Lease cancellation expenditures.

If a corporate taxpayer decides to cancel a lease--even for a valid business purpose--it may be required to pay a cancellation fee. If a fee is paid, may the taxpayer deduct it or must it be capitalized? The Tax Court considered this question in a recent case.

U.S. Bancorp leased a computer for five years under a noncancelable lease. One year later, the company decided it needed a more powerful computer. U.S. Bancorp negotiated with the lessor the right to cancel the lease early in exchange for a $2.5 million payment. The cancellation contract provided for an increased payment if the company did not lease another computer from the lessor. The contract also said that the payment was due in installments over the life of the new lease. U.S. Bancorp deducted the $2.5 million payment on its tax return. The IRS rejected the deduction, saying the company had to capitalize the payment and amortize it over the life of the new lease. The company appealed.

Result: For the IRS. The Tax Court said the tax treatment of a typical lease cancellation payment is well established. A taxpayer can deduct a payment made to cancel a lease if the payment does not produce income but instead is a penalty for terminating an existing contract. However, if the taxpayer negotiates a new lease for property covered by an old lease, the cancellation payment should be capitalized and amortized over the life of the new lease. This payment is, in effect, a modification payment that generates benefits over the life of the new lease. The payment made by U.S. Bancorp fell between these two extremes.

The court concluded that the company's payment was more a modification payment than a cancellation penalty. The court based its finding on the fact that the cancellation and the new lease were effectively integrated. The cancellation agreement, in fact, specifically required U.S. Bancorp to obtain a new lease from the lessor. That the cancellation agreement provided for a higher payment if a second lease was not negotiated was more than offset by the fact the payment was due in installments and the contract referred to the payment as a rollover charge. Therefore, the court treated the payment as a modification fee to be capitalized and amortized over the life of the new lease.

Companies that want to deduct cancellation payments should not lease replacement property from the original lessor. If they do, it is important that they separate any cancellation payment from the new lease. A company will find it easier to prove the existence of separate contracts if the cancellation fee is due and payable in a lump sum regardless of any new lease. If the fee is payable in installments, the payments should not coincide with payments on the new lease.

* U. S. Bancorp and its Subsidiaries v. Commissioner, 111 TC no. 10.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School o[Accountancy, University of Alabama, Tuscaloosa.