IRS allows deduction for severance payments after Sec. 338 election.

• Author: Brodman, Howard
• Position: Internal Revenue Code section 338

In Letter Ruling (TAM) 9721002, the IRS analyzed the question of whether severance payments made by a new target corporation are required to be capitalized in the basis of the assets acquired from an old target corporation as a result of a Sec. 338 election.

B acquired the stock of T, a wholly owned subsidiary of P, in a qualified stock purchase, and the parties filed a timely election under Sec. 338(g) and (h) (10). Two days after the purchase, B issued termination notices to certain T employees, who were entitled to severance pay pursuant to contracts previously entered into with T and T's personnel policy. B deducted these payments on its consolidated income tax return as ordinary and necessary business expenses.

The Service first analyzed the issue of whether these payments by "New" T resulted from "Old" T liabilities, either fixed or contingent, that New T may be considered to have assumed. In such a situation, the payments would have to be capitalized. In holding that these obligations were not liabilities of Old T, the IRS held that the events most critical to the creation of the liability (in this case, the actual termination of the employees) took place after the purchase, even though the amount of the severance payments was based on employment status and length of service with Old T.

The Service then discussed whether New T may deduct these payments currently, or whether they were capitalizable as a cost', of acquiring Old T. Generally, costs incurred incident to the acquisition of another entity should be capitalized. However, the fact that an expense is incurred in a corporate acquisition does not convert an otherwise deductible expense into a capital expenditure. Under the "origin of the claim doctrine," established by the Supreme Court in Gilmore, 372 US 39 (1963), the origin and character of a...