 833 (1960) and cases there cited. 

 

   /21/ Dynamics Corporation of America v. United States, 392 F.2d 241, 246-247 (Ct. Cl. 1968); United States v. Smith, 418 F.2d 589, 593-594 (5th Cir. 1969); Waldheim v. Commissioner, 244 F.2d 1,5 (7th Cir. 1957). 

 

   /22/ Commissioner v. Tellier, 383 U.S. 687, 689 (1966). 

 

   /23/ See, e.g., Welch v. Helvering, 290 U.S. 111, 113 (1933) (we should be slow to override the taxpayer's judgment as to whether an expense is 'necessary.'). 

 

   /24/ 472 F.2d 449 (5th Cir. 1973). 

 

   /25/ 472 F.2d at 452. 

 

   /26/ 703 F.2d 154 (5th Cir. 1983). 

 

   /27/ 703 F.2d at 156. See also Cummins Diesel Sales, Inc. of Oregon v. United States, 207 F. Supp. 746, 748-49 (D. Or.1962) aff'd 321 F.2d 503 (9th Cir. 1963)(medical expenses to keep alive the principal officer and shareholder of the corporation were dividends, not corporate expenses, because they benefited primarily the shareholder). 

 

   /28/ Picker v. United States, 371 F.2d 486, 496 (Ct. Cl. 1967). 

 

   /29/ Id. 

 

   /30/ Spreckels v. Commissioner, 315 U.S. 626 (1942)(stock broker's commissions); Helvering v. Union Pacific RR Co., 293 U.S. 282 (1934) (costs of selling bonds); Third National Bank in Nashville v. United States, 427 F.2d 343, 344 (6th Cir. 1970) (dissenter's costs in merger appraisal litigation); Treas. Reg. section 1.263(a)- 2(e)(1987). 

 

   /31/ Estate of McGlothlin v. Commissioner, 370 F.2d 729,732 (5th Cir. 1967)(costs incurred under shareholder warranty of the asset value of target in a merger). 

 

   /32/ 1975-2 C.B. 108. 

 

   /33/ 918 F.2d at 433. 

 

   /34/ Treas. Reg. section 1.355-2(b)(2) (1989)( personal planning purpose of shareholder is not a corporate business purpose under 355).

 

   /35/ Hillsboro National Bank Co. v. United States, 460 U.S. 370, 392 (1983). Cf. Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929). 

 

   /36/ Jack's Maintenance Contractors, Inc. v. Commissioner, 703 F.2d 154 (5th Cir. 1983). 

 

   /37/ Ames v. Commissioner, 14 B.T.A. 1067, 1071 (1920) aff'd 49 F.2d 853 (8th Cir. 1931) (shareholder required to capitalize cost of paying corporate employees because shareholder's return would come in the increase of shareholder's shares rather than by direct income). 

 

   /38/ Estate of Steckel v. Commissioner, 26 T.C. 600 (1956) (shareholder could not deduct costs of legal proceeding against misappropriating management because suit benefitted the corporation and all other shareholders). 

 

   /39/ Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943); Deputy v. du Pont, 308 U.S. 488, 494 (1940). See also cases cited Picker v. United States, 371 F.2d 486, 495 n.11 (Ct. Cl. 1967). 

 

   /40/ 237 F.Supp. 80 (D.Conn. 1964) cited, Petition for Writ of Certiorari in Indopco, Inc. v. Commissioner, Doc 90-1278 at 16 (1990), Tax Notes Microfiche Doc 91-3926. 

 

   /41/ Rev. Rul. 67-1, 1967-1 C.B. 28. 237 F. Supp. at 83 & 85. 

 

   /42/ Cf. IRC section 132(e)(allowing exclusion of de minimis fringe benefits if the value of benefit is 'so small as to make accounting for it unreasonable or administratively impracticable'). 

 

   /43/ 93 T.C. at 74. 

 

   /44/ Accounting Principles Board Opinion No. 16, supra note 11, para. 16 (1970)(emphasis added). Accountants believe in erring on the side of low income and assets (Accounting Principles Board No. 4, Basic Concepts and Accounting Principles para. 171 (1970)) and they strongly oppose 'bypassing' inherent in the concept of constructive dividends under which reductions in corporate net worth are shown on the balance sheet but not on the income statements. (Accounting Principles Board No. 9, Reporting the Results of Operations 17 (1966).) Accordingly the accountants in fact require an immediate write off of all of the corporate-level costs of a reorganization in the period when paid (Id. at para. 58). The accounting rule is in stark contrast to the well-established tax rule under which reorganization costs are capitalized. See discussion accompanying infra notes 68, 87-107. Conservative understatement is hardly the watchword of good tax accounting and constructive dividends are a well-established concept in tax accounting. 

 

   /45/ 918 F.2d. at 427. 

 

   /46/ 918 F.2d at 432. A Morgan Stanley report had found there was synergism and the Tax Court disbelieved the taxpayer's arguments, judging that it was in the corporation's long term interest to shift ownership of the corporate stock to Unilever. 93 T.C. at 71. 

 

   /47/ Petition for Writ of Certiorari in Indopco, Inc. v. Commissioner, Doc 90-1278 at 3 (1990), Tax Notes Microfiche Doc 91- 3926.

 

   /48/ Accounting theory makes costs an asset, either a separate and distinct one or as an addition to some other asset account, if the costs provide significant value beyond the end of the reporting year. See infra note 139. 

 

   /49/ 93 T.C. at 76. In the same paragraph, however, the Tax Court said that there was an immediate benefit in the 'availability of the resources of Unilever' which broadened the taxpayer's opportunities. 

 

   /50/ Losses are involuntary events that occur because of events beyond the taxpayers' control. Hoile v. Commissioner, 4 T.C.M. (CCH) 247, 253-254 (1945) (voluntary contribution can not be called a loss). 

 

   /51/ See, e.g., Porreca v. Commissioner, 86 T.C. 821, 843 (1986) (video master tax shelter). 

 

   /52/ Interstate Transit Lines v. Commissioner, 319 U.S. 590 (1943); Deputy v. du Pont, 308 U.S. 488 (1940). 

 

   /53/ It may bear repeating here that the primary benefit test for a dividend overwhelms the deduction, even if the taxpayer were able to show that expense was minimally related to its own profit as an ordinary and necessary expense. See, text accompanying notes 22- 27. 

 

   /54/ United States v. Mews, 923 F.2d 67, 68 (7th Cir. 1991) (Posner, J.). 

 

   /55/ Sammons v. Commissioner, 472 F.2d 449, 452 (5th Cir. 1972) (indirect or incidental benefit to shareholder does not make distribution a dividend). 

 

   /56/ UCC section 6-105. 

 

   /57/ See discussion accompanying infra notes 63-66, 89-105. 

 

   /58/ IRC section 368(a)(1)(A). 

 

   /59/ IRC section 368(a)(1)(C), (a)(2)(G). 

 

   /60/ IRC section 368(a)(1)(B). 

 

   /61/ Formal Ethics Opinion 85-352 (1985), 39 Tax Lawyer, 631,634 (1986); AICPA, Statements on Responsibilities in Tax Practice, section .02a. at p.4 (1988 revision). 

 

   /62/ Graetz, Federal Income Taxation: Principles and Policies 79 (2d. ed. 1988). 

 

   /63/ APB No. 16, supra note 11, at para. 19. 

 

   /64/ The acquirer's costs would thus be treated as basis for assets or for the enterprise as a going concern. See discussion accompanying infra notes 120-132. The target company's costs would be treated as costs of sale of assets, properly offset against deferred gain from the sale, and as such the costs would become basis, attached to assets sold or to a separate goodwill-like asset of the enterprise as a whole. See discussion accompanying infra notes 87- 112, 120-131.

 

   /65/ Accounting Principles Board Opinion No. 16, supra note 11, para. 16 (1970) (emphasis added). 

 

   /66/ Id. 

 

   /67/ See, infra notes 78-83, 89-105. 

 

   /68/ National Starch, 918 F.2d at 428,433-434; McCrory Corp. v. United States, 651 F.2d 828, 832 (2d Cir. 1981); E.I.duPont de Nemours and Co. v. United States, 432 F.2d 1052, 1059 (3d Cir. 1970); General Bancshares Corp. v. Commissioner, 326 F.2d 712, 715 (8th Cir. 1964) (Blackman, J.); Mills Estate v. Commissioner, 206 F.2d 244, 246 (2d Cir. 1953). Strictly speaking, none of the 'infinite asset' cases deal with target side costs. 

 

   /69/ The courts seem to be fully aware of the nondepreciable asset they are generating. National Starch, 918 F.2d at 434; Mills Estate v. Commissioner, 206 F.2d 244, 246 (2d Cir. 1953). 

 

   /70/ In fairness, the corporate-structure-asset rational does not seem to have been applied to target side costs. The rationale given on the target side is that the costs are not 'ordinary' (Motion Picture Capital Corp. v. Commissioner, 80 F.2d 872, 873 (2d Cir. 1936) or that they are just not recognized losses (Estate of McGlothlin v. Commissioner, 370 F.2d 729, 732 (5th Cir. 1967). 

 

   /71/ Tax jargon for the letters given to reorganizations comes from IRC section 368(a)(1). An 'A' reorganization is described by IRC section 368(a)(1)(A), for instance, as a merger. 

 

   /72/ IRC section 368(a)(1)(C). 

 

   /73/ I do not believe in general that there is any distinction between acquirer's and target's costs in a reorganization. In a valid reorganization, two groups of shareholders have agreed to pool their interest. The benefits of the amalgamation accrue to them both. As a matter of economics, the costs of both parties are together a barrier between the buyer's willing offer and the seller's strike price; both sets of costs must be covered before the parties can reach a bargain. In modern tax practice, moreover, which corporation is the nominal acquirer and which is the nominal target is a malleable issue that can be played either way. Thus the target's costs should be aggregated with the acquirer's costs and both should be treated the same by the ongoing enterprise. Still there is considerably more plausibility to the improved-corporate-structure asset for acquirer's costs than there is for the target's costs. If dividends to the acquirer's shareholders are too much to take, then perhaps the acquirer's costs could be considered an indefinite life asset, improved corporate structure, rather than a dividend. 

 

   /74/ Bittker and Eustice, supra note 7, para. 7.05 AT 7-35 (5th ed. 1987). 

 

   /75/ See Levmore, 'Recharacterizations and the Nature of Theory in Corporate Tax Law,' 136 U.Penn.L.Rev. 1019 (1988) (arguing that IRS may not recharacterize transactions set up by the taxpayer unless it has a complete and consistent alternative description of the transaction).

 

   /76/ Cf. IRC section 358(a)(1)(A)&(B) increasing shareholder basis by gain recognized in a reorganization but not withdrawn as cash. In general, tax basis is increased by amounts that have been taxed, even if they have no pretax cost. Brown, 'The Growing 'Common- Law' of Taxation,' 1961 So. Calif. Tax. Inst. 1, 7-8. 

 

   /77/ Spreckels v. Commissioner, 315 U.S. 626 (1942); Helvering v. Union Pacific Co., 293 U.S. 282 (1934); Treas. Reg. section 1.263(a)-2(e)(1987). Even if the transaction were overall a tax-free exchange, shareholders receiving boot may appropriately offset the fees against the boot. Rev. Rul. 72-456, 1972-2 C.B. 468 (boot received in a reorganization may be offset by sale costs). 

 

   /78/ Estate of McGlothlin v. Commissioner, 370 F.2d 729, 732 (5th Cir. 1967). 

 

   /79/ IRC section 354; Estate of McGlothlin v. Commissioner, 370 F.2d 729, 732 (5th Cir. 1967). The shareholders in Indopco relied on IRC section 351 for nonrecognition and there, too, no loss is allowed. IRC section 351(b)(2). 

 

   /80/ See, supra note 77. 

 

   /81/ Assume, for instance, a shareholder who purchased National Starch stock for $100 incurred $5 cost in a tax-free exchange for Unilever stock and then sold the Unilever stock for $125. Treating the $5 cost as if it were just less Unilever stock received (e.g., $120 rather than $125) would have no impact on the tax-free exchange (IRC section 354). The shareholder's original $100 basis would then just carry over into her new shares (IRC section 358) and she would have $25 taxable gain from the $125 sale of her Unilever shares. But as a matter of economics, that result overstates the shareholder's income when the deferred gain is finally recognized. Over the course of the whole transaction, the shareholder has $125 receipts and $105 outlays for a total gain of $20. The right result, which the text argues is in fact reached, is that the $5 cost is added to the shareholder's basis for the Unilever shares. The extra $5 basis in the Unilever stock, recognized when and if the $20 gain is recognized, makes the tax accounting describe what in fact went on. 

 

   /82/ See also infra note 89-105. 

 

   /83/ See, e.g., IRC section 1014 (stepping up basis at death so that all gain and all prior basis disappears). 

 

   /84/ IRC section 368(a)(1)(B)('B' reorganizations). See Chapman v. Commissioner, 618 F.2d 856 (1st Cir. 1980); Pierson v. United States, 621 F.2d 1227 (3d Cir. 1980) (even cash for less than 20 percent of the target stock will destroy a 'B' reorganization). 

 

   /85/ Reverse subsidiary mergers also require issuance of voting stock, but only for 80 percent of the true target's stock. IRC section 368(a)(2)(E)(ii). 

 

   /86/ As to 'B' reorganizations, see, e.g., Rev. Rul. 55-440, 1955-2 C.B. 226 (eve-of-reorganization redemption of stock by target does not destroy 'B' even though not completed until after the acquisition exchange). As to reverse subsidiary mergers, see Treas. Reg. section 1.368-2(j)(7) ex. (2)&(3) (1980) (eve-of-reorganization stock redemptions are not counted in determining whether the target was acquired for voting stock).

 

   /87/ Bittker & Eustice, supra note 7, para. 5.06, at 5-33. 

 

   /88/ Id., at 5-34. 

 

   /89/ IRC section 361 (corporate transferors); section 354 (shareholders). 

 

   /90/ IRC sections 362(b) (corporate carryover basis) and 358 (shareholder carryover basis). 

 

   /91/ The 'cost of any given type of income is to be accorded the same tax character as the income produced.' Alphaco, Inc. v. Nelson, 385 F.2d 244 (7th Cir. 1967). 

 

   /92/ Accounting Principles Board No. 4, Basic Concepts and Accounting Principles, paras. 115, 157 (1970) (expenses which cause revenue are charged to that revenue). 

 

   /93/ Spreckels v. Commissioner, 315 U.S. 626 (1942) and authorities cited supra note 30. 

 

   /94/ See discussion accompanying supra notes 78-83. 

 

   /95/ '[A] business combination is a significant economic event which results from bargaining between independent parties. Each party bargains on the basis of his assessment of the current status and future prospects of each constituent as a separate enterprise and as a contributor to the proposed combined enterprise. The agreed terms of the combination recognize primarily the bargained values.' APB No. 16, supra note 11, at para. 19. 

 

   /96/ Estate of McGlothlin v. Commissioner, 370 F.2d 729,732 (5th Cir. 1967)(costs incurred by shareholder were not recognized under reorganization nonrecognition rules). 

 

   /97/ IRC section 261, as interpreted by Idaho Power, 418 U.S. 1, 19 (1973). 

 

   /98/ See, e.g., Page v. Commissioner, 524 F.2d 1149 (9th Cir. 1975); Connery v. United States, 460 F.2d 1130 (3d Cir. 1973); Lanrao, Inc. v. United States, 422 F.2d 481 (6th Cir. 1970) cert. denied 398 U.S. 928 (1970); Alphaco, Inc. v. Nelson, 385 F.2d 244 (7th Cir. 1967); Winer v. Commissioner, 371 F.2d 684 (1st Cir. 1967); Stewart v. Commissioner, 63 T.C. 682 (1975). 

 

   /99/ Benedict Oil Co. v. United States, 582 F.2d 544 (10th Cir. 1978)(Tenth Circuit reversing itself on the issue); Of Course, Inc. v. Commissioner, 499 F.2d 754, 756 (4th Cir. 1974) (Fourth Circuit reversing itself on the issue). 

 

   /100/ IRC section 368(a)(1)(C)(asset transfer). 

 

   /101/ IRC section 368(a)(1)(A)(merger). 

 

   /102/ See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331 (1945)(corporation taxed on sale, although consideration passed directly to shareholders); Bush Brothers & Co. v. Commissioner, 668 F.2d 252, 255 (6th Cir. 1982)(corporate participation in the sale of inventory was sufficient to impute income to corporation); Commissioner v. Transport Trading & Terminal Corp., 176 F.2d 570 (2d Cir. 1949).

 

   /103/ See supra note 95. 

 

   /104/ Even in a 'B' reorganization, IRC section 368(a)(1)(B) (stock transfer), there has been an arm's-length bargaining that sets the total value for the enterprise. If not, then B reorganization costs are dividends. 

 

   /105/ The IRS has ruled that costs of a tax-free, section 332 liquidation of a wholly owned (or 80-percent owned) subsidiary are deductible (Rev. Rul. 63-233, 1963-2 C.B. 113). The ruling is distinguishable on the ground that liquidation of a wholly owned subsidiary is a mere housekeeping chore, involving the trivial cost of surrendering the state law charter. Such a liquidation is not even a bargained transfer to an outsider that would be a realization of deferred gain as a matter of economics. The costs are so trivial, moreover, so as to not even amount to an investment worth keeping basis for. 

 

   /106/ Technical Advice Memoranda 9043003 and 9043004 (July 9, 1990)(target costs in a friendly takeover are capitalized but target costs defending against a hostile takeover are expensed). 

 

   /107/ Victory Market, Inc. v. Commissioner, Docket No. 11276-90. 

 

   /108/ See, e.g., Libson Shops, Inc. v Koehler, 48 AFTR 1988, 1993 (D. Mo. 1955) (costs of rejected alternative ways to merge corporations to preserve net operating losses were not abandoned costs, because rejected and adopted alternatives were all done with one purpose in mind) aff'd on another issue, 229 F.2d.220 (8th Cir. 1956) aff'd 353 U.S. 382 rehearing den'd 354 U.S. 943 (1957). 

 

   /109/ Woodward v. Commissioner, 397 U.S. 572, 577 (1970) (cost of redeeming dissenters shares are not expired (deductible) costs because costs originate in capital transaction); United States v. Hilton Hotels, 397 U.S. 580 (1970). 

 

   /110/ Treasury Reg. section 1.461-1(a)(1) and authorities cited infra note 134. 

 

   /111/ National Starch, 918 F.2d at 428,433-434; McCrory Corp. v. United States, 651 F.2d 828, 832 (2d Cir. 1981); E.I. duPont de Nemours and Co. v. United States, 432 F.2d 1052, 1059 (3d Cir. 1970); General Bancshares Corp. v. Commissioner, 326 F.2d 712, 715 (8th Cir. 1964); Mills Estate v. Commissioner, 206 F2d 244, 246 (2d Cir. 1953). 

 

   /112/ IRC sections 362(b)(basis) and 381 (other tax accounts). 

 

   /113/ Treas. Reg. section 368-1(b)(1980); Atlas Tool Co. Inc. v. Commissioner, 614 F.2d 860, 866 (3d Cir. 1980) (crucial that new corporation carries forward the business of the old). 

 

   /114/ Vulcan Materials Co. v. United States, 446 F.2d 690, 694 (5th Cir. 1971) (target's prior corporate structure assets may not be deducted upon is merger). Cf. FEC Liquidating Corp. v. Commissioner, 548 F.2d 924, 927 (Ct. Cl. 1977) (transaction is either a liquidation or a reorganization, not both). 

 

   /115/ IRC sections 362 (basis carryover) and 381 (carryover of net operating loss, earnings and profits, methods of accounting and other tax accounts).

 

   /116/ See, e.g., Pacific Coast Biscuit Co. v. Commissioner, 32 B.T.A. 39, 43 (1935); Malta Temple Ass'n v. Commissioner, 16 B.T.A. 409 (1929). 

 

   /117/ Tax Reform Act of 1984, Pub. Law No.98-369, section 63, enacting IRC section 368(a)(2)(G). The target may avoid liquidating in fact, with Treasury permission (IRC section 368(a) (2)(G)(ii)), but only if the corporation is a lifeless shell that has been liquidated in substance. Rev. Proc. 89-50, 1989-2 C.B. 631. See Bittker & Eustice, supra note 7, para. 14.14(4.) at 14-60. 

 

   /118/ A true liquidation generates taxable gain for both corporation and shareholders (IRC sections 331, 336), but the dissolution of the target in a 'C' reorganization is considered part of the reorganization, not a liquidation and neither the target nor the shareholders recognize the normal liquidation gain. IRC sections 361(c)(1), 354. IRC section 336(a)(requiring corporate gains upon liquidation) does not even have to refer to section 361(c)(1) for an exception from its scope because everybody knows that a 'C' target liquidation is not really a liquidation. See also FEC Liquidating Corp. v. United States, 548 F.2d 924, 927 (Ct. Cl. 1977) (the nature of the inquiry is either/or: the transaction is either a liquidation or a reorganization but not both). 

 

   /119/ In Kingsford Co. v. Commissioner, 41 T.C. 646 (1964), the Tax Court allowed the taxpayer to deduct the costs of a C reorganization liquidation. The decision may be correct read very narrowly as meaning only the trivial housekeeping costs of surrendering the state charter as a matter of state law. Read any broader, the decision is inconsistent with Vulcan Material Company v. United States, 446 F.2d 690 (5th Cir. 1971), which held that an 'A' reorganization is not the occasion to deduct prior corporate structure assets. It is also doubtful that Kingsford survives the 1984 amendments, supra note 114, which clarified that a 'C' is indistinguishable from an 'A' reorganization. 

 

   /120/ Ironically, while the taxpayer in Indopco argues that capitalization requires a separate and distinct asset (see text accompanying infra note 133-138), the taxpayer chances for a more favorable recovery method seem better if no separate basis is created and the basis is instead allocated among all of the enterprises assets. 

 

   /121/ See discussion accompanying supra note 91-105. 

 

   /122/ IRC section 338. 

 

   /123/ Temporary Treas. Reg. section 1.338(b)-2T (1986). 

 

   /124/ Easson v. Commissioner, 33 T.C. 963, 975 (1960) (boot received in a section 351 transaction allocated according to potential gain on the assets) rev'd on other grounds 294 F.2d 653 (9th Cir. 1961). 

 

   /125/ Fellows, 'A Comprehensive Attack on Tax Deferral,' 88 Mich. L. Rev. 722, 730 (1990). 

 

   /126/ Johnson, 'Soft Money Investing Under the Income Tax,' 1989 Ill. L. Rev. 1019, 1039-1053 (1990). 

 

   /127/ Samuelson, 'Tax Deductibility of Economic Depreciation to Insure Invariant Valuations,' 72 J. Pol. Econ. 604 (1964), is the pioneering article. See also Warren, 'Accelerated Capital Recovery, Debt, and Tax Arbitrage,' 38 Tax Law. 549 (1985). 

 

   /128/ See, e.g., Thrifticheck Services Corp. v. Commissioner, 287 F.2d 1 (2d Cir. 1961); Misegades v. Commissioner, 53 T.C. 477 (1969). 

 

   /129/ If there is no goodwill, the assets of the firm will by definition be as valuable in other uses as they were in the enterprise. Abandonment of the going concern breaking up the assets would be proof that the goodwill has in fact melted and the costs of the goodwill have expired. Short of breaking up the going concern, however, loss in value of the goodwill will undoubtedly have to be treated as unrealized loss, if there was goodwill at the time of initial purchase. 

 

   /130/ 651 F.2d 828, 833-34 (2d Cir. 1981). 

 

   /131/ The acquisition in McCrory was, as in all reorganizations, an acquisition with stock. The court in McCrory remanded the case for the acquirer to allocate its costs between costs of assets, deductible when the acquired business was abandoned, and costs of issuing the stock, which the court held were not deductible. 

 

   /132/ Gunn, 'The Requirement That A Capital Expenditure Create or Enhance an Asset,' 15 B.C. Indus. & Com. L. Rev. 443 (1974) argues that the problems of handling the write-off periods of intangible assets are so severe that we should allow immediate deduction of intangible investments. For my argument that Gunn badly underestimates the importance of capitalization, see Johnson, supra note 126, at 1021 (n. 9-11.), 1073-1075. The text argues that recovery of the costs can be handled quite successfully enough to allow capitalization in the first place. 

 

   /133/ 403 U.S. 345 (1971). Petition for Writ of Certiorari in Indopco, Inc. v. Commissioner, Doc 90-1278 at i (1990), Tax Notes Microfiche Doc 91-3926. 

 

   /134/ See, e.g., National Starch, 918 F.2d. at 429-430; Cleveland Electric Illuminating v. United States, 55 AFTR.2d 85-652, 655, 7 Ct.Cl. 220 (1985); Central Bank Block Ass'n v. Commissioner, 19 B.T.A. 1183, 1185 (1930)(broker's fee for lease was capitalized because it was 'acquisition of something from which income will be derived in the future') aff'd 57 F.2d 5 (5th Cir. 1932); Lovejoy v. Commissioner, 18 B.T.A. 1179, 1182 (1930)(up front charges for loans are assets because the costs exhausted proportionately over period of years); Treasury Reg. section 1.461-1(a)(1)(improvements, e.g., to leasehold, are capitalized because they have substantial value beyond year end); Note, 'Income Tax Accounting: Business Expense or Capital Outlay,' 47 Harv. L. Rev. 669 (1934). 

 

   /135/ NCNB Corp. v. United States, 684 F.2d 285 (4th Cir. 1982) (en banc) rev'g 651 F.2d 942 (1981)(panel decision). 

 

   /136/ Cleveland Electric Illuminating v. United States, 55 AFTR.2d 85-6252, 7 Ct.Cl. 220 (1985); National Starch v. Commissioner, 918 F.2d. at 429-430. 

 

   /137/ Bittker & Eustice, supra note 7, para. 5.06, at 5-35. There is no conflict among the lower courts as to how to treat reorganization expenses; they are uniformly capitalized, although the reasons given are not uniform. See discussion accompanying supra notes 68, 87-108.

 

   /138/ In Javaras & Maynes, 'Do Briarcliff Candy and Code Section 195 Stiff National Starch,' 49 Tax Notes 1223 (1990), the authors aruge that IRC section 195 stiffs the rule that reorganization expenditures are capitalized. Javaras and Mayner cite IRC section 195 as if it generally allowed immediate deduction of intangible investments. Section 195 is very narrow, drafted-after-midnight legislation, having nothing to do with the problem here. Section 195 on its face has no application to any costs that are in fact investments or capital expenditures, as here. IRC section 195(c)(1)(B). Section 195, moreover, allows not immediate deduction of the costs within its scope but rather a five-year amortization schedule for its costs. National Starch entered into a trade or business many years before 1978, so a statute dealing with preopening expenses of taxpayers who have not yet entered into business can give National Starch neither sorrow nor solace. 

 

   /139/ Financial Accounting Standards Board ('FASB'), Statement of Financial Accounting Concepts No. 3 19,20,104 (essence of definition of 'asset' is future economic benefit). For tax law use of the future benefit standard, see, e.g., authorities cited supra note 134. 

 

   /140/ See, e.g., Central Texas Savings and Loan v. United States, 731 F.2d 118 (5th Cir. 1984) (Even an intangible right, such as the nontransferable right to do business, can be an asset). 

 

   /141/ See, e.g., Johnson, supra note 126, 1989 Ill. L. Rev. 1019 (1990) for an explanation of the thesis that exemption income and allowing deduction of investments are equivalent and for an argument that the importance of capitalization has been underestimated. 

 

   /142/ Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955). 

 

   /143/ Congress is sovereign and has allowed some taxpayers to expense some investments for subsidy purposes. See, e.g. IRC section 174 (research and experimental investments may be deducted when made. No such subsidy is intended here. See supra note 5, which implies that Congress would be perfectly willing to penalize these costs. 

 

   /144/ See, e.g., 'Mundstock, Taxation of Business Intangible Capital,' 135 U.Penn.L.Rev. 1179 (1987). 

 

   /145/ See discussion accompanying supra notes 89-105. 

 

   /146/ 460 U.S. 370 (1983)(O'Connor, J.) (no 'recovery' needed for the tax benefit rule to work to reverse a prior, now inappropriate deduction into income). 

 

   /147/ Spreckels v. Commissioner, 315 U.S. 626 (1942); Helvering v. Union Pacific Co., 293 U.S. 282 (1934). 

 

   /148/ Arrowsmith v. Commissioner, 344 U.S. 6 (1952). 

 

   /149/ Woodward v. Commissioner, 397 U.S. 572, 577 (1970) (cost of redeeming dissenters shares are not expired (deductible) costs because costs originate in capital transaction); United States v. Hilton Hotels, 397 U.S. 580 (1970).

 

   /150/ Adoption of the origin-of-the-claim test was interpreted by the lower courts as the occasion to overrule or avoid their (dubious) prior precedents that had allowed current deduction of various costs that related to capital transactions rather than to current operations. See, e.g., Of Course, Inc. v. Commissioner, 499 F.2d 754, 756 (4th Cir. 1974) (citing Woodward and other authorities to overrule prior decisions allowing deduction of costs of tax-exempt (old IRC section 337) sale of assets); Jim Walter Corp. v. United States, 498 F.2d 631, 638-39 (5th Cir. 1974) (capitalizing corporation's price paid to redeem shares, notwithstanding precedent allowing deduction of redemption price where purpose was to protect the business); Vestal v. United States, 498 F.2d 487, 495 (8th Cir. 1974) (citing Woodward to capitalize a fee for investment advice and distinguishing prior cases allowing a deduction); Helgerson v. United States, 426 F.2d 1293, 1298 (8th Cir. 1970) (capitalizing expenses of litigation to collect stock sale proceeds, under Woodward, notwithstanding prior cases allowing deduction of the cost of collecting income). 

 

   /151/ Welch v. Helvering, 290 U.S. 111 (1933) (denying a deduction for payment of bankruptcy-discharged debts, because the expense was not 'ordinary and necessary') is an irresponsible, self- indulgent decision because the Court did not say whether the cost disallowance was permanent (as, e.g., a personal cost or a payments of debts that had already been deducted) or simply a temporary disallowance (as an amortizable or nonamortizable investment). Did the Court expect Mr. Welch to come back to the Supreme Court in every year hence to find out if this was the year for a deduction? Would the Court answer every year, 'Not this year, Mr. Welch.' Or at some point would it give us its theory of the case? Each tax year may technically be considered a different case, but a Court nonetheless must give a theory of the case that makes the outcome for all years complete and satisfying. The Court should tell us under which part of 'life in all its fullness' (290 U.S. at 115) the taxpayer lost, so that we can ascertain the tax treatment for all years and go about other business. 

 

   /152/ But see, supra, note 104. 

 

 

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