Recent developments narrow the scope of Sec. 162(k)

Stock repurchase amoritzation deductions remain intact.
Robert WillensJune 12, 2002

In 1986, Halley’s comet disappointed skywatchers as the celestial mass failed to provide the brilliant display earth dwellers had hoped for. But not all stargazers missed out that year. In fact, corporate denizens following the Fifth Circuit Court of Appeals decision on the Five Star Manufacturing Co. case were treated to an IRS first—the enactment of Sec. 162(k).

The purpose of 162(k) was to eliminate any vestiges of the Five Star decision, a case that determined that under narrowly defined circumstances, a corporation may be able to deduct the amounts it expends to repurchase its stock. Sec. 162(k) saps the Five Star decision of any vitality; it prohibits a corporation from deducting any amount paid or incurred in connection with a redemption of its stock.

At one time, the IRS interpreted the “in connection with” clause to conclude that Sec. 162(k) covered not only the costs of effecting the redemption, but also the costs of arranging a loan to finance such redemptions. The rule had some success asserting this position. For example, it triumphed on this issue in the Fort Howard case.

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However, Congress intervened and enacted an addition to Sec. 162(k) which had an effective date retroactive to the date on which Sec. 162(k) was originally enacted. The addition makes it clear that the cost of arranging a loan to finance a buyback, to which Sec. 162(k) otherwise applies, will be amortizable over the life of the loan. (See Rev. Rul. 86-67.)

There was some fear that the IRS should prevent the amoritzation of covenants not to compete. That is, with covenants obtained by a corporation in connection with the repurchase of a departing shareholder’s stock. Note that a covenant is covered by Sec. 197 (“Sec. 197 intangible”), so it is amortizable over 15 years whenever there is a related purchase of a business (or a substantial portion of a business) through the purchase of assets or stock. Thus, a covenant is unique in that it is the only type of Sec. 197 intangible in a transaction that is not treated as a taxable purchase of assets.

However, this fear should now be dispelled, mainly because of the outcome of a recent case involving Frontier Chevrolet. In the case, the Tax Court concluded that a covenant obtained in connection with such a redemption was a Sec. 197 intangible&$8212;Sec. 197 applies, according to the court, even when the grantee of the covenant is acquiring an interest in a business that such grantee already conducts.

Moreover, the court did not mention the potential application of Sec. 162(k) to deny the resultant amortization deductions. This suggests that the IRS did not even raise the issue for the court’s consideration.

It is well established that in connection with an acquisition, an acquired corporation can obtain tax deductions for payments it makes to its optionees—normally to cancel the vested options. The option spread is the amount by which the value of the stock exceeds the strike price of the option. Even though these payments are made in connection with an acquisition, and hence might be regarded as capital expenditures, they have been ruled to be deductible. That is because the cancellation of the options satisfies a pre-existing obligation of a compensatory nature, rather than the satisfaction of a new obligation generated by the acquisition itself.(See Rev. Rul. 73-146)

Sec. 162(k) does not change this result. This is true even though, under Sec.318(a)(4), a person who has an option to acquire stock is deemed to own the stock.

Nevertheless, it has been held that this rule does not affect the deductibility of these cancellation payments. Most important, Sec. 318(a)(4) only applies to treat the holder of an option as the holder of the underlying stock, where it is expressly made applicable and Sec. 318(a)(4) does not apply for purposes of Sec. 162(k). In addition, even if Sec. 318(a)(4)applied for purposes of Sec. 162(k), its provisions would not operate to disallow the deduction: The fact that persons own the stock underlying an option does not mean that the option is treated as stock (but compare Rev. Rul. 82-150).

Accordingly, since Sec. 162(k) only applies with respect to redemptions by a corporation of its stock, the provision cannot, by its terms, have an impact with respect to the cancellation of a corporation’s outstanding options.