Shirley Dennis-Escoffier Shirley Dennis-Escoffier, Ph.D., CPA, is an associate professor of accounting at the University of Miami in Coral Gables, Florida. She previously worked in public accounting and for several corporations. She has published numerous articles in tax journals. Good News, Bad News IRS 155 I n the usual mix of things in the tax world, taxpayers have won one and lost one. The win is that a stay-on-premises policy can result in tax-free meals for employees while yielding a 100-percent deduction for employers. The loss is in an Internal Revenue Service (IRS) ruling that no amortization will be allowed for business investigation expenses incurred after the acquisition decision has been made. Under this ruling, costs incurred after the taxpayer decides whether to enter a new business and which new business it will enter or acquire must be capitalized, even if a legally binding obligation to acquire another business does not yet exist. Lets start with the bad news and close with the good news. BUSINESS INVESTIGATION COSTS Taxpayers starting a new business or expanding an existing one incur a variety of costs. Some of these costs will be currently deductible as ordinary and necessary business expenses (under Code Section 162), others will be capitalized (Section 263), and some will be eligible for 60-month amortization (under Section 195). Determining the proper characterization of an expense can be challenging because the classification depends on the facts and circumstances of each case. Qualifying investigation costs may, at the election of the taxpayer, be amortized over a period of not less than 60 months (beginning in the month the business begins). If no election is made to amortize, the costs are just capitalized. Qualifying investigation expenses for 60-month amortization is particularly important in a stock acquisition because capitalizing amounts paid in connection with an acquisition of stock is tantamount to never recovering those costs or recovering them so far in the future that their present value is insignificant. Under Code Section 195, expenses eligible for 60-month amortization include those costs paid or incurred in connection with investigating the creation or acquisition of any active trade or business. To be amortizable, these costs must pass an additional hurdle. They must be expenses that would, if Shirley Dennis-Escoffier 156 The Journal of Corporate Accounting and Finance/Autumn 1999 incurred in connection with the operation of an existing active trade or business in the same field, be currently deductible. Investigation costs include costs incurred in reviewing a prospective business before reaching a final decision to acquire or enter that business, such as expenses to analyze or survey potential markets, products, labor supply, transportation facilities, and similar expenditures. Qualifying expenses do not include amounts paid or incurred as part of the acquisition cost of a business or the cost of buying depreciable or amoritzable assets; these costs must be capitalized. Revenue Ruling 99-23 IRS has now established a new rule for deciding whether a cost is a qualifying investigation expense. Under this new interpretation, expenses to determine whether to enter a new business and which new business to enter (other than costs incurred to acquire capital assets used in the search or investigation) are investigation costs that are qualifying expenses amortizable under Code Section 195. In contrast, costs incurred in an attempt to acquire a specific business do not qualify under Section 195 and must be capitalized. IRS says whether an expense is an investigation cost to facilitate the whether and which decision or an acquisition cost to facilitate consummation of the acquisition, will depend on all the facts and circumstances of the transaction. An example of costs that must be capitalized as part of the acquisition cost would be paying lawyers to draft regulatory approval documents. After the decision has been made to acquire a company, due-diligence costs incurred to review its internal documents, books, and records, and to draft acquisition agreements must also be capitalized as part of the acquisition cost. IRS points out that the label used by the parties to describe the cost, the point in time at which the cost is incurred, and the point at which the parties are legally obligated to complete a transaction, do not necessarily determine the nature of the cost. They will look through these labels to determine the true nature of the expenditure and if it came before or after the whether and which points occurred. Revenue Ruling 99-23 includes three examples to illustrates its conclusions: Example 1: In April, X Corporation hired an investment banker to investigate the possibility of buying a business unrelated to its existing business. The banker researched several industries and evaluated publicly available financial information relating to several businesses. After X narrowed its focus to one industry, the investment banker evaluated several businesses within that industry, including V Corporation and several of Vs competitors. The banker then commissioned appraisals of Vs assets and an in-depth review of its books and records to determine a fair acquisition price. In November, X entered into an agreement to purchase all of Vs assets. Before that date, X did not prepare or submit a letter of intent or any other preliminary written document indicating its intent to buy V. In its ruling, IRS states that the costs relating to the appraisals of Vs assets and in-depth review of Vs books and records to establish the purchase price facilitated the consummation of the acquisition and must therefore be capitalized as part of the acquisition cost. The costs incurred to conduct industry research and to evaluate publicly available financial information are investigation costs eligible for amortization under Section 195. The costs incurred to evaluate V and Vs competitors also may be investigation costs, but only to the extent they were IRS The Journal of Corporate Accounting and Finance/Autumn 1999 157 incurred to assist X in determining whether to acquire a business and which business to acquire. If the evaluation of V and Vs competitors occurred after X had made its decision to acquire V (for example, in an effort to establish the purchase price for V), such evaluation costs are nonamortizable capital acquisition costs. Note that these conclusions would be the same even if Xs internal staff had done the investigation work . Example 2: In May, W Corporation began searching for a business to acquire. In anticipation of finding a suitable target, it hired an investment banker to evaluate three potential businesses and a law firm to begin drafting regulatory approval documents for a target. W Corporation decided to buy X Corporations assets and entered into an acquisition agreement with it in December. IRS concludes that Ws costs of evaluating potential businesses are investigation costs eligible for 60-month amortization to the extent they related to the whether and which decisions. However, the costs of drafting regulatory approval documents are not amortizable, even though these activities took place during the general search period, because they were incurred to facilitate an acquisition rather than to investigate whether to buy and which business to buy. Example 3: In June, Y Corporation hired a law firm and an accounting firm to help in the potential acquisition of Z Corporation by performing preliminary due diligence services including researching Zs industry and its competitors and analyzing Zs financial projections. In September, Y asked its lawyers to prepare and submit a letter of intent to Z. The offer resulted from prior discussions and specifically said that a binding commitment would result only upon the execution of an acquisition agreement. After that point, the lawyers and accountants continued to perform due diligence services including a review of Zs internal documents and records and preparation of an acquisition agreement. In October, Y signed an agreement to buy all of Zs assets. IRS states that Y made its decision to buy Z in September, around the time when it told its lawyers to prepare and submit the letter of intent. As a result, the cost of preliminary due diligence services provided prior to that time (including the costs of conducting research on Zs industry and in reviewing financial projects of Z) are amortizable investigation costs. However, the due diligence costs incurred to review Zs internal documents, to review their book and records, and to draft the acquisition agreements are not eligible for amortization under Section 195 and must be capitalized under Section 263 as acquisition costs. It is strongly recommended that any taxpayer investigating the purchase of a business instruct employees, as well as the outside professionals it engages, to keep detailed records delineating time and money spent on (1) general or preliminary investigation expenses and (2) acquisitionrelated expenses incurred after a purchase decision has been made. Without detailed records, IRS may require capitalization for what should be qualifying Section 195 expenditures. STAY-ON-PREMISES POLICY RESULTS IN FAVORABLE TREATMENT FOR EMPLOYEE MEALS A year ago this column reported on the Tax Courts Boyd Gaming Corporation decision regarding tax treatment for employee meals. Recently, the Ninth Circuit Court of Appeals reversed the Tax Courts decision and held that a casino could deduct 100 percent of the cost of providing free on-premises meals to Shirley Dennis-Escoffier 158 The Journal of Corporate Accounting and Finance/Autumn 1999 employees while these meals are tax-free to the employees. The key to this win was the casinos requirement that its employees remain on-premises during their shifts for valid business reasons. Under Section 274(n), an employer can usually deduct only 50 percent of the otherwise allowable cost of business meals. However, an employer may deduct 100 percent of the cost of meals furnished in a Section 119 employer-provided eating facility (one provided for valid business reasons for the convenience of the employer) as a tax-free de minimis fringe benefit under Section 132. This decision could mean tax savings for any employer that provides employee meals to facilitate a stay-on-premises policy. Background In 1997, the Tax Court (in Boyd Gaming Corp. et al. v. Commission, 74 TCM 759, following their previous decision in 106 TC 343) held that the taxpayers in Boyd Gaming were not entitled to deduct 100 percent of the cost of the employer-provided meals because the casino did not furnish meals to each of substantially all of their employees for a substantial noncompensatory business reason under Section 119. The IRS then issued a Technical Advice Memorandum indicating that a 90-percent threshold was necessary to meet the substantially all test. The gaming industrys response was to get a statutory fix under which the entire facility would qualify under Section 119 if the majority (more than 50 percent) of the meals were served for noncompensatory business reasons. Specifically, the IRS Restructuring and Reform Act of 1998 lowered the substantially all threshold to 50 percent by providing that if more than half of the meals are furnished on the premises for the convenience of the employer, then the employer gets the full deduction. New Ninth Circuit Decision In its recent decision (Boyd Gaming Corp. et al. v. Commissioner, 99-1 USTC 50,530), the Ninth Circuit ruled that the taxpayer could deduct 100 percent of the cost of providing employees with meals. The court held that once the stay- on-premises policy (one that requires employees to remain on the premises during their entire shift) was adopted, employees had no choice but to eat on the premises. The furnished meals were indispensable to the proper discharge of their duties, and the convenience of employer test was therefore met. The appellate court reached its decision to allow a 100-percent deduction using the following reasoning: If more than half the meals provided at the on-premises eating facility are provided for the employers convenience, then the balance of the meals also are treated as provided for the employers convenience, even those meals that were not supplied for the convenience of the employer. Once all the meals are deemed to have been provided for the employers convenience, they are all tax-free to the employees under Section 119. Because all the meals are tax-free to the employees under Section 119, the employer-operated eating facility will automatically qualify as a de minimis fringe benefit under Section 132. Because the employer-operated eating facility will automatically qualify as a de minimis fringe benefit under Section 132, all the expenses in operating it will be deductible since an employer may fully deduct the cost of meals that are tax-free de minimis fringe benefits under Section 132. IRS The Journal of Corporate Accounting and Finance/Autumn 1999 159 The Ninth Circuit cautioned that simply saying that a business had an on-premises policy would not be enough to justify a 100-percent meal deduction. Boyd Gaming did support its policy with adequate evidence of legitimate business reasons. The Ninth Circuit Court elaborated that although reasonable minds might differ on whether the policy was necessary for security and logistics (as argued by Boyd Gaming), the court said it would not second-guess the taxpayer. IRS has since announced (Announcement 99-77) its acquiescence to the Ninth Circuits decision saying it will not challenge whether meals provided to employees of similar businesses meet the Section 119 convenience-of-employer test where business policies and practices would otherwise prevent employees from getting a proper meal within a reasonable meal period. IRS also said that a bona fide and enforced policy requiring employees to stay on the employers business premises during their normal meal period is only one example of the type of business practice that could result in an exclusion for employer-provided meals. Another example could be a practice requiring checkout procedures for employees leaving the premises to address the same type of security concerns that were relevant in Boyd Gaming. IRS seems to suggest that if employees would rather have a meal on premises than have to go through one security check on the way out to get lunch, and another at the end of their shift, then on-premises eating facilities can qualify. IRS also indicated that when applying the business meal rules of Section 119 to any business, it would not second-guess the taxpayers judgment on which business practices are best suited to its needs. The acquiescence, and IRSs statement that it would take a relaxed stance for other, noncasino businesses, could mean tax-savings for any employer that provides in-house meals to facilitate a stay-on-premises rule. IRS did emphasize that an employer cannot justify a 100-percent deduction by simply saying it has a stay-on-premises policy. The Service will consider whether such a policy is reasonably related to the needs of the employers business (other than a mere desire to provide additional compensation) and whether the policy is in fact followed in the actual conduct of the business. However, if reasonable procedures are adopted and applied, and they preclude employees from getting a proper meal off-premises during a reasonable meal period, the meals will be tax-free for employees and 100-percent deductible for employers. Recommendations Employers in situations similar to that of Boyd Gaming may consider filing refund claims if they have been claiming only a 50-percent deduction for on- premises employee meals. If more than half of the meals provided meet the business necessity test, 100 percent of the employee meal cost is deductible. There could also be payroll tax refunds due an employer because the qualifying meals would be excludable from employee income. Additionally, income tax and payroll tax refunds may also be due to employees if meals were reported as taxable income and can now be retroactively reclassified as tax-free. Employers that have not provided employees with free meals in the past may now consider doing so. Employers who are competing for employees in hotels, restaurants, hospitals, or other businesses that have been or will be taking Shirley Dennis-Escoffier 160 The Journal of Corporate Accounting and Finance/Autumn 1999 advantage of this approach to employee meals may face a competitive disadvantage in the future if they do not provide free meals. Free meals with no employee tax consequences can, all other things being equal, make one job more attractive to employees than another. Similarly, the employers ability to deduct 100 percent of the cost of meals rather than only 50 percent will allow more compensation to be paid to employees or more profit to flow to the bottom line. Qualifying employers should definitely consider taking advantage of the Ninth Circuits probusiness decision. o