Congress clarifies denial of redemption expenses under sec. 162(k).

Sec. 162(k), added by the Tax Reform Act of 1986 (TRA), denies a deduction for any amount paid or incurred by a corporation in connection with the redemption of its stock. The IRS has taken the position that loan costs incurred to fund redemption cannot be amortized over the period of the loan, because such costs are incurred in connection with a redemption within the meaning of Sec. 162(k). However, the courts have reached conflicting conclusions on the issue. The Tax Court found in favor of the Service in Fort Howard Corp., 103 TC 345 (1994), but the Ninth Circuit reached a contrary decision in Kroy (Europe) Limited, 27 F3d 367 (1994). The issue has been addressed by a technical correction to Sec. 162(k) included in the Small Business Job Protection Act of 1996 (SBJPA). The SBJPA reverses the IRS's position, clarifying that amounts properly allocable to indebtedness on which interest is deductible and properly amortized over the term of the indebtedness are not subject to the disallowance provisions of Sec. 162(k). This clarification will be effective retroactively as if included in the TRA.

As a consequence of this clarification, the Service can be expected to abandon its current litigating position, thereby allowing corporations to amortize such loan costs without the threat of challenge. Also, any pending IRS examination concerning this issue may now be resolved. Corporations that made a financial statement provision for exposures relating to such deductions should review such reserves.

In addition, the retroactive effective date of this technical correction might provide corporations with an opportunity for a refund in certain circumstances. For example, a corporation might claim a refund for tax years in which it followed the Service's position and accordingly did not amortize such loan costs. Note, however, that in certain circumstances, recouping amortization that should have been claimed in prior tax years might constitute an accounting method change. Also, a recovery might be precluded if a corporation settled this issue with the IRS by entering into a closing agreement.

In addition to the taxpayer-favorable clarification concerning loan costs, the SBJPA also broadens the application of Sec. 162(k), by clarifying that its rule apply to any amount paid or incurred by a corporation in connection with any acquisition of its previously outstanding stock or of the stock of any related person described in Sec. 465(b)(3)(C). Consequently, the denial of a deduction applies to any reacquisition of previously outstanding stock, regardless of whether: - the transaction is treated as a redemption for purposes of subchapter C (see, e.g., Sec. 317(b)), - the reacquisition is afforded sale or dividend treatment, or - the transaction qualifies as a reorganization or other transaction.

This broadening clarification generally will be effective for amounts paid or incurred after Sept. 13, 1995. However, legislative history indicates that no inference is intended as to whether such costs are deductible under prior law.