Settlement Costs and Legal Fees Stemming from Corporate Reorganization Are Non-Deductible

Settlement Costs and Legal Fees Stemming from Corporate Reorganization Are Non-Deductible

If a capital transaction produces litigation, the potentially resulting settlement costs and associated legal fees are capital acquisition costs. As such, these amounts cannot be deducted. This was the holding in the recent court case Ash Grove Cement Company vs. U.S., 113 AFTR 2d 2014-759 (10th Cir.). In Ash Grove, a minority shareholder filed a class action suit against a company and its board members, claiming that the company’s reorganization had unfairly diluted the minority shareholders’ interests.

The lawsuit was settled, the company paid $15 million into a trust for the class, and various legal fees were incurred by the company in defending the suit. The company deducted both the settlement payments and legal fees as ordinary and necessary business expenses on its tax return, but the IRS denied these deductions.

The Court of Appeals for the 10th Circuit, affirming the district court decision, determined that payments made by the company to settle the claim and associated legal fees were capital expenditures and not currently deductible. The court reasoned that:

1) Regarding corporate reorganization:

    • Expenses incurred for the purpose of changing corporate structure for the benefit of future operations are NOT ordinary and necessary business expenses;
    • Expenses connected with the reorganization of a corporation qualify as organizational expenses only if they are directly incident to the creation of a corporation.

2) Regarding litigation expenses:

    • Whether litigation expenses are characterized as “ordinary income” or “capital income” is determined by the “origin of the claim test”, which asks (a) what is the transaction or activity from which the taxable event proximately resulted, or (b) what is the event that led to the tax dispute?

In Ash Grove, the complaint sought, among other remedies, rescission of the reorganization transaction. Meaning the legal fees and settlement amount were derived from the corporation’s effort to defend and maintain the reorganization itself. Because reorganization expenses are not ordinary and necessary business expenses, the payments made by Ash Grove were non-deductible capital expenses.

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If you have any questions about this Tax Tip, please contact your WithumSmith+Brown professional, a member of WS+B’s National Tax Services Group or email us at [email protected].

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Author: David Springsteen, CPA, MBA | [email protected]

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