Background

Transaction expenses, including fees for legal counsel, accountants, financial advisors, brokers and other third parties, are an ineluctable aspect of mergers and acquisitions. The ability of parties to deduct at least a portion of such expenses upfront for U.S. federal income tax purposes takes away some of the sting of receiving a surfeit of invoices for professional services. However, parties cannot arbitrarily assign a transaction-related tax deduction to the taxpayer that would reap the greatest tax benefit therefrom — even if that may be a newly acquired subsidiary — and determining which party is eligible to take a deduction for a particular transaction expense can be murky. A recent Tax Court memorandum opinion — Plano Holding LLC v. Commissioner — affords useful guidance in this area, holding on the facts before it that payment of a “finder’s fee” to a professional firm by a target corporation on behalf of its acquiror failed to qualify as an ordinary and necessary business expense of the target deductible under Section 162.^[1]

Section 162(a) provides in general that taxpayers are entitled to deduct all ordinary and necessary business expenses paid or incurred during a taxable year in carrying on any trade or business. An expense is “ordinary” if it is customary or usual within a particular trade or business or relates to a common or frequent occurrence in the type of business involved. An expense is “necessary” if it is appropriate and helpful to the development of the taxpayer’s business. Treasury Regulation Section 1.162-1(a) provides in general that deductible business expenses must be those ordinary and necessary expenses “directly connected with or pertaining to” the taxpayer’s trade or business.

It is well established that one taxpayer generally may not deduct the payment of the expenses of another. However, the Tax Court in Lohrke v. Commissioner has recognized a slender exception to this rule, where (1) the taxpayer’s primary motive for paying the other’s obligation is to “protect or promote” the taxpayer’s own business and (2) the expenditure is an ordinary and necessary expense of the taxpayer’s business.^[2] Plano Holding sheds light on the meaning of each of these two prongs of the Lohrke exception and presents a cautionary tale to acquirors seeking to maximize transaction tax deductions in the hands of target portfolio companies.

The Case

Plano Molding Co. (Plano) is a longtime manufacturer of plastic storage equipment, the majority of the outstanding shares of which had been acquired by a private equity firm in 2007. In 2010, Plano retained a financial advisor (Baird) in connection with a possible sale of the company. No sale took place at that time. A couple of years later, Baird suggested Plano as a potential acquisition candidate to the Ontario Teachers’ Pension Plan Board (OTPP), a large Canadian institutional investor. Within weeks of Baird’s suggestion, Plano exclusively engaged an investment banking and financial advisor (Harris Williams) in connection with its possible sale. On Nov. 20, 2012, OTPP affiliates signed a merger agreement with Plano and an affiliate, pursuant to which Plano would become a wholly owned subsidiary of an acquisition corporation formed by OTPP (Holding). The merger agreement set the purchase price at approximately $240 million, subject to downward adjustment for, among other things, transaction expenses, defined as all unpaid fees or expenses (including fees and expenses payable to financial advisors) incurred by Plano or for which it was liable in connection with the planned merger. The merger closed on Dec. 21, 2012. In the month between signing and closing, OTPP and Baird entered into an agreement stemming from OTPP’s determination that Baird should be rewarded for suggesting Plano as an acquisition candidate. OTPP agreed to pay Baird $1.5 million for Baird’s services as OTPP’s “exclusive financial advisor,” which services were rendered “solely for the benefit” of OTPP. The agreement specified that it could not be assigned by OTPP without Baird’s consent. Notwithstanding the language of the agreement, the Tax Court found that Baird provided no financial advisory or other services to OTPP with respect to the acquisition — it simply presented Plano to OTPP as a candidate ripe for acquisition, assessed the majority shareholder of Plano’s interest in a potential sale, and attempted (unsuccessfully) to arrange a luncheon meeting of representatives of OTPP and the majority shareholder.

Following the closing, Plano paid Harris Williams a fee for its services in connection with the merger. Plano also paid $1.5 million to Baird in accordance with the Baird/OTPP agreement. The Harris Williams fee was treated as a transaction expense under the terms of the merger agreement and resulted in a downward adjustment to Plano’s purchase price; the Baird fee was not so treated.

After completion of the merger, Plano joined Holding, a limited liability company electing to be taxed as a corporation, and others in filing a consolidated U.S. federal income tax return for 2012 in which 70 percent of the Baird fee paid by Plano was deducted (with the balance capitalized) pursuant to a safe harbor election under Revenue Procedure 2011-29. The Internal Revenue Service (the Service) issued Holding a notice of deficiency for 2012, disallowing the claimed deduction of the Baird fee on the ground that Baird had not provided any services to Holding or Plano and assessing a 20 percent accuracy-related penalty under Section 6662(a). Holding thereafter filed a petition with the Tax Court.

At the outset of its analysis, the Tax Court stated that OTPP had entered into a nonassignable agreement to pay the Baird fee, such that the Holding group was seeking a deduction for a payment Plano made on behalf of another. As a result, the Tax Court framed its discussion around whether Plano satisfied the two-pronged Lohrke test. Holding and the Service disputed (1) whether Plano benefited from the payment of the Baird fee and (2) whether the payment of such fee was an ordinary and necessary expense of Plano’s business.

With respect to the first Lohrke prong, the Tax Court noted that a corporation’s payment of a shareholder’s expense is closely scrutinized, and the demonstration of the primary benefit to the corporation must be strong. Holding highlighted Baird’s matchmaking role and argued that Plano made the Baird payment to facilitate its acquisition by OTPP, whose deep pockets enabled Plano to subsequently expand its business. The Tax Court disagreed, noting that no “direct link” had been established between the purported business purpose of being acquired by a well-heeled investor and Plano’s payment of the Baird fee. In that connection, the merger agreement was signed prior to OTPP’s agreement to pay Baird, and Holding failed to establish that Plano’s manufacturing business would have been in proximate danger or otherwise suffered adverse consequences if Plano had not paid the fee. The Tax Court stated that OTPP, rather than Plano, was the “primary” beneficiary of the payment of the Baird fee, as it had a strong interest in rewarding companies bringing attractive acquisition candidates to its attention.

With respect to the second Lohrke prong, the Tax Court stated that it was not persuaded that the payment of a finder’s fee by a plastics manufacturer (as opposed to an institutional investor) was ordinary and necessary in that line of business. Holding contended that Plano’s payment of the Baird fee was analogous to the payment of fees at issue in the Tax Court’s prior taxpayer-favorable decision in Square D Co. v. Commissioner.^[3] In that case, a corporate parent negotiated a loan commitment and agreed to pay certain fees on behalf of its “to-be-organized subsidiary.” Upon formation, the subsidiary received the loan proceeds and took over the payment of costs (either directly or indirectly), for which it claimed deductions. The Tax Court held that, where the loan acquisition costs were incurred on behalf of the taxpayer subsidiary and then paid by the subsidiary, it was appropriate to allow the subsidiary to deduct such costs.^[4] Holding argued that, like the corporate parent of the taxpayer in Square D, OTPP entered into the Baird agreement on Plano’s behalf because Plano could not do so. In that regard, while Plano was not a “to-be-organized” company, Plano was unable to enter into a fee agreement with Baird because (1) it had earlier retained Harris Williams as its exclusive financial advisor and (2) if the Baird fee were treated as a transaction expense of Plano’s under the merger agreement, Plano’s selling shareholders would have suffered a reduction in the purchase price.

The Tax Court readily dismissed Holding’s argument, noting that the parties had expressly stipulated that OTPP entered into the agreement with Baird because it determined that Baird should be compensated for bringing Plano to its attention. Stated differently, OTPP acted on its own behalf — not on behalf of Plano — in agreeing to the Baird payment, and the language of the agreement to the effect that it was “solely for the benefit” of OTPP underscored that conclusion. In contrast, in Square D, the recipient of the benefit (the newly formed subsidiary that ultimately received the loan proceeds) was the same party claiming the deduction. The Tax Court was not convinced that Plano itself saw a need to compensate Baird for mere introductions made months beforehand, or that it wanted to, but could not, enter into an agreement to pay a finder’s fee to Baird directly. In that connection, while Plano had entered into an exclusive arrangement with Harris Williams to provide financial advisory services, such services commenced only after Baird’s identification of Plano as a potential target. In any event, as noted above, the Tax Court found that Baird did not provide any financial advisory services that could have been regarded as violative of Plano’s exclusive arrangement with Harris Williams. Finally, the Tax Court rejected the argument that Plano’s selling shareholders would have suffered financially had Plano directly undertaken to pay the Baird fee inasmuch as Holding failed to demonstrate such fee would even have constituted a purchase price-reducing transaction expense as defined by the merger agreement. Even if it had, it is not clear that a negative impact to Plano’s selling shareholders would have had any bearing on the Tax Court’s analysis.

In view of the taxpayer’s failure to satisfy the requirements for the Lohrke exception to apply, the Tax Court held that Plano’s payment of the Baird fee was not a deductible ordinary and necessary business expense of Plano.^[5] Moreover, the Tax Court sustained the Service’s imposition of the 20 percent accuracy-related penalty on the ground that the facts in the authorities upon which taxpayer sought to rely, including Square D, were materially distinguishable from the facts before it.

Implications

The result in Plano Holding should come as no great surprise given the facts and as evidenced by the Tax Court’s sustaining of the accuracy-related penalty. It is somewhat surprising, however, that the fact that Plano had itself previously retained Baird just two years earlier to promote its business for sale appears not to have been given any weight in the Tax Court’s analysis, notwithstanding that such retention was almost certainly the basis for Baird’s putting Plano in OTPP’s sights. It also bears noting that the taxpayer appears to have been hampered to some degree in its arguments by facts to which it had stipulated. Nevertheless, Plano Holding emphasizes the importance of the manner in which parties negotiate, describe and arrange for payment of transaction expenses in mergers and acquisitions. While the finder’s fee at issue in Plano Holding may be somewhat unique, and each case involving transaction tax deductions is heavily dependent on the facts, the Tax Court’s opinion illuminates certain actions acquisition parties should take — or avoid taking — to increase the likelihood that expenses paid by the target in respect of a liability incurred by the acquiror may be deductible, at least in part, by the target, including the following: 

• Making completion of the acquisition contingent in part on the target’s agreement to pay the transaction advisory or other fee
• Avoiding language in any deal advisory or other agreement entered into by an acquiror that any services provided thereto for which a deduction may be sought by the target are rendered solely for the benefit of acquiror or that such agreement cannot be assigned by the acquiror to the target upon successful completion of the acquisition absent consent of the advisor or service provider
• Making clear in engagement letters or other documentation that a transaction advisor or other service provider whose fee the target seeks to deduct is providing services that redound at least in part to target’s benefit, including by describing how the fee bears a relationship to or promotes or protects the trade or business in which target is engaged
• Ensuring that transaction fees are itemized and agreed to prior to signing of the acquisition agreement, with a determination made by target’s board after due consideration that payment by the target of any such fee is in the target’s interest

^[1] Plano Holding LLC v. Comm’r, T.C. Memo. 2019-140. All section references are to sections of the Internal Revenue Code of 1986, as amended, unless otherwise indicated.

^[2] 48 T.C. 679, 688 (1967).

^[3] 121 T.C. 168 (2003).

^[4] Id. at 201.

^[5] In a footnote the Tax Court indicated that its holding should not be taken as its opinion as to whether a payment stemming from Baird’s 2010 efforts on Plano’s behalf would have been deductible as an ordinary and necessary expense of Plano’s business. It is not clear why the Tax Court believed such a footnote was necessary, as such a payment, at least in some amount, should almost certainly be considered deductible under Section 162(a) and the principles of Revenue Procedure 2011-29. To the extent it raises any negative implication, the footnote should be disregarded as dicta.

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