I recently encountered a situation in which a partially-liquidated corporation sought to claim a net operating loss (“NOL”) as a result of payments made by the corporation in settlement of certain claims relating to its business. The corporation had previously distributed its business assets, but had retained liquid assets in an amount that it estimated would be sufficient to defend against the claims and to satisfy any liability arising therefrom. Under these circumstances, the corporation was allowed to treat the payments as deductible business expenses that generated an NOL for the year of payment that the corporation was able to carry back two years.

Subsequently, I came across an IRS advisory in which the taxpayer did not fare as well. The IRS considered whether amounts paid by the taxpayer in settlement of a claim qualified as “ordinary and necessary” trade or business expenses that were currently deductible, or as amounts paid to “defend or perfect title” to property that had to be capitalized.

The Reorg

Corp. was engaged in business A through its subsidiary, Sub, which was also engaged in business B.

Corp. went through a series of steps as part of a somewhat convoluted reorganization in order to separate Sub’s A business from its B business, and then to merge the B business into Taxpayer.

As a result of the reorganization, business A was spun off to Corp.’s shareholders, and Corp. was left with the stock of Sub (owning business B) as its primary asset.

Corp. then merged into Taxpayer.

The Lawsuits

At the time of the merger, Corp. and Sub were defendants in numerous lawsuits arising out of business A. Taxpayer also became a defendant in a number of lawsuits alleging that, as a result of the reorganization, it was responsible for the liabilities of the corporation (Newco) to which business A had been transferred.

The basis of these suits against the Taxpayer was either that the transfer of business B was a fraudulent transfer or that the reorganization transaction resulted in successor liability for Taxpayer.

The lawsuits settled, and the settlement provided for Taxpayer (which indirectly owned business B) to transfer the sum of $X million in cash, together with Y million shares of Taxpayer’s common stock, in exchange for a release from all claims under the litigation.

These payments were made to one or more trusts. The transfers were not avoided.

The settlement did not state an allocation of the transferred amounts among the various claims in the complaint.

Taxpayer’s Request

Taxpayer sought approval of its intention to deduct, on its income tax return for the year in which the payments were made, the amounts transferred to the trusts pursuant to the settlement as an ordinary and necessary business expense – that would generate an NOL in the year of payment – and to carry back the loss to the preceding tax years.

The Code provides that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The Code also provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. Regulations promulgated under the Code provide that amounts paid to defend or perfect title to property are amounts paid to acquire or produce property and must be capitalized.

Origin of the Claim

The IRS considered the tax treatment of the fraudulent conveyance claims under the “origin of the claim” test. This test generally is applied to determine whether an amount incurred in litigation is currently deductible. Thus, the substance of the underlying claim or transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure.

In applying the origin of the claim test, a taxpayer’s purpose in undertaking or defending a particular piece of litigation is not relevant. The origin of the claim test is an objective inquiry to determine the origin and character of the claim, taking into account all of the facts and circumstances. Thus, while amounts paid by a business in connection with business-related litigation generally are deductible as ordinary and necessary expenses (as described in the first paragraph of this post), amounts with their origin in a capital transaction are required to be capitalized under the origin of the claim test.

According to the IRS, litigation costs incurred to defend or perfect title to property were capital expenditures that were not deductible as ordinary and necessary business expenses. The IRS looked to the nature and objectives of the litigation as evidenced by the various counts of the complaint and other language in the complaint to determine the origin of the claims, noting that the counts included claims for fraudulent transfer. These included transfers made with the intent to hinder, delay, defraud creditors, as well as assertions that assets were unfairly or improperly transferred from the debtor, for inadequate consideration at a time when the debtor was insolvent or nearly so (or made insolvent by the asset transfers), thereby draining the pool of assets available to satisfy creditors’ claims from the debtor’s bankruptcy estate.

The IRS Ruling

The settlement agreement did not allocate the amounts amongst the various claims. The IRS determined that, to the extent that settlement amounts were attributable to the fraudulent conveyance claims, they were not deductible business expenses, based on the application of the origin of the claim analysis. Fraudulent conveyance claims have their origin, the IRS said, in a defense of title to property because they seek to restore improperly transferred property back to the bankruptcy estate for the benefit of creditors; the dispute in each claim is over ownership of, or title to, property.

The IRS stated that Taxpayer could not point to the first in the chain of events that was the reason for the reorganization and asset transfer – a liability that arose out of the operation of business A, the payment of which would have generated a business deduction. Because the settlement payment had its origin in a fraudulent conveyance claim, the essence of the action was a claim for the return of property or a payment in lieu thereof. Part of the controversy settled in the case was over a dispute regarding ownership of property. Amounts paid in settlement of such claims were capital in nature, the IRS stated. Therefore, the amounts attributable to the fraudulent conveyance claims were not deductible.

Facts & Circumstances – And Timing

What a difference they make.

Of course, if the above reorganization had not occurred, any payments made in settlement of the lawsuits would probably have been deductible since the acts that gave rise to the litigation were performed in the ordinary conduct of the taxpayer’s business. Query, however, how different the terms of the settlement may have been.

Let’s change the facts, above. What if the corporate taxpayer had completely liquidated prior to the settlement of the claims? Assume, for example, that as part of its plan of liquidation, it had transferred some of its assets to a trust to meet both known and contingent claims against the corporation arising out of business A,  recognizing that they could not be settled in the short-term.

For purposes of the income tax, it is likely that the corporation’s shareholders would be treated as having constructively received these assets in a taxable distribution (reduced by the amount of the known liabilities), and then as having directed them to the trust for their own benefit (a grantor trust).

But what if, in a subsequent year, the trust discharged a contingent liability of the corporation? In that case, the discharge would give rise to a capital loss in the year of the discharge (to offset the earlier capital gain realized by the shareholders in the liquidation), notwithstanding that the claim arose out of the operation of the corporation’s business. The origin of the claim was the liquidating distribution to the shareholders, not the business-related liability.

As a business or legal matter, there were probably several avenues that the players in the above IRS ruling could have pursued in settling the litigation. Unfortunately, it appears that Taxpayer did not properly consider the potential tax exposure, and the resulting economic cost, that were generated by its acquisition of business B, including the exposure arising out of the settlement of the ongoing litigation. If it had, query whether the terms of the acquisition would have been different so as to account for the additional economic risk and cost.