Lease termination payments not deductible.
Not surprisingly, the IRS relied on INDOPCO, Inc., 503 US 79 (1992), in which the Supreme Court stated that deductions are exceptions to the norm of capitalization. According to Sec. 162 and the underlying regulations, current deductions are specifically listed; therefore, expenditures not found specifically within the law become subject to disallowance. Sec. 263, relating to capitalization, however, does not provide such detail; rather, it contains a general discussion on distinguishing capital items from current expenses. Thus, INDOPCO stated that deductions are strictly construed and allowed only when there is a clear provision therefor. The Court also noted that realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is a current deduction or a capital expenditure. An important determination that must be made is whether or not the expenditure is for an asset or an income-producing item that extends beyond the current tax year. If payment for an item that benefits more than merely the current year is deducted, it would obviously cause a distortion of income in the current period. Applying this rationale to the lease termination payment, the Service reasoned that the payment related to the acquisition of the new property and benefited periods beyond the current year.
By contrast, in similar situations, courts have generally allowed deductions for payments made to reduce expenses or eliminate unproductive income-producing activities, and specifically, lease termination payments. In Cassatt, 137 F2d 745 (3d Cir. 1943), the taxpayer made a payment for the cancellation of certain leases. The court allowed the payment as a current deduction because the payment was in the form of damages to allow the taxpayer to be released from an unprofitable contract. Also, in Rev. Rul. 69-511, the IRS ruled that a lessee was allowed a deduction for a lump-sum payment made to be relieved from a lease for the purpose of reducing expenses.
Payments made to terminate a lease have not, however, always been allowed as a current deduction. In Pig & Whistle Co., 9 BTA 668 (1927), a payment made to extinguish an original lease was held to be part of the cost of acquiring a new lease on the same premises and was required to be amortized over the life of the new lease. Lease termination payments made by lessors are generally capitalizable due to the fact that the expenditure represents an effort to acquire possession of the property. The taxpayer in Letter Ruling 9607016 made a lumpsum payment to be relieved from a lease. Somewhat like a lessor, it did so for the purpose of acquiring property; it was not done to reduce expenses or for damages. By terminating its lease, the taxpayer acquired a right to use and enjoy its newly purchased property. Since the two events were interrelated (one was contingent on the other), it was all part of one single overall plan. The interrelation between the lease termination and the acquisition of the new site led to the conclusion that the payment is properly treated as a cost of acquiring the new property and thus capitalizable.
In planning for a payment such as that described here, in order to achieve the best tax treatment, taxpayers should structure their agreements so as not to be linked with other transactions or activities as part of an overall plan. Also, they should analyze the facts closely to be sure to obtain deductibility if in fact they are entitled to do so--based on all the circumstances of the transaction or situation.
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|Author:||Brown, Robert R., Jr.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1996|
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