Court rebuffs IRS and allows deduction for lease termination payment
ABC Beverage Corporation & Subsidiaries v. U.S., (DC MI 8/27/2008) 102 AFTR 2d ¶ 2008-5231
A district court has allowed a party that exercised an option to buy property that it was leasing to deduct a portion of the amount tendered in the transaction as a lease termination payment. In so doing, the court rejected IRS‘s argument that full amount tendered had to be capitalized as part of the purchase price. The record, however, was insufficient for the court to determine the proper year for taking the deduction.
Facts. In ’87, Corporate Property Associates (Landlord) entered into a lease with Tandem Holdings, Inc. for property located at 555 McDonnell Boulevard (McDonnell Property) in Hazelwood, Missouri. The initial lease period lasted 300 months and provided for five successive five-year renewal options. Through a series of corporate and stock transactions, one of the subsidiaries of the taxpayer ABC Beverage Corporation acquired the lease in ’95. The lease included a provision for calculating the amount of rent owed each month.
The lease also contained a clause allowing the tenant the option to purchase the McDonnell Property with the purchase price calculated under a formula in the lease. On Dec. 10, ’96, the then tenant notified Landlord it was exercising its right to purchase the property. However, even with the formula, the parties couldn’t agree on the purchase price. The parties remained at an impasse and on Oct. 2, ’97, Landlord notified ABC that it considered ABC in default under the lease for failure to pay the full amount of rent owed. Landlord exercised its remedies under the lease and requested ABC to make an offer to purchase the property. A day later, Landlord filed suit in state court over the amount of rent due. While the action was pending, the parties entered into an agreement in January ’99 in which they agreed the fair market value of the property would be no less than $9 million and no greater than $11.5 million. Later in ’99, they agreed on a purchase price of $11 million.
On its ’97 tax return, ABC claimed a deduction for $6,250,000 as a lease termination expense and capitalized the McDonnell Property for $2,750,000. These figures were based on a $9 million minimum purchase price. On Nov. 17, 2005, IRS assessed an income tax deficiency of over $2.4 million against ABC. The dispute over the lease termination payment deduction wound up in district court where each party sought summary judgment.
Background. Code Sec. 167(c)(2) provides that where property is acquired subject to a lease, no basis is allocated to the leasehold interest.
Parties’ arguments. IRS argued that Code Sec. 167(c)(2) prohibits any allocation of the purchase price of the property to the leasehold interest. As a result, IRS concluded that ABC could not claim any of the cost of terminating the leasehold as a business expense. Alternatively, it argued that if a deduction is allowable, the proper year for the deduction is ’99 not ’97.
Court allows deduction. The court determined that Code Sec. 167(c)(2) did not apply. It noted that the property in question was subject to a lease before ABC acquired it with ABC as lessee. Therefore, when ABC acquired the property, the leasehold merged with the larger estate and the property was no longer subject to a lease. The contract included evidence that the parties intended title to merge upon the purchase of the property by the lessee.
The court further explained its reasoning as follows. Whether property is acquired by the lessee of that property or by a third party makes a significant difference in terms of both the rights acquired and the tax consequences of the acquisition. IRS argued that, under Code Sec. 167(c)(2), it should not make any difference who acquires the property. But the Court noted that if leased property is sold by the owner to a third party, the third party acquires a reversion, but no concurrent right to possession. The tax consequences of the third party’s acquisition are outlined under Code Sec. 167(c)(2). However, when the lessee of the property acquires the property, the lease and the reversion merge and there is no lease burdening the estate. Consequently, Code Sec. 167(c)(2) would not apply because the property is not subject to a lease.
Observation: The Tax Court, in Union Carbide Foreign Sales Corp., (2000) 115 TC 423, reached an opposite conclusion with respect to the application of Code Sec. 167(c)(2) when a tenant pays a lease termination fee in conjunction with the purchase of the property it leased (see Federal Taxes Weekly Alert 11/16/2000). Specifically, in that case, the taxpayer purchased a ship in order to terminate a burdensome lease on it. In a case of first impression, the Tax Court held that the taxpayer could not allocate a portion of the cost of acquiring the vessel to the termination of the lease because Code Sec. 167(c)(2) required the entire cost to be allocated to the basis of the vessel. The district court acknowledged the Tax Court decision but respectfully disagreed with its reasoning and conclusions.
The district court then held that, under Cleveland Allerton Hotel, (CA 6 1948) 36 AFTR 862, ABC was entitled to claim, as a business expense, the cost associated with buying out an onerous lease.
Record not sufficient to determine year for taking the deduction. IRS also argued that the economic performance requirement of Code Sec. 461(h) was not satisfied until the seller transferred title to the property in ’99, and therefore the deduction was not proper until ’99. ABC claimed that liability was established six months after it notified Landlord in December ’96 it was exercising its right to purchase the property. The court said that, viewing the evidence in a light most favorable to ABC, there was a genuine issue of material fact when the amount of liability was established with reasonable accuracy.
Bottom line. Under Sixth Circuit precedent, the Court held that ABC was entitled to claim a deduction for the portion of the purchase price that could be attributed to buying out the excessive lease. ABC established the fair market value of the property, that the lease was excessive, and that the amount it paid to acquire the property over the fair market value of the property was attributable to buying out the onerous lease. However, a genuine issue of material fact precluded summary judgment on when the deduction could be taken. The proper deduction year would have to be determined in an additional proceeding.
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