Finder’s fee nondeductible, tax penalty imposed
When a taxpayer pays the expense of another, is the taxpayer allowed tax deduction for the payment? While the answer generally is no, if the expense is sufficiently related to the taxpayer’s business, the answer can be yes. This tax question comes up in many contexts. It came up in a merger and acquisition (M&A) transaction context in Plano Holding LLC v. Commissioner, T.C. Memo. 2019-140.
Acquisition and fee
Plano Molding Co. (Target), a plastics manufacturer, was acquired by Plano Holding in 2012. Plano Holding was affiliated with a foreign pension fund (Fund). In July 2012, Robert W. Baird & Co., Inc. (Baird), introduced Fund, as a potential acquirer, to Target. Later in July 2012, Target engaged another investment banking firm as its exclusive advisor with respect to a potential sale.
Target, Fund and Plano Holding entered into an acquisition agreement in or about November 2012. Later in November, Fund agreed to pay Baird a $1.5 million fee for financial advisory services because Baird had introduced Fund to Target. In December 2012, Fund (through Plano Holding) acquired Target, and Target paid the $1.5 million to Baird.
No tax deduction
On its consolidated federal income tax return, Target claimed a deduction for 70% of the $1.5 million fee pursuant to an election under Rev. Proc. 2011-29. The IRS denied the deduction, assessing additional tax and a penalty.
For a taxpayer to receive a deduction for the expense of another, the Tax Court required that two elements be present: (1) the taxpayer’s primary motive for paying the other’s obligation was to protect or promote the taxpayer’s own business and (2) the expenditure was an ordinary and necessary expense of the taxpayer’s business. (The court cited Lohrke v. Commissioner, 48 T.C. 679 (1967) as authority for these requirements). In this case, the Tax Court held neither element was present.
With respect to the first element, Target’s asserted business purpose for the payment was that it benefited from the acquisition. The court noted that this purported business purpose did not suffice because Fund (through Plano Holding) was already obligated to acquire Target at the time Fund agreed to pay Baird. Target also did not claim any adverse consequences would have befallen it if it did not pay Baird the amount Fund owed. The court found that the Fund, not Target, obtained benefit from the Baird payment.
With respect to the second element, the court stated that the payment to Baird was in the nature of a finder’s fee. As a result, the court considered the payment an ordinary and necessary expense for Fund’s business, but not for Target’s.
The fact that the payor was not the party that incurred the expense does not necessarily preclude the payor from deducting the payment. A taxpayer may claim a deduction for fees incurred by another party on behalf of the taxpayer. In this case, Target argued that Fund incurred the Baird fee on Target’s behalf and as such Target was eligible to claim the deduction. The court disagreed, pointing out that the agreement between Fund and Baird contradicted that argument, and stating that the record did not reflect any services provided by Baird on Target’s behalf.
In addition to the IRS’ denial of the deduction for the Baird fee, the court also addressed the IRS’ assessment of the 20% accuracy-related penalty. The taxpayer claimed that its deduction position was supported by substantial authority. The court did not agree and therefore upheld the penalty assessment.
The Plano Holding case illustrates the principle that one taxpayer generally can deduct the expenses of another only under limited circumstances, and that documentation must support an argument that costs were incurred by another on behalf of or for the benefit of the taxpayer.
In addition to this principle, expenses paid or incurred in connection with M&A transactions are subject to various other detailed tax rules, and are often significant in amount. Companies should consult with their tax advisors regarding the treatment of expenses paid or incurred in M&A transactions. Our white paper on M&A transaction costs, available here, provides a more in depth analysis of the topic.