Securities-litigation settlement and related costs are deductible business expenses

Plain-English summary

The IRS ruled that a corporation may deduct liabilities paid to settle a securities lawsuit, including related legal fees and other expenses, as ordinary and necessary business expenses under IRC § 162. The lawsuit followed a merger and alleged that disclosures about the target and the acquiring company caused losses in the acquiring company's stock price. The plaintiffs did not challenge the merger, seek rescission, or seek to change the merger consideration. Applying the origin-of-the-claim test, the IRS concluded that the claims arose from the company's ordinary business activities and did not facilitate the merger or form part of the price paid for the target. The ruling therefore treated the settlement and related costs as current deductions rather than capital expenditures.

Ruling snapshot

• Question: Are the securities-litigation settlement, legal fees, and related expenses deductible under IRC § 162 or capitalizable under § 263(a)?
• Outcome: Approved
• Key authorities: IRC §§ 162(a), 263(a); Treas. Reg. §§ 1.263(a)-4, 1.263(a)-5

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201412002 Third Party Communication: None
Release Date: 3/21/2014 Date of Communication: Not Applicable
Index Number: 162.00-00
Person To Contact:
------------------------- ---------------------- ------------------------
--------------------------------- Telephone Number:
----------------------------------------------------------- -------------------
----------------------------- Refer Reply To:
--------------------- CC:ITA:B03
---------------------------- PLR-121178-13
Date:
December 13, 2013
-------------------------------------------
----------------
-----------------------

              TY: -------

Legend

Taxpayer = -----------------------------------------------------------
Target = --------------------------
Date 1 = -------------------
Year 1 = -------
Date 2 = -------------
Date 3 = -----------
Year 2 = -------
Year 3 = -------
Amount 1 = ------------------

Dear ----------------:

   This is in response to your request for a ruling that the liabilities incurred to settle

a lawsuit, including legal fees and other expenses attributable to the lawsuit, are
deductible as ordinary and necessary business expenses under section 162 of the
Internal Revenue Code. We conclude that Taxpayer’s payment of these liabilities is
deductible as ordinary and necessary business expenses under section 162.

                                                   FACTS

   On Date 1, ---------, Taxpayer and Target, publicly traded corporations, entered

into a merger agreement under which Taxpayer agreed to acquire Target in a stock-for-
stock transaction. The merger closed on Date 2, ---------.

PLR-121178-13 2

     In ---------, litigation was filed against Taxpayer, Target, and other defendants for

alleged securities law violations relating to Target’s and Taxpayer's alleged
misrepresentations and omissions made prior to Date 2, ---------, in disclosures required
by federal securities laws, e.g., ---------------------------------------------------------------------------
---------------. The alleged misrepresentations and omissions related to undisclosed
---------------incurred by Target and -----------------------------------------------------------------------
in ---------. The plaintiffs also alleged that Taxpayer’s board of directors was aware of
material facts regarding the ---------------------------.

    --------------------------------------------------------------------------------------------. The

plaintiffs’ claims were based on Taxpayer stock other than stock acquired in the merger.
All plaintiffs were holders of Taxpayer securities at some time during the period
beginning ---------------after Taxpayer and Target entered into the merger agreement and
ending --------------------after the merger closed. The eventual settlement was paid not
only to plaintiffs who held Taxpayer securities at the time of the merger, but also to
plaintiffs who acquired Taxpayer securities after the merger. None of the settlement
was allocated to stock acquired from the exchange of Target stock in the merger.

     The plaintiffs claimed that the alleged misrepresentations and omissions were

material facts affecting the post-merger price of Taxpayer stock. The plaintiffs did not
question the validity of the merger, request rescission of the merger, or seek to adjust
the consideration in the merger. Thus, their claimed damages were measured by drops
in Taxpayer’s stock price after -------------------------disclosures that occurred after Date 2,
---------.

   In ---------, Taxpayer paid Amount 1 to the plaintiffs to settle all of the plaintiffs’

claims.

                                      LAW & ANALYSIS

   Under section 162(a) of the Internal Revenue Code, there shall be allowed as a

deduction all the ordinary and necessary expenses paid or incurred during the taxable
year in carrying on a trade or business.
year in carrying on a trade or business.

   In order to be deductible under section 162, an expenditure must be (i) paid or

incurred during the taxable year; (ii) sustained in carrying on a trade or business; (iii) an
expense; (iv) a necessary expense; and (v) an ordinary expense. Commissioner v.
Lincoln Savings and Loan Association, 403 U.S. 345, 352 (1971).

   Section 263(a) prohibits a deduction for capital expenditures. Under section

263(a), an expense must be capitalized if incurred for new buildings, permanent
improvements, or betterments made to increase the value of any property or estate.
Treasury Regulation section 1.263(a)-4(c)(1) provides, in part, that a taxpayer must
capitalize an amount paid to another party to acquire any intangible from that party in a

PLR-121178-13 3

purchase or similar transaction. For these purposes, an intangible includes an
ownership interest in a corporation, partnership, trust, estate, limited liability company or
other entity. Treas. Reg. § 1.263(a)-4(c)(1)(i). In addition, a taxpayer must capitalize
amounts paid to facilitate (i.e., investigate or otherwise pursue) the acquisition of an
intangible. See Treas. Reg. § 1.263(a)-4(b)(1)(iv); Treas. Reg. § 1.263(a)-4(e)(1)(i).

   Under § 1.263(a)-5, a taxpayer must capitalize an amount paid to facilitate a

business acquisition or reorganization transaction described in § 1.263(a)-5(a), which
includes a merger. In general, an amount is paid to facilitate a transaction described in §
1.263(a)-5(a) if the amount is paid in the process of investigating or otherwise
pursuing the transaction. Facilitative costs are generally for services provided to the
taxpayer in the process of an acquisition or reorganization. Whether an amount is paid
in the process of investigating or otherwise pursuing the transaction is determined
based on all of the facts and circumstances. See § 1.263(a)-5(b)(1).

   Generally, amounts paid in settlement of lawsuits are currently deductible if the

acts which gave rise to the litigation were performed in the ordinary conduct of the
taxpayer’s business. See, e.g., Federation Bank & Trust Co. v. Com-missioner, 27 T.C.
960 (1957) (allowing petitioner to deduct amounts paid in settlement of legal
proceedings charging petitioner with mismanagement in the liquidation of assets).
Similarly, amounts paid for legal expenses in connection with litigation are allowed as
deductible business expenses where such litigation is directly connected to, or
proximately results from, the conduct of a taxpayer’s business. See, e.g., Howard v.
Commissioner, 22 B.T.A. 375 (1931) (legal fees incurred by taxpayer to settle a
shareholder’s claim of misrepresentation in the conduct of business are deductible
business expenses).

   If litigation arises from a capital transaction, the settlement costs and legal fees

associated with such litigation are characterized as acquisition costs and must be
capitalized under section 263(a). See Woodward v. Commissioner, 397 U.S. 572, 575
(1970) (holding litigation costs incurred by corporation in appraisal proceedings
mandated by state law to determine the value of dissenter’s shares were part of the cost
of acquiring those shares).

     However, business expenses are not converted into capital expenditures solely

because they have some connection to a capital transaction. In determining whether
litigation costs are deductible expenses or capital expenditures, the courts and the
Service have looked to the “origin of the claim” to which the settlement or other litigation
costs relate. See Woodward, 397 U.S. at 577; United States v. Gilmore, 372 U.S. 39,
47 (1963). Under the origin of the claim test, the character of a particular expenditure is
determined by the transaction or activity from which the taxable event proximately
resulted. Gilmore, 372 U.S. at 47. The purpose, consequence, or result of the
expenditure is irrelevant in determining the origin of the claim, and therefore, the

PLR-121178-13 4

character of the litigation cost for tax purposes. McKeague v. Commissioner, 12 Cl. Ct.
671, (1987), aff’d without opinion, 852 F.2d 1294 (Fed. Cir. 1988).

   In the present case, the issue is whether Taxpayer’s payment to settle its lawsuit,

as well as legal and other expenses attributable to its lawsuit, may be deducted under
section 162 as an ordinary and necessary business expense or must be capitalized
under section 263(a). Under the origin of the claim test, the inquiry is whether
the claims in the litigation had their origin in the conduct of the taxpayer’s ordinary and
necessary business activities or whether the claims were rooted in a capital transaction.

     Here, while the facts of the case involve a capital transaction, the plaintiffs’

claims were that the alleged misrepresentations and omissions harmed the value of
their investment in post-merger Taxpayer. The plaintiffs did not challenge the validity of
the merger or the price of the merger. Further, none of the plaintiffs’ claims were based
upon Taxpayer stock received in exchange for shares of Target, and some of the
plaintiffs acquired shares on the open market after the merger. The origin of the claim
here is in the manner and extent to which Taxpayer’s board of directors provided
information to shareholders in securities filings concerning Target’s --------------- -----------
-------------------------. Thus, the amounts paid to settle the claims did not facilitate the
transaction within the meaning of § 1.263(a)-5. Further, the amounts are not otherwise
part of the price paid for Target.

                                        RULING

   We conclude that Taxpayer’s payment of liabilities incurred to settle the

securities lawsuit, including any legal fees and other expenses attributable to the lawsuit
and settlement thereof, are deductible as ordinary and necessary business expenses
under section 162.
under section 162.

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.

   A copy of this letter must be attached to any income tax return to which it is

relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.

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  The ruling contained in this letter is based upon information and representations

submitted by Taxpayer and accompanied by a penalty of perjury statement executed by
an appropriate party. While this office has not verified any of the material submitted in
support of the request for rulings, it is subject to verification on examination.

                                 Sincerely,



                                 Robert M. Casey
                                 Senior Technician Reviewer, Branch 3
                                 (Income Tax & Accounting)

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