C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y Tax Accounting BY JAMES E. SALLES tal, and represents gain to the extent that it exceeds I n this month’s column available basis, 7 as the proceeds of a partial (or com- plete, as the case may be) disposition of the goodwill. 8 King v. United States 1 presents the issue of The associated costs are treated as additions to basis • or offsets to the amount received or (what amounts to whether litigation costs incurred in pursuing a the same thing) the proceeds are apportioned net of shareholder derivative suit are capital or ordinary; costs. 9 • A Treasury official confirms that the long-prom- If the taxpayer retains ownership of the property, both ised proposed regulations on general capitaliza- the recovery and the related costs are treated as tion principles are still under way; adjustments to basis. Iowa Southern Utilities Co. v. • The Federal Circuit upholds the IRS’ refusal to Commissioner 10 involved a successful shareholder apply a revenue procedure dealing with deferred derivative suit alleging, among other things, that the tax- payments for services to credit card fees in payer had overpaid for certain property. The taxpayer American Express Co. v. United States 2 ; and • The Sixth Circuit affirms in United Dairy Farmers, treated the gross recovery as an adjustment to basis, Inc. v. United States, 3 requiring the taxpayer to but sought to deduct the attorneys’ fees and costs as capitalize environmental cleanup costs when the business expenses. The Eighth Circuit held that the expenditures were capital. properties were contaminated when the taxpay- er acquired them. Recoveries of Cash LITIGATION COSTS CAPITALIZED By contrast, in California & Hawaiian Sugar Refining Corp. v. United States , 11 the Court of Claims allowed a A recent district court case, King v. United States , 4 deduction for the cost of recovering unconstitutional discusses the treatment of litigation costs incurred in “floor stocks taxes,” although the refund itself was not connection with capital transactions. includable in income, because “a tax refund, though it Background may be a return of capital, is not the kind of ‘property’ to which the statute and regulation [concerning capitaliza- Costs associated with “separate and distinct” assets tion] refer” and lacked a basis to adjust. The rule are capitalized into the basis of the asset concerned. appears to be that an expenditure cannot be capital- The capitalization requirement applies both to “ancil- lary” costs of acquiring the property 5 and (except for ized as relating to “property” if there is no property with a basis to adjust 12 (although this does not necessarily dealers) the costs of disposing of the property, 6 includ- mean that the expenditure can be deducted). 13 ing the costs of litigation. On similar reasoning, the taxpayer in Newark Morning The same principle applies to the costs of pursuing Ledger Co. v. United States 14 was allowed to deduct the the recovery of a capital asset or obtaining a recovery expenditures of a shareholders’ derivative suit against relating to an asset. For example, business disputes the former management of a newly acquired newspa- frequently involve allegations of impairment to goodwill per. The dispute did not involve the acquisition or own- in addition to, or in lieu of, lost income. The portion of ership, and the court held that the target corporation the recovery that is attributable to the goodwill is capi- could have deducted the expenditures itself, because “[e]xpenses incurred to recover diverted operating rev- Jim Salles is a member of Caplin & Drysdale in Washington, D.C. enue or false charges to operating revenues are not N O V E M B E R 2 0 0 1 21
C O R P O R A T E B U S I N E S S T A X A T I O N M O N T H L Y capital expenditures even though their aim is to recover Turgeon of the Treasury’s Office of Tax Policy discussed an ‘asset.’” 15 the prospects for regulatory guidance at a conference in early October. 22 She confirmed that guidance on King v. United States “self-developed intangibles” and some form of “ de min- In King , a minority shareholder sued claiming the imis ” threshold for capitalization were under considera- majority shareholders had plundered the corporation. tion, and added a new wrinkle by suggesting that the In settlement, he gave up his shares for a cash payment regulations might cover not only what expenditures which (apart from the interest component) the parties have to be capitalized but over what period they could agreed produced capital gain. The question was how be recovered. While the department had originally to treat the associated litigation costs. hoped to publish something by June 30, 2002 (hence In a reversal of the traditional litigation postures, the the project’s inclusion on the current business plan 23 ), taxpayer argued that the expenses were an addition to according to Turgeon present expectations are that the basis while the Government contended that they were proposed regulations will be issued “in a year or so.” currently deductible. The Government’s argument was CREDIT CARD FEES NOT that the costs were not incurred in connection with the taxpayer’s disposition of his stock but in an effort to pre- DEFERRABLE serve its value against the depredations of the majority In American Express Co. v. United States , 24 the shareholders. That theory would leave the taxpayer Federal Circuit has upheld the Court of Federal Claims’ entitled to a deduction for investment expenses under decision that Revenue Procedure 71-21 25 did not entitle Code Section 212, but that deduction would be subject American Express to defer reporting income from its to the 2 percent “floor” for regular tax purposes, 16 and annual credit card fees. not allowable in computing the alternative minimum tax at all. 17 The taxpayer was thus better off with an offset to Background capital gain. The IRS reads Schlude v. Commissioner 26 and its ilk The district court analyzed the issue under the “origin as establishing that income from services must be of the claim” test. The Supreme Court applied this test reported when paid, when payment is due, or when the in Gilmore v. United States 18 to determine whether litiga- services are performed, whichever happens first. 27 tion was business-related or personal, and later extend- Revenue Procedure 71-21, designed to ease the ed it to the determination of whether litigation relates to impact of this rule on common contractual arrange- a capital transaction. 19 The court in King concluded that ments, permits deferring most advance payments for the critical question was whether the taxpayer’s suit services if the corresponding services are to be per- “implicitly sought to terminate” his ownership of the formed by the end of the year following receipt. stock or merely to restore its value. Citing Brown v. However, the IRS does not consider credit card fees to United States , 20 a similar case in which the government be payments for services for this purpose. In this case, had successfully argued for capital treatment when the the Court of Federal Claims had sustained the IRS’ shoe was on the other foot, the court denied the gov- refusal to grant permission for a change of accounting ernment’s motion for summary judgment. The parties method so that American Express could use the proce- will thus get to argue whether the facts more closely dure for its fees, and the taxpayer appealed. resemble Newark Morning Ledger , with its “garden- Like the court below, the Federal Circuit declined to variety” shareholder derivative suit, or the various try to determine whether the fees paid were for services authorities dealing with dispositions of property. based upon the distinctions drawn in the Tax Court cases of Barnett Banks of Florida v. Commissioner 28 and PROSPECTIVE Signet Banking Corp. v. Commissioner . 29 The court CAPITALIZATION REGS held that — regardless of whether the credit card fees The promised proposed regulations on capitaliza- might be considered a “fee for services” — the real tion 21 are still under active development, although the question was whether the IRS had abused its discretion schedule appears to be slipping somewhat. Christine by issuing a relief procedure that it had consistently 22 22 N O V E M B E R 2 0 0 1
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