T.C. Memo. 2004-45
UNITED STATES TAX COURT
CHIEF INDUSTRIES, INC. AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2007-00. Filed March 2, 2004.
Gerald P. Laughlin, Kent O. Littlejohn, and Frank J. Reida,
for petitioner.
William R. Davis, Jr., for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Petitioner seeks redetermination of
deficiencies in Federal income tax for the taxable years ended
June 30, 1996 and 1997, of $619,501 and $431,062, respectively.
The issues relate solely to respondent’s disallowance of a
- 2 -
claimed deduction for the taxable year ended June 30, 1996. The
deficiencies arose in 2 taxable years because respondent’s
adjustment affected the amount of the general business credit
carried forward and applied to the taxable year ended June 30,
1997.
After concessions by the parties, we are left to decide
whether petitioner may deduct a $3,082,710 payment that it made
to its former employee/shareholder Virgil R. Eihusen (V.
Eihusen). Petitioner made the payment to V. Eihusen in
relinquishment of its obligations under an employment agreement
with him and in settlement of various legal claims which he had
filed against petitioner. At the same time, petitioner also paid
V. Eihusen other amounts in reacquisition of all of his stock in
petitioner.
We hold that petitioner may deduct the $3,082,710 payment
under section 162(a) as an ordinary and necessary business
expense and that section 162(k) does not preclude this deduction.
Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the subject years. Rule
references are to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Many facts were stipulated, and we incorporate the parties’
stipulation of facts and the accompanying exhibits by this
- 3 -
reference. When the petition was filed, petitioner’s principal
place of business was in Nebraska.
1. Background
Petitioner is a manufacturer that was established in 1954.
Its principal founder, V. Eihusen, was closely involved with
petitioner’s business operations for several decades. Under his
leadership, petitioner grew from a small construction company
with two employees into a large conglomerate which, during each
of the subject years, had over $200 million in gross sales and
over 1,200 employees. Petitioner’s growth was attributable, in
part, to its addition of key employees and its strategic
acquisitions.
In 1987, V. Eihusen voluntarily relinquished his position as
petitioner’s president to his son, Robert G. Eihusen (R.
Eihusen). V. Eihusen retained his positions as chairman of
petitioner’s board of directors (board) and its chief executive
officer (CEO). In these capacities, V. Eihusen continued to play
a leading role on special projects, one of which was petitioner’s
1990 acquisition of an ethanol plant in Hastings, Nebraska.
Because of its need for expansion of the ethanol facility,
petitioner required additional financing. After extensive
negotiations with several financial institutions, petitioner
entered into a $35 million loan agreement (loan agreement) with
the Boatmen’s National Bank of St. Louis (bank) on November 4,
- 4 -
1992. The loan agreement contained various covenants restricting
petitioner’s ability to alter its business practices without
previous approval from the bank.
Also in 1992, in furtherance of his continuing efforts to
explore investment opportunities for petitioner, V. Eihusen
considered having petitioner pursue a joint venture equity
investment in Russia (Russia project). Members of the board
became concerned that pursuing the Russia project could cause
petitioner to breach one or more of the covenants spelled out in
the loan agreement.
2. Removal of V. Eihusen and Its Immediate Aftermath
On March 5, 1993, the board held a special meeting (meeting)
at which it removed V. Eihusen as petitioner’s chairman and CEO
and elected R. Eihusen to these positions. At this time V.
Eihusen remained one of petitioner’s directors, shareholders, and
employees. Also at the meeting, the board elected R. Eihusen,
Linda M. Berney, Barbara J. Saladen, and David Schocke as the
sole members of the administration committee (ESOP committee) of
the Employee Stock Ownership Plan (ESOP) of Chief Industries,
Inc. Petitioner had established the ESOP and the related trust
in 1976 and had appointed First National Bank of Omaha (First
National) to serve as trustee.
Commencing at the meeting and continuing afterward, V.
Eihusen and the board engaged in a prolonged struggle over
- 5 -
managerial control of petitioner. V. Eihusen was then the
largest (but neither majority nor controlling) shareholder of
petitioner by virtue of his direct ownership of 364,047 shares of
common stock (4,219 of which were restricted shares) and his
indirect ownership of 8,757.706 shares of common stock held
through the ESOP. The board did not want V. Eihusen to be able
to dictate the course of action with respect to petitioner’s
management and business affairs. V. Eihusen desired to regain
managerial control of petitioner and to protect his lifetime
investment therein.
On April 3, 1993, petitioner and V. Eihusen entered into an
employment agreement (employment agreement). The employment
agreement provided that V. Eihusen could use the title “chairman
of the board emeritus” but could not hold himself out as able to
bind petitioner or to direct, hire, or fire any employee of
petitioner. Petitioner’s obligations under the employment
agreement included continuing to pay V. Eihusen an annual salary
of $120,000, to provide him with health and dental benefits, and
to reimburse him for vehicle and office expenses in specified
monthly amounts. The employment agreement did not have a
definite term but could be terminated by petitioner upon breach
of that agreement by V. Eihusen.
Following the meeting, V. Eihusen met with lawyers and
discussed various courses of action relating to, among other
- 6 -
matters, his removal as petitioner’s chairman and CEO. V.
Eihusen on several occasions also communicated with First
National representatives and objected to First National, in its
role as the ESOP’s trustee, voting the ESOP’s shares in
petitioner as directed by the ESOP committee because of what he
believed was the ESOP committee’s conflict of interest. First
National continued receiving directives from the ESOP committee
with respect to voting the ESOP’s shares in petitioner. The
voting maintained V. Eihusen’s lack of control of petitioner’s
board and management.
3. ESOP Litigation
Because it was receiving conflicting directives from the
ESOP committee and from V. Eihusen, First National on October 11,
1994, filed a lawsuit in the U.S. District Court for the District
of Nebraska (ESOP litigation), under the caption “First National
Bank of Omaha, as Trustee of the Chief Industries, Inc. Employee
Stock Ownership Plan and Trust, Plaintiff vs. Chief Industries,
Inc.; Robert G. Eihusen, Linda M. Berney, David Schocke, Barbara
Saladen, as members of the Administration Committee of the Chief
Industries, Inc. Employee Stock Ownership Plan; Virgil R.
Eihusen, Individually; and Robert G. Eihusen, Individually,
Defendants”. First National essentially sought through this
lawsuit a declaratory judgment that it might vote the shares in
petitioner held by the ESOP in accordance with the specific
- 7 -
directives of the ESOP committee, and that such actions were a
reasonable exercise of its discretion in its capacity as the
ESOP’s trustee. At that time, 32.27 percent of the outstanding
shares in petitioner were held by the ESOP.
V. Eihusen counterclaimed in the ESOP litigation, alleging
conflict of interest and self-dealing on the part of the ESOP
committee. He sought a ruling that the ESOP’s trustee was
required to allow passthrough voting of the ESOP’s shares in
petitioner in accordance with the direction of the participants.
In September 1995, the District Court ruled that petitioner could
direct the ESOP’s trustee on the voting of the ESOP’s shares in
petitioner. V. Eihusen’s counterclaims were not included in this
ruling, and they remained pending.
V. Eihusen had in his answer also cross-claimed against the
ESOP committee, alleging a breach of fiduciary duty, conversion,
and civil conspiracy. He sought through these cross-claims both
equitable relief and compensatory damages. The District Court
found these cross-claims to be preempted by Federal law and
dismissed them on October 10, 1995.
4. Intermodal Litigation
On or about May 15, 1995, petitioner and Mid-Am Intermodal
Sales Co. (Mid-Am) entered into a plan of reorganization (Mid-Am
purchase agreement). The Mid-Am purchase agreement was
negotiated and executed without the knowledge of V. Eihusen, who
- 8 -
was still a member of the board at that time. Pursuant to the
Mid-Am purchase agreement, petitioner acquired Mid-Am, and Mid-
Am’s sole shareholder, Thomas Hastings (Hastings), received,
among other things, 58,366 shares of stock in petitioner, a put,
and the entitlement to more shares as an earn-out. The
consideration received by Hastings, a college friend of R.
Eihusen, was unusually generous as compared with the
consideration petitioner used in other acquisitions, and V.
Eihusen believed that this transaction was undertaken for the
purpose of diluting his ownership interest in petitioner.
V. Eihusen filed a third-party complaint in the ESOP
litigation against members of the board, alleging that they
committed a breach of fiduciary duty owed to him and to other
shareholders of petitioner and that they engaged in civil
conspiracy. Subsequently, he amended the third-party complaint
to name petitioner and Hastings as defendants. V. Eihusen prayed
in the third-party complaint for an injunction, the rescission of
agreements among and between petitioner, Mid-Am, and Hastings, an
award of attorney’s fees and costs, and for the ordering of other
types of relief. On October 30, 1995, the District Court
dismissed the third-party complaint, as amended, for lack of
subject matter jurisdiction.
Following this dismissal, V. Eihusen on November 14, 1995,
filed a lawsuit in the District Court of Hall County, Nebraska
- 9 -
(Intermodal litigation), against petitioner, Thomas Hastings,
individually, and R. Eihusen, Linda M. Berney, Melvin Auch, and
Carolyn Loschen, as members of the board. V. Eihusen alleged in
this lawsuit that the named board members had breached a
fiduciary duty, and he prayed for the cancellation and rescission
of the Mid-Am purchase agreement and any stock issuance
thereunder, or, alternatively, an order that petitioner issue
additional shares to V. Eihusen to restore his voting rights and
power to the same as it was before the acquisition of Mid-Am.
Other forms of relief V. Eihusen prayed for were various
injunctions, attorney’s fees, and costs.
5. Negotiations for Settlement
The board believed petitioner’s position to be strong in
both the ESOP litigation and the Intermodal litigation and
vigorously denied any wrongdoing on the part of it and
petitioner. At the same time, the board appreciated the risks
involved in litigation and was mindful of the substantial time
and expense that petitioner needed to devote to this litigation.
In accordance with these considerations, petitioner and V.
Eihusen considered a settlement proposal on November 1, 1995
(November 1995 proposal), under which V. Eihusen would withdraw
his claims in the ESOP litigation and Intermodal litigation and
surrender all of his stock in petitioner. Petitioner, R.
Eihusen, and V. Eihusen amended that proposal on March 1, 1996.
- 10 -
Under the amended proposal (March 1996 proposal), V. Eihusen
would transfer all of his stock in petitioner, either owned
directly or indirectly through the ESOP, to petitioner, R.
Eihusen, or an entity controlled by R. Eihusen, and would
withdraw any claim against petitioner, its directors, and its
officers. V. Eihusen would also immediately place 30,000 of
those shares in an escrow account and would agree to forfeit
those shares to R. Eihusen if V. Eihusen breached any of the
agreed-upon terms.
Petitioner, in turn, would under the March 1996 proposal
agree to forgive a judgment (Hall County judgment) that it had
received against V. Eihusen;1 pay V. Eihusen $100 per share for
359,828 shares of stock in petitioner that he owned directly and
8,757.706 shares of stock in petitioner that he owned indirectly
through the ESOP; pay V. Eihusen $86.09 per share for 4,219
restricted shares of stock in petitioner; convey to V. Eihusen a
fee simple ownership, free of liens, of real property known as
the Indian Head Golf Club, certain real estate adjacent to it,
and all related personal property necessary to operate that
business;2 and indemnify V. Eihusen under certain circumstances,
1
This judgment arose from V. Eihusen’s obligation with
respect to a mid-1980s loan made by petitioner to a partnership,
in which V. Eihusen was a partner. The judgment amounted to
$1,386,951 including interest, as of June 28, 1996.
2
The parties stipulated that the value of the Indian Head
(continued...)
- 11 -
which were significantly more limited in scope than those
contained in the November 1995 proposal.
6. The Final Settlement and Share Repurchase
As contemplated by the March 1996 proposal, petitioner and
V. Eihusen entered into an “Agreement for the Purchase and Sale
of Stock and Settlement of Claims” on April 19, 1996 (definitive
agreement). The definitive agreement replaced and superseded all
of the previous agreements and set forth the entire understanding
between the parties with respect to its subject matter.
The terms of the definitive agreement were generally similar
to the terms of the March 1996 proposal. One of the significant
differences between the documents was the form of conveyance of
the Indian Head Golf Club assets. Instead of an outright
transfer of the assets, petitioner and V. Eihusen engaged in an
exchange of stock, with petitioner transferring to V. Eihusen all
of the shares of Indian Head Golf Club, Inc., in exchange for
16,740 unrestricted shares of stock in petitioner, so as to
purportedly qualify that exchange for tax-free treatment under
section 355. The definitive agreement also contained the
obligation of petitioner and R. Eihusen to make a joint tender
offer (tender offer) for all issued and outstanding shares of
common stock in petitioner except for shares owned by V. Eihusen,
2
(...continued)
Golf Club and the related property was $1,673,735.
- 12 -
R. Eihusen, or members of the latter’s immediate family. The
tender offer was required to be set at a minimum of $100 per
share.
After the execution of the definitive agreement but before
its closing on June 28, 1996 (closing), V. Eihusen alleged that
petitioner had defaulted on the definitive agreement with respect
to a clause that obligated petitioner to continue operating the
Indian Head Golf Club in the ordinary course of business. In
settlement of this allegation, petitioner agreed to assume the
lease obligations for certain golf carts, thereby incurring an
additional cost of $21,759 (golf cart adjustment).
As contemplated by the definitive agreement, the parties
thereto exchanged certain items at closing. Specifically,
petitioner transferred to V. Eihusen $32,308,800 in redemption of
323,088 unrestricted shares of stock in petitioner owned directly
by him; R. Eihusen transferred to V. Eihusen $2 million in
exchange for 20,000 unrestricted shares of stock in petitioner
owned directly by him; petitioner transferred to V. Eihusen
$875,770 in redemption of 8,757.706 unrestricted shares of stock
in petitioner owned indirectly by him through the ESOP;
petitioner transferred to V. Eihusen all of the shares of Indian
Head Golf Club, Inc., in redemption of 16,740 unrestricted shares
of stock in petitioner owned directly by him; and petitioner
transferred to V. Eihusen $363,214 in redemption of 4,219
- 13 -
restricted shares of stock in petitioner owned directly by him.
Petitioner also transferred to V. Eihusen $1,674,000, forgave the
Hall County judgment of $1,386,951, and factored in the golf cart
adjustment of $21,759 in release of litigation and employment
claims which V. Eihusen had, or may have had, primarily against
petitioner and its directors, officers, and employees. V.
Eihusen, in turn, delivered to petitioner in addition to the
noted shares of stock: (1) Certificates evidencing dismissal,
with prejudice, of all claims which he had outstanding against
petitioner in both the ESOP litigation and the Intermodal
litigation; (2) a global release of all claims he may have had
against petitioner, its subsidiaries, First National, the ESOP
committee, and petitioner’s officers, directors, employees, and
agents; (3) his resignation as a director, officer, and employee
of petitioner; and (4) his release of petitioner’s obligations
under the employment agreement.
Petitioner deducted $3,082,710 ($1,674,000 + $1,386,951 +
$21,759) as an ordinary and necessary business expense, noting on
its tax return that this expense was a “lawsuit settlement cost”.
Respondent disallowed the deduction, determining that the payment
in question was a nondeductible expense either because it was
capital or because it was made in connection with petitioner’s
reacquisition of its stock.
- 14 -
OPINION
The Commissioner’s determinations are presumed correct, and
taxpayers bear the burden of proving them wrong. Rule 142(a)(1);
Welch v. Helvering, 290 U.S. 111, 115 (1933). As one exception
to this rule, section 7491(a) places upon the Commissioner the
burden of proof with respect to any factual issue relating to
liability for tax if the examination of the taxpayer’s records
for the subject year began after July 22, 1998, and the taxpayer
maintained adequate records, satisfied the substantiation
requirements, cooperated with the Commissioner, and introduced
during the court proceeding credible evidence with respect to the
factual issue. In that the record is sufficient for us to decide
this case on its merits, and neither party alleges the
applicability of section 7491(a) or of any other exception, we
need not and do not decide the burden of proof issue.3 D’Angelo
v. Commissioner, T.C. Memo. 2003-295.
We decide first whether the disputed payment of $3,082,710
is otherwise deductible as an ordinary and necessary business
3
Respondent argues that petitioner has failed to establish
that the $3,082,710 was not paid as consideration for the
redeemed stock. We find to the contrary. Respondent does not
question the fairness of the price paid for the stock in
petitioner. Presuming without conceding that the price
approximated the value of the stock in petitioner, we note that
petitioner can pinpoint $3,082,710 as attributable to its
settlement of the litigation and employment claims by subtracting
from the total consideration paid under the definitive agreement
the total consideration paid for the stock.
- 15 -
expense under section 162(a). Given our conclusion that it is,
we decide second whether its deduction is precluded by section
162(k), which applies to payments made “in connection with” the
reacquisition of stock.
1. Section 162(a)
Section 162(a) allows a deduction for all ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business. To qualify for a deduction
under section 162(a), an item must (1) be paid or incurred during
the taxable year, (2) be for carrying on any trade or business,
(3) be an expense, (4) be a necessary expense, and (5) be an
ordinary expense. Commissioner v. Lincoln Sav. & Loan
Association, 403 U.S. 345 (1971); Wells Fargo & Co. v.
Commissioner, 224 F.3d 874 (8th Cir. 2000), affg. in part and
revg. in part Norwest Corp. v. Commissioner, 112 T.C. 89 (1999);
Lychuk v. Commissioner, 116 T.C. 374 (2001).
Respondent argues that petitioner may not deduct its payment
of $3,082,710 to V. Eihusen under section 162(a) for many of the
same reasons respondent advances in connection with section
162(k); namely, that the payment was made in connection with
petitioner’s reacquisition of its stock, or, in other words, in
connection with an acquisition of a capital asset. Respondent
also argues for purposes of section 162(a) that the payment in
question is a capital expenditure because the claims settled by
- 16 -
this payment originated with V. Eihusen’s attempt to regain his
former positions with petitioner. According to respondent,
ensuring that this attempt is unsuccessful “can” increase the
value of petitioner. Petitioner argues that the payment is
deductible under section 162(a) in that the payment was made in
part to defend against attacks on petitioner’s business practices
and, as to the rest, made in cancellation of an employment
agreement. We agree with petitioner.
This Court has recently concluded that an expenditure must
be capitalized when it (1) creates or enhances a separate and
distinct asset, (2) produces a significant future benefit, or (3)
is incurred “in connection with” the acquisition of a capital
asset. Lychuk v. Commissioner, supra at 385-386. Respondent
focuses his argument on the first and third prongs. Respondent
does not assert, and thus we have no occasion to find, that any
portion of petitioner’s payment to V. Eihusen produced a
significant long-term benefit to petitioner so as to require that
this payment be capitalized under INDOPCO, Inc. v. Commissioner,
503 U.S. 79 (1992). As to the third prong, i.e., an expense
incurred in connection with the acquisition of a capital asset,
we reject that argument for the reasons discussed infra as to
section 162(k). As to the first prong, i.e., creation or
enhancement of a separate and distinct asset, we conclude below
that the test of Lincoln Sav. & Loan is satisfied with respect to
- 17 -
both the litigation settlement and the release of the employment
agreement, and therefore reject that argument as well.
Pursuant to the definitive agreement, petitioner and R.
Eihusen purchased all of V. Eihusen’s stock in petitioner for
$37,223,114. Contemporaneously with that purchase, but
independent therefrom, petitioner also transferred to V. Eihusen
a value of $3,082,710 in settlement of existing and potential
disputes between the two of them and in relinquishment of V.
Eihusen’s rights under the employment agreement. More
specifically, petitioner paid part of the $3,082,710 to V.
Eihusen to settle all of the claims which he advanced against
petitioner in the ESOP litigation and the Intermodal litigation,
and to settle all other claims which he may have had against
petitioner, First National, the ESOP committee, and petitioner’s
directors, officers, employees, and agents. Petitioner paid the
rest of the $3,082,710 to V. Eihusen for his resignation as a
director, officer, and employee of petitioner and for his release
of petitioner from its obligations under the employment
agreement.
As to the portion of the payment pertaining to the
settlement of litigation, payments made to settle litigation are
deductible as ordinary and necessary business expenses when they
have business origin and otherwise satisfy the mandates of
section 162(a). Anchor Coupling Co. v. United States, 427 F.2d
- 18 -
429 (7th Cir. 1970); Eisler v. Commissioner, 59 T.C. 634 (1973);
Old Town Corp. v. Commissioner, 37 T.C. 845 (1962); Oliver v.
Commissioner, T.C. Memo. 1997-84. A settlement payment has
business origin when the transaction or activity causing the
litigation originates in a trade or business; the potential
consequences of a failure to prosecute or defend the litigation
are secondary. See Woodward v. Commissioner, 397 U.S. 572, 577
(1970); United States v. Gilmore, 372 U.S. 39, 44-51 (1963);
Wells Fargo & Co. v. Commissioner, supra at 887; Anchor Coupling
Co. v. United States, supra at 433. The courts have created
three independent tests which are helpful to determine whether a
settlement payment with a business origin is deductible. These
tests are (1) whether the taxpayer/payor lacked confidence that
it would have prevailed in the lawsuit if it was not settled, (2)
whether the taxpayer/payor made the payment to avoid damages or
liability which might have resulted in the absence of the
settlement, and (3) whether the belief held by the taxpayer/payor
concerning the validity of the claim against him or her was
justified to the extent that a reasonable person in his or her
place would have thought that settlement was necessary. Old Town
Corp. v. Commissioner, supra at 858-859. An answer in the
affirmative to any of these tests tends to establish that the
settlement payment is deductible under section 162(a).
- 19 -
Here, the claims underlying the settlement payment and
alleging mismanagement by petitioner of its business, originated
in petitioner’s business decision to remove V. Eihusen as its
chairman and CEO. In addition, in accordance with the three
tests enunciated by the Court in Old Town Corp., we conclude that
(1) members of the board lacked confidence that petitioner would
prevail in the subject litigation; (2) petitioner made the
settlement payment to avoid damages or liability it could have
incurred absent the settlement; and (3) members of the board were
justified in taking V. Eihusen’s claims seriously and acted
reasonably in attempting to settle the ESOP litigation and the
Intermodal litigation so as to reduce the expenditure of time and
the money. Also, applying the test of Commissioner v. Lincoln
Sav. & Loan Association, 403 U.S. 345 (1971), to the portion of
petitioner’s payment made to settle the ESOP litigation and the
Intermodal litigation, we find that it (1) was paid or incurred
during the subject years; (2) was incurred in connection with
petitioner’s trade or business as it was directly related to
petitioner’s business practices; (3) was an expense; (4) was a
necessary expense in that petitioner was required to expend a
significant amount of resources in defending itself and its
directors, officers, and employees and hence settled the claims
so as to avoid larger expenditures in continuing to litigate
without any certainty of prevailing; and (5) was an ordinary
- 20 -
expense in that litigation, and the associated settlement costs,
commonly arise in the course of conducting business. In view of
the foregoing, we conclude that the portion of the $3,082,710
relating to the settlement of litigation is deductible under
section 162(a) as an ordinary and necessary business expense.
As to the portion of the payment made in discharge of
petitioner’s outstanding obligations under the employment
agreement, that portion also qualifies for deductibility under
section 162(a) to the extent it meets that section’s
requirements. Peninsular Metal Prods. Corp. v. Commissioner, 37
T.C. 172 (1961); Driskill Hotel Co. v. Commissioner, a Memorandum
Opinion of this Court dated May 22, 1953. Applying the test of
Commissioner v. Lincoln Sav. & Loan Association, supra, to the
portion of petitioner’s payment made to discharge its obligations
under the employment agreement, we find that this portion (1) was
paid or incurred during the subject years; (2) was incurred in
connection with petitioner’s trade or business as it was directly
related to conducting petitioner’s business; (3) was an expense;
(4) was a necessary expense in that petitioner had an obligation
to compensate V. Eihusen pursuant to the employment agreement;
and (5) was an ordinary expense in that costs associated with
maintaining or terminating an employment relationship commonly
arise in the course of conducting business. Thus, we hold that
- 21 -
petitioner is entitled to deduct the portion of its payment to V.
Eihusen relating to the employment agreement.
In sum, we find petitioner’s payment of $3,082,710 to V.
Eihusen to be deductible under section 162(a) as an ordinary and
necessary business expense. Because we conclude that the entire
payment is deductible, we need not and do not apportion that
payment between the litigation settlement and the employment
agreement.
2. Section 162(k)
Respondent argues that petitioner may not deduct the payment
of $3,082,710 because it was made in connection with a
reacquisition of stock under section 162(k)(1). We disagree with
respondent.
Section 162(k)(1) disallows an “otherwise allowable”
deduction for any amounts “paid or incurred by a corporation in
connection with the reacquisition of its stock”. By enacting
this provision in 1986, Congress wished to provide expressly that
all expenditures incurred in reacquisition by a corporation of
its own stock are nonamortizable capital expenditures. In that
the record establishes that petitioner’s redemption of its shares
owned by V. Eihusen was a “reacquisition” under section 162(k),
our inquiry focuses on whether petitioner’s payment of $3,082,710
to V. Eihusen occurred “in connection with” that reacquisition.
- 22 -
The phrase “in connection with” has been ascribed a broad
meaning both with respect to section 162(k) and with respect to
other statutory sections. See, e.g., Snow v. Commissioner, 416
U.S. 500, 502-503 (1974); Huntsman v. Commissioner, 905 F.2d
1182, 1184 (8th Cir. 1990), revg. and remanding 91 T.C. 917
(1988); Ft. Howard Corp. v. Commissioner, 103 T.C. 345 (1994),
supplemented by 107 T.C. 187 (1996). An expense, however, does
not fall within the broad meaning afforded it under section
162(k) simply because the expense is paid at a time that is
proximate to a redemption. As the conferees made explicit in
their report underlying the enactment of section 162(k):
while the phrase “in connection with [a]
redemption” is intended to be construed broadly,
the provision is not intended to deny a deduction
for otherwise deductible amounts paid in a
transaction that has no nexus with the redemption
other than being proximate in time or arising out
of the same general circumstances. For example, if
a corporation redeems a departing employee’s stock
and makes a payment to the employee in discharge of
the corporation’s obligations under an employment
contract, the payment in discharge of the
contractual obligation is not subject to
disallowance under this provision. * * * Payments
in discharge of other types of contractual
obligations, in settlement of litigation, or
pursuant to other actual or potential legal
obligations or rights, may also be outside the
intended scope of the provision to the extent it is
clearly established that the payment does not
represent consideration for the stock or expenses
related to its acquisition, and is not a payment
that is a fundamental part of a “standstill” or
similar agreement. [H. Conf. Rept. 99-841 (Vol.
II), at II-168 to II-169 (1986), 1986-3 C.B. (Vol.
4) 1, 168-169.]
- 23 -
The same conference report also explains that section 162(k) does
not apply to a discharge of a corporate obligation even when an
employment contract and a redemption agreement are contained in
the same document and are negotiated at the same time. Id. at
II-169 n.4, 1986-3 C.B. (Vol. 4) at 169.
The setting here is specifically referenced in the
conference report, which places outside of section 162(k) both a
payment in settlement of litigation and a payment in discharge of
a corporation’s obligation to a departing employee. Respondent
attempts to downplay this portion of the report and in fact does
not even discuss it, focusing instead on our opinion in Ft.
Howard Corp. v. Commissioner, supra, and on the opinion of the
Court of Appeals for the Eighth Circuit in Huntsman v.
Commissioner, supra, for the proposition that the phrase “in
connection with” is construed broadly to reach all costs
connected in any way with a company’s reacquisition of its stock.
Respondent observes that V. Eihusen’s lawsuits centered on his
attempt to retain his lost positions and that these claims were
settled at the same time as his stock was redeemed. Respondent
draws from this proximity and the broad construction given to the
phrase “in connection with” that the first event occurred “in
connection with” the second event.
We agree with respondent that section 162(k) reaches broadly
to deny deductibility of all expenses which are paid “in
- 24 -
connection with” a reacquisition of stock and does not simply
encompass those amounts which were paid for the reacquired stock
itself. We disagree with respondent, however, that the payment
in question was made “in connection with” the reacquisition of
stock within the meaning of section 162(k). In accordance with
the quoted legislative history underlying section 162(k),
payments, although arising out of the same general circumstances
as a reacquisition and made proximate thereto, are not denied
deductibility by section 162(k) when they lack any other nexus to
the reacquisition. Such may be the case, the conference report
clarifies, where, as here, a reacquisition payment is accompanied
by a payment in settlement of claims as to litigation or
employment.
In Ft. Howard, the taxpayer incurred expenses in obtaining
funds necessary to effect a leveraged buyout (LBO). We concluded
that these financing expenses, except for certain interest
payments, were incurred “in connection with” the LBO because the
LBO would not have been possible without the financing. We found
that the financing costs were both a cause and an effect of the
redemption. We noted that financing was “necessary” to the
transaction as a whole and was an “integral part” of a detailed
plan. Id. at 352-353. Here, by contrast, there was no similar
relationship between petitioner’s settlement of the litigation
and employment claims, on the one hand, and its repurchase of
- 25 -
shares on the other hand. In fact, the two transactions are not
linked in any way except that they were executed and negotiated
by the same parties and at the same time.
In Huntsman, the Court of Appeals for the Eighth Circuit
construed the meaning of the phrase “in connection with” in the
context of section 461(g)(2), which allows for the deduction of
“points” paid on indebtedness incurred “in connection with” the
purchase or improvement of a principal residence. The court read
the statute to require that the incurrence of indebtedness needs
only to have an “association” or “relation” with the purchase of
a residence to be connected with that purchase. The court
allowed the taxpayers to deduct points which they paid nearly 3
years after the acquisition of their residence to obtain
financing used to satisfy their original 3-year balloon loan.
Id. at 1183-1186. In our case we find no “association” or
“relation” between petitioner’s repurchase of V. Eihusen’s stock
and the settlement of the referenced claims.
We have considered all arguments of the parties related to
our holdings set forth herein and, to the extent not discussed,
find those arguments to be irrelevant or without merit.
Decision will be entered
for petitioner.