Ellis Banking Corp. v. C. I. R.

• Decision Date: 15 October 1982
• Docket Number: No. 81-5895,81-5895
• Parties: 82-2 USTC P 9630 ELLIS BANKING CORPORATION, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 1376

688 F.2d 1376

82-2 USTC P 9630

ELLIS BANKING CORPORATION, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 81-5895.

United States Court of Appeals Eleventh Circuit.

Oct. 15, 1982.

Carlton, Fields, Ward, Emmanuel, Smith & Cutler, P.A., Michel G. Emmanuel, Nathaniel L. Doliner, Tampa, Fla., for petitioner-appellant.

John F. Murray, Act. Asst. Atty. Gen., Michael L. Paup, Glenn L. Archer, Jr., Gary R. Allen, Kristina E. Harrigan, Tax Div., Appellate Section, Dept. of Justice, Washington, D.C., for respondent-appellee.

Appeal from the Tax Court of the United States.

Before WISDOM, ^* RONEY and HATCHETT, Circuit Judges.

WISDOM, Circuit Judge:

This case presents the question: are expenditures made in the investigation of the financial condition of a corporation, in preparation for a proposed acquisition of its stock, deductible as ordinary and necessary business expenses under section 162 of the Internal Revenue Code ¹ or expenditures that must be capitalized under section 263? Predictably, the taxpayer contends that the expenditures are currently deductible; the Commissioner insists on capitalization. We agree, for the most part, with the Commissioner.

I.

The taxpayer, Ellis Banking Corporation, is a bank holding company doing business in Florida. During 1974, the tax year at issue, Florida law did not permit branch banking, so, to expand into new geographic markets, Ellis had no choice but to acquire the stock of other banks or to organize new banks.

On August 21, 1973, Ellis executed an agreement with Parkway National Bank of Tallahassee and certain Parkway shareholders to acquire all the stock of Parkway in exchange for Ellis stock. The agreement was subject to a number of conditions, including the following:

(1) the Federal Reserve Board would approve the acquisition,

(2) the Securities and Exchange Commission would register the Ellis stock to be exchanged,

(3) for accounting purposes, Ellis would be able to treat the acquisition as a "pooling of interests", and

(4) Parkway's financial condition would not be materially different from that set forth in financial statements supplied to Ellis.

Upon execution of the agreement, but not before, Ellis was entitled to inspect Parkway's books and records to evaluate Parkway's financial condition, to obtain the information necessary for the various applications to governmental agencies, and to verify that the exchange ratio specified in the agreement was an accurate reflection of the relative values of the Ellis and Parkway stocks. The stock exchange was finally consummated on July 12, 1975, after a downward adjustment of the exchange ratio to reflect the results of Ellis's examination of Parkway's records. Ellis capitalized the purchase price of the stock. ²

In 1974, in connection with the examination of Parkway's books, Ellis made the following expenditures:

                Office supplies         $41.86
                Filing fees             100.00
                Travel expenses       3,041.58
                Accounting expenses   5,894.00
                                     ---------
                Total                $9,077.44
                

The accounting expenses included two separate amounts charged by Peat, Marwick, Mitchell & Co., Ellis's independent certified public accountant. First, Ellis paid $3,400 to Peat Marwick in connection with the registration of the Ellis stock with the SEC. The registration required Ellis to submit certain data that Peat Marwick had previously certified, but, before Peat Marwick would consent to the use of its name in connection with the certification, it determined whether any material change had occurred. Second, Ellis paid $2,494 to Peat Marwick. In a letter to Ellis, Peat Marwick explained that part of the accountants' time was spent observing Ellis's auditors, in anticipation of including Parkway in Ellis's consolidated statements and of certifying those statements. Also, Peat Marwick explained that much of the time was devoted to researching whether treatment as a "pooling of interests" was available.

Ellis deducted the $9,077.44 as an ordinary and necessary business expense under section 162. The Commissioner disallowed the deduction, and the Tax Court upheld his determination. Ellis Banking Corporation v. Commissioner, 1981, 41 T.C.M. 1107. The taxpayer appeals.

II.

To be deductible under section 162, ³ an expenditure must meet five conditions, set out in Commissioner v. Lincoln Savings and Loan Association, 1971, 403 U.S. 345, 91 S.Ct. 1893, 29 L.Ed.2d 519. First, it must be paid or incurred during the taxable year. Second, it must be made to carry on a trade or business. Third, it must be an expense. Fourth, it must be a necessary expense. Finally, it must be an ordinary expense. ⁴

The expenditures at issue here unquestionably meet most of the requirements. Ellis made the payments during the taxable year for which it claims the deductions and in the course of its business of promoting banks. Also, the payments undoubtedly met the minimal standard embodied in the requirement that the expense be "necessary", for that term is construed to mean nothing more than "appropriate and helpful". Commissioner v. Tellier, 1966, 383 U.S. 687, 689, 86 S.Ct. 1118, 1119, 16 L.Ed.2d 185, 187-88. The sole issue, then, is whether the expenditures were current, ordinary expenses or capital expenditures.

While current expenses are deductible under section 162, section 263 denies a deduction for any amounts paid out for assets with lives in excess of one year. § 263(a). ⁵ The requirement that costs be capitalized extends beyond the price payable to the seller to include any costs incurred by the buyer in connection with the purchase, such as appraisals of the property or the costs of meeting any conditions of the sale. See, e.g., Woodward v. Commissioner, 1970, 397 U.S. 572, 90 S.Ct. 1302, 25 L.Ed.2d 577; United States v. Hilton Hotels Corp., 1970, 397 U.S. 580, 90 S.Ct. 1307, 25 L.Ed.2d 585. Further, the Code provides that the requirement of capitalization takes precedence over the allowance of deductions. §§ 161, 261; see generally Commissioner v. Idaho Power Co., 1974, 418 U.S. 1, 94 S.Ct. 2757, 41 L.Ed.2d 535. Thus an expenditure that would ordinarily be a deductible expense must nonetheless be capitalized if it is incurred in connection with the acquisition of a capital asset. ⁶ The function of these rules is to achieve an accurate measure of net income for the year by matching outlays with the revenues attributable to them and recognizing both during the same taxable year. When an outlay is connected to the acquisition of an asset with an extended life, it would understate current net income to deduct the outlay immediately. To the purchaser, such outlays are part of the cost of acquisition of the asset, and the asset will contribute to revenues over an extended period. Consequently, the outlays are properly matched with revenues that are recognized later and, to obtain an accurate measure of net income, the taxpayer should deduct the outlays over the period when the revenues are produced.

These principles, we conclude, require capitalization of most of the expenditures in this case. ⁷ Ellis expected to realize benefits over the course of its ownership of the Parkway stock, and the investigation expenditures, which were directly related to an examination of this specific property, were part of the cost to Ellis of owning the stock. Those expenditures should be deducted only when the related benefits are realized. See, e.g., Union Mutual Life Insurance Co. v. United States, 1 Cir. 1978, 570 F.2d 382, cert. denied, 439 U.S. 821, 99 S.Ct. 87, 58 L.Ed.2d 113; ⁸ Cagle v. Commissioner, 5 Cir. 1976, 539 F.2d 409; Beneficial Industrial Loan Corp. v. Handy, D. Del. 1936, 16 F.Supp. 110, aff'd, 3 Cir. 1937, 92 F.2d 74 (per curiam); Rev. Rul. 77-254, 1977-2 Cum. Bull. 63; Rev. Rul. 74-104, 1974-1 Cum. Bull. 70; Rev. Rul. 71-191, 1971-1 Cum. Bull. 77, clarified, Rev. Rul. 79-346, 1979-2 Cum. Bull. 84. ⁹

One of the major functions of the examination of Parkway's books was to determine the appropriateness of the exchange ratio, or the acquisition price. In Woodward and Hilton, the Supreme Court held that the taxpayers had to capitalize the costs of appraisal proceedings as part of the cost of the stock acquired, saying, "When property is acquired by purchase, nothing is more clearly part of the process of acquisition than the establishment of a purchase price." Woodward, 397 U.S. at 579, 90 S.Ct. at 1307, 25 L.Ed.2d at 583; see Hilton, 397 U.S. at 584, 90 S.Ct. at 1309, 25 L.Ed.2d at 588. And in Beneficial Industrial Loan Corp. v. Handy, D. Del. 1936, 16 F.Supp. 110, aff'd, 3 Cir. 1937, 92 F.2d 74 (per curiam), the court held that it was "too clear for argument" that the costs of obtaining an accountants' evaluation of a target corporation were not deductible. 16 F.Supp. at 112. Those expenditures should therefore be capitalized.

Ellis relies on two main arguments in favor of deductibility. First, it makes a general argument about all the costs-that the expenditures were not made in connection with the acquisition but in connection with the decision to acquire the stock and with the evaluation of the Tallahassee market. Next, Ellis falls back on a specific argument about the accounting fees-that the accounting firm was performing its general duty of supervising Ellis's auditors to provide Ellis with financial information and to prepare Ellis's income tax returns. ¹⁰ We think that neither argument supports the entire deduction, but the second argument compels us to remand to the Tax Court for a determination of the appropriateness of a partial deduction.

In connection with its first argument, Ellis notes that it was not committed to purchase the Parkway stock at the time it made the expenditures because the contract was subject to several conditions. In fact, the examination of Parkway's books revealed changes in its financial condition that would have excused Ellis's...