In Plano Holding LLC v. Commissioner, T.C. Memo. 2019-140, the Tax Court held that the target in an acquisition could not deduct a finder's fee that it paid to a service provider that was engaged by an institutional investor affiliated with the acquirer. The institutional investor agreed to pay a $1.5 million finder's fee to its financial advisor, which recommended a potential acquisition of target. The engagement agreement provided that the services were rendered solely for the benefit of institutional investor and the parties' obligations could not be assigned without the service provider's prior written consent. The target ultimately paid the fee and claimed 70% of the fee as a deduction under the success-based fee safe harbor. The Tax Court disallowed the deduction, assessing more than $100,000 in deficiencies and penalties, holding that the target failed to establish a "direct link" between the benefits it derived from the transaction and the payment.

Facts

In 2010, Plano Molding Co. (Plano), an Illinois plastics manufacturer, retained Robert W. Baird & Co., Inc. (Baird) as its financial advisor to assist with a potential sale of the company. No sale took place at that time.

In 2012, Baird suggested Plano as a potential acquisition candidate to the Ontario Teachers' Pension Plan Board (OTPP), a Canadian corporation and large institutional investor. Baird attempted to set up a lunch meeting between OTPP and Plano's shareholder, Tinicum. While the lunch never transpired, OTPP and Tinicum later discussed the potential acquisition by phone. Baird had no further involvement in the acquisition that followed.

On July 26, 2012, Plano retained Harris Williams LLC (Harris Williams) as its exclusive investment banker and financial advisor.

On November 20, 2012, Plano and New Plano Molding, LLC entered into a merger agreement with Plano Holding LLC (Holding) and Plano Acquisition LLC, newly formed wholly owned subsidiaries of OTPP.

On November 28, 2012, OTPP agreed to pay Baird $1.5 million for his services as its exclusive financial advisor upon the successful acquisition of Plano. The agreement provided that Baird's services were rendered solely for the benefit of OTPP and the parties' obligations could not be assigned by OTPP without Baird's prior written consent. This agreement stemmed from OTPP's determination that Baird should be compensated for suggesting Plano as a potential acquisition candidate and attempting to arrange an introductory meeting.

On December 21, 2012, the transaction closed. Under the terms of the merger agreement, Holding acquired Plano for approximately $240 million. As a result of the acquisition, Plano became a wholly owned subsidiary of Holding.

Upon consummation of the transaction, Plano paid fees of $2.89 million to Harris Williams and $1.5 million to Baird. While the fee paid to Harris Williams was treated as a transaction expense that reduced the purchase price of Plano, the Baird fee was not.

Holding filed a consolidated federal income tax return for 2012, in which 70% of the Baird fee paid by Plano was deducted (with the balance capitalized) under the safe harbor election under Revenue Procedure 2011-29. The IRS denied the deduction because it noted that Baird did not provide services to Plano or Holding. As a result, the IRS issued a notice of deficiency of $90,385 and an accuracy-related penalty of $18,077.

Analysis

IRC Section 162(a) allows a deduction for ordinary and necessary business expenses paid or in carrying on a trade or business incurred during the tax year. The Tax Court, however, observed that taxpayers generally may not "deduct the payment of another person's expenses." An exception to that rule was set out in Lohrke v. Commissioner, 48 T.C. 679, 684 (1967). The Court in Lohrke held that a taxpayer may deduct the payment of another person's expenses if "(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." The Tax Court held that Plano failed both prongs of this test.

Citing Bone v. Commissioner, T.C. Memo. 2001-43, 81 T.C.M. (CCH) 1199, 1202 (2001), aff'd, 324 F.3d 1289 (11th Cir. 2003), the Court pointed out that taxpayers must show that a direct nexus exists between the payment's purpose and their business or income-producing activities to establish that they made the payment to benefit their business. Holding argued that, as a result of Baird's matchmaking role, Holding acquired Plano, which allowed Plano to expand. Rejecting this argument, the Court found that Holding did not prove that a direct link existed between Plano's acquisition and the payment to Baird. Specifically, the Court noted, Plano and OTPP had already agreed to the merger more than a week before OTPP contracted to pay Baird; therefore, the merger was not contingent on Plano's payment of the Baird fee. Additionally, Holding failed to show that there would be "direct and proximate adverse consequences to Plano's business of manufacturing plastic goods had it not covered OTPP." While Plano expanded its market presence after the acquisition, the Court reasoned, there is no evidence that "OTPP would have scaled back its plans or financial backing had Plano not paid the fee." Finally, while recognizing the significant role that Baird played in the early days of the potential acquisition, the Court could not discern any benefit to Plano from the Baird payment. Instead, the Court concluded that OTPP primarily benefitted from the payment to Baird. Therefore, the Court held, Holding failed to meet the first prong of the Lohrke test.

The Court also held that Holding failed to meet the second prong because the payment was not an ordinary and necessary expense of Plano's business of manufacturing plastic goods. First, the Court noted, neither party suggests that Plano's payment of the Baird fee was for Baird's attempts to find a purchaser for Plano in 2010; rather, the Court noted, the parties "agreed that the Baird payment came about because OTPP felt obligated to Baird for its legwork (in 2012) in identifying a potential acquisition for OTPP." Thus, the Court observes, "[t]he Baird payment is in the nature of a finder's fee that OTPP decided to bestow months after the fact. Were we looking at the business of an institutional investor, like OTPP, we very well might conclude that a fee of this sort (if it were not a capital expenditure to acquire Plano) would be an ordinary and necessary expense that could be deducted. But we are not."

In its analysis of the second prong of the Lohrke test, the Court rejected Holding's reliance on Square D v. Commissioner, 121 T.C. 168, 200 (2003). Holding argued that, similar to the facts in Square D, "Plano could not enter a fee agreement with Baird directly because of (1) Plano's retention of Harris Williams as financial advisor and (2) financial repercussions for its shareholders if the Baird payment were treated as a transaction expense." The Court found that "OTPP acted on its own behalf, not on behalf of Plano, in agreeing to the Baird payment, thus distinguishing this case from Square D, where the recipient of the benefit was the taxpayer who made the payments and claimed the deduction." Further, the Tax Court noted that PLR 200953014 addressed a factual situation similar to Square D, concluding that a company could deduct transaction costs arranged on its behalf, but Holding failed to establish that any services for the Baird fee were rendered on Plano's behalf.

Accordingly, the Tax Court sustained the IRS's deficiency and accuracy-related penalty determinations.

Implications

When analyzing transaction costs, it is important to determine the proper entity to take the costs into account for tax purposes (i.e., location). Location factors include whether the party (1) had the legal liability to pay, (2) bore the economic burden of the expense and (3) benefited from the expense. In our experience, it is not uncommon to see scenarios in which all of the location factors do not align. For example, one entity initially engages the service provider (legal liability) and another entity pays the costs of the service provider (economic burden). Additionally, more than one party may benefit from the same expense.

This case illustrates the importance of developing facts to support the proper location of transaction costs - particularly the "benefit" factor. The Tax Court noted that the case did not turn on the "presence or absence of a legal obligation." With respect to benefit, Holding argued that Plano made the Baird payment to facilitate its acquisition, which allowed Plano to expand. The Court concluded, however, that Holding failed to establish a "direct link" between the benefits of the transaction and the payment to Baird.

Thus, when a taxpayer takes a position on the proper location of transaction costs, it is important to gather sufficient documentation to support which legal entity incurred the costs. Such documentation should indicate the activities performed by the service provider and the benefits realized by the party taking the costs into account. Based on the outcome in Plano, taxpayers should be aware that the absence of sufficient facts establishing that a taxpayer benefitted from the transaction and transaction costs may subject the taxpayer to accuracy-related penalties.

Additionally, this case illustrates that the language in an engagement agreement can significantly affect the benefit analysis. In Plano, the engagement agreement provided that the services were rendered solely for the benefit of OTTP. The Court pointed to this language in the engagement as support for its conclusions that the primary benefit from the Baird payment redounded to OTPP.

Finally, the Tax Court seemingly misapplied the Lohrke line of cases by seemingly conflating the analysis in the Lohrke line of cases with the "on behalf of" analysis in Square D, which was the taxpayer's primary argument. Specifically, the Court seemed to view Square D as part of the Lohrke progeny. The Square D decision specifically did not apply the Lohrke line of cases in reaching its conclusions that a target could deduct certain expenses for which the acquirer was originally liable. In reaching its conclusion, the Square D court applied an "on behalf of" analysis, which it viewed as separate and distinct from the Lohrke line of cases. In fact, the Court noted in Square D that the reliance on the Lohrke line of cases was "misplaced."

One of the reasons that the Plano court distinguished Square D also seems incorrect. In Plano, the Court notes that the costs in Square D were incurred on behalf of a "to-be-formed subsidiary." The "to-be-formed subsidiary" in Square D was a transitory merger subsidiary, which is generally disregarded for US federal income tax purposes,¹ that merged into the target corporation. Instead, any costs incurred by a transitory merger subsidiary are typically viewed as costs of the target corporation. Implicit in the Plano court's analysis is that, if the costs would have been incurred on behalf of Plano Acquisition LLC (the transitory merger subsidiary), the analysis in Square D would have applied. This distinction is curious; for US federal income tax purposes, any costs incurred on behalf of Plano Acquisition LLC would have been taken into account by Plano (because Plano Acquisition LLC would have been disregarded for US federal income tax purposes).

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ENDNOTES

¹ See, e.g., Revenue Ruling 73-427, 1973-1 C.B. 294; Revenue Ruling 78-250, 1978-1 C.B. 83; Revenue Ruling 79-273, 1979-2 C.B. 125; Revenue Ruling 90-95, 1990-2 C.B. 67.