The following article is adapted from reprinted from the M&A Tax Report, Vol. 8, No. 1, August 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

Good costs vs. bad costs (to borrow a dichotomy from the tax-exempt bond arena). Deductible vs. nondeductible. Black vs. white, not grey.

It is well-settled that costs that are paid or incurred incident to a reorganization should be capitalized and are not deductible in the tax year in which they are paid or incurred. See, Revenue Rulings 67-125 and 73-580. Clearly, however, not all costs paid or incurred in close time proximity to a reorganization are regarded as incident to the transaction. Closeness in time to the reorganization certainly isn't everything. There are various costs that, in light of their proximity to the reorganization, may be viewed as coincidental to the reorganization but, because these costs are not technically "incident" to the transaction, may be deducted after all. Confused?

The Good, the Bad and the Ugly

A little confusion here is not surprising. Still, the shadowy distinction between these two types of costs can best be discerned by focusing on the origin of the costs. The costs that may be deducted are those that do not have their origin in the reorganization. As these costs can be quite large, the radically different tax treatment between them can be of momentous effect. A recent letter ruling serves as a good illustration of the situation.

In Letter Ruling 9923047, a corporation engaged in a Morris Trust transaction and then declared a special dividend. A Morris Trust transaction, M&A Tax Report readers will recall, is one in which a corporation, immediately prior to its acquisition, distributes, via a tax-free spinoff, a business (or businesses) that the acquirer does not wish to annex. The traditional Morris Trust transaction, was based on the Morris Trust case, reported at 367 F.2d 974 (4th Cir. 1966). Morris Trust was a popular acquisition technique in which a target could be acquired on a tax-free basis without acquiring one or more unwanted businesses owned by the target.

Put simply, the target spun off the unwanted businesses to its shareholders before the acquisition. In the halcyon days prior to 1997 with its amendments to Section 355, both the spinoff and the acquisition were tax-free. The Morris Trust transaction was accomplished by distributing one of the corporate businesses to a new corporation via Section 351, spinning off the new corporation, and then having shareholders of the distributing corporation transfer stock in the distributing corporation in exchange for stock in an unrelated corporation. This efficient model allowed a company to dispose of a portion of its business to new shareholders without recognition of gain.

Interestingly, in the actual Morris Trust case, after the Section 355 distribution, the distributing entity merged with an unrelated corporation. However, the shareholders of the distributing corporation controlled more than 50% of the shares of the merged corporation. Consequently, even if the new 1997 rules had applied to the facts, the result in Morris Trust would not have changed. This is an amusing anecdote, given that the 1997 amendment to Section 355 was almost universally known as the anti-Morris Trust amendment.


These transactions are less common than they used to be, in light or the enactment of Section 355(e). That provision renders the spinoff taxable at the corporate level, where the shareholders of the acquired corporation do not emerge with a majority of the stock, by voting power and value, of the acquirer. On this topic, see Wood, "Guidance on the Anti-Morris Trust Provision," Vol. 6, No. 5, The M&A Tax Report (December 1997), p. 6; and Wood, "Amended Spinoff Law: How Bad Is It?" Vol. 6, No. 3, The M&A Tax Report (October 1997), p. 1. See also Willens, "What's a ‘Plan' for Purposes of 355(e)?" Vol. 7, No. 3, The M&A Tax Report (October 1998), p. 7.

But back to Letter Ruling 9923047, where, immediately following the spinoff, the distributed corporation declared a special dividend. This special dividend was an integral part of the sale, and this fact was duly pointed out in the accompanying prospectus. In addition, the parties openly admitted that the special dividend also functioned as an inducement to the parent's shareholders to approve the integrated transaction.

However, it was equally clear that the reorganization was not dependent on the special dividend, and that the reorganization would proceed whether or not the special dividend was paid. A portion of the special dividend was paid to the taxpayer's Restricted Stock Plan participants, as well as its ESOP plan participants. These payments would be deductible provided that they were not capital expenditures, a distinction that turned on whether the payments were "incident" to the reorganization.

What's "Incident" To a Reorg?

The IRS found that the particular payments in Letter Ruling 9923047 not to be incident to the reorganization. Hence, they were properly deductible. The special dividend did not have its origin in the reorganization. Why? The IRS placed great weight on the fact that the reorganization was not dependent on the special dividend, and that the transaction would have proceeded whether or not the special dividend was paid. This was a kind of but/for analysis focusing on the express link between the two events.

Thus, under traditional step-transaction doctrine analysis, the special dividend was functionally separate from the reorganization. The events were not mutually interdependent. In the peculiar parlance of the step transaction doctrine, this meant that the transaction was okay.

Furthermore, the IRS concluded that the special dividend originated in the distributed corporation's newly adopted "asset management strategy." Apparently, the distributed corporation was engaged in the real estate business. In conjunction with its spinoff, the company decided that it would change its business model. Henceforth, it would minimize its ownership of real estate and seek to obtain management and franchise contracts with respect to real estate. Due to this fundamental change in business philosophy, the corporation would need far less capital in its new manner of operating. Consequently, borrowing to remit a special dividend seemed to make eminent sense.

Why pay the dividend and then borrow? It enabled the corporation to realize a higher return on equity and higher earnings per share. Presumably, it would also spell a higher stock price. The costs were therefore ruled to be deductible, despite their admitted temporal connection to the reorganization. The IRS sensibly found that these costs were separate from the reorganization. Under a kind of origin-of-the-claims test, they did not originate with the reorganization and were therefore distinct.

INDOPCO Hits Reorgs—What's Deductible and What's Not, Vol. 8, No. 1, The M&A Tax Report (August 1999), p. 7.