IRS Revenue Ruling
1999-23

 
 Code Secs. 195, 162, 263

<<FULL TEXT>>

[See Ann. 99-89, 1999-36 IRB 408, for corrections.]

(Also sections 162, 263; 26 CFR 1.162-1, 1.263(a)-1)

Start-up expenditures, business expenses, capital expenditures.
Guidance is provided on the types of expenditures that will qualify as
investigatory costs that are eligible for amortization as start-up
expenditures under section 195 of the Code when a taxpayer acquires the
assets of an active trade or business.


REV. RUL. 99-23

ISSUE

When a taxpayer acquires the assets of an active trade or business,
which expenditures will qualify as investigatory costs that are eligible
for amortization as startup expenditures under section 195 of the Internal
Revenue Code?


FACTS

SITUATION 1

In April 1998, corporation U hired an investment banker to evaluate the
possibility of acquiring a trade or business unrelated to U's existing
business. The investment banker conducted research on several industries
and evaluated publicly available financial information relating to several
businesses. Eventually, U narrowed its focus to one industry. The
investment banker evaluated several businesses within the industry,
including corporation V and several of V's competitors. The investment
banker then commissioned appraisals of V's assets and an in-depth review
of V's books and records in order to determine a fair acquisition price.
On November 1, 1998, U entered into an acquisition agreement with V to
purchase all the assets of V. U did not prepare and submit a letter of
intent, or any other preliminary agreement or written document evidencing
an intent to acquire V prior to executing the acquisition agreement.


SITUATION 2

In May 1998, corporation W began searching for a trade or business to
acquire. In anticipation of finding a suitable target to acquire, W hired
an investment banker to evaluate three potential businesses and a law firm
to begin drafting regulatory approval documents for a target. Eventually,
W decided to purchase all the assets of corporation X. W and X entered
into an acquisition agreement on December 1, 1998.


SITUATION 3

In June 1998, corporation Y hired a law firm and an accounting firm to
assist in the potential acquisition of corporation Z by performing certain
services that the parties labeled as "preliminary due diligence." These
"due diligence" services included conducting research on Z's industry
(including information relating to competitors of Z), and analyzing
financial projections for Z for 1998 and 1999. In September 1998, at Y's
request, the law firm prepared and submitted a letter of intent to Z. The
offer contained in the letter of intent resulted from prior discussions
between Y and Z, and specifically stated that a binding commitment with
respect to the proposed transaction would result only upon execution of an
acquisition agreement. Thereafter, the law firm and accounting firm
continued to provide services labeled as "due diligence," including a
review of Z's internal documents relating to insurance policies, employee
agreements, and lease agreements, an in-depth review of Z's books and
records, and preparation of an acquisition agreement. On October 10, 1998,
Y entered into an acquisition agreement with Z to purchase all the assets
of Z.

In each of the three situations, the trades or businesses of the
targets are active trades or businesses unrelated to the trades or
businesses of U, W, and Y. U, W, and Y each use an accrual method of
accounting and a calendar taxable year. Each of the acquisition agreements
entered into by U, W, and Y were subject to customary conditions of
closing. Finally, U, W, and Y each completed the acquisitions in 1998 and
timely elected on their 1998 federal income tax returns to amortize
start-up expenditures over a period of not less than 60 months under
section 195(b).


LAW AND ANALYSIS

Section 195(a) provides that, except as otherwise provided in section
195, no deduction is allowed for start-up expenditures.

Section 195(b) provides that start-up expenditures may, at the election
of the taxpayer, be treated as deferred expenses that are allowed as a
deduction prorated equally over a period of not less than 60 months
(beginning with the month in which the active trade or business begins).

Section 195(c)(1) defines "start-up expenditure," in part, as any
amount (A) paid or incurred in connection with investigating the creation
or acquisition of an active trade or business, and (B) which, if paid or
incurred in connection with the operation of an existing active trade or
business (in the same field as the trade or business referred to in
subparagraph (A)), would be allowable as a deduction for the taxable year
in which paid or incurred. Thus, in order to qualify as start-up
expenditures under section 195(c)(1), a taxpayer's "investigatory costs"
must satisfy the requirements in both sections 195(c)(1)(A) and (B). In
addition, the term "start-up expenditure" does not include any amount with
respect to which a deduction is allowable under section 163(a), 164, or
174.

Sections 162 and 1.162-1(a) of the Income Tax Regulations allow a
deduction for all the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or business. Courts
generally have construed section 162 as containing five conditions that an
expenditure must meet to qualify for deduction. The expenditure must be
(1) an expense, (2) ordinary, (3) necessary, (4) paid or incurred during
the taxable year, and (5) made to carry on a trade or business. See
Commissioner v. Lincoln Savings and Loan Ass'n., 403 U.S. 345 (1971).

Sections 263 and 1.263(a)-1(a) provide that no deduction is allowed for
any amounts paid out for new buildings or for permanent improvements or
betterments made to increase the value of any property or estate. Section
1.263(a)-2(a) provides that capital expenditures include the cost of
acquisition, construction, or erection of buildings, machinery and
equipment, furniture and fixtures, and similar property having a useful
life substantially beyond the taxable year.

Through provisions such as sections 162(a) and 263(a), the Code
generally endeavors to match expenses with the revenues of the taxable
period to which the expenses are properly attributable, thereby resulting
in a more accurate calculation of net income for tax purposes. See, e.g.,
INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992).

In describing the law prior to section 195, Congress explained that
"Investigatory expenses," which were "costs incurred in seeking and
reviewing prospective businesses prior to reaching a decision to acquire
or enter any business," normally were not deductible because they were not
incurred in carrying on a trade or business within the meaning of section
162. See H.R. Rep. No. 1278, 96th Cong., 2d Sess. 9 (1980) (House Report);
S. Rep. No. 1036, 96th Cong., 2d Sess 10 (1980) (Senate Report). The
"carrying on a trade or business" requirement was not met where
investigatory expenses were incurred by a taxpayer who was not yet
carrying on any trade or business, or where a taxpayer was carrying on a
trade or business but incurred costs to investigate the creation or
acquisition of another, unrelated trade or business. Id. However, a
taxpayer incurring costs to investigate the expansion of an existing
business generally could deduct those costs under section 162, assuming
the other requirements of that section were met. This disparity in the tax
treatment of investigatory expenses resulting from the "carrying on a
trade or business" requirement discouraged taxpayers from investigating
the creation or acquisition of new trades or businesses. Section 195 was
enacted, in part, to minimize this disparity and thereby encourage
formation of new businesses by providing an amortization deduction for
eligible investigatory expenses.

Accordingly, under section 195(c)(1)(B), expenditures described in
section 195(c)(1)(A) that are incurred before the establishment of an
active business are deemed to be paid or incurred in the operation of an
existing active trade or business (in the same field as the business that
the taxpayer is investigating whether to create or acquire), i.e., they
are deemed to satisfy the carrying on a trade or business requirement.
However, because section 195(c)(1)(B) also requires that an expenditure
described in section 195(c)(1)(A) be allowable as a deduction for the
taxable year in which paid or incurred, the expenditure still must meet
all the other requirements of section 162. Thus, the expenditure must be
an ordinary expense under section 162, and not a capital expenditure, to
be a start-up expenditure under section 195. "Section 195 did not create a
new class of deductible expenditures for existing businesses. . . . [I]n
order to qualify under section 195(c)(1)(B), an expenditure must be one
that would have been allowable as a deduction by an existing trade or
business when it was paid or incurred." FMR Corp. v. Commissioner, 110
T.C. No. 30 (June 18, 1998). See also sections 161 and 261 (deductions are
allowed, subject to capitalization provisions). Whether an expenditure is
an ordinary expense or is capital in nature is a question of fact that
depends on the context in which the expenditure is incurred. See
Commissioner v. Idaho Power Co., 418 U.S. 1 (1974); Deputy v. duPont, 308
U.S. 488 (1940); Welch v. Helvering, 290 U.S. 111 (1933).

The legislative history of section 195 provides the following guidance
regarding whether an expenditure is an ordinary investigatory cost that is
an eligible start-up expenditure, or a capital acquisition cost:

Eligible expenses consist of investigatory costs incurred prior to
reaching a final decision to acquire or enter that business. These costs
include expenses incurred for the analysis or survey of potential markets,
products, labor supply, transportation facilities, etc.

Start-up expenditures eligible for amortization do not include any
amount with respect to which a deduction would not be allowed to an
existing trade or business for the taxable year in which the expenditure
was paid or incurred. . . . In addition, the amortization election for
start-up expenditures does not apply to amounts paid or incurred as part
of the acquisition cost of a trade or business. Also, start-up
expenditures do not include amounts paid or incurred for the acquisition
of property to be held for sale or property which may be depreciated or
amortized based on its useful life . . . Whether an amount is
consideration paid to acquire a business depends upon the facts and
circumstances of the situation.


House Report at pages 10-11; Senate Report at pages 11-12.

Rev. Rul. 77-254, 1977-2 C.B. 63, which is specifically referenced by
the legislative history of section 195 (House Report at 9, Senate Report
at 10), considers which costs incurred in the potential acquisition of a
new business are capital acquisition costs for purposes of sections 165
and 263. That ruling provides that expenses incurred in the course of a
general search for, or an investigation of, a business that relate to the
decisions whether to purchase a business and which business to purchase
are investigatory costs. However, once a taxpayer has focused on the
acquisition of a specific business, expenses that are related to an
attempt to acquire that business are capital in nature. Thus, the "final
decision" referred to in the legislative history of section 195 is the
point at which a taxpayer makes its decision whether to acquire a
business, and which business to acquire, rather than the point at which a
taxpayer and seller are legally obligated to complete the transaction.

Courts have long held that legal, brokerage, accounting, appraisal, and
similar costs incurred to acquire a capital asset are capital expenditures
under section 263. Woodward v. Commissioner, 397 U.S. 572 (1970) (when
property is acquired by purchase, nothing is more clearly a part of the
process of acquisition than the establishment of a purchase price); United
States v. Hilton Hotels Corp., 397 U.S. 580 (1970); Beneficial Industrial
Loan Corp. v. Handy, 16 F. Supp. 110, 112 (D. Del. 1936), aff'd, 92 F.2d
74 (3d Cir. 1937); Rev. Rul. 73-580, 1973-2 C.B. 86.

For example, in Ellis Banking Corp. v. Commissioner, T.C. Memo.
1981-123, aff'd in part & rem'd in part, 688 F.2d 1376 (11th Cir. 1982),
the taxpayer incurred expenses for office supplies, filing fees, travel,
and accounting services in connection with its examination of target's
books and records. The examination was performed pursuant to an
acquisition agreement for the purchase of target's stock that was
contingent on several terms and conditions, such as regulatory approval.
The Tax Court concluded that the expenses were nondeductible capital
expenditures incurred in the acquisition of a capital asset. The Court of
Appeals for the Eleventh Circuit substantially affirmed, noting that the
requirement that costs be capitalized extends beyond the price payable to
include any costs incurred by the buyer in connection with the purchase,
such as appraisals of the property or the costs of meeting any conditions
of sale.

Accordingly, expenditures incurred in the course of a general search
for, or an investigation of, an active trade or business, i.e.,
expenditures paid or incurred in order to determine whether to enter a new
business and which new business to enter (other than costs incurred to
acquire capital assets that are used in the search or investigation), are
investigatory costs that are start-up expenditures under section 195.
Alternatively, costs incurred in the attempt to acquire a specific
business are capital in nature and thus, are not start-up expenditures
under section 195. The nature of the cost must be analyzed based on all
the facts and circumstances of the transaction to determine whether it is
an investigatory cost incurred to facilitate the whether and which
decisions, or an acquisition cost incurred to facilitate consummation of
the acquisition. The label that the parties use to describe the cost and
the point in time at which the cost is incurred do not necessarily
determine the nature of the cost.

In Situation 1, an examination of the nature of the costs incurred
indicates that U made its decision to acquire V after the investment
banker conducted research on several industries and evaluated publicly
available financial information. The costs incurred to conduct industry
research and review public financial information are typical of the costs
related to a general investigation. Accordingly, the costs incurred to
conduct industry research and to evaluate publicly available financial
information are investigatory costs eligible for amortization as start-up
expenditures under section 195. However, the costs relating to the
appraisals of V's assets and an in-depth review of V's books and records
to establish the purchase price facilitate consummation of the
acquisition, and thus, are capital acquisition costs. The costs incurred
to evaluate V and V's competitors also may be investigatory costs but only
to the extent they were incurred to assist U in determining whether to
acquire a business and which business to acquire. If the evaluation of V
and V's competitors occurred after U had made its decision to acquire V
(for example, in an effort to establish the purchase price for V), such
evaluation costs are capital acquisition costs.

In Situation 2, the costs incurred to evaluate potential businesses are
investigatory costs eligible for amortization as start-up expenditures
under section 195 to the extent they relate to the whether and which
decisions. However, the costs incurred to draft regulatory approval
documents prior to the time W decided to acquire X are not start-up
expenditures under section 195. The costs related to such activities, even
if the activities occurred during the period W is engaged in a general
search for a business, were not incurred in order to investigate whether
to acquire a business and which business to acquire, but rather to
facilitate an acquisition.

In Situation 3, an examination of the nature of the costs incurred by Y
indicates that Y made its decision to acquire Z in September 1998, around
the time that Y instructed the law firm to prepare and submit the letter
of intent. The costs related to the "preliminary due diligence" services
provided prior to that time (including the costs of conducting research on
Z's industry and in reviewing financial projections of Z) are typical of
the costs incurred during an investigation to determine whether to acquire
a new business and which new business to acquire. Thus, these costs are
investigatory costs that are eligible for amortization as start-up
expenditures under section 195. The costs related to "due diligence"
services provided after that time, however, relate to the attempt to
acquire the business and must be capitalized under section 263 as
acquisition costs. Thus, the "due diligence" costs incurred to review T's
internal documents, books and records, and to draft the acquisition
agreements are not eligible for amortization under section 195.


HOLDING

Expenditures incurred in the course of a general search for, or
investigation of, an active trade or business in order to determine
whether to enter a new business and which new business to enter (other
than costs incurred to acquire capital assets that are used in the search
or investigation) qualify as investigatory costs that are eligible for
amortization as start-up expenditures under section 195. However,
expenditures incurred in the attempt to acquire a specific business do not
qualify as start-up expenditures because they are acquisition costs under
section 263. The nature of the cost must be analyzed based on all the
facts and circumstances of the transaction to determine whether it is an
investigatory cost incurred to facilitate the whether and which decisions,
or an acquisition cost incurred to facilitate consummation of an
acquisition.


DRAFTING INFORMATION

The principal author of this revenue ruling is Susie K. Bird of the
Office of Assistant Chief Counsel (Income Tax and Accounting). For further
information regarding this revenue ruling contact Ms. Bird on (202)
622-4950 (not a toll-free call).

<<END RULING>>
 

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