The Tax Court held that a manufacturer of plastic products could not take a deduction for a finder's fee paid to a financial advisory firm that the manufacturer paid on behalf of an institutional investor that acquired the manufacturer.
Plano Molding Co. (Plano) specializes in the manufacture of plastic storage equipment for outdoor sports. Founded in Illinois in 1932, it introduced the first plastic tackle box to the fishing world 20 years later and since then has expanded its product lines to include archery and gun cases, ammunition boxes, shelving, toolboxes, and cosmetics cases. In February 2007, Tinicum Capital Partners (Tinicum), an investment firm, became Plano's majority shareholder.
In 2010, Plano, with an eye to selling the company, retained Robert W. Baird & Co. Inc. (Baird) as its financial adviser. In 2012, Baird suggested Plano as a potential acquisition candidate to the Ontario Teachers' Pension Plan Board (OTPP), one of Canada's largest institutional investors.
OTPP acquired Plano, using a subsidiary merger transaction that closed in December 2012. After the merger, OTPP owned Plano through Plano Holding LLC (Holding). The merger agreement set the purchase price at $240 million, subject to certain adjustments, including an adjustment for estimated transaction expenses. Estimated transaction expenses were defined in the agreement as all unpaid fees or expenses incurred by Plano or its subsidiaries (or for which they were liable) in connection with the planned merger.
The definition of transaction expenses in the agreement included fees and expenses payable to financial advisers. Plano paid Baird a fee of $1.5 million. This fee was paid under a November 2012 agreement between Baird and OTPP that stated it was for Baird's services as OTPP's "exclusive financial adviser" and that the services were provided solely for the benefit of OTPP's managers and directors. Despite the description of the services provided as financial advisory services, the agreement stemmed from OTPP's determination that Baird should be compensated for initially suggesting Plano as an acquisition candidate. Baird did not provide and was not compensated for any financial advisory or other services to OTPP for the acquisition. This fee was not treated as a transaction expense that reduced the purchase price of Plano.
All of the financial advisory services needed by Plano for the acquisition were provided by another company hired by Plano. The $2.89 million fee paid to this company was treated as a transaction expense that reduced the purchase price of Plano.
In their 2012 consolidated return, Holding, Plano, and certain other affiliated corporations claimed a deduction for 70% of the Baird fee (with the balance being capitalized) pursuant to an election under Rev. Proc. 2011-29.
The IRS, on examination, concluded that Plano should not have claimed this deduction. It issued a notice of deficiency to Holding disallowing the expense, stating that Plano had not shown that it paid the Baird fee for ordinary or necessary business purposes or that any part of the fee qualified as a business expense under the Code.
Holding filed a petition with the Tax Court challenging the IRS's determination.
The Tax Court's decision
The Tax Court held that Holding could not deduct the Baird fee. The court applied the two-part analysis from Lohrke, 48 T.C. 679 (1967), in making its decision.
Under both Supreme Court and Tax Court precedent, a taxpayer generally may not deduct the payment of another person's expenses. However, in Lohrke, the Tax Court recognized a narrow exception to this rule if two conditions are met: (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. The court found that Plano failed to meet either condition, so the IRS had properly disallowed the deduction for the Baird fee payment.
First Lohrke condition: To meet the first Lohrke condition, a taxpayer must establish that it made a payment primarily to benefit its own business, and it must show a direct connection between the purpose of the payment and the taxpayer's business or income-producing activities. A common way to do this, the Tax Court explained, is to show its business would have faced direct and proximate adverse consequences if it had not made the payment for the other person.
Holding argued that Plano made the payment to facilitate its acquisition by OTPP, which would and did allow Plano to expand its plastic molding business. The Tax Court, though, found that Holding had failed to establish the requisite direct link between this ostensible business purpose and the Baird payment. The court observed that Holding did not contend that the merger was contingent on Plano's paying the Baird fee or demonstrate any direct and proximate adverse consequences to Plano's business of manufacturing plastic goods had Plano not paid the Baird fee. While Plano had expanded after the acquisition, the court found it had not proved that OTPP would have reduced its financial backing to Plano if it had not paid the fee.
Thus, the court stated, it could "discern no benefit to Plano from the Baird payment, as distinguished from the merger itself." Rather, it concluded that the primary benefit from the Baird payment was to OTPP. Consequently, it found that Holding had failed to satisfy the first Lohrke condition.
Second Lohrke condition: Although the failure to meet the first Lohrke condition was enough for the court to affirm the IRS's disallowance of the claim, it also addressed the second condition. The court stated that if Plano, like OTPP, was an institutional investor, it might find that a fee like that paid to Baird, if it were not capitalizable as an expenditure to acquire Plano, was a deductible ordinary and necessary business expense. However, because Plano's business was "manufacturing plastic goods, primarily storage items for outdoor sports," the court was not persuaded that the payment qualified as ordinary or necessary for Plano's line of business. Holding pointed to two Tax Court decisions, Waring Prods. Corp., 27 T.C. 921 (1957), and Square D Co., 121 T.C. 168 (2003), as support for the proposition that the Baird payment was an ordinary and necessary expense for Plano, but the court found that "neither of these fact-driven decisions" supported that conclusion.
Although the Tax Court does not mention it explicitly, the reason OTPP had Plano pay the fee instead of paying it itself is that, as a Canadian not-for-profit, OTPP would presumably not have benefited from the deduction, whereas, if the fee was paid by Plano, Plano could take a deduction, which would increase the net amount of income flowing through to OTPP.
Plano Holding LLC, T.C. Memo. 2019-140