The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 4, November 2000, Panel Publishers, New York, NY.


By Robert W. Wood

In Part One of this article (which appeared in the October issue, p. 7), we looked at United Dairy Farmers, Inc., et al. v. United States, No. C-1-97-1043 (S.Dist. Ohio, May 23, 2000), Tax Analysts Doc. No. 2000-17988, 2000 TNT 128-41. We also noted IRS Field Service Advice No. 200035021, and gave the facts in Letter Ruling 9942025. Further details about Letter Ruling 9942025 are discussed below.

Multiple Rulings

The IRS ruled that the target could currently deduct the environmental cleanup costs. The IRS assumed that the costs would otherwise have been deductible and not capitalized under Revenue Ruling 94-38, 1994-1 C.B. 35. The IRS ruled that the costs should not be disallowed as deductions either because they related back to the sale of its stock or because they were subject to reimbursement.

The principles and case law discussed in the ruling are predictable. First, of course, is Arrowsmith v. Commissioner, 344 U.S. 6 (1952). The Arrowsmith case actually had facts helpful to the analysis of the cleanup costs here. In Arrowsmith, two former shareholders of a liquidated company were required (as transferees of the assets) to pay a judgment against the corporation several years after the liquidation. While the gain from the liquidation was a capital gain to the shareholders, they deducted the payment of the judgment as an ordinary loss. The court found the loss to be capital — it would have been capital had it been made in the same year as the liquidation.

Following the rule in Arrowsmith, subsequent indemnity payments required to be made pursuant to a transfer of stock have been found to result in an adjustment to the sales price of the stock of the buyer. The ruling here (Letter Ruling 9942025) concludes that the indemnity payments would be adjustments to the target stock, and not net income (or capital gain for that matter) to the target. See Freedom Newspaper v. Commissioner, TC Memo 1977-429 (1977).

Other case law also supports deductibility in Letter Ruling 9942025. See VCA Corp v. U.S., 566 F. 2nd 1192 (Ct. Cl. 1977). In VCA, the taxpayer deducted an expense that was (at least in part) indemnified under a merger agreement. In Revenue Ruling 83-73, 1983-1 C.B. 84, the IRS went along with the VCA, holding that indemnified expenses arising out of a merger were deductible. Revenue Ruling 83-73 also determined that indemnity payments should be treated as if they were contributions to the capital of the transferor corporation, made by its shareholders immediately before the merger.

Interestingly, the Service in Letter Ruling 9942025 finds that the Court holding in VCA (and its own ruling in Revenue Ruling 83-73) were simply inconsistent with disallowing the deductibility of the environmental remediation costs that were at issue in Letter Ruling 9942025. According to the IRS, Arrowsmith said that the costs could not be disallowed as current deductions because they related back to the sale of the target's stock. Revenue Ruling 83-73 stands directly contrary to the notion that it is impermissible for a taxpayer to deduct indemnified expenses.

Plus, the cleanup costs could not be disallowed on the grounds that they were subject to reimbursement. Instead, the IRS ruled that the indemnity payment should be treated as a contribution to the capital of the target just before its sale of stock. Finally, the IRS ruled that the tax benefit rule should not be applied to the indemnity payments and the corresponding deduction of the expense by the target.

Environmental Remediation and Asbestos Removal: More INDOPCO Trash? (Part Two), Vol. 9, No. 4, The M&A Tax Report (November 2000), p. 1.