The following article is reprinted from The M&A Tax Report, Vol. 13, No. 3, October 2004, Panel Publishers, New York, NY.


By Robert W. Wood and Dominic Daher

Whether to deduct or capitalize legal fees has always been a Hobson's choice. The incentives for taxpayer are pretty clear. As high as attorneys' fees can be, they can be made significantly less painful if an ordinary deduction is available. In the wake of such landmark cases as INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 112 S. Ct. 1039 (1992), the circumstances in which legal fees have to be capitalized has been expanded.

In Winter v. Commissioner, T.C. Memo 2002-173, the Tax Court addressed a situation where a couple who had litigation over the price of an asset after the sale was completed. The Tax Court held that the couple must capitalize legal and consulting fees paid in connection with litigation over the price of an asset after the sale.

On February 20, 1991, Jeffrey and Karen Winter executed a contract offering to purchase the Truckee Hotel for $1.2 million from the Meglin Hotel Partnership (MHP). Gerhard Meglin was the general partner of MHP, which accepted the offer and he provided the couple with income and expense statements for the hotel for 1989-1991. The couple found inconsistencies in the information in a brochure and that provided during escrow. The couple completed the purchase on April 4, 1991. They paid a portion of the purchase price down and executed a promissory note for the balance. After the purchase, more irregularities were found, and the couple filed a complaint for damages in local court against MHP and Meglin. After arbitration failed, the couple had an appraisal of the hotel done and the report valued the hotel at the time of the sale at $800,000.

The parties settled in 1994, and Meglin agreed to pay the couple $271,474 by releasing them from that amount under the promissory note. The couple paid legal and consulting fees for the lawsuit and deducted them on their 1994 Schedule C. In 2000 the IRS issued the couple a deficiency notice disallowing the legal fees deductions because they were incurred in connection with the establishment of the hotel's purchase price and should be capitalized. The couple argued that the fees were postacquisition expenditures not related to the purchase, that the origin of the claim wasn't the purchase, and that acquisition costs must be capitalized only when a new asset is acquired.

The Tax Court Judge noted that just because legal costs are incurred after a capital asset doesn't necessarily mean they weren't incurred in connection with the acquisition. The court dismissed the couple's reliance on Freeland v. Commissioner, T.C. Memo. 1986-10, concluding that those fees arose out of a foreclosure action and the fees in this case arose from misrepresentations by Meglin that caused the couple to pay an inflated price for the hotel. Judge Ruwe, rejecting the argument that the acquisition costs can be capitalized only if they create or add value to a capital asset, noted that the test for capitalization doesn't hinge on the amount of value added to the property but looks to the nature of the expense. Thus, Judge Ruwe held that the couple acquired a capital asset and, on discovering that they were overcharged, filed suit for damages for causing them to pay more than the hotel was worth.

Capitalizing Legal Fees Related to Acquisitions: Will INDOPCO Ever Die?, by Robert W. Wood and Dominic L. Daher, Vol. 13, No. 3, The M&A Tax Report (October 2004), p. 7.