Are Due Diligence Costs Deductible?

This investigation, or "due diligence," can be quite time-consuming and expensive. The company will incur both the direct costs of outside attorneys, consultants and accountants, plus the indirect cost of the time spent by officers and employees engaged in due diligence. A recent case has held that "due diligence" costs incurred by a company could not be deducted.

Norwest Corp. vs. Commissioner
The case is Norwest Corporation and Subsidiaries v. Commissioner, Docket No. 25613-95., 112 TC --, No. 9., filed March 8, 1999. The case involved the acquisition by Norwest Corporation and Subsidiaries, of DBTC, an Iowa state bank. DBTC incurred legal fees directly related to its eventual merger into the Norwest group, which DBTC conceded were not deductible. These included fees relating to the negotiation of price, preparation of a fairness opinion, advising board members with respect to fiduciary duties, and satisfying securities law requirements.

In addition, however, DBTC incurred expenses that it asserted should be deducted. These expenses related to investigating the products, services and reputation of the acquiring company, ascertaining whether there would be a good business fit, ascertaining whether the proposed transaction would be good for the Davenport, Iowa community, and a due diligence review. The expenses in question included more than $100,000 in legal fees, and a substantial portion of the salaries and wages of DBTC's officers and employees.

The ruling of the court was that all of the above expenses had to be capitalized. This was true both of direct costs relating to the merger, and to indirect, investigatory and due diligence costs.

INDOPCO vs. Commissioner
The decision in this case continues the ongoing exploration of the limits of the 1992 U.S. Supreme Court case, INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), which held that costs incurred that result in benefits in future years must be capitalized. Generally, IRC 263 requires that all costs related to an acquisition of stock be capitalized as part of the cost of the stock. None of these acquisition costs are deductible. This is true for both the acquiring company and the target.

In INDOPCO, the Court held that the following costs should be capitalized under IRC 263: Investment banking fees and expenses.

Legal fees and expenses related to advice given to the taxpayer and its board on their legal rights and obligations with respect to the transaction, the participation in negotiations, the preparation of documents, and the preparation of a request for a ruling from the Commissioner on the tax-free acquisition plan.

Other Relevant Cases
Later cases fleshed out the rules set out in INDOPCO. In one case, Victory Mkts., Inc. & Subs. v. Commissioner, 99 T.C. 648 (1992), the Tax Court held that INDOPCO prohibited a taxpayer from currently deducting professional expenses because they were incurred incident to the taxpayer's change of ownership from which it derived significant long-term benefits.

Also, in A.E. Staley Manufacturing Co. & Subs. v. Commissioner, 105 T.C. 166 (1995), revd. and remanded, 119 F.3d 482 (7th Cir. 1997), the Tax Court held that INDOPCO prevented the taxpayer from currently deducting expenses for investment bankers' fees and printing costs incurred incident to a hostile takeover.

The cases of INDOPCO, Victory Markets, and A.E. Staley all addressed direct costs of a corporate acquisition. In Norwest, the costs were incurred both before and incidentally with an acquisition. The taxpayer asserted the costs were deductible because they were incurred in investigating the expansion of its existing business, before the taxpayer formally decided to enter into the transaction by approving the agreement.

The Tax Court disagreed, saying that while the disputed expenses are mostly preparatory expenses that enabled DBTC to achieve the long-term benefit that it desired from the transaction, and the fact that the costs were incurred before DBTC's management formally decided to enter into the transaction does not change the fact that all these costs were sufficiently related to the transaction. In accordance with INDOPCO, the costs must be capitalized because they are connected to an event (namely, the transaction) that produced a significant long-term benefit.

The court noted that all costs relating to a potential stock acquisition must be capitalized, even where the success of the potential merger is not certain. The court cited Ellis Banking Corp. v. Commissioner, T.C. Memo, 1981-123, which said the expenses of investigating a capital investment are properly allocable to that investment and must therefore be capitalized.

That the decision to make the investment is not final at the time of the expenditure does not change the character of the investment. When a taxpayer abandons a project or fails to make an attempted investment, the preliminary expenditures that have been capitalized are then deductible as a loss under section 165.

Conclusion
E-commerce companies that are potential targets will incur substantial costs in exploring the benefits provided by potential suitors. Companies must carefully identify, and capitalize, those costs, plus a portion of the salaries and wages of officers and employees engaged in these activities. Because costs related to unsuccessful transactions can be deducted, companies engaged in a series of exploratory activities should carefully tract the activities, writing off costs relating to failed efforts.