A district court in Kansas has concluded in Ash Grove Cement Co, et al. v. U.S (2013 U.S. Dist. LEXIS 15944) that a taxpayer's litigation expenses arose from the acquisition of a business and were nondeductible capital expenses.
On Dec. 31, 2000, the taxpayer completed a multistep tax-free reorganization (the transaction). In January 2012, a minority shareholder of the taxpayer filed a class action suit against all nine of the taxpayer's directors and the taxpayer. The complaint alleged that the transaction improperly diluted the liquidation value of the shares held by the minority shareholders and their proportionate voting power. In August 2005, the taxpayer settled the litigation for $15 million without any officers or directors admitting fault. In 2005, the taxpayer also paid $43,345 for legal fees to defend the directors. The taxpayer deducted the settlement payment and legal fees as ordinary and necessary business expenses on its 2005 U.S. federal income tax return.
To determine whether an expense is a capital expenditure under Section 263(a) or an ordinary expenditure under Section 162, the "origin and character" of the claim for which the taxpayer incurred expenses must be determined. The object of such a test is to determine whether the claim arises in connection with the taxpayer's profit-seeking activities. The district court, citing Woodward v. Commissioner (397 U.S. 572), determined that the lawsuit challenged the fairness of the transaction and that the settlement of the lawsuit preserved the transaction. Accordingly, the district court concluded that the expenses arose out of the transaction and were capital expenditures, and therefore nondeductible.
The taxpayer argued that the above analysis failed to distinguish between claims against the directors' breach of fiduciary duties and the directors' indemnity claims against the taxpayer. The taxpayer viewed the $15,043,345 of litigation expenses as deductible ordinary and necessary business expenses, because the litigation did not allege any wrongdoing by or seek money damages from the taxpayer. Therefore, the taxpayer viewed the litigation expenses as amounts paid to honor its indemnity obligations to its directors. Because indemnity expenses are ordinary and necessary business expenses, the taxpayer argued that it should be allowed to deduct these expenses.
The district court rejected the taxpayer's arguments. The district court stated that if the taxpayer's approach was accepted (i) companies could always deduct litigation expenses any time a director is used in connection with a capital transaction and the company has an indemnity obligation, and (ii) the taxpayer's approach could encourage creatively structured settlements. The district court concluded that such results were contrary to the case law and would allow companies to manipulate the tax laws.
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