IRS Won't Follow Tax Court Decision on Deductibility of Forbearance Payments.
(Parker's Federal Tax Bulletin: July 31, 2013)
Recently, a conflict erupted between the IRS and the Tax Court on the issue of whether or not payments made under a forbearance agreement are deductible. A forbearance agreement generally refers to an agreement to defer payment to a creditor. In Media Space v. Comm'r, 135 T.C. 424 (2010), a corporation entered into several consecutive forbearance agreements whereby the corporation's preferred shareholders agreed to forgo their redemption rights in exchange for payments (i.e., forbearance payments) from the corporation. The corporation deducted the payments as interest, or alternatively as business expenses, while the IRS took the position that none of the payments were deducible. The court rejected the IRS's arguments and allowed a partial deduction. On July 23, 2013, the IRS issued AOD-2012-08 in which it rejected the Tax Court's analysis and said that it would continue to pursue the positions it took against the taxpayer in Media Space.
Media Space Decision
In 2003, Media Space issued shares of preferred stock shortly after its incorporation. Media Space's charter granted its preferred shareholders redemption rights that, if exercised, triggered obligations by Media Space to pay the redemption amount. If Media Space was unable to pay the redemption amount, it was required to pay interest on the redemption amount. In 2004 and 2005, Media Space entered into several consecutive forbearance agreements whereby the preferred shareholders agreed to forgo their redemption rights in exchange for forbearance payments. The 2004 agreement covered 12 months or less. But, due to extensions, the 2005 agreement was found to cover more than 12 months.
Media Space reported the 2004 payments as interest expense and the 2005 payments as an ordinary and necessary business expense. The IRS disallowed both deductions. In the Tax Court, the IRS argued that Code Sec. 263(a) and Reg. Sec. 1.263(a)-4 required that the forbearance payments be capitalized as amounts paid to create an intangible asset. In the alternative, the IRS argued that the payments were nondeductible distributions made to shareholders with respect to their stock under Code Sec. 301, Code Sec. 162(k), and Code Sec. 361(c).
The Tax Court held that the payments were not interest and could not be deducted as interest expense. However, the court held that the forbearance payments satisfied the "ordinary and necessary" test of Code Sec. 162(a). The court also determined that Reg. Sec. 1.263(a)-4(d)(2)(i) required capitalization of the forbearance payments, but that the 12-month rule of Reg. Sec. 1.263(a)-4(f)(5) (i) removed the 2004 forbearance agreement from the purview of Reg. Sec. 1.263(a)-4(d)(2)(i).
The 12-month rule in Reg. Sec. 1.263(a)-4(f)(5)(i) provides that, unless otherwise provided, a taxpayer is not required to capitalize amounts paid to create (or to facilitate the creation of) any right or benefit for the taxpayer that does not extend beyond the earlier of (1) 12 months after the first date on which the taxpayer realizes the right or benefit, or (2) the end of the tax year following the tax year in which the payment is made. Thus, the court held that the forbearance payments relating to the 2004 agreements fell within the 12-month rule and were deductible as business expenses under Code Sec. 162.
However, the court ruled that the forbearance payments relating to the 2005 agreements did not fall within the 12-month rule, due to an extension of the agreement, and had to be capitalized under Reg. Sec. 1.263(a)-4(d)(2)(i).
The court further found that there was neither a reacquisition nor an exchange of stock to which either Code Sec. 162(k) or Code Sec. 361(c)(1) applied. The court also found that the payments were not distributions under Code Sec. 301. The IRS appealed to the Second Circuit, which subsequently dismissed the appeal after an agreement was reached between the IRS and Media Space.
In July 2013, the IRS issued AOD-2012-08, in which it formalized its disagreement with the Tax Court's findings and said it would nonacquiescence on the issues ruled on by the Tax Court.
Requirement to Capitalize Intangibles
Amounts paid or incurred to acquire an intangible from another party are generally capitalized under Reg. Sec. 1.263(a)-4(c)(1). Similarly, Reg. Sec. 1.263(a)-4(d)(2)(i) provides that a taxpayer must capitalize amounts paid or incurred to create certain intangibles, including certain financial interests. Financial interests covered by this capitalization rule include:
an ownership interest in an entity;
a debt instrument or other intangible treated as debt (such as a deposit, a stripped bond, a stripped coupon, or a regular interest in a REMIC or FASIT);
a financial instrument (including a letter of credit, a credit card agreement, a notional principal contract, a foreign currency contract, a futures contract, a forward contract, an option, or any other financial derivative);
an endowment contract, annuity contract, or insurance contract that has (or may have) cash value; nonfunctional currency; and
an agreement providing either party with the right to use, possess, or sell any of the above intangibles.
Do Forbearance Payments Create a Financial Interest that Must Be Capitalized?
As noted above, a taxpayer must capitalize amounts paid to create an intangible described in Reg. Sec. 1.263(a)-4(d)(2). Stock in a corporation is among the financial interests described. The general rule requires capitalization of amounts paid to create, originate, enter into, renew or renegotiate such an interest. According to the IRS, the Tax Court correctly concluded that, as amounts paid to renegotiate a financial interest, the forbearance payments were subject to the general capitalization requirements applicable to created intangibles.
However, the IRS said the court erred in holding that the 12-month rule of Reg. Sec. 1.263(a)-4(f)(1) exempts the forbearance payments from the general capitalization requirement applicable to intangibles because the payments effected a modification rather than a creation. That rule, the IRS noted, provides that an expenditure that gives rise to a benefit that lasts no more than 12 months need not be capitalized. But the IRS noted, under Reg. Sec. 1.263(a)-4(f)(3), created financial interests are excepted from the 12-month rule. Consequently, the IRS said that the rule of capitalization should apply to the forbearance payments at issue. In the IRS's opinion, the Tax Court read the word create narrowly in Reg. Sec. 1.263(a)-4(f)(3), applying it inconsistently with the broader reading it gave the word in Reg. Sec. 1.263(a)-4(f)(1). Thus, the IRS said it will continue to litigate the issue, taking the position that payments that affect a financial interest are excepted from the 12-month rule and must be capitalized.
OBSERVATION: In Media Space, the Tax Court noted that Reg. Sec. 1.263(a)-4(f)(3) provides that the 12-month rule does not apply to amounts paid to create a Code Sec. 197 intangible or amounts paid to create an intangible described in Reg. Sec. 1.263(a)-4(d)(2). However, the court said that, while it had previously found that the terms of the investor's redemption rights were modified by the forbearance agreement, no intangible (i.e., stock) was created by the forbearance agreement. Therefore, the court concluded that Reg. Sec. 1.263(a)-4(f)(3) did not prevent the 12-month rule from applying.
Are the Forbearance Payments Like Those in Media Space Nondeductible Distributions to the Shareholders under Code Sec. 301?
In AOD-2012-08, the IRS states that, even if the forbearance payments are deductible under Reg. Sec. 1.263(a)-4(d)(2), the payments are nonetheless nondeductible distributions to the taxpayer's preferred shareholders under Code Sec. 301. According to the IRS, allowing the deduction of the forbearance payments would impermissibly allow a corporation a deduction for its payment to a shareholder of a return on the shareholder's investment. That Media Space received value for the forbearance payments, specifically the retention of equity capital, does not remove the forbearance payments from the scope of Code Sec. 301, the IRS said, because providing equity capital is a shareholders' function. The IRS concluded that compensation paid to a shareholder for providing equity capital is not deductible.
Are the Forbearance Payments Like Those in Media Space Nondeductible Distributions to the Shareholders under Code Sec. 162(k) or Code Sec. 361(c)?
In AOD-2012-08, the IRS states that forbearance payments of the type in Media Space are nondeductible distributions to the taxpayer's preferred shareholders under Code Sec. 162(k) (providing for nondeductibility of amounts paid or incurred in connection with reacquisitions of stock) and Code Sec. 361(c) (providing that a corporation a party to a reorganization in Media Space's case, a recapitalization under Code Sec. 368(a)(1)(E) does not recognize any gain or loss on its distribution to shareholders of property in pursuance of the plan of reorganization). The forbearance agreement is a significant enough modification, the IRS said, to constitute a deemed exchange of the original preferred stock for new preferred stock and money (i.e., the forbearance payments).
According to the IRS, this argument is in accord with the case law principle regarding debt, eventually drafted into Reg. Sec. 1.1001-3, that a significant modification of a debt instrument results in a deemed taxable exchange of the original debt instrument for a modified instrument. Before entering into the forbearance agreement, the preferred shareholders possessed the right at any time to force redemption and be paid in full if they, for instance, sensed that the corporation's finances might deteriorate. By entering into the forbearance agreement, however, the shareholders exchanged the right to demand redemption at any time for (1) the forbearance payment received (which is smaller than the redemption payment would be); and (2) only a postponed right to demand redemption. A right to demand redemption at any time, the IRS noted, is significantly different from a postponed right to demand redemption. The postponed right to demand redemption is less valuable because there is an additional risk that the corporation's finances will deteriorate and the corporation will be unable to pay at the postponed redemption date.
According to the IRS, where there is a deemed exchange of old preferred stock for new preferred stock, such a transaction leads to the conclusion that both Code Sec. 162(k) and Code Sec. 361(c)(1) preclude deduction of the forbearance payments.
While the Tax Court seems inclined to hold that forbearance payments are deductible as long as they relate to an agreement that falls within the 12-month rule, it will be interesting to see if other courts follow suit. For taxpayers, it's important that any agreement that will result in forbearance payments must not be seen as existing beyond 12 months. Otherwise, the payments must be capitalized. As the Tax Court noted, the duration of a right under an agreement includes any renewal period if all the facts and circumstances in existence during the tax year in which the right is created indicate a reasonable expectancy of renewal. Thus, if there is a reasonable expectancy of renewal or extension of a forbearance agreement that leads to an agreement of more than 12 months, the 12-month rule would not apply, and the taxpayer must capitalize the forbearance payments.
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