Employee compensation attributable to acquisitions.

• Author: Packard, Pamela

On Jan. 17, 2002, the IRS issued an advance notice of proposed rulemaking (REG-125638-01) to provide guidance "regarding expenditures incurred in acquiring, creating, or enhancing intangible assets." Taxpayers expect the proposed regulations to identify several categories of expenditures requiring capitalization under Sec. 263 or, alternatively, appropriately expensing items in the year incurred.

One of the expenditure categories the proposed regulations will address is transaction costs. This category includes certain costs incurred in transactions that facilitate the acquisition, creation, reorganization or structuring of a business entity, as well as Sec. 1060 asset acquisitions.

Generally, employers can deduct employees' salaries (including corporate officers) under Sec. 162, subject to the reasonableness standard of Sec. 162 (a) (1) and, for publicly held companies, Sec. 162(m). Generally, businesses must capitalize costs that they incur as a direct result of a merger or acquisition (such as investment banking and attorney fees) (INDOPCO, Inc., 503 US 79 (1992)). Often at issue in the context of an employer's merger or acquisition is whether the employer must capitalize the salaries and bonuses of existing employees allocable to the time they spent on the transaction.

The controlling cases in this area are Lincoln Savings & Loan Ass'n, 403 US 345 (1971), INDOPCO and Wells Fargo & Co., 224 F3d 874 (8th Cir. 2000). In Lincoln, the Supreme Court required capitalization of insurance premiums when such expenditures created or enhanced a separate and distinct asset (an insurance reserve). The primary criteria for capitalization in Lincoln focused on asset creation or enhancement. Nevertheless, expenditures remained deductible despite the existence of a "future benefit." In INDOPCO, the Court narrowed the prior deduction-friendly environment it had established under Lincoln. Not only did INDOPCO reiterate the standard set forth in Lincoln (that creation or enhancement of a separate and distinct asset requires capitalization), it further added a capitalization requirement for costs that result in a future benefit for a business. While providing ready material for discussion, INDOPCO further complicated the lives of those responsible for characterizing expenditures incurred during the course of a merger or acquisition due to the subjectivity of the so-called future-benefit standard.

In Wells Fargo, the issue was the treatment of the salaries of...