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Expenses of stock redemption necessary for corporation's survival were not deductible.

The W Corporation was a car dealership. As a condition for obtaining an extension from its distributor, W was required to redeem the stock from all but its majority shareholder. (The continuation of this distributorship was necessary for W's survival.)

On its return, W deducted the purchase price of the stock and the expenses attributable to the redemption ratably over the five-year term of the extension agreement. The IRS disallowed these deductions, treating them as capital expenditures. In a reviewed decision, the Tax Court (opinion Parker, J.) agrees with the Service; applying the "origin and nature of the transaction" test, both the stock's purchase price and the redemption expenses were nondeductible capital expenditures.

The issue is whether the costs (purchase price and expenses) incurred in connection with a corporation's redemption of its own stock are deductible under Sec. 162(a) or are amortizable despite the Sec. 311(a) prohibition against the recognition of gain or loss on stock redemptions. Sec. 311(a) provides:

(a) GENERAL RULE.--Except as provided in subsection (b), no gain or loss shall be recognized to a corporation on the distribution . . . with respect to its stock of--

(1) its stock (or rights to acquire its stock), or

(2) property.

Sec. 317 provides:

(a) PROPERTY.--For purposes of this part, the term "property" means money, securities, and any other property; except that such term does not include stock in the corporation making the distribution (or rights to acquire such stock). (b) REDEMPTION OF STOCK.--For purposes of this part, stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.

W relies on the Fifth Circuit's opinion in Five Star Mfg. Co., 355 F2d 724 (1966), rev'g 40 TC 379 (1963), to support the proposition that stock redemption costs (purchase price and expenses) incurred in the face of an outside threat to the survival of the corporation are deductible as ordinary and necessary business expenses under Sec. 162(a). The IRS asks us to decline to follow the Fifth Circuit's Five Star opinion and to adhere to our own opinion that such costs are nondeductible capital expenditures.

We note that Sec. 311 was never an issue in Five Star before either the Tax Court or the Fifth Circuit. Thus, the opinions in Five Star do not address Sec. 311 or the situation in which a corporation redeems stock of its shareholders in their capacity as shareholders.

In this case the Service argues that Sec. 311(a) applies to the distribution, thereby precluding deductibility of the costs of redemption. W argues that Sec. 311(a) applies only to gain or loss and does not preclude deductibility of these costs. Our initial inquiry will focus on whether or not the costs of a stock redemption would be deductible in the absence of Sec. 311(a).

Five Star Mfg. Co. concluded that the payment for shares was an ordinary and necessary business expense under Sec. 162. The opinion of the Fifth Circuit centered on the likelihood that the company would not have survived absent payment of the amounts at issue.

Although stating that the resolution of whether the cost of repurchasing the stock was an ordinary expense depended on the nature of the transaction, the Fifth Circuit in effect applied a principal purpose or business purpose test. The Fifth Circuit rejected the nature of the transaction (the purchase of the stock) and concentrated instead on the principal purpose or business reason for acquiring the stock.

Subsequent cases have severely limited the application of Five Star, holding its allowance of a current deduction for an otherwise capital expenditure to the situation in which the survival of the corporate business is at stake. However, in Woodward, 397 US 572 (1970), the Supreme Court rejected the "primary purpose" test, and substituted therefore a standard that looks to the fundamental nature of the transaction, rather than the reasons for entering into it, as being determinative of the tax treatment to be afforded. The "primary purpose" test no longer correctly applies the law.

We are now faced with the issue of whether to apply Five Star to a redemption that is brought about by an outside force and is necessary to the survival of the corporation. We respectfully decline to follow the Fifth Circuit's Five Star opinion.

In determining deductibility of legal expenses, one must look to the origin and nature of the claim with respect to which the expense was incurred. If an expense is capital, it cannot be deducted as "ordinary and necessary." A stock redemption is the reacquisition of a corporation's stock from its shareholders in exchange for property. W's stock is a capital asset. The cost of the redeemed stock is a capital expenditure, not a deductible expense.

The flaw in the Five Star exception is that it requires the trier of fact to look to the primary purpose of the transaction in order to determine whether an otherwise capital expenditure can be treated as an ordinary and necessary business expense under Sec. 162. While the Fifth Circuit purported to look to the nature of the transaction, its ultimate focus was on the purpose or business reasons for which the stock was purchased. The Supreme Court in Woodward, and more recently in Arkansas Best Corp., 485 US 212 (1988), has made it clear that this line of inquiry is inappropriate. Finding the "primary purpose" test to be "uncertain and difficult," the Supreme Court rejected that test in favor of looking to the "origin and nature" of the transaction. The Court noted that any test relying on the purpose of the transaction "would encourage resort to formalisms and artificial distinctions." Thus, the only acceptable inquiry is whether the transaction in question is a capital one. Recognizing that "stock is most naturally viewed as a capital asset," the Supreme Court recently reaffirmed that a taxpayer's motivation or business purpose for purchasing an asset is irrelevant in determining that the asset (i.e., stock) is a capital asset. Accordingly, we respectfully decline to follow the Fifth Circuit's Five Star opinion in this case, and we hold to our Five Star rationale that redemption of stock is a nondeductible capital transaction. The reasons behind the redemption cannot transform the transaction into one of a noncapital nature.
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Author:Fiore, Nicholas J.
Publication:The Tax Adviser
Date:Jan 1, 1992
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