1

The Honorable William Brevard Hand, United States District Judge for the

Southern District of Alabama, sitting by designation.

United States Court of Appeals

FOR THE EIGHTH CIRCUIT

___________

No. 99-3307

___________

WELLS FARGO & COMPANY )

AND SUBSIDIARIES, )

)

Petitioner-Appellant, )

) Appeal from the United

v. ) States Tax Court.

)

COMMISSIONER OF INTERNAL )

REVENUE, )

Respondent-Appellee. )

___________

 Submitted: June 12, 2000

Filed: August 29, 2000

___________

Before LOKEN and BRIGHT, Circuit Judges, and HAND1

, District Judge.

___________

HAND, United States District Judge for the Southern District of Alabama, sitting by

designation.

This case is before the Court on appeal from the Tax Court, which determined

that $150,000 worth of salaries paid to Davenport's corporate officers must be
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capitalized, rather than deducted fully during the year in which the salaries were paid.

The Tax Court also held that $111,270 of fees and disbursements paid to Davenport's

attorneys must capitalized. The Tax Court determined that the United States Supreme

Court case, INDOPCO, Inc. v. Commissioner, required capitalization of these

expenses. 503 U.S. 79 (1992). It is this Court's determination that the Tax Court is

due to be REVERSED IN PART.

FACTUAL HISTORY

For the purposes of this decision, the Court hereby adopts most of the facts

found by the Tax Court. The following are the facts, as found by the Tax Court, with

only minor changes (noted in brackets), which are made to facilitate continuity within

this opinion.

1. General Information

Norwest is a bank holding company that was incorporated in 1929.

It is the parent corporation of an affiliated group of corporations (Norwest

consolidated group) that files consolidated Federal income tax returns. Its

affiliates include 79 commercial banks in 12 States and numerous other

corporations which provide financial services. Norwest's stock is traded

on the New York and Midwest Stock Exchanges.

Bettendorf Bank, National Association ([Bettendorf]), is a member

of the Norwest consolidated group. [Bettendorf] is a national banking

association operating under a charter granted by the Office of the

Comptroller of the Currency (OCC). [Bettendorf] conducts a general

banking business from its main office in Bettendorf, Iowa, and from two

branches, one in Bettendorf and the other in Davenport, Iowa.

[Davenport] is an Iowa State bank that was incorporated in 1932.

Before the transaction (defined below), it provided banking and related

services in the four-city area that consists of Davenport, Bettendorf, Rock

Island, Illinois, and Moline, Illinois (Quad Cities area). Its main office

was in Davenport, and it had four branches, three in Davenport and one

in Donahue, Iowa. It filed a consolidated Federal income tax return with

two wholly owned subsidiaries.
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[Davenport]'s only class of stock was thinly traded in the

Davenport over-the-counter market. It had 1.2 million shares outstanding,

and [Davenport]'s founder (V.O. Figge) and his five children (collectively,

the Figges) owned, collectively and beneficially, the following numbers

and percentages of these shares:

 

 Number Percentage 

 ------- ---------- 

 

V.O. Figge 41,843 3.5 

John K. Figge 61,140 5.1 

James K. Figge 63,450 5.3 

Thomas K. Figge 71,855 6.0 

Ann Figge Brawley 77,890 6.5 

Marie Figge Wise 69,655 5.8 

 ------- ---------- 

 385,833 32.2 

 

[Davenport]'s directors and executive officers, other than the Figges,

owned another 69,727 (5.8 percent) of these shares on September 18,

1991.

 2. The Transaction

In 1989, Iowa adopted interstate banking legislation that allowed,

for the first time, the acquisition of Iowa banks by banking institutions

located in States which were contiguous with Iowa and which had

enacted reciprocal legislation. [Davenport]'s management expected that

national banking would follow and that many large banks, including some

from outside Iowa, would be competing in the Quad Cities area.

[Davenport]'s management was concerned that banks of [Davenport]'s

size (i.e., larger than the small community banks and smaller than the

large regional banks) would be unable to compete in the future.

During 1990, Norwest began talking to [Davenport] about joining

their businesses, and these discussions intensified in early 1991.

[Davenport] retained the law firm of Lane & Waterman (L & W) to assist
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it in these discussions. L & W investigated whether [Davenport] would

strategically fit with Norwest and its affiliates, and whether a

reorganization between [Davenport] and Norwest would be good for the

community.

On June 10, 1991, [Davenport]'s board of directors met to consider

merging [Davenport] into Norwest. Over V.O. Figge's objection to the

merger, the board authorized John K. Figge, James K. Figge, and Thomas

K. Figge, in their capacities as executive officers, to negotiate with

Norwest and to hire legal and other representatives with the intent to

recommend to [Davenport]'s board a letter of intent between [Davenport]

and Norwest on a plan of reorganization. The board also appointed an ad

hoc committee (special committee) consisting of four outside directors to

perform an independent due diligence review, to obtain professional

advice, and to report to [Davenport]'s board as to the fairness and

appraisal of the proposed transaction. Norwest's board of directors, on the

same day, authorized using up to 10 million shares of Norwest common

stock to effect a transaction with [Davenport].

[Davenport] retained J.P. Morgan & Co., Inc., as its financial

adviser for any transaction with Norwest and to render an opinion as to

the fairness of the consideration that [Davenport]'s shareholders might

receive in the transaction. [Davenport] retained KPMG Peat Marwick to

render opinions primarily on whether the proposed transaction would be

a reorganization for Federal income tax purposes, and whether the

proposed transaction would qualify for a desired method of accounting.

On July 22, 1991, [Davenport]'s board met to consider a

transaction (transaction) whereby [Davenport] and [Bettendorf] would be

consolidated to form a national bank (New Davenport) which would be

wholly owned by Norwest. At the meeting, the special committee

recommended that the transaction be approved, and J.P. Morgan opined

that the transaction was fair to [Davenport]'s shareholders from a financial

point of view. [Davenport]'s board approved the transaction. On the same

day, [Bettendorf]'s board approved the transaction.

Four other events also occurred on July 22, 1991, with respect to

the transaction. First, Norwest, [Bettendorf], and [Davenport] entered into

an agreement (agreement) whereby they agreed to the transaction subject

to regulatory approval, approval of [Davenport]'s and [Bettendorf]'s

shareholders, and the satisfaction of certain conditions which included: (1)
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The receipt of regulatory approvals, including the approval of the OCC,

without any requirement or condition that Norwest would consider unduly

burdensome, and (2) the receipt of Peat Marwick's opinions that the

transaction would qualify for the desired method of accounting and as a

tax-free reorganization.

Second, Norwest entered into voting agreements with certain

[Davenport] shareholders. These shareholders held 24.5 percent of

[Davenport]'s stock and included John Figge, James Figge, Thomas Figge,

and other members of the Figge family. The voting agreements provided

that these shareholders would vote their shares in favor of the transaction

and that they would help Norwest complete the transaction.

Third, [Bettendorf] entered into employment agreements with V.O.

Figge, John Figge, James Figge, Thomas Figge, and Richard R. Horst.

The employment agreements provided that the five listed people would

be employed as officers of New Davenport for 1 year at the same salaries

they were receiving from [Davenport]. The parties to the transaction

contemplated that John Figge, James Figge, and Thomas Figge would

become senior vice presidents of New Davenport and that the members

of [Davenport]'s board would become members of New Davenport's

board. Norwest agreed to cause John Figge to be elected to its board.

Fourth, Norwest issued a press release announcing that it had

agreed with [Davenport] to acquire [Davenport]. The release, quoting

V.O. Figge, stated in part: 

 After extensive deliberations, the Board [of [Davenport] has

determined that it is in the best interests of Davenport Bank

and its stockholders, customers, employees, and the

community it serves, to become part of a larger and more

diversified financial institution that offers local, national and

international resources through what might be termed a

personal hometown presence * * *

 * * * * * * *

It is for these reasons that the board has given careful

consideration to a merger with an organization that

competes aggressively on a regional and national basis, and

can provide the Quad-Cities with a broader array of banking

products and services.
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Following the signing of the agreement, Norwest commenced a due

diligence review on [Davenport] and on [Davenport]'s business activities.

[Davenport] employees and L & W helped Norwest perform the review,

which lasted throughout August. L & W primarily acted as the contact for

both Norwest and [Davenport].

On or about August 29, 1991, Norwest applied to the OCC for

approval to consolidate [Davenport] and [Bettendorf]. At or about the

same time, a prospectus was filed with the Securities and Exchange

Commission (SEC) for the issuance to [Davenport] shareholders of up to

10 million shares of Norwest common stock upon the consummation of

the transaction. The prospectus also served as the proxy statement for a

special meeting (special meeting) of [Davenport]'s shareholders to be held

on November 26, 1991, for the purpose of voting on the transaction. The

SEC approved the proxy statement, and it became effective on October

23, 1991. On the effective date, [Davenport] notified its shareholders of

the special meeting, advised them that its board recommended voting in

favor of the transaction, and mailed them a copy of the proxy statement.

On November 20, 1991, [Bettendorf]'s board called a special

shareholder meeting for December 19, 1991, for the purpose of voting on

the transaction.

At the special meeting on November 26, 1991, [Davenport]'s

shareholders approved the transaction. Approximately 3 weeks later,

[Bettendorf]'s shareholders approved the transaction.

On or about January 29, 1992, the OCC approved [Davenport]'s

consolidation with [Bettendorf], effective January 19, 1992. Shortly

before the approval, [Davenport] and [Bettendorf] had entered into an

agreement providing that the transaction would be effective as of 12:01

a.m. on the date that it was approved by the OCC. Thus, on January 19,

1992, the transaction became effective. Among other things, (1)

[Davenport] and [Bettendorf] were merged to form a consolidated

national banking association under [Bettendorf]'s charter and under the

name "Davenport Bank and Trust Company" and (2) New Davenport

became a wholly owned subsidiary of Norwest, Norwest exchanging

9,665,713 shares of its common stock for the stock of [Davenport] (other

than fractional shares and shares with respect to which dissenter's

appraisal rights were exercised and for which $33,341 was paid) and then
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receiving all the stock of New Davenport in exchange for the stock of

[Davenport].

Following the transaction, New Davenport carried on a banking

business. New Davenport's main office was the same office as

[Davenport]'s, and New Davenport's branches were at the four locations

at which [Davenport] had formerly operated (not including the main

office) and at each of the three locations at which [Bettendorf] had

formerly operated (including the location that had been [Bettendorf]'s

main office). New Davenport offered a wider array of products and

services than [Davenport] had offered before the transaction and

continued [Davenport]'s tradition of being a charitable and community

leader.

[Davenport]'s board and management anticipated that the

transaction would produce significant long-term benefits for [Davenport]

and its shareholders, among others.

3. Costs Incurred by [Davenport] in 1991

During 1991, [Davenport] paid L & W $474,018 for services

rendered ($460,000) and disbursements made ($14,018) during the year.

[Davenport] deducted the $474,018 on its 1991 Federal income tax

return.

Petitioner concedes that [Davenport]'s $474,018 deduction was

improper, alleging that the deduction should have been $111,270.

[Davenport] paid $83,450 of the $111,270 for services rendered (and

disbursements made) before July 21, 1991, in investigating the products,

services, and reputation of Norwest and [Bettendorf], ascertaining

whether Norwest and [Bettendorf] would be a good business fit for

[Davenport], and ascertaining whether the proposed transaction with

Norwest and [Bettendorf] would be good for the Davenport community.

None of the $83,450 was for fees or disbursements related to services

performed by L & W in negotiating price, working on the fairness

opinion, advising [Davenport]'s board with respect to fiduciary duties, or

satisfying securities law requirements.

Twenty-three thousand, seven hundred dollars of the $111,270

related to services performed (and disbursements made) by L & W in late

July and August 1991 in connection with Norwest's due diligence review.

The remainder of the amount alleged to be deductible ($4,120) related to

services performed (and disbursements made) by L & W in connection
2The caption of this case on Appeal lists "Wells Fargo" as the Petition-Appellant,

rather than Norwest. This is due to another (subsequent) bank merger.

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with investigating whether Norwest's director and officer liability

coverage would protect [Davenport]'s directors and officers following the

transaction, for acts and omissions occurring beforehand. At the time of

the services, [Davenport] had a director and officer policy that was due

to expire on January 23, 1992. Norwest agreed with [Davenport] to

maintain insurance until at least January 18, 1995, that would protect

[Davenport]'s directors and officers against acts and omissions occurring

before January 19, 1992, [. . .]. Norwest eventually bought such a policy.

During 1991, [Davenport] had 9 executives and 73 other officers

(collectively, the officers). John Figge, James Figge, Thomas Figge, and

Richard Horst worked on various aspects of the transaction, as did other

officers. None of the officers were hired specifically to render services on

the transaction; all were hired to conduct [Davenport]'s day-to-day

banking business. [Davenport]'s participation in the transaction had no

effect on the salaries paid to its officers. Of the salaries paid to the

officers in 1991, $150,000 was attributable to services performed in the

transaction. [Davenport] deducted the salaries, including the $150,000, on

its 1991 Federal income tax return. Respondent disallowed the $150,000

deduction; i.e., the portion attributable to the transaction.

Norwest Corp. and Subsidiaries v. Commissioner, 112 T.C. 89 (1999) (footnotes

omitted).2

ISSUES OF LAW

The issue before this Court is twofold: 1) whether the Tax Court erred in holding

that $150,000 of Davenport's officer's salaries must be capitalized and 2) whether the

Tax Court erred in holding that $111,270 of Davenport's legal expenses associated with

its consolidation must be capitalized. These are questions of law which the Court will

review de novo.
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The Internal Revenue Code allows deductions for "all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or business."

I.R.C. §162(a). On the other hand, "§263 of the Code allows no deduction for a capital

expenditure— an 'amount paid out for new buildings or for permanent improvements

or betterments made to increase the value of any property or estate.'" INDOPCO Inc.

v. Commissioner, 503 U.S. 79, 83 (1992) (quoting I.R.C. §263). To qualify for a

deduction, "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 Savings and Loan Assoc., 403

U.S. 345 (1971). The parties to this case agree that the first four requirements are met

here. However, it is disputed whether the expenses in this case can properly be

characterized as "ordinary". 

The principle function of the term "ordinary" is to distinguish a deductible

expense from one that is capital. Commissioner v. Tellier, 383 U.S. 687, 689-90

(1966). An ordinary expense may be fully deducted during the taxable year. A capital

expenditure, on the other hand, must be depreciated over the life of the asset with

which the expenditure is associated, or, where no specific asset or useful life can be

ascertained, it is deducted upon dissolution of the enterprise. INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 83-84 (1992). The Tax Court determined that none of the

expenses at issue here were ordinary. Therefore, the Tax Court held that all of the

expenses must be capitalized rather than deducted. For the reasons set forth below, the

Tax Court's decision is due to be REVERSED.

Supreme Court Precedents

The Tax Court erred in its interpretation of the INDOPCO case. In order to most

effectively explain the Tax Court's error in logical reasoning, this Court will first

analyze another Supreme Court case, Lincoln Savings, which spurred similar logical
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fallacies among the Circuit Courts of Appeals. Eventually, the Supreme Court decided

INDOPCO in an attempt to clarify the meaning of Lincoln Savings.

Lincoln Savings

In 1971, the Supreme Court decided the case of Commissioner v. Lincoln

Savings and Loan Assoc., 403 U.S. 345 (1971). In Lincoln Savings, the issue was

whether a Savings and Loan association could deduct an "additional premium" which

it paid to the Federal Savings and Loan Insurance Corporation (FSLIC). Initially

Savings and Loan companies were only required to pay one premium to the FSLIC.

However, beginning January 1, 1962, the insureds were required to pay two premiums.

The first premium funded the Primary Reserve, which was a general insurance fund for

all participants. The "additional premium" funded the Secondary Reserve, of which

Lincoln held a pro rata share. In other words, Lincoln had an actual property interest

in the Secondary Reserve. For reasons more fully explained in the text of the Lincoln

Savings decision, the Supreme Court determined that the "additional premium" paid by

Lincoln created or enhanced a separate and distinct additional asset for Lincoln. One

of the arguments put forth by Lincoln was "that the possibility of a future benefit from

the expenditure does not serve to make it capital in nature as distinguished from an

expense." Id. at 354. Responding to this argument, the Court stated, "the presence of

an ensuing benefit that may have some future aspect is not controlling; many expenses

concededly deductible have prospective effect beyond the taxable year." Id. Justice

Blackmun continued: "What is important and controlling, we feel, is that the [additional

premium] payment serves to create or enhance for Lincoln what is essentially a

separate and distinct additional asset and that, as an inevitable consequence, the

payment is capital in nature and not an expense, let alone an ordinary expense,

deductible under §162(a). . . ." Id. 

No less than five of the Federal Circuit Courts of Appeals erroneously

interpreted the above quoted language from Lincoln Savings to mean that the Supreme
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Court had adopted a new test for determining whether an expenditure was currently

deductible or must be capitalized. See e.g. Briarcliff Candy Corp. v. Commissioner,

475 F.2d 775 (2nd Cir. 1973); NCNB Corp. v. United States, 684 f.2d 285 (4th Cir.

1982); Central Texas Savings & Loan Assoc. v. United States, 731 F.2d 1181 (5th Cir.

1984); Colorado Springs National Bank v. United States, 505 F.2d 1185 (10th Cir.

1974); First Security Bank of Idaho v. Commissioner, 592 F.2d 1050 (9th Cir. 1979)

(adopting the 10th Circuit's Colorado Springs decision). Each of these Circuits, in

response to the Lincoln Savings decision, adopted a new "separate and distinct

additional asset" test, or some variation thereof. The new test permitted necessary

business expenditures to be fully deducted during the taxable year unless the

expenditure created or enhanced a separate and distinct additional asset.

The Courts which adopted this new test tended to focus on two assertions made

by Justice Blackmun: 1) the presence of a "future benefit" characteristic is "not

controlling", and 2) it was important and controlling that a separate and distinct asset

had been created by the expenditure. See Briarcliff, 475 F.2d at 782; NCNB Corp.,

684 F.2d at 289, 291; Central Tex. Sav., 731 F.2d at 1184; Colorado Springs, 505 F.2d

at 1192. These Circuits misunderstood Lincoln Savings to hold that only expenditures

which created or enhanced a distinct asset should be capitalized, and all other

expenditures, regardless of their "future benefit" characteristics, should be deducted.

Such a mistake in logic is quite simple and all too common. However, the

impact of such a fallacy is dramatic. "In order to give precision to our ideas and

eliminate the risk of confusion resulting from the somewhat vague meanings attached

to words in ordinary usage, it is sometimes helpful to use arbitrary symbols in place of

words." WADDELL, WARD JR., STRUCTURE OF LAWS:AS REPRESENTED BY SYMBOLIC

METHODS 1 (1961). Therefore, to simplify this analysis we can speak in terms of logic

equations and diagrams, using the following symbols:
3The "squiggly" line (-) is properly known as the "not" symbol. Therefore, -A

is read "not A".

4We can say that -C is equal to a deduction because we are assuming all other

requirements for deduction are present. If the expense is ordinary, then it will not be

capitalized but will instead be deducted.

5

In fact, this expression is best symbolized as: AoC. See WADDELL, Supra at

4. However, for the ease of readers who are unaccustomed to interpreting many of the

symbols used in logical equations, the body of this opinion will intermix language with

symbols. 

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 A = physical capital ASSET created or enhanced;

-A

3

 = NO physical capital ASSET created or enhanced;

 B = BENEFIT beyond the taxable year;

-B = NO Benefit beyond the taxable year;

 R = the expense is directly Related to B;

-R = the expense is only indirectly Related to B;

 C = CAPITALIZE;

-C = do NOT Capitalize =4

 D = DEDUCT.

Lincoln Savings, held that if an expenditure creates or enhances a separate and distinct

physical asset, then you must capitalize that expenditure. Lincoln Savings 403 U.S. at

354 (because the payments created or enhanced a capital asset, "as an inevitable

consequence, the payment is capital in nature. . . ." (emphasis added)). In other words,

"if A then C".5 The mistake in logic occurs when courts misread "if A then C" as if it
6Once again the proper symbolic expression is: C A (which is properly read,

"C, if, and only if, A.") Id. For ease of reading, we will simply substitute the phrase

"only if A then C" for the term C A. Symbolically however, it is clear that (AoC)

(C A).

7-Ao-C. Id.

8AoC is not necessarily equivalent CoA.

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read "only if A then C".6 Clearly, the two statements are different and yield different

results. Another way to misstate the holding of Lincoln Savings is to say "if -A then

-C,"7 but this too is not interchangeable with the actual holding, "if A then C." An

equally poor reading of the term "if A then C", would be "if C then A."8 Unless two

terms are proven to be reflexive of one another, they can not be haphazardly

interchanged. And yet these are the very mistakes in logic that some Circuits were

laboring under while misinterpreting Lincoln Savings. By establishing a "new test"

which would not require capitalization unless a new asset was created, those courts

were reading Lincoln Savings to hold one of the following: 1) "if C then A", 2) "only

if A then C" or 3) "if -A then -C", none of which is equivalent to the true holding, "if

A then C."

Furthermore, in Lincoln Savings, Justice Blackmun wrote, "the presence of an

ensuing benefit that may have some future aspect is not controlling; many expenses

concededly deductible have prospective effect beyond the taxable year." (emphasis

added) Lincoln Savings, 403 U.S. at 354. Using our logic terms, we can re-write this

statement: "B C." (B does not equal C.) This however, was misunderstood to mean

that B is irrelevant when trying to determine C. This simply is not true. When

determining whether a necessary business expenditure must be capitalized or deducted,

it is of critical importance to determine whether the expenditure resulted in a long term
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benefit (B). INDOPCO, 503 U.S. at 87, 88 (Justice Blackmun once again writing for

the Court). 

INDOPCO v. Commissioner

After more than twenty years of confusion and disagreement among the Circuits,

the Supreme Court issued its opinion in INDOPCO, Inc. v. Commissioner, 503 U.S.

79 (1992). Once again writing for the Court, Justice Blackmun attempted to clarify the

holding of Lincoln Savings. "Lincoln Savings stands for the simple proposition that a

taxpayer's expenditure that 'serves to create or enhance. . . a separate and distinct' asset

should be capitalized under §263. It by no means follows, however, that only

expenditures that create or enhance separate and distinct assets are to be capitalized

under §263." Id. at 86, 87. Thus, INDOPCO clearly and unequivocally demonstrates

that statements such as "only if A then C", and "if -A then -C" are false statements.

Justice Blackmun continues his explanation of Lincoln Savings by stating: "In short,

Lincoln Savings holds that the creation of a separate and distinct asset well may be a

sufficient, but not a necessary, condition to classification as a capital expenditure." Id.

at 87. So it appears that the inquiry may end once it is determined that the expenditure

DID create a separate and distinct asset (A). This would be true because, it is "an

inevitable consequence [that] the payment is capital in nature" when it "serves to create

or enhance . . . a separate and distinct additional asset." ("if A then C") Lincoln

Savings, 403 U.S. at 354. On the other hand, the inquiry continues if it is determined

that the expenditure DID NOT create a new capital asset (-A). And this was the point

of the INDOPCO case.

In INDOPCO, the Supreme Court required capitalization of expenses incurred

by the target corporation during a planned friendly takeover by another company. 503

U.S. at 90. To facilitate a friendly takeover, the taxpayer in INDOPCO paid for

investment banking services, legal services, and miscellaneous expenses directly
9This direct relationship becomes important later in the analysis.

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related to the takeover.9 Unlike the case at hand, INDOPCO was not a situation

wherein the Commissioner sought to capitalize portions of the taxpayers salary

expenditures. Citing Lincoln Savings as authority, the taxpayer in INDOPCO argued

that although the expenditures at issue were directly related to the takeover, and

provided the taxpayer with long term benefits, they did not create or enhance a separate

and distinct asset and therefore should not be capitalized. (See Pet. Br. in INDOPCO

at 1991 WL 521588). In other words, the taxpayer argued the false proposition "if -A

then -C." As explained above, Justice Blackmun dispelled such a notion. In an effort

to drive home this point, and eliminate the myth that long term benefits (B) are

irrelevant when deciding whether to capitalize or deduct, the Court wrote:

Nor does our statement in Lincoln Savings, that "the presence of an

ensuing benefit that may have some future aspect is not controlling"

prohibit reliance on future benefit as a means of distinguishing an ordinary

business expense from a capital expenditure. Although the mere presence

of an incidental future benefit--"some future aspect"--may not warrant

capitalization, a taxpayer's realization of benefits beyond the year in

which the expenditure is incurred is undeniably important in determining

whether the appropriate tax treatment is immediate deduction or

capitalization.

 

(citation omitted) (footnote omitted) INDOPCO, 503 U.S. at 87. 

This tells the reader that B is "undeniably important in determining whether" D

or C is "the appropriate tax treatment." Id. In fact B is "a prominent, if not

predominant, characteristic of a capital item." Id. at 87, 88. On the other hand, Lincoln

Savings tells the reader that "the presence of [B] is not controlling. . . ." Is it possible

the same Justice wrote both of these apparently contradictory statements without

intending to contradict himself? The answer is "yes". In Lincoln Savings, the issue of
10See Lincoln Savings 403 U.S. at 354.

11See INDOPCO 503 U.S. at 86-88.

12WADDELL supra at 7.

13Id.

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B was not controlling because it became moot once the Court decided that the

expenditure created or enhanced a separate and distinct asset. Such an asset, by its

very nature, is capital, and the associated expenses must therefore be capitalized ("if

A then C"). INDOPCO points out that a prominent characteristic of a capital item is

that it provides B ("if C then B"). Building on the two propositions "if A then C"10 and

"if C then B"11, we can conclude "if A then C then B."12 Put more simply, "if A then

B."13 This conclusion not only follows logically, but it also makes legal sense.

Essentially, we are saying that if an expenditure creates or enhances a separate and

distinct asset, then it is a capital item which (by its very nature) provides long term

benefits and must be capitalized. See e.g. Lincoln Savings 403 U.S. at 354; See e.g.

INDOPCO 503 U.S. at 86-88. This is the holding of Lincoln Savings as explained by

INDOPCO. 

According to INDOPCO there are occasions when an expenditure does not

create a new asset (-A), and yet the expense must still be capitalized (C). However,

we also know that there are occasions when -A results in a deduction (D). Thus we

conclude, "if -A then (C or D)." How then do we determine whether capitalization or

deduction is the proper tax treatment when considering an expenditure which does not

create or enhance a separate and distinct asset (-A)? This determination is dependant,

to a certain extent, on the presence of a long term benefit (B) associated with the

expenditure. If there is not a long term benefit (-B) associated with the expenditure,
14This concept can be expressed as follows: "if (-A and -B) then D". Or more

precisely: -AC-BoD.

15Thus, the concepts expressed in the previous footnote can be even more

concisely expressed as follows: "if -B then D"; or in pure symbols: -BoD. In fact,

whether or not B exists ought to be the first question when trying to determine whether

the proper tax consequence is capitalization or current deduction. Because without B

the result will always be D. However, if B is present the analysis continues.

-17-

then the appropriate tax treatment is current deduction.14 This, of course, is true

because "the [Internal Revenue] Code endeavors to match expenses with the revenues

of the taxable period to which they are properly attributable, thereby resulting in a more

accurate calculation of net income for tax purposes." INDOPCO 503 U.S. at 84. If

there is no long term benefit, there is no need to postpone the tax benefit into later

years.15

On the other hand, what if the expenditure does not create or enhance a separate

and distinct asset (-A), but does provide a long term benefit (B)? There is no easy

answer for this question. Which is why Justice Blackmun wrote in INDOPCO,

The Court has recognized, however, that the "decisive distinctions"

between current expenses and capital expenditures "are those of degree

and not of kind," Welch v. Helvering, 290 U.S., at 114, 54 S.Ct., at 9,

and that because each case "turns on its special facts," Deputy v. Du

Pont, 308 U.S., at 496, 60 S.Ct., at 367, the cases sometimes appear

difficult to harmonize. See Welch v. Helvering, 290 U.S., at 116, 54

S.Ct., at 9.

INDOPCO 503 U.S. at 86.

Justice Cardozo most appropriately wrote "[o]ne struggles in vain for any verbal

formula that will supply a ready touchstone. The standard set up by the statute is not
-18-

a rule of law; it is rather a way of life. Life in all its fullness must supply the answer

to the riddle." Welch v. Helvering, 290 U.S. 111, 114 (1933).

 

The Tax Court's Illogical Reading of INDOPCO

From Lincoln Savings we established that "B C." And we have established

from INDOPCO, "if C then B." Thus, the statement, "if B then C" is false and not

reflexive with the true statement "if C then B." The veracity of this conclusion is

demonstrated when the Supreme Court writes in INDOPCO that "the mere presence

of an incidental future benefit [B]--'some future aspect'-- may not warrant capitalization

[C]." INDOPCO, 503 U.S. at 87. Likewise, the Court stated in Lincoln Savings that

"many expenses concededly deductible have prospective effect beyond the taxable

year." So it is safe to say that the statement "B C" is a true statement, while the

statement "if B then C" is a false statement. This brings us to the error made by the

Tax Court in the instant case.

In essence, the Tax Court committed a similar error in logic as was committed

by the Courts of Appeals which improperly interpreted the Lincoln Savings decision.

As explained above, one way to misread the Lincoln Savings holding ("if A then C")

was to read it in the reflexive so that it read "if C then A." Similarly, it would be wrong

to interpret the INDOPCO proposition, "if C then B", as if it read "if B then C." But

this is essentially what the Tax Court did in the instant case.

The Tax Court initially erred when it failed to perform an independent analysis

to determine the fate of Davenport's officers' salaries, and another for the investigatory

costs associated with the acquisition. Instead, the Tax Court lumped the two together

and found that Davenport "incurred the disputed costs before and incidentally with its

acquisition." (emphasis added) Norwest Corp. and Subsidiaries v. Commissioner, 112

T.C. 89, 100 (1999). The Tax Court went on to hold: "In accordance with INDOPCO,

[all] the costs must be capitalized because they are connected to an event (namely, the
16As a reminder to the reader, it was demonstrated earlier that the holding of

INDOPCO was, "if C then B," and this is not equivalent to the statement, "if B then C."

17"If one really takes seriously the concept of a capital expenditure as anything

that yields income, actual or imputed, beyond the period (conventionally one year) in

which the expenditure is made, the result will be to force the capitalization of virtually

every business expense. It is a result courts naturally shy away from. . . . The

administrative costs of conceptual rigor are too great." Encyclopaedia Britannica, Inc.

v. Commissioner, 685 F.2d 212, 217 (7th Cir. 1982) (citation omitted). 

-19-

transaction) that produced a significant long-term benefit." Id. at 100. This is a

misinterpretation of INDOPCO. The Tax Court is saying that C must result because

of the presence of B. This is equivalent to "if B then C," which we have previously

proven to be a false statement.16 Herein lies the mistake of the Tax Court. Just as the

Court in Lincoln Savings did not create a new test for determining whether current

deduction or capitalization is the proper tax consequence of an expenditure, it also did

not create a new test in the INDOPCO case. Therefore, it is not proper to decide that

a cost must be capitalized solely because the fact finder determines that the cost is

'incidentally' 'connected' with a long term benefit. This is supported by both Lincoln

Savings and INDOPCO. Lincoln Savings states, "many expenses concededly

deductible have prospective effect beyond the taxable year." 403 U.S. at 354.

Likewise, INDOPCO states, "the mere presence of an incidental future benefit--'some

future aspect'--may not warrant capitalization. . . ." 503 U.S. at 87. Thus, the Court

did not create a new test requiring capitalization whenever an expenditure is

incidentally connected with some future benefit.17 On the contrary, INDOPCO points

out that federal courts have "long" required capitalization of expenses similar to those

at issue in INDOPCO. 503 U.S. at 89. 

Therefore, we conclude it was error for the Tax Court to require capitalization

of the expenses at issue simply because they were incidentally connected with a future

benefit. Instead, the Tax Court should have performed an independent and appropriate
18It was established above that the expenses at issue here meet the other

requirements for deductibility.

-20-

legal analysis to determine whether each of the expenditures at issue were 'ordinary'.18

In addition to the previously cited characteristics of an 'ordinary' expense, an additional

qualification is that "the expense must relate to a transaction 'of common or frequent

occurrence in the type of business involved.'" INDOPCO, 503 U.S. at 85, 86 (quoting

Deputy v. Du Pont, 308 U.S. 488, 495 (1940)).

Davenport's Officers' Salaries are a Fully Deductible Expense

Lest one should doubt that paying salaries to corporate officers is a transaction

"of common or frequent occurrence" in the business world, we note that courts have

traditionally permitted current deductions for expenses attributable to salaries similar

to those at issue here. See e.g. Dixie Frosted Foods, Inc. v. Commissioner, 6 T.C.M.

(CCH) 586 (1947); Fort Howard Paper Co. v. Commissioner, 49 T.C. 275 (1967).

However, "INDOPCO, which signaled that the Supreme Court's previously announced

tests for capitalization were not exhaustive, may well have been viewed by the IRS as

a green light to seek capitalization of costs that had previously been considered

deductible in a number of businesses and industries." PNC Bancorp, Inc., v.

Commissioner, 2000 WL 655747, *3 (3rd Cir.).

The Tax Court erred when it so easily dismissed a major distinction between the

instant case and INDOPCO. The INDOPCO case addressed costs which were directly

related to the acquisition, while the instant case involves costs which were only

indirectly related to the acquisition. Norwest Corp. and Subsidiaries v. Commissioner,

112 T.C. 89, 100 (1999). According to cases which explain and apply the "origin of

the claim doctrine", such a distinction effects the outcome of the case. See Woodward

v. Commissioner, 397 U.S. 572 (1970); United States v. Hilton Hotels Corp., 397 U.S.

580 (1970); Deputy v. DuPont, 308 U.S. 488, 494 (1940).
19For instance, although this Court agrees with the "origin of the claim" analysis

performed by the I.R.S. in the cited rulings, we do not agree with statements like,

"[g]enerally, expenditures incident to the alteration of the capital structure of a

corporation for the benefit of future operations constitute non-deductible capital

expenditures under section 263 of the Code." (emphasis added) TAM 9540003

(06/30/1995). This Court does not agree that expenditures which are merely

"incidental to" an acquisition or merger necessarily are non-deductible. This is

particularly true if one understands the phrase "incidental to" to be equivalent with

"indirectly related to".

-21-

Although the "origin of the claim doctrine" was originally used to distinguish

personal expenses from business expenses, it has been extended to distinguish capital

business expenses from ordinary business expenses. When used in this context, the

ultimate question is whether the expense is directly related to the transaction which

provides the long term benefit. The IRS has applied this "origin" analysis in a number

of recent private rulings while holding compensation payments to employees are

deductible in the context of acquisitions. See TAM 9540003 (6/30/1995); PLR

9326001 (03/18/1993); TAM 9527005 (03/15/1995); TAM 9721002 (01/24/97); TAM

9731001 (01/31/1997). According to I.R.C. §6110 these private rulings (known as

Technical Advice Memoranda and Private Letter Rulings) have no precedential value,

but they do "reveal the interpretation put upon the statute by the agency charged with

the responsibility of administering the revenue laws" and may provide evidence of the

proper construction of the statute. Hanover Bank v. Commissioner, 369 U.S. 672, 686

(1962); see also Oetting v. United States, 712 F.2d 358, 362 (8th Cir.1983) (Revenue

Ruling, while not controlling authority, was persuasive).

This Court is hesitant to fully incorporate and adopt the private rulings of the

IRS.19 However, we certainly agree that payments made by an employer are deductible

when they are made to employees, are compensatory in nature, and are directly related

to the employment relationship (and only indirectly related to the capital transaction,
20Symbolically, this can be generally expressed: (-A B) (-R)oD, which

states, "if the expense does not create a new asset, but does generate a long term

benefit, and the expense is only indirectly related to the long term benefit, then the

expense is deductible." We do not endeavor to explain exactly how one determines

whether the expense is properly characterized as R or -R. This is one of the questions

which will turn on the particular facts and circumstances of each case. It will suffice

to say that in this case we determine the salary expenses to be directly related to the

employment relationship and only indirectly (or incidentally) related to the acquisition

(which provides B).

-22-

which provides the long term benefit).20 See e.g., TAM 9540003 (6/30/1995).

Likewise, it is true that, 

a deductible expense is not converted into a capital expenditure solely

because the expense is incurred as part of the terms of a corporate

reorganization. Rather, the important consideration in determining the

nature of an expenditure for tax purposes is the origin and character of the

claim for which the expenditure is incurred. See Woodward v.

Commissioner, 397 U.S. 572, 577 (1970); United States v. Gilmore, 372

U.S. 39, 47 (1963). Under the "origin of the claim doctrine," the

character of a particular expenditure is determined by the transaction or

activity from which the taxable event proximately resulted. Gilmore, 372

U.S. at 47. . . . In the present case, . . . the origin of the payments was not

the acquisition, but rather the employment relationship between the

taxpayer and [its employees].

TAM 9540003 (06/30/1995).

Thus the distinction between the case at hand, and the INDOPCO case lies in the

relationship between the expense at issue and the long term benefit. In INDOPCO, the

expenses in question were directly related to the transaction which produced the long

term benefit. Accordingly, the expenses had to be capitalized. See INDOPCO, 503

U.S. 79. We conclude that if the expense is directly related to the capital transaction
21Symbolically expressed as: (-A B)(R)oC, which states, "if the expense does

not create a new asset, but does generate a long term benefit, and the expense is

directly related to the long term benefit, then the expense must be capitalized."

22Acer Realty is the only case in our Circuit, that we are aware of, which denies

the taxpayer a deduction for salary expenses.

-23-

(and therefor, the long term benefit), then it should be capitalized.21 See e.g.

INDOPCO, 503 U.S. 79 (1992). In this case, there is only an indirect relation between

the salaries (which originate from the employment relationship) and the acquisition

(which provides the long term benefit [B]). 

Similarly, the instant case is distinguishable from Acer Realty Co. v.

Commissioner22, wherein this Court held that the salaries paid to two officers for

"unusual, nonrecurrent services" had to be capitalized. 132 F.2d 512, 513 (8th Cir.

1942). The taxpayer was a corporation whose only business was leasing real estate to

a related corporation. Its officers were paid no salaries prior to their undertaking a

large building program, at which point the two officers began acting as general

contractors and "performed all the services necessary to the management of the

construction of the buildings." Acer Realty, 132 F.2d at 514. Because the salaries

were clearly and directly related to the capital project, this Court determined that most

of the salaries paid were extraordinary or incremental expenses which had to be

capitalized. Acer Realty Co. v. Commissioner, 132 F.2d 512 (8th Cir. 1942).

The instant case is easily distinguishable from Acer Realty because Davenport's

officers had always received salaries, even before the acquisition was a possibility.

There was no increase in their salaries attributable to the acquisition, and they would

have been paid the salaries whether or not the acquisition took place. Therefore, we

determine that the salary expenses in this case originated from the employment
-24-

relationship between the taxpayer and its officers. Indirectly, the payment of these

salaries provided Davenport with a long term benefit.

By comparing the relevant symbolic expressions, one can easily see the

distinction between cases like INDOPCO (which require capitalization) and cases

wherein deduction would be permissible. The former is "(-A B)(R)", and the latter

is "(-A B)(-R)": the only difference being the direct/indirect relationship between the

expense and the long term benefit it provides. 

Upon consideration of the facts and circumstances of this case, we determine

that Davenport's salary expenses are directly related to (and arise out of) the

employment relationship, and are only indirectly related to the acquisition itself.

Furthermore, this case more closely parallels those cases and IRS rulings which have

traditionally permitted a current deduction for expenses attributable to employee

compensation. Wherefore, Davenport's officers' salaries are a fully deductible expense.

See Woodward v. Commissioner, 397 U.S. 572 (1970); United States v. Hilton Hotels

Corp., 397 U.S. 580 (1970); Deputy v. DuPont, 308 U.S. 488, 494 (1940); TAM

9540003 (6/30/1995); PLR 9326001 (03/18/1993); TAM 9527005 (03/15/1995); TAM

9721002 (01/24/97); TAM 9731001 (01/31/1997).

Davenport's Legal/Investigatory Expenses

It is undisputed by the parties that the Tax Court erred when it determined that

INDOPCO required capitalization of all of Davenport's legal fees, paid to Lane &

Waterman. The Commissioner now agrees that at least $83,450 of Davenport's legal

expenses may be deducted, because they were attributable to the "investigatory stage"

of the transaction. Thus, the parties only disagree as to whether the remaining $27,820

in fees ought to be characterized as capital expenditures or deductible "investigatory

costs".
-25-

Both parties rely on the IRS's Revenue Ruling 99-23 to argue their respective

positions. Obviously, the Commissioner takes the position that the remaining fees

should be capitalized, and Petitioner argues the fees may be deducted (either fully or

at least partially). Before deciding this matter, the Court will analyze the Revenue

Ruling in question. 

The issue under consideration in Revenue Ruling 99-23 was stated as follows:

"When a taxpayer acquires the assets of an active trade or business, which expenditures

will qualify as investigatory costs that are eligible for amortization as start-up

expenditures under §195 of the Internal Revenue Code?" At first blush this Issue may

not seem pertinent to the case at hand, because it deals with "amortization" of "start-up"

costs. However, one requirement for an expense to be eligible for amortization under

§195 is that it be an expense which would be deductible if it were incurred by an

existing business. For this reason, the IRS discussed the differences between

"investigatory" expenses which may be deducted, versus those expenses which must

be capitalized. 

The IRS determined that investigatory expenses which are related to the

questions "whetherto acquire a business" and "which business to acquire" are properly

deductible. On the other hand, once the "whether" and "which" questions have been

answered, and the "final decision" is made to acquire a particular business, then any

further "investigatory" expenses become expenses attributable to facilitating

consummation of the acquisition. According to the IRS, these facilitating expenses are

not deductible. 

Along with the parties, this Court agrees with the IRS that any investigatory

expenses which post-date the "final decision" to acquire a business ought to be

capitalized. The parties in this case disagree, however, as to when the "final decision"

occurred. 
-26-

Without adopting all of the IRS's conclusions in Revenue Ruling 99-23, this

Court agrees that:

[t]he nature of the cost must be analyzed based on all the facts and

circumstances of the transaction to determine whether it is an

investigatory cost incurred to facilitate the whether and which decisions,

or an acquisition cost incurred to facilitate consummation of the

acquisition. The label that the parties use to describe the cost and the

point in time at which the cost is incurred do not necessarily determine the

nature of the cost.

Rev. Rul. 99-23.

Based on the facts and circumstances of this case, and after reviewing all pertinent

portions of the record, it is the determination of this Court that Davenport made its

"final decision" regarding acquisition no later than July 22, 1991. On that date,

Davenport and Norwest entered into the Agreement and Plan of Reorganization. Our

determination on this point is not to be construed as a "bright line rule" for determining

when a "final decision" has been made. The facts and circumstances of each case must

be evaluated independently to make a proper finding on that issue.

We are simply holding that, in this case, the final decision regarding this

acquisition was made on July 22, 1991, and all other "due diligence" and/or

"investigatory" expenses incurred after that date, were incurred to facilitate

consummation of the acquisition. Accordingly, these expenses, which amount to

$27,820, must be capitalized. See INDOPCO, 503 U.S. at 89, 90.

CONCLUSION

After a full and proper review of the record, and based on the foregoing legal

analysis, we hold that the Tax Court has misread INDOPCO and is hereby
23To further assist the reader, the Court has provided an Appendix which

includes a flow chart illustrating the Court's rationale.

-27-

REVERSED IN PART. The $150,000 of officers' salaries in dispute is fully

DEDUCTIBLE, as is $83,450 of Davenport's legal/investigatory expenses which were

incurred prior to Davenport's "final decision" regarding the acquisition. The remaining

$27,820 of legal/investigatory expenses were incurred after the "final decision" and

therefore must be capitalized. Inasmuch as the Tax Court's conclusion required the

capitalization of this $27,820, we AFFIRM.

23

BRIGHT, Circuit Judge, concurring.

I concur in Judge Hand's fine opinion. I write separately to emphasize that the

record in this case is inadequate to show that the portion of the salaries in question,

$150,000, was directly or substantially related to the acquisition. Moreover, the tax

court's findings of fact on this issue does not address the direct or indirect relationship

of the work of the officers to the acquisition. That finding recited:

During 1991, DBTC had 9 executives and 73 other officers

(collectively, the officers). John Figge, James Figge, Thomas Figge, and

Richard Horst worked on various aspects of the transaction, as did other

officers. None of the offices were hired specifically to render services on

the transaction; all were hired to conduct DBTC's day-to-day banking

business. DBTC's participation in the transaction had no effect on the

salaries paid to its officers. Of the salaries paid to the officers in 1991,

$150,000 was attributable to services performed in the transaction.

DBTC deducted the salaries, including the $150,000, on its 1991 Federal

income tax return. Respondent disallowed the $150,000 deduction; i.e.,

the portion attributable to the transaction.

Add. at 11a-12a.
-28-

This finding does not address whether some officers at any particular period of

time devoted substantial work to the acquisition or whether the officers during the

period of time in question only incidentally worked on the acquisition while doing

regular banking duties.

In order to determine whether an allocation of officers' salaries to an acquisitiontransaction such as made here qualifies as a deduction from income or should be

capitalized, the taxing authorities should require the taxpayer to show officers' time

devoted to the acquisition as compared to time spent on regular work during a

particular and relevant time period.

The finding made by the tax court here does not justify capitalization of the

officers' salaries.

A true copy.

 ATTEST:

CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.
A-1

APPENDIX

To qualify for a deduction, "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

Savings and Loan Assoc., 403 U.S. 345 (1971). Assuming the first four requirements

are met, the following flow chart will be helpful when determining the proper tax

consequence of a business expenditure. By answering the "either or" questions in the

flow chart, one can follow the chart to determine whether an expense should be

capitalized or deducted. A legend is provided to assist the reader.
A-2

B or -B

B -B

D

A or -A

A -

No easy answer. Apply facts and

circumstances of each case to

determine whether there is such a

direct relationship (R) between

the expense and B, that

capitalization is required. Or

is the expense more directly

related to something more

ordinary, and only so indirectly

related (-R) to B that deduction

is appropriate?

C

R -

C D

LEGEND

 A = physical capital ASSET created or enhanced;

-A = NO physical capital ASSET created or enhanced;

 B = BENEFIT beyond the taxable year;

-B = NO Benefit beyond the taxable year;

 R = the expense is directly RELATED to B;

-R = the expense is indirectly related to B;

 C = CAPITALIZE;

 D = DEDUCT.