The following article is reprinted from The M&A Tax Report, Vol. 12, No. 12, July 2004, Panel Publishers, New York, NY.


By Robert W. Wood

Tax allocation provisions, along with tax indemnity provisions, are a standard feature of corporate America. Indeed, in virtually every acquisition, tax allocation issues need to be discussed. Of course, this is not merely limited to U.S. acquisitions, cross-border acquisitions, and acquisitions of multi nationals typically have even greater tax allocation and tax indemnity concerns. Then, there are all of the state tax issues, including state sales and use taxes. Sometimes, there are arguments made about the ethicacy of the provisions in the acquisition documents. Although some Internal Revenue Code sections (notably Section 1060 and Section 338) address tax allocations provisions, there is also a general lore about the effectiveness of such provisions. Predictably, much of the discussion focuses on whether the tax provisions are arrived at based on arm's length and good faith bargaining between parties with averse interests. This is sometimes clear and sometimes not.

One of the reasons I especially like this line of repetitive authority is that there is substantial cross-over between this acquisition topic and another of my pet topics, the tax treatment of litigation payments and recoveries. Indeed, in that field, perhaps even more than this corporate acquisitions, there is a body of case law dealing with the supposed arm's length bargaining that is supposed to take place between parties with adverse interests. See, e.g., McKay v. Commissioner, 102 T.C. 465 (1994), vacated on other grounds, 84 F.3d 433 (5th Cir. 1996); Robinson v. Commissioner, 102 T.C. 116 (1994), aff'd in part, (5th Cir. 1995), cert. denied, 117 S. Ct. 83, 65 U.S.L.W. 3257 (U.S. 1996).

My most recent favourite case, though, is one that effectively combines reference to these two areas: tax allocations and acquisitions, as well as tax allocations in litigation.

In Chief Industries v. Commissioner, T.C. Memo 2004-45, a corporation was permitted to deduct settlement payments it made to its founder to cancel his employment agreement and quash future attacks on the business. This deduction was permitted, even though these amounts were authorized by a settlement agreement which also included a substantial payment to redeem the founder's stock. (I think that qualifies as a home run!).

Eihusen founded Chief Industries in 1954. In 1987, Eihusen voluntarily stepped down as Chief's president, and his son took over as president. Even so, Eihusen stayed on as Chief's CEO and a member of its Board of Directors (Senior Ombudsman?). In 1993, Eihusen and Chief Industries inked an employment deal which named Eihusen Chairman of the Board Emeritus.

In 1995, without Eihusen's knowledge or consent, Chief Industries agreed to acquire another company. When Eihusen learned of the planned acquisition, he was furious. Eihusen sued the members of the Board of Directors for breach of fiduciary duty (nothing like suing your own board). Eihusen went so far as to ask the court to nullify the acquisition agreement.

Settlement and Tax Effects

In 1996, Eihusen and Chief Industries settled the lawsuit. In the settlement agreement, Chief Industries (and Eihusen's son) agreed to purchase all of Eihusen's stock for roughly $37M. The settlement agreement also provided that Chief Industries would pay Eihusen roughly $3M to settle other claims Eihusen had against Chief and to terminate Eihusen's employment contract. Predictably, Chief Industries deducted the roughly $3M payment as a Section 162(a) business expense.

The Service did not agree with Chief's characterization of the $3M payment. Instead, the Service asserted that the payment had been made in connection with the reacquisition of stock, and its deduction was therefore barred by Section 162(k)(1). The Tax Court found for Chief Industries. It held that the entire $3M payment was paid to cancel Eihusen's employment agreement and to defend against further attacks on the business. Both of these items constituted ordinary and necessary business expenses for purposes of Section 162(a).

Ultimately, the Tax Court dismissed the Service's claim that the $3M payment had been made in connection with the reacquisition of Eihusen's stock and was therefore nondeductible under Section 162(k)(1). The Tax Court held that the payment of $37M and $3M amounts at the same time-and by way of the same settlement instrument-did not conclusively establish that the $3M was paid as part of the redemption. Accordingly, the Tax Court found the $3M payment to be deductible under Section 162(a) and not barred by Section 162(k)(1).

Reasonable allocations are long something I've preached about to anyone who will listen (well, I haven't yet resorted to street corners or in dingy Left-Cost coffee houses. They truly can work, as Chief proves yet again.

Tax Allocations Really Do Work, Vol. 12, No. 12, The M&A Tax Report (July 2004), p. 6.