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Good News, Bad News
Shirley Dennis-Escoffier
n the usual mix of things in the tax world, taxpayers have won one and lost one.
The win is that a stay-on-premises policy can result in tax-free meals for
employees while yielding a 100-percent deduction for employers. The loss is in
an Internal Revenue Service (IRS) ruling that no amortization will be allowed for
business investigation expenses incurred after the acquisition decision has been
made. Under this ruling, costs incurred after the taxpayer decides whether to
enter a new business and which new business it will enter or acquire must be
capitalized, even if a legally binding obligation to acquire another business does
not yet exist. Let’s start with the bad news and close with the good news.
Shirley Dennis-Escoffier, Ph.D.,
CPA, is an associate professor of
accounting at the University of
Miami in Coral Gables, Florida.
She previously worked in public
accounting and for several
corporations. She has published
numerous articles in tax journals.
Taxpayers starting a new business or expanding an existing one incur a
variety of costs. Some of these costs will be currently deductible as ordinary and
necessary business expenses (under Code Section 162), others will be capitalized
(Section 263), and some will be eligible for 60-month amortization (under
Section 195). Determining the proper characterization of an expense can be
challenging because the classification depends on the facts and circumstances of
each case.
Qualifying investigation costs may, at the election of the taxpayer, be
amortized over a period of not less than 60 months (beginning in the month the
business begins). If no election is made to amortize, the costs are just capitalized.
Qualifying investigation expenses for 60-month amortization is particularly
important in a stock acquisition because capitalizing amounts paid in connection
with an acquisition of stock is tantamount to never recovering those costs or
recovering them so far in the future that their present value is insignificant.
Under Code Section 195, expenses eligible for 60-month amortization
include those costs paid or incurred in connection with investigating the
creation or acquisition of any active trade or business. To be amortizable, these
costs must pass an additional hurdle. They must be expenses that would, if
CCC 1044-8136/99/1101155-06
© 1999 John Wiley & Sons, Inc.
Shirley Dennis-Escoffier
incurred in connection with the operation of an existing active trade or business
in the same field, be currently deductible. Investigation costs include costs
incurred in reviewing a prospective business before reaching a final decision to
acquire or enter that business, such as expenses to analyze or survey potential
markets, products, labor supply, transportation facilities, and similar
expenditures. Qualifying expenses do not include amounts paid or incurred as
part of the acquisition cost of a business or the cost of buying depreciable or
amoritzable assets; these costs must be capitalized.
Revenue Ruling 99-23
IRS has now established a new rule for deciding whether a cost is a qualifying
investigation expense. Under this new interpretation, expenses to determine
“whether” to enter a new business and “which” new business to enter (other than
costs incurred to acquire capital assets used in the search or investigation) are
investigation costs that are qualifying expenses amortizable under Code Section
195. In contrast, costs incurred in an attempt to acquire a specific business do not
qualify under Section 195 and must be capitalized.
IRS says whether an expense is an investigation cost to facilitate the “whether”
and “which” decision or an acquisition cost to facilitate consummation of the
acquisition, will depend on all the facts and circumstances of the transaction. An
example of costs that must be capitalized as part of the acquisition cost would be
paying lawyers to draft regulatory approval documents. After the decision has
been made to acquire a company, due-diligence costs incurred to review its
internal documents, books, and records, and to draft acquisition agreements
must also be capitalized as part of the acquisition cost. IRS points out that the
label used by the parties to describe the cost, the point in time at which the cost
is incurred, and the point at which the parties are legally obligated to complete
a transaction, do not necessarily determine the nature of the cost. They will look
through these labels to determine the true nature of the expenditure and if it
came before or after the “whether” and “which” points occurred.
Revenue Ruling 99-23 includes three examples to illustrates its conclusions:
Example 1: In April, X Corporation hired an investment banker to investigate
the possibility of buying a business unrelated to its existing business. The banker
researched several industries and evaluated publicly available financial
information relating to several businesses. After X narrowed its focus to one
industry, the investment banker evaluated several businesses within that industry,
including V Corporation and several of V’s competitors. The banker then
commissioned appraisals of V’s assets and an in-depth review of its books and
records to determine a fair acquisition price. In November, X entered into an
agreement to purchase all of V’s assets. Before that date, X did not prepare or
submit a letter of intent or any other preliminary written document indicating
its intent to buy V.
In its ruling, IRS states that the costs relating to the appraisals of V’s assets
and in-depth review of V’s books and records to establish the purchase price
facilitated the consummation of the acquisition and must therefore be capitalized
as part of the acquisition cost. The costs incurred to conduct industry research
and to evaluate publicly available financial information are investigation costs
eligible for amortization under Section 195. The costs incurred to evaluate V and
V’s competitors also may be investigation costs, but only to the extent they were
The Journal of Corporate Accounting and Finance/Autumn 1999
incurred to assist X in determining whether to acquire a business and which
business to acquire. If the evaluation of V and V’s competitors occurred after X
had made its decision to acquire V (for example, in an effort to establish the
purchase price for V), such evaluation costs are nonamortizable capital acquisition
costs. Note that these conclusions would be the same even if X’s internal staff had
done the investigation work .
Example 2: In May, W Corporation began searching for a business to
acquire. In anticipation of finding a suitable target, it hired an investment banker
to evaluate three potential businesses and a law firm to begin drafting regulatory
approval documents for a target. W Corporation decided to buy X Corporation’s
assets and entered into an acquisition agreement with it in December. IRS
concludes that W’s costs of evaluating potential businesses are investigation
costs eligible for 60-month amortization to the extent they related to the
“whether” and “which” decisions. However, the costs of drafting regulatory
approval documents are not amortizable, even though these activities took place
during the general search period, because they were incurred to facilitate an
acquisition rather than to investigate whether to buy and which business to buy.
Example 3: In June, Y Corporation hired a law firm and an accounting firm
to help in the potential acquisition of Z Corporation by performing “preliminary
due diligence” services including researching Z’s industry and its competitors
and analyzing Z’s financial projections. In September, Y asked its lawyers to
prepare and submit a letter of intent to Z. The offer resulted from prior
discussions and specifically said that a binding commitment would result only
upon the execution of an acquisition agreement. After that point, the lawyers and
accountants continued to perform “due diligence” services including a review of
Z’s internal documents and records and preparation of an acquisition agreement.
In October, Y signed an agreement to buy all of Z’s assets.
IRS states that Y made its decision to buy Z in September, around the
time when it told its lawyers to prepare and submit the letter of intent. As a
result, the cost of “preliminary due diligence” services provided prior to that
time (including the costs of conducting research on Z’s industry and in
reviewing financial projects of Z) are amortizable investigation costs.
However, the “due diligence” costs incurred to review Z’s internal documents,
to review their book and records, and to draft the acquisition agreements are
not eligible for amortization under Section 195 and must be capitalized
under Section 263 as acquisition costs.
It is strongly recommended that any taxpayer investigating the purchase of
a business instruct employees, as well as the outside professionals it engages, to
keep detailed records delineating time and money spent on (1) general or
preliminary investigation expenses and (2) acquisition–related expenses incurred
after a purchase decision has been made. Without detailed records, IRS may
require capitalization for what should be qualifying Section 195 expenditures.
A year ago this column reported on the Tax Court’s Boyd Gaming Corporation
decision regarding tax treatment for employee meals. Recently, the Ninth
Circuit Court of Appeals reversed the Tax Court’s decision and held that a casino
could deduct 100 percent of the cost of providing free on-premises meals to
The Journal of Corporate Accounting and Finance/Autumn 1999
Shirley Dennis-Escoffier
employees while these meals are tax-free to the employees. The key to this win
was the casino’s requirement that its employees remain on-premises during
their shifts for valid business reasons. Under Section 274(n), an employer can
usually deduct only 50 percent of the otherwise allowable cost of business meals.
However, an employer may deduct 100 percent of the cost of meals furnished in
a Section 119 employer-provided eating facility (one provided for valid business
reasons for the convenience of the employer) as a tax-free de minimis fringe
benefit under Section 132. This decision could mean tax savings for any
employer that provides employee meals to facilitate a stay-on-premises policy.
In 1997, the Tax Court (in Boyd Gaming Corp. et al. v. Commission, 74 TCM 759,
following their previous decision in 106 TC 343) held that the taxpayers in Boyd
Gaming were not entitled to deduct 100 percent of the cost of the employer-provided
meals because the casino did not furnish meals to each of “substantially all” of their
employees for a substantial noncompensatory business reason under Section 119.
The IRS then issued a Technical Advice Memorandum indicating that a 90-percent
threshold was necessary to meet the “substantially all” test. The gaming industry’s
response was to get a statutory fix under which the entire facility would qualify under
Section 119 if the majority (more than 50 percent) of the meals were served for
noncompensatory business reasons. Specifically, the IRS Restructuring and Reform
Act of 1998 lowered the “substantially all” threshold to 50 percent by providing that
if more than half of the meals are furnished on the premises for the convenience of
the employer, then the employer gets the full deduction.
New Ninth Circuit Decision
In its recent decision (Boyd Gaming Corp. et al. v. Commissioner, 99-1 USTC
¶50,530), the Ninth Circuit ruled that the taxpayer could deduct 100 percent of
the cost of providing employees with meals. The court held that once the “stayon-premises” policy (one that requires employees to remain on the premises
during their entire shift) was adopted, employees had no choice but to eat on the
premises. The furnished meals were indispensable to the proper discharge of
their duties, and the convenience of employer test was therefore met.
The appellate court reached its decision to allow a 100-percent deduction
using the following reasoning:
If more than half the meals provided at the on-premises eating facility
are provided for the employer’s convenience, then the balance of the
meals also are treated as provided for the employer’s convenience, even
those meals that were not supplied for the convenience of the employer.
Once all the meals are deemed to have been provided for the employer’s
convenience, they are all tax-free to the employees under Section 119.
Because all the meals are tax-free to the employees under Section 119,
the employer-operated eating facility will automatically qualify as a de
minimis fringe benefit under Section 132.
Because the employer-operated eating facility will automatically qualify as
a de minimis fringe benefit under Section 132, all the expenses in operating
it will be deductible since an employer may fully deduct the cost of meals
that are tax-free de minimis fringe benefits under Section 132.
The Journal of Corporate Accounting and Finance/Autumn 1999
The Ninth Circuit cautioned that simply saying that a business had an
on-premises policy would not be enough to justify a 100-percent meal
deduction. Boyd Gaming did support its policy with adequate evidence of
legitimate business reasons. The Ninth Circuit Court elaborated that although
reasonable minds might differ on whether the policy was necessary for
security and logistics (as argued by Boyd Gaming), the court said it would
not second-guess the taxpayer.
IRS has since announced (Announcement 99-77) its acquiescence to the
Ninth Circuit’s decision saying it will not challenge whether meals provided to
employees of similar businesses meet the Section 119 convenience-of-employer
test where business policies and practices would otherwise prevent employees
from getting a proper meal within a reasonable meal period. IRS also said that
a bona fide and enforced policy requiring employees to stay on the employer’s
business premises during their normal meal period is only one example of the
type of business practice that could result in an exclusion for employer-provided
meals. Another example could be a practice requiring checkout procedures for
employees leaving the premises to address the same type of security concerns
that were relevant in Boyd Gaming. IRS seems to suggest that if employees would
rather have a meal on premises than have to go through one security check on
the way out to get lunch, and another at the end of their shift, then on-premises
eating facilities can qualify.
IRS also indicated that when applying the business meal rules of Section 119
to any business, it would not second-guess the taxpayer’s judgment on which
business practices are best suited to its needs. The acquiescence, and IRS’s
statement that it would take a relaxed stance for other, noncasino businesses,
could mean tax-savings for any employer that provides in-house meals to
facilitate a stay-on-premises rule.
IRS did emphasize that an employer cannot justify a 100-percent deduction
by simply saying it has a stay-on-premises policy. The Service will consider
whether such a policy is reasonably related to the needs of the employer’s
business (other than a mere desire to provide additional compensation) and
whether the policy is in fact followed in the actual conduct of the business.
However, if reasonable procedures are adopted and applied, and they preclude
employees from getting a proper meal off-premises during a reasonable meal
period, the meals will be tax-free for employees and 100-percent deductible for
Employers in situations similar to that of Boyd Gaming may consider filing
refund claims if they have been claiming only a 50-percent deduction for onpremises employee meals. If more than half of the meals provided meet the
business necessity test, 100 percent of the employee meal cost is deductible.
There could also be payroll tax refunds due an employer because the qualifying
meals would be excludable from employee income. Additionally, income tax
and payroll tax refunds may also be due to employees if meals were reported as
taxable income and can now be retroactively reclassified as tax-free.
Employers that have not provided employees with free meals in the past may
now consider doing so. Employers who are competing for employees in hotels,
restaurants, hospitals, or other businesses that have been or will be taking
The Journal of Corporate Accounting and Finance/Autumn 1999
Shirley Dennis-Escoffier
advantage of this approach to employee meals may face a competitive disadvantage
in the future if they do not provide free meals. Free meals with no employee tax
consequences can, all other things being equal, make one job more attractive to
employees than another. Similarly, the employer’s ability to deduct 100 percent
of the cost of meals rather than only 50 percent will allow more compensation
to be paid to employees or more profit to flow to the bottom line. Qualifying
employers should definitely consider taking advantage of the Ninth Circuit’s
probusiness decision. ♦
The Journal of Corporate Accounting and Finance/Autumn 1999
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