Recent Private Letter Ruling Addresses Deductibility of Settlement and Litigation Costs Resulting from Corporate Acquisition

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January 02, 2007

A recent Private Letter Ruling demonstrates how the IRS will analyze taxpayers’ deductions of litigation and settlement costs originating in financial improprieties that are concurrent with a business acquisition. Generally, taxpayers must capitalize legal fees and litigation settlement amounts that facilitate or arise in business acquisitions. In contrast, taxpayers may currently deduct legal fees and litigation settlement amounts if the taxpayers perform the acts giving rise to the litigation in the ordinary and necessary conduct of their business.

In PLR 200649011, December 8, 2006, the IRS considered legal fees and settlement amounts temporally related to a business acquisition but not originating in the business acquisition. A newly formed subsidiary of Taxpayer, a corporation, merged with another corporation, and the other corporation survived as a wholly owned subsidiary of Taxpayer.

Following the acquisition, Taxpayer issued a press release announcing its earnings after the first post-merger financial accounting period. Taxpayer also filed statements regarding these earnings with the U.S. Securities and Exchange Commission. Soon after the press release, Taxpayer learned that the subsidiary had improperly booked revenue for financial accounting purposes. Taxpayer issued another press release announcing that it (i) had discovered accounting improprieties, (ii) had reversed the accounting for certain transactions, and (iii) could discover more accounting improprieties as a financial audit progressed. After completing its investigation, Taxpayer revised its revenue downwards over several accounting periods to reflect corrections of the subsidiary’s accounting improprieties.

Some of Taxpayer’s investors filed lawsuits, alleging that Taxpayer’s public dissemination of financial information based on accounting improprieties was part of a scheme to intentionally defraud the public markets. The plaintiffs had two primary claims. First, the plaintiffs claimed that Taxpayer had knowingly misled the public with untrue and misleading financial statements. Second, the plaintiffs claimed that Taxpayer and its subsidiary released a false and misleading joint proxy statement regarding the subsidiary’s financial results in conjunction with the acquisition. Taxpayer settled the lawsuits by agreeing to contribute funds to an escrow account that would be distributed to the plaintiffs under a court-approved plan. In addition to the settlement amount, Taxpayer incurred legal fees.

The IRS applied the “origin of the claim” doctrine, which has an established history in U.S. federal courts, to determine whether Taxpayer could currently deduct the litigation costs and settlement amounts. The IRS examined each of the plaintiffs’ claims separately to determine whether each claim had its origin in Taxpayer’s ordinary and necessary business activities or whether each claim had its origin in the acquisition. Taxpayers must capitalize costs originating in acquisitions, but can currently deduct costs originating in ordinary and necessary business activities.

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The IRS determined that preparing financial statements is a “common and routine activity in the carrying on of a trade or business.” Taxpayer prepared consolidated financial statements, and the subsidiary prepared standalone financial statements before the acquisition, independent of the acquisition. The IRS’s analysis of the plaintiffs’ first claim — that Taxpayer knowingly misled the public through untrue and misleading financial statements — led it to conclude that this claim would exist regardless of the acquisition and did not originate in the acquisition.

In contrast, Taxpayer’s joint proxy statement with the subsidiary was not independent of the acquisition; rather, it stemmed from the acquisition. Yet the information in the joint proxy statement was merely a compilation of Taxpayer’s and its subsidiary’s previously released financial information. Thus, the IRS determined that the plaintiffs’ second claim — that they were damaged by the information in the joint proxy statement — was of the same essence as their first claim. The second claim likewise originated in Taxpayer’s preparation of financial information even though the second claim would not exist but for the acquisition.

The IRS ruled that the legal fees and settlement amounts originated in Taxpayer’s ordinary and necessary business activities. Taxpayer could currently deduct these expenditures as ordinary and necessary business expenses and did not need to capitalize them in the acquisition.

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