Ash Grove Cement Company v. United States of America

Filing 41

MEMORANDUM AND ORDER granting 31 Motion for Summary Judgment; denying as moot 38 Motion for Hearing; denying as moot 34 Motion to Exclude. Signed by District Judge Carlos Murguia on 2/6/2013. (kao)

IN THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF KANSAS

ASH GROVE CEMENT COMPANY
and its Subsidiaries, as a Consolidated Group,
Plaintiffs,
v.
UNITED STATES OF AMERICA,
Defendant.
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Case No. 11-2546-CM

MEMORANDUM AND ORDER
This is a tax refund case. Currently before the court is the government’s motion for summary
judgment (Doc. 31). In that motion, the parties dispute whether the litigation expenses incurred by
Ash Grove Cement Company (“Ash Grove”) in resolving a class action lawsuit are deductible as
ordinary and necessary business expenses under 26 U.S.C. § 162 or are non-deductible capital
expenses under 26 U.S.C. § 263. Because the origin of the claim for which Ash Grove incurred these
expenses arose from a capital transaction, the court grants the government’s motion.1
I.

BACKGROUND2

Ash Grove’s primary business activity is the manufacture and sale of cement. Before
December 31, 2000, Vinton Corporation (“Vinton”) owned 67 percent of the outstanding Ash Grove
stock. The remainder of the outstanding Ash Grove stock was owned by certain Sunderland family

1

For simplicity, the court refers to Ash Grove Cement Company and Ash Grove and its subsidiaries as a consolidated
group interchangeably as “Ash Grove.”

2

The parties stipulated to the following facts in the Pretrial Order.

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members (approximately six percent), Ash Grove’s employee stock ownership plan (less than two
percent), and approximately 150 other shareholders unrelated to the Sunderland family.
Before December 31, 2000, Vinton was wholly owned by or for the benefit of multiple
generations of the Sunderland family. For many years prior to December 31, 2000, Vinton had a
wholly-owned subsidiary, Lyman-Richey Corporation (“Lyman-Richey”), which is a ready-mix
concrete company. For various business reasons, the Sunderland family, Vinton, and Ash Grove
determined that Ash Grove should acquire Lyman-Richey and Vinton, with the Sunderland family
members receiving Ash Grove stock in exchange for their Vinton stock.
Ash Grove had a nine-member Board of Directors (“the Board”). Four directors were
members of the Sunderland family. Three directors were full-time employees of Ash Grove. Two
directors were not employees of Ash Grove but had been on the Board for fifteen years. As the
Sunderland family members and Ash Grove employees constituted a majority of the Board, the Board
on May 3, 2000, appointed a committee composed of the two independent Ash Grove directors to
negotiate the deal between Ash Grove, Vinton, and Lyman-Richey (“the Special Committee”).
Throughout the rest of 2000, the Special Committee negotiated the reorganization terms on
behalf of Ash Grove with Vinton and the Sunderland family. The Special Committee approved the
reorganization on November 2, 2000, which provided for an exchange ratio of 876 Ash Grove shares
for each Vinton share. The transaction at issue in this case consists of multiple steps involving taxfree reorganizations (collectively, “the Transaction”), through which Ash Grove acquired all of
Vinton’s assets, including all of the issued and outstanding Lyman-Richey stock. After all of the steps
were completed, Ash Grove owned Lyman-Richey and the Sunderland family members that owned
Vinton stock became the direct owners of the Ash Grove stock owned by Vinton, including the stock
received in exchange for Lyman-Richey. The Transaction was completed on December 31, 2000.

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On January 18, 2002, Daniel Raider, a minority shareholder in Ash Grove, filed a class action
complaint (“the Raider Complaint”) in the Delaware Court of Chancery against all nine of Ash
Grove’s directors (“Directors”) and Ash Grove (“the Raider Litigation”). The Raider Complaint
alleged that the Transaction improperly diluted the liquidation value of the shares held by the minority
stockholders and, therefore, their proportionate voting power. The relief sought by the Raider
Complaint was that the Transaction be declared unfair to non-Sunderland family shareholders and
rescinded, that shares wrongfully issued to the Sunderland family be cancelled, and that compensation
be paid for losses sustained by the class as a result of the Transaction.
In August 2005, the Raider Litigation was settled without Ash Grove or its officers or directors
admitting any liability. As part of the settlement, Ash Grove placed $15,000,000 into a trust to be
divided up, after legal fees of the Raider plaintiffs were paid, among the class members based on the
ratio of shares they owned to the total number of minority-held shares. In addition to the payments
made to settle the Raider Litigation, Ash Grove also paid $43,345 during its 2005 tax year for legal
fees incurred to defend the Directors. Article V of Ash Grove’s bylaws provided indemnification
rights for directors and officers of Ash Grove.
In its federal income tax return for 2005, Ash Grove deducted the settlement payment and the
payment of legal fees as an ordinary and necessary business expenses under “Legal Settlement
Expense.” During its examination of the 2005 return, the Internal Revenue Service (“IRS”)
disallowed the deduction for these payments based upon its determination that the payments should be
considered capital expenditures under 26 U.S.C. § 263. Ash Grove paid the tax deficiency and timely
filed a Form 1120X, claiming it was entitled to a refund of $7,730,308. That claim was denied in full
by the IRS, after which Ash Grove properly filed its complaint in this court within two years after the
claims were denied by the IRS.

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II.

ANALYSIS

The government moved for summary judgment (Doc. 31). Summary judgment is appropriate
when “there is no genuine dispute as to any material fact” and the moving party “is entitled to
judgment as a matter of law.” Fed. R. Civ. P. 56(a); see also Matsushita Elec. Indus. Co. v. Zenith
Radio Corp., 475 U.S. 574, 586–87 (1986) (outlining summary judgment burden).
In this case, the issue before the court is whether the $15,043,345 in litigation expenses
incurred by Ash Grove in resolving the Raider Litigation are deductible “ordinary and necessary”
business expenses under 26 U.S.C. § 162 or nondeductible capital expenses under 26 U.S.C. § 263.
The parties agree that Ash Grove, as the party seeking the deduction, bears the burden of
demonstrating entitlement to the deduction. (Doc. 32 at 8 (citing Indopco, Inc. v. Comm’r, 503 U.S.
79, 84 (1992)); Doc. 33 at 6 (agreeing that Ash Grove “bears the burden of proving that it is entitled . .
. to the claimed deductions”).)
Ash Grove is a taxable corporation and is allowed to deduct “all ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business . . . .” 26 U.S.C.
§ 162(a). But Ash Grove is not allowed to deduct expenses it incurs with respect to the acquisition or
creation of a capital asset or to defend or perfect title to a capital asset. Instead, such expenses must
be capitalized as part of the cost of such property. 26 U.S.C. § 263.
To determine whether an expense is capital or ordinary, federal courts apply the “origin of the
claim” test. This test examines the “origin and character” of the claim for which the taxpayer incurred
the expense. Woodward v. Comm’r, 397 U.S. 572, 577 (1970). The object of this test is to determine
“whether or not the claim arises in connection with the taxpayer’s profit-seeking activities.” United
States v. Gilmore, 372 U.S. 39, 48 (1963) (emphasis in original). And the test focuses on the

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substance of the claim rather than its form. Clark Oil & Refining Corp. v. United States, 473 F.2d
1217, 1220 (7th Cir. 1973).
The Supreme Court explained this test in Woodward. In that case, the taxpayers owned or
controlled the majority of the common stock in an Iowa publishing corporation. The taxpayers—over
the dissent of a minority shareholder—voted to extend the corporation’s charter, which triggered a law
that required the taxpayers to purchase the minority shareholder’s stock. Appraisal litigation ensued
to determine the purchase price. The taxpayers attempted to deduct the litigation and appraisal fees as
ordinary and necessary business expenses, which the IRS denied.
The Supreme Court agreed with the IRS because the origin of the claim in the appraisal
litigation was the determination of the purchase price. Because determination of the price is clearly
part of the process of acquisition, the litigation and appraisal fees were properly treated as part of the
cost of the stock and were not deductible. In reaching this conclusion, the court rejected the
taxpayers’ attempt to rely on the “primary purpose” test because “[a] test based on the taxpayer’s
‘purpose’ in undertaking or defending particular piece of litigation would encourage resort to
formalisms and artificial distinctions.” 397 U.S. at 577.
The Court clarified the “origin of the claim” test in United States v. Hilton Hotel Corp., 397
U.S. 580 (1970), which was a companion case to Woodward. In determining that the challenged
expenses were not deductible, the Court explained that “the expenses of litigation that arise out of the
acquisition of a capital asset are capital expenses” regardless of the “taxpayer’s purpose in incurring”
them. Id. at 583.
In this case, it is undisputed that Ash Grove was a defendant in the Raider Litigation at the
time the litigation expenses were incurred. The Raider Lawsuit challenged the fairness of the terms of
the Transaction, through which Ash Grove acquired Lyman-Richey and merged with Vinton,

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challenged the accuracy of the valuations of the companies, and sought rescission of the Transaction.
Settlement of this lawsuit preserved the Transaction. As such, the court concludes that expenses
incurred in the Raider Litigation arise out of Ash Grove’s acquisition of Lyman-Richey, are capital
expenses, and are not deductible.
Ash Grove argues that this analysis fails to distinguish between the plaintiffs’ claims in the
Raider Litigation that the Directors’ breached their fiduciary duties and the Directors’ indemnity
claims against Ash Grove. Ash Grove contends that the $15,043,345 in litigation expenses are
deductible as ordinary and necessary business expenses because the Raider Litigation did not allege
any wrongdoing by—or seek monetary damages from—Ash Grove. Therefore, Ash Grove only
incurred these expenses as a result of honoring its indemnity obligations to its Directors. Because
indemnity expenses are ordinary and necessary business expenses, Ash Grove argues that it should be
allowed to deduct these expenses.
The rationale underlying Ash Grove’s argument, however, is inconsistent with Woodward.
Ash Grove focuses on the identity of the defendants in the Raider Litigation and the form of the
litigation. Ash Grove is correct that in both Woodward and Hilton the taxpayer was the party accused
of wrongdoing and that such is not the situation in this case. But the origin of the claim test explained
in Woodward does not hinge on such technical issues. Indeed, the Supreme Court expressly rejected a
test that encouraged parties to “resort to formalisms and artificial distinctions” in deciding whether
expenses were capital or ordinary. Woodward, 397 U.S. at 577. Instead, the test focuses on the
substance of the claim giving rise to the expenses. And, in this case, the substance of the claim from
which the expenses arose was capital.3

3

Ash Grove argues that the government’s position encourages companies to disregard their indemnity obligations
thereby forcing their directors to file a subsequent breach of contract lawsuit. The court disagrees. In the second
lawsuit, the director would have to show that it is entitled to indemnification. This would require the court to at least

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To make its argument, Ash Grove primarily relies on the Second Circuit’s opinion in
Larchfield Corp. v. United States, 373 F.2d 159 (2d Cir. 1966). Admittedly, in Larchfield the
taxpayer was allowed to deduct certain attorney’s fees it incurred as a result of its indemnity
obligations to a board member. But this case is not controlling on this court, predates Woodward by
several years, and applies the rejected “primary purpose” test.4 Id. at 167. The other cases relied on
by Ash Grove suffer from some or all of the same deficiencies. See Ingalls Iron Works Co. v.
Patterson, 158 F. Supp. 627 (N.D. Ala. 1958); B.T. Harris Corp. v. Comm’r, 30 T.C. 635 (1958).
Ash Grove’s approach also raises practical concerns. Specifically, if Ash Grove’s approach is
accepted, then companies could always deduct litigation expenses as ordinary and necessary business
expenses any time a director acting in good faith is sued in connection with a capital transaction so
long as the company has an indemnity obligation. It is also possible that Ash Grove’s approach could
encourage companies to creatively structure settlement agreements in litigation brought against it and
its directors so that the bulk of the settlement amount—if not the entire amount—would be deductible.
Such results are contrary to the rationale of Woodward and would allow companies to manipulate the
tax laws.
For all of these reasons, the court concludes that Ash Grove has not met its burden to survive
summary judgment. Absent more clear direction from the Supreme Court or the Tenth Circuit, this
court is unwilling to narrow the scope of Woodward in the manner Ash Grove suggests. Accordingly,
the court grants the government’s motion for summary judgment (Doc. 31). Also before the court is
the government’s motion to exclude Ash Grove’s expert (Doc. 34) and Ash Grove’s motion for oral

analyze the capital transaction and determine whether the director acted in good faith. The substance of the
subsequent lawsuit would still be the capital transaction.
4

Ash Grove notes that Larchfield was decided after Gilmore, which was the underlying case for the Supreme Court’s
decision in Woodward. Although true, the court notes that Larchfield never cites to or discusses Gilmore and, as
noted above, applies the “primary purpose” test.

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argument (Doc. 38). Because the court is granting summary judgment, the court denies both of these
motions as moot and without prejudice.
IT IS THEREFORE ORDERED that the United States’ Motion For Summary Judgment
(Doc. 31) is granted.
IT IS FURTHER ORDERED that the United States’ Motion To Exclude Expert Testimony
(Doc. 34) is denied as moot and without prejudice.
IT IS FURTHER ORDERED that Plaintiffs’ Request For Oral Argument (Doc. 38) is denied
as moot and without prejudice.
Dated this 6th day of February, 2013, at Kansas City, Kansas.
__s/ Carlos Murguia_____________________
CARLOS MURGUIA
United States District Judge

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