ABC Beverage Corp. (then known as Beverage America) in 1995 acquired via its subsidiary another bottling company, including a lease with an option to purchase its business site in Hazelwood, Mo. A rent escalator clause in the lease made it advantageous to buy the property in 1997, the only purchase period permitted. The price under the purchase option was well above the fair market value of the property exclusive of the lease. Therefore, ABC capitalized the property at the appraised value of $2,750,000 and deducted the difference between it and the negotiated minimum purchase price of $9 million (it actually paid $11 million), or $6,250,000, as a lease termination expense. The IRS assessed a deficiency of more than $2.46 million, for which ABC sued for a refund.
The IRS argued that IRC § 167(c)(2) prohibited any allocation of the purchase price to the leasehold interest. That provision says that none of a property’s basis shall be allocated to a leasehold if it is “acquired subject to a lease.” But the district court in western Michigan hearing the case held that the phrase “subject to a lease” applies to a third-party purchaser who acquires a reversion in the continuing lease, not to a lesseepurchaser whose purchase extinguishes the lease, as here. Thus, section 167(c)(2) did not apply, and the amount paid for the property could be treated separately from the amount paid for the onerous lease.
In holding for the taxpayer, the court noted that its appellate circuit, the Sixth, had allowed a business deduction for the cost of buying out an onerous lease in Cleveland Allerton (36 AFTR 862 (1948)). The IRS, however, contended that the precedent of Cleveland Allerton was nullified by the Supreme Court in Millinery Center (350 U.S. 456, 49 AFTR 171 (1956)). In that case, the Supreme Court reviewed a Second Circuit decision denying a deduction to a tenant-purchaser because the Sixth Circuit’s Cleveland Allerton decision was in apparent conflict with it. The Supreme Court denied the deduction, but the district court in ABC said a careful analysis of Millinery Center indicates the reason for disallowing the deduction was a lack of evidence that the rent was onerous. In other words, the ABC court believed the conflict between the circuits could not be resolved in Millinery Center because the taxpayer in that case could not reach the factual threshold of proving an onerous lease, as the taxpayer in the instant case had.
n ABC Beverage Corp. v. U.S., 102 AFTR2d 2008-5905
By Larry Maples, CPA (inactive), DBA, professor of accounting, Tennessee State University, Nashville, Tenn., and Mark A. Turner, CPA, DBA, associate professor of accounting, University of St. Thomas, Houston.