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Shelling out extra capital to prop up a company's reputation is tax deductible in many cases – even if the taxpaying corporation garners longer-term benefits.
Robert Willens, CFO.com | US
January 11, 2010
In general, payments made for the principal purpose of protecting an entity's goodwill and reputation are deductible. That's the case even if the payments also provide the taxpayer with long-term benefits that extend well beyond the close of the taxable year in which the expenditures are made.
For example, the Internal Revenue Service released a private letter ruling on the subject in 2002,1 which dealt with a large commercial bank that was the investment adviser to more than a dozen proprietary mutual funds. Two of the bank's largest funds, which had interests in "structured securities," ran into difficulties because of increases in interest rates. Investors in the troubled funds began redeeming their shares "in droves," which necessitated sales of fund assets at a substantial loss to meet the high rate of redemptions.
The net asset value of each fund approached $1.00, and the funds grew perilously close to "breaking a buck." So to stanch the bleeding, the bank transferred a total of "$x" to the two funds. The bank received no shares in the funds in exchange for its transfer, but the bank did deduct the transfers on its tax return. In turn, the funds treated the transfers as capital gains.
In addition, internal memoranda from the bank detailed a number of reasons for bailing out the funds, including to:
• Avoid damage to the bank's goodwill and reputation;
• Avoid mutual-fund shareholder lawsuits;
• Avoid mutual-fund shareholder redemptions; and
• Support and build the bank's proprietary mutual-fund business, which was seen as (1) helping the bank defend its core retail franchise and (2) having substantial profit potential in its own right.
An expenditure that is otherwise an ordinary and necessary business expense (and, therefore, deductible under the tax code2) must be capitalized if it is a capital expenditure. The Supreme Court has held that a taxpayer must capitalize the following: (1) the costs of creating or acquiring a separate and distinct asset with a useful life extending beyond the end of the taxable year in which the expenditure is made, (2) expenses incurred "in connection with" the acquisition of a capital asset,3 and (3) expenditures that generate "significant future benefits."4
In the instant case, the bank's payments did not create a separate and distinct asset, nor were the payments incurred in connection with the acquisition of a capital asset. Moreover, the ruling concludes that the payments did not provide the bank with significant long-term benefits. In fact, the ruling notes that, generally, expenditures made to protect or promote a taxpayer's business are deductible.
Payments made to protect goodwill, to prevent lawsuits and redemptions, and to protect the core business would all seem to fall within the category of payments that are made to protect and preserve a taxpayer's business. Moreover, the ruling states that this analysis applies even though the protection of the business and reputation — along with the protection of the bank's future income stream (the management fees it expects to earn from advising the funds) — produces long-term benefits.
As a result, it can be safely concluded that capitalization is not required for each expenditure that produces some future benefit. In fact, the IRS has already acknowledged this reality. That is, the agency permits the deduction of the costs of training (see Revenue Ruling 96-62, 1996-2 C.B. 9), "incidental" repair costs (see Revenue Ruling 94-12, 1994-1 C.B. 36), and advertising costs (see Revenue Ruling 92-80, 1992-2 C.B. 57), among others, even though each of these varieties of outlays may have some future benefit or, at a minimum, some "future effect" on business activities. Accordingly, it can be concluded with a high degree of confidence that expenditures made primarily to protect and preserve an established business are deductible — even if a secondary result of such expenditures, for such protection and preservation, is the derivation of long-term benefits.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 LTR 200247004, July 29, 2002.
2 Section 162(a).
3 See Commissioner v. Idaho Power Co., 418 US 1 (1974).
4 See in this regard Indopco v. Commissioner, 503 US 79 (1992).