Corporate tax lawyers are worried that a decision last month by the U.S. Court of Appeals in Philadelphia may have changed the rules on which new business expenses can be deducted immediately and which must be amortized over a number of years.
In theory, normal operating expenses are deductible the year the checks are written. Spending on buildings and equipment are written off over the life of the investment, or capitalized. But the bifurcation isn't always that neat, and it's not always clear which outlays can be called expenses and which must be capitalized.
Businesses, of course, almost always would rather take deductions as soon as possible. That's why companies have been fighting with the Internal Revenue Service about how to treat the significant costs a company can run up when it gets a takeover bid. One of the leading fighters was been National Starch and Chemical Co., which refused to go along with an IRS determination that it could not deduct as a current expense fees paid to investment bankers and others who helped corporate management negotiate its takeover by Unilever.
The question of whether such expenditures should be deductible has baffled even the IRS. Although in March 1989 it told National Starch no, the IRS announced that it would let a company deduct as current expenses the cost of defending itself against a hostile takeover. Four months later, the tax collectors decided that it made no sense to have a different policy for the expenses of evaluating friendly and hostile takeovers, so it withdrew its March ruling. But then this summer, the IRS went back to its previous position, ruling that a company can take an immediate deduction for the costs of defending against an acquisition bid that management opposes but that costs of assessing a friendly bid must be capitalized.
On Nov. 13, the Philadelphia judges, ruling in the National Starch case, agreed with at least the latter half of the IRS position -- the half less favorable to business.
Tax specialists are upset about the appellate judges' rationale for disallowing the deduction. It "is in disagreement with a number of other courts of appeals on the standard for what costs must be capitalized," two Chicago lawyers, George B. Javaras and Todd F. Maynes, wrote in last week's issue of Tax Notes.
For there to be deductible business expenses, there has to be a business. So it has always been tricky to determine how to treat start-up costs. When the business is new, those initial expenditures must be capitalized. But it is far less obvious what the rule is when the new business is an expansion of an existing operation.
In the 1970s, the IRS spent a lot of time in court in conflict with banks that were aggressively moving into the credit card business.
The IRS kept insisting the credit card ventures were new businesses, and the costs of starting them had to be capitalized. But the courts kept siding with the banks, calling the move into credit cards an ordinary expansion of the existing business, and prompting immediate tax deductions.
Those bank rulings were based on, and confirmed, a 1973 rulings form the U.S. Court of Appeals in New York in Briarcliff Candy Corp. v. Commissioner. It involved an attempt by the IRS to force Briarcliff, which had sold its candy only in city locations, to capitalize the costs of moving into suburban distribution.
The judges held that going after new customers is the very lifeblood of a business and the costs of such market expansion should be immediately deductible. The only exception: expenditures that create "a separate and distinct additional asset." There has been general agreement on what the yardstick is -- until now.
What so worries business lawyers about the National Starch decision is not that the company lost, but that the Philadelphia judges rejected the Briarcliff Candy precedent and all the later cases based on it.
Any expenditure on a new line of business that produces "a not insignificant future benefit that is more than merely routine" must be capitalized, the decision said. That would mean deductions would be denied for almost any kind of market research, sales promotion or general investigation of new business ideas.
And because these outlays do not produce a physical asset that can be amortized, the result is not merely to stretch out the deduction, but to deny it entirely.
Daniel B. Moskowitz is a Washington editor with Business Week newsletters.