Finder's Fee Paid in Connection with Merger Was Not a Deductible Business Expense

(Parker Tax Publishing October 2019)

The Tax Court held that a $1.5 million fee a manufacturing company paid to a financial advisor for introducing it to an institutional investor that eventually acquired the company in a merger was not a deductible business expense of the acquired company because the fee had been agreed to by the institutional investor for its own reasons and on its own behalf. The court found that, while a taxpayer may deduct expenses paid for another as ordinary and necessary business expenses if certain conditions are met, the acquired company in this case did not benefit from paying the fee to the financial advisor because the merger was not contingent on it, and the fee was in the nature of a finder's fee that was not ordinary and necessary to the company's manufacturing business. Plano Holding LLC v. Comm'r, T.C. Memo. 2019-140.

Background

Plano Molding Co. is an Illinois company that manufactures of plastic storage equipment for outdoor sports. In February 2007, Tinicum Capital Partners (Tinicum), an investment firm, became Plano's majority shareholder. In 2010, Plano retained Robert W. Baird & Co., Inc. (Baird) as its financial advisor with an eye to a potential sale of the company. No sale took place at that time, however.

In 2012, Baird suggested Plano as a potential acquisition candidate to the Ontario Teachers' Pension Plan Board (OTPP), a Canadian nonprofit corporation and a major institutional investor. After gauging Tinicum's interest in selling Plano, Baird's managing director sent an email to set up an introductory lunch. Although lunch proved unworkable, representatives of OTPP and Tinicum later discussed the matter by phone. Baird did not participate on the call and had no further input into the acquisition that followed.

Plano later retained Harris Williams LLC (Harris Williams) as its investment banker and financial advisor for the possible sale. Plano expressly agreed that it had engaged Harris Williams exclusively to act in that capacity. During September and October 2012, Harris Williams and OTPP exchanged correspondence and information, and OTPP performed its due diligence. In December 2012, OTPP completed the acquisition of Plano for $240 million, with Plano becoming a wholly owned subsidiary of Plano Holding LLC (Holding), a holding company wholly owned by OTPP.

When the deal closed, Plano made two different payments to purported financial advisors. Plano first paid Harris Williams $2.89 million for its services in connection with the merger. Plano also paid $1.5 million to Baird pursuant to a November 2012 agreement between Baird and OTPP. OTPP had determined that Baird should be compensated for suggesting Plano as a potential acquisition candidate and attempting to arrange an introductory meeting between representatives of OTPP and Plano. OTPP agreed to pay Baird $1.5 million (upon the successful acquisition of Plano) for Baird's services as its exclusive financial advisor in connection with the acquisition. The agreement provided that Baird's services were rendered solely for the benefit and use of OTPP's management and directors.

Holding and Plano filed a consolidated federal income tax return for tax year 2012 in which 70 percent of the Baird fee ($1.05 million) paid by Plano was deducted (with the balance capitalized) pursuant to an election under Rev. Proc. 2011-29. The IRS thereafter issued a notice of deficiency disallowing the claimed deduction. The IRS determined a deficiency of $90,385 and an accuracy-related penalty under Code Sec. 6662(a) of $18,077. Holding took its case to the Tax Court.

A deduction is allowed under Code Sec. 162(a) for ordinary and necessary business expenses paid or incurred during the tax year in carrying on a trade or business. Under Reg. Sec. 1.162-1(a), ordinary and necessary expenses must be directly connected with or pertaining to the taxpayer's trade or business in order to be deductible. In general, a taxpayer may not deduct the payment of another person's expenses. However, in Lohrke v. Comm'r, 48 T.C. 679 (1967), the Tax Court recognized a narrow exception where (1) the taxpayer's primary motive for paying the other's obligation is to protect or promote the taxpayer's own business, and (2) the expenditure is an ordinary and necessary expense of the taxpayer's business.

Holding argued that the Baird payment was deductible because Plano made the payment to facilitate its acquisition by OTPP, which allowed Plano to expand its business. Holding noted that Plano's market footprint expanded after its acquisition. Holding further contended that OTPP entered into the Baird agreement on Plano's behalf because Plano could not enter into the agreement itself because of (1) its retention of Harris Williams, and (2) the financial repercussions for its shareholders if the Baird payment were treated as a transaction expense. In making its arguments, Holding relied on the Tax Court's decision in Waring Products Corp. v. Comm'r, 27 T.C. 921 (1957) and Square D Co. v. Comm'r, 121 T.C. 168 (2003).

Tax Court's Analysis

The Tax Court agreed with the IRS and upheld the deficiency and the penalty after finding that the Lohrke exception, which neither party referred to, did not apply to the Baird payment. The court explained that under the first prong of the Lohrke rule, the taxpayer must demonstrate a direct nexus between the purpose of the payment and the taxpayer's business. For example, a taxpayer's primary motive is to promote its own business if it would face direct and proximate adverse consequences by not making the payment on behalf of the other person.

The court found that Holding failed to establish a direct link between the ostensible business purpose (Plano's acquisition by a deep-pocketed investor) and the Baird payment. The court noted that the merger was not contingent on Plano's picking up OTPP's tab to Baird. To the contrary, Plano and OTPP had already agreed to the merger more than a week before OTPP contracted to pay Baird. Nor did Holding demonstrate, in the court's view, any direct and proximate adverse consequences to Plano's business had it not covered OTPP. The court found that Holding did not establish that OTPP would have scaled back its plans or financial backing had Plano not paid the fee and said that it could discern no benefit to Plano from the Baird payment. Rather, the court concluded that that the primary benefit of the Baird payment accrued to OTPP.

The court also determined that the Baird payment was not an ordinary and necessary expense of Plano's business. The court characterized the payment as a finder's fee that OTPP decided to bestow months after the fact. In the court's view, the payment was neither ordinary nor necessary to Plano's business of manufacturing plastic goods. The court found that Holding offered no support the idea that Plano itself saw a need to compensate Baird for introductions provided several months before. The court also found that Plano's agreement with Harris Williams did not bar the payment of a finder's fee to Baird, which the court noted provided no financial advisory services at any point and whose role concluded well before the retention of Harris Williams. The court also was not convinced of the supposed negative financial repercussions for Plano's selling shareholders. According to the court, the Baird fee would likely not be treated as a transaction expense reducing Plano's purchase price to the detriment of the shareholders given that Baird provided no services in connection with the merger.

The court upheld the substantial understatement penalty because it found that Holding did not have substantial authority for its treatment of the Baird fee because the authorities it cited were materially distinguishable. The court concluded that although the transactions discussed in those authorities bore some surface similarities to the instant case, Plano received no services or other benefit from its payment of the Baird fee, and the payment was not an ordinary and necessary expense of Plano's business.

For a discussion of the deductibility of trade or business expenses, see Parker Tax ¶90,101.

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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