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Legal Fees to Fight Class Action Suit Were Nondeductible Capital Expenses.
(Parker Tax Publishing May 12, 2014)

Litigation expenses incurred in resolving a class action lawsuit were not deductible as ordinary and necessary business expenses or were not non-deductible capital expenses because the origin of the claim for which the taxpayer incurred these expenses arose from a reorganization, i.e., a capital transaction. Ash Grove Cement Company & Subs v. U.S., 2014 PTC 199 (10th Cir. 4/22/14).

Ash Grove Cement Company manufactures and sells cement. Before December 31, 2000, Vinton Corporation owned approximately two-thirds of the outstanding Ash Grove stock. Vinton also owned the Lyman-Richey Corporation, a ready-mix cement company. In turn, Vinton was wholly owned by or for the benefit of the Sunderland family. The rest of the outstanding stock in Ash Grove was owned by members of the Sunderland family (about 6 percent), the company's employee stock ownership plan (less than 2 percent), and approximately 150 other shareholders unrelated to the Sunderlands.

Under the terms of a reorganization plan, Ash Grove acquired Vinton and Lyman-Richey, and the Sunderland family received Ash Grove stock in return. To execute the plan and negotiate the proposed transaction, Ash Grove's board of directors created a special committee comprised of the two members of the board who were neither members of the Sunderland family nor employees of Ash Grove. On November 2, 2000, that committee approved the reorganization, with an exchange rate of 876 shares in Ash Grove for each share in Vinton. As a result of the transaction, which was completed on December 31, 2000, Ash Grove owned the Lyman-Richey Corporation and the Sunderland family members who had owned stock in Vinton became direct owners of stock in Ash Grove.

In 2002, Daniel Raider, a minority shareholder in Ash Grove, filed a class action suit against Ash Grove and each member of its board of directors. Raider alleged that the reorganization constituted self-dealing by the Sunderlands and that the special committee of the board was not meaningfully independent of the family. He claimed that the transaction had unfairly diluted the minority shareholders' interests in Ash Grove. Among other remedies, Raider sought rescission of the transaction, imposition of a constructive trust on all of the "profits and benefits" the individual defendants had "wrongfully obtained," and compensation to Raider and the class for all losses sustained as a result of the transaction.

In 2005, the suit was settled without the admission of liability by any defendant. As part of the settlement, Ash Grove paid $15 million into a trust for the class. During the 2005 tax year, Ash Grove also paid $43,345 for legal fees incurred in defense of its board members and related to the suit, which it deducted on its 2005 tax return as an ordinary and necessary business expense. The IRS disallowed the deduction on the ground that the legal fees were capital expenditures. A district court agreed with the IRS and Ash Grove appealed to the Tenth Circuit.

Courts have repeatedly concluded that litigation costs arising out of corporate reorganizations are capital expenditures. Ash Grove attempted to distinguish its situation by arguing that: (1) the Raider litigation did not involve the purchase of a capital asset or setting the price of a capital asset, and (2) Ash Grove was not the real party in interest in Raider's suit.

The Tenth Circuit affirmed the district court and held that the legal fees were not deductible. The characterization of litigation expenses, the court noted, is governed by the origin-of-the-claim test. The object of this test, the court said, is to find the transaction or activity from which the taxable event proximately resulted, or the event that led to the tax dispute. The court rejected Ash Grove's arguments, concluding that Raider's complaint expressly concerned the terms of the reorganization, particularly the purchase price for Vinton and the Lyman-Richey Corporation. The court noted that the complaint sought, among other remedies, rescission of the transaction. Thus, the Tenth Circuit held, the legal fees and settlement operated to defend and maintain the reorganization itself and were nondeductible capital expenditures.

For a discussion of the deductibility of legal fees as a trade or business expense, see Parker Tax ΒΆ99,150. (Staff Editor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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