Some Forbearance Payments Deductible, Some Not

The Tax Court held that a corporation could deduct forbearance payments made to its shareholders in return for their promise not to exercise their stock redemption rights under the first two of several agreements. However, the court also held that payments under a subsequent agreement had to be capitalized, since there was a reasonable expectation the agreement would be renewed and, therefore, a right was created with a duration of more than 12 months.

Treas. Reg. § 1.263(a)-4(d)(2)(i) requires the capitalization of amounts paid to another party that create, renew, renegotiate or modify an ownership interest in a corporation. Some of those costs, however, generally can be deducted using Treas. Reg. § 1.263(a)-4(f)(1) if the benefit or right created lasts no more than 12 months and extends no longer than the end of the tax year following the tax year of payment. The duration of the right or benefit includes any renewal period if renewal is reasonably expected to occur.

Media Space Inc. was a media advertising sales company operating in Connecticut. In 1999 and 2000, when raising startup capital, the company issued preferred stock that shareholders could redeem on Sept. 30, 2003, or later, at a price stated in the corporate charter. The charter also required payment of interest to shareholders who had exercised their redemption rights but received no immediate payment because Media Space was unable legally or financially to make immediate payment.

Prior to Sept. 30, 2003, Media Space and its investors realized the corporation was incapable of redeeming the stock, and if the redemption rights were exercised, its auditors would have to issue a going-concern statement. On Sept. 30, 2003, the investors agreed to not exercise their rights for one year, in return for a payment on Sept. 30, 2004. That payment was equal to the interest that would have accrued to the shareholders on Sept. 30, 2004, under the charter if they had received no immediate payment after exercising their rights on Sept. 30, 2003. On Sept. 30, 2004, the agreement was extended until May 31, 2005, under similar terms and was subsequently extended each May 31 on an annual basis. The company accrued and deducted $874,955 on its 2004 income tax return as interest expense and $1,229,367 as forbearance expense on its 2005 return. In 2008, the IRS issued a deficiency notice that disallowed those deductions. Media Space contested the notice and subsequently petitioned the Tax Court for relief.

The court agreed with the taxpayer that the payments were not stock redemption costs, corporate reorganization costs or corporate distributions, but agreed with the IRS that the payments were not interest. According to the court, the payments could be interest only if Media Space had an obligation to pay the redemption amount under the terms of the charter. However, Media Space only would have an obligation to pay the redemption amount if and when the shareholders exercised their redemption rights. Since those rights were never exercised, there was no obligation.

The court held that the forbearance payments were ordinary and necessary expenses under section 162. The court found that the payments were ordinary, because an expert witness testified that such payments were common in business, and that they were necessary, because the forbearance agreement prevented the company’s auditors from issuing a going-concern statement, which helped the taxpayer’s financial situation. However, the court held that unless the 12-month rule applied, the payments must be capitalized under Treas. Reg. § 1.263(a)-4(d)(2)(i) because they modified the terms of a financial interest (the preferred stock).

The court permitted deduction of the forbearance payments related to the September 2003 and September 2004 agreements since each agreement had a duration of 12 months or less. According to the court, neither agreement had a reasonable expectation of renewal because at the time of the agreements, no renewal history had yet been established, and the taxpayer’s improving cash flow situation might allow redemption of the stock. However, the court held the 2006 extension must be combined with the 2005 extension, resulting in a duration greater than 12 months, since at the time of the 2005 extension the forbearance had been extended twice already and the taxpayer’s worsening cash flow situation indicated Media Space would want to renew the agreement.

By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.

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