An Illinois plastics manufacturer and its holding company couldn’t deduct the finder’s fee paid to a financial adviser that suggested the business as a potential acquisition candidate to a Canadian pension plan.
Plano Molding Co. couldn’t deduct the finder’s fee, because the fee was on behalf of the purchaser, the Ontario Teachers’ Pension Plan Board (OTPP), and wasn’t an ordinary business expense of Plano, the U.S. Tax Court ruled Oct. 16 in Plano Holding LLC v. Commissioner.
Plano Molding Co. specialized in the manufacture of plastic storage equipment for outdoor sports. In February 2007, Tinicum Capital Partners, an investment firm, became Plano’s majority shareholder.
In 2012, Robert W. Baird & Co., Inc., suggested Plano as a potential acquisition candidate to the OTPP, a major institutional investor.
On July 26, 2012, Plano retained Harris Williams LLC as investment banker and financial adviser. OTPP organized Plano Holding LLC and Plano Acquisition LLC as Delaware limited liability companies. On Nov. 20, 2012, these two entities entered into a merger agreement to bring Plano “into the OTPP fold” as a wholly-owned subsidiary of Holding. The deal closed on Dec. 21, 2012.
When the deal closed, Plano made two different payments to purported financial advisers. Plano first paid Harris Williams a fee of roughly $2.89 million for its services in connection with the merger. Plano also paid $1.5 million to Baird, pursuant to a Nov. 28, 2012, agreement between Baird and OTPP. The November 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 between representative of OTPP and Plano.
The agreement provided that Baird’s services were rendered “solely for the benefit and use of OTPP’s management and directors in considering the transaction(s) to which they relate.” In summary, Baird’s sole activities regarding the acquisition consisted of (1) suggesting Plano as an acquisition target to OTPP, (2) gauging Tinicum’s interest, and (3) attempting to set up a lunch between OTPP and Tinicum representatives. At no time, the court noted, did Baird provide any financial advisory services (or other services) to OTPP with respect to the acquisition.
Holding, Plano, and certain other affiliated corporations filed a consolidated federal income tax return for 2012 in which 70% of the Baird fee (i.e., $1.05 million) was deducted (with the balance capitalized) pursuant to an election under Revenue Procedure 2011-29, which permits taxpayers to elect, no questions asked, to deduct 70% of the amount of an otherwise “facilitative” success fee, and requires the capitalization of the remainder of the fee. The Internal Revenue Service disallowed the deduction.
‘Lohrke’ Tests Not Satisfied
Tax code Section 162(a) provides a deduction for all of the ordinary and necessary business expenses paid or incurred during the taxable year in carrying on any trade or business. To be deductible, the expenses must be “directly connected with or pertaining to the taxpayer’s trade or business.”
A taxpayer, generally, may not deduct the payment of another person’s expenses. We have, the court noted, “recognized a narrow exception to this rule where (1) the taxpayer’s primary motive for paying the other’s obligations 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. See Lohrke v. Commissioner.
Here, OTPP entered into an agreement to pay Baird $1.5 million, which means that a deduction was sought for a payment Plano made on behalf of another. “We thus look to Lohrke,” the court said.
To establish that it acted primarily to benefit its own business, the taxpayer must “demonstrate a direct nexus between the purpose of the payment and the taxpayer’s business or income-producing activities.” See Bone v. Commissioner. Where, as here, the party making the payment and the beneficiary of the payment were a corporation and a controlling shareholder, respectively, the corporation’s payment of the shareholder’s expense is “closely scrutinized.”
Holding suggested that Plano made the Baird payment to facilitate its acquisition by OTPP, as would—and did—allow Plano to expand. Holding, however, failed to establish a direct link between the ostensible business purpose (i.e., Plano’s acquisition by a deep-pocketed investor) and the Baird payment. Holding did not contend that the merger was in any way contingent on Plano’s picking up OTPP’s tab to Baird. Nor did Holding demonstrate any direct and proximate adverse consequences that would have befallen Plano’s business of manufacturing plastics had it not covered OTPP.
In fact, the court remarked, “we discern no benefit to Plano from the Baird payment, as distinguished from the merger itself.” The record, the court concluded, “convinces us that the primary benefit from the Baird payment redounded to OTPP, an institutional investor with a strong interest in rewarding and developing productive relationships with companies that bring attractive acquisition candidates to its sight.” Holding, therefore, failed to satisfy the first prong of the two-pronged Lohrke analysis.
The Baird payment, the court observed, is in the nature of a “finder’s fee” that OTPP decided to bestow months after the fact. Were we looking, the court said, at the business of an institutional investor, like OTPP, “we very well might conclude that a fee of this sort…would be an ordinary and necessary expense that could be deducted” (but not if the fee was found to be an amount paid or incurred to facilitate any of the transactions enumerated in Treasury Regulation Section 1.263(a)-5(a)). But, the court lamented, “we are not.” Plano’s business is manufacturing plastic goods. Holding, the court said, “fails to persuade us that such a payment qualifies as either ordinary or necessary to that line of business.”
OTPP acted on its own behalf, not on behalf of Plano, in agreeing to the Baird payment, thus distinguishing this case from Square D v. Commissioner (on which Holding heavily relied) where, unlike here, the recipient of the benefit was the very taxpayer who made the disputed payment and claimed the deduction. OTPP agreed to the payment for its own reasons and on its own behalf. Accordingly, Square D is of no moment. Holding, the court concluded, failed to establish the applicability of the Lohrke exception. Accordingly, Plano’s payment of the Baird fee was not deductible as an ordinary and necessary business expense within the meaning of Section 162(a).
Underpayment Penalty Assessed
Pursuant to Section 6662(a), a taxpayer may be liable for a penalty of 20% of an underpayment of tax attributable to a “substantial understatement of income tax.” Holding did not contest the fact that there was such a substantial understatement but argued that the penalty should not apply because “substantial authority” supported the deduction. The court disagreed.
The facts in each of the authorities cited by Holding (including the Square D case and Private Letter Ruling 200953014, Dec. 31, 2009) are “materially distinguishable” from the facts of the instant case. Accordingly, Holding failed to establish that it had substantial authority in support of the treatment of the Baird fee in the 2012 consolidated tax return.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.