Tax Court Decision Limits Ability to Claim Deduction
Recent Tax Court Decision
- In the recent U.S. Bancorp v. Commissioner decision, the Tax Court denies a deduction claimed by a lessee with respect to amounts paid to a lessor in order to be relieved of obligations under a lease.
Times change. Circumstances change. Business decisions that seemed prudent when made may have to be undone, sometimes at substantial cost. One way to defray a portion of that cost is to deduct it for income tax purposes. A recent decision of the Tax Court reminds us, however, of some of the limits on a taxpayer's ability to claim such a deduction. The decision, U.S. Bancorp v. Commissioner (September 21, 1998), denied a deduction claimed by a lessee with respect to amounts paid to a lessor in order to be relieved of obligations under a lease. Although the lease involved in that decision covered computer equipment, the principals set out by the Court will be of relevance to lessees of real property as well.
In August 1989, West One Bancorp leased an IBM 3090 mainframe computer from IBM Credit Corp. The lease term was to run for almost five years, to June 28, 1994, and West One was to pay rent to IBM of $128,701 per month. In just one year, however, the 3090 proved inadequate to West One's needs and, in October 1990, West One and IBM agreed that West One would be released from its obligations under the lease of the 3090 and would enter into a new five-year lease for a more powerful IBM 580 mainframe computer. The rent for the 580 was $128,709 per month; moreover, West One agreed to pay a "rollover charge" of $53,775 per month for the 60-month term of the 580 lease, representing apparently a lump-sum charge of $2,500,000 plus interest thereon. The rollover charge, which was billed monthly along with rent for the 580, was payable in connection with cancellation of the lease for the 3090.
West One contended that it was entitled to deduct the entire $2,500,000 rollover charge in 1990, the year during which it became obligated to pay that charge in connection with the cancellation of the 3090 lease. The IRS contended that the charge had to be amortized over the 60-month term of the 580 lease. The Tax Court agreed with the IRS.
It is well established that a payment made by a lessee in order to terminate a lease is currently deductible. The theory behind this rule is that, while capitalization and amortization of expenditures may be appropriate when they are incurred in order to produce future income over a period of time, payments made to terminate a lease do not produce income, but simply procure release from an unprofitable arrangement. The cases that established this principle involved circumstances in which no new lease was entered into between the parties. On the other hand, it is also well established that a lessee that has purchased a leasehold cannot deduct the unamortized cost of the purchase in the event that the lease is then cancelled and the parties enter into a new lease of the same premises.
The Tax Court felt that these two lines of authority set the parameters for its decision in this case and that what was required was to determine whether West One's facts were nearer to those in the favorable "pure" lease cancellation cases or those in the unfavorable "cancellation and release" cases. The Tax Court agreed with the IRS that this case was nearer to the latter cases, on the basis of the "integrated nature of the agreements and transactions by which the First Lease was terminated and the Second Lease was entered into." Because these events were integrated, the obligation to pay the rollover charge arose from West One's need to obtain a more powerful computer. In reaching this conclusion, the Court seemed to be influenced by the fact that IBM took West One's willingness to lease a new computer from it into account in setting the rollover charge, although one might equally well have argued that this demonstrated only that a portion of the rent nominally payable with respect to the 580 should really be attributed to cancellation of the lease for the 3090! (After all, although there was some evidence that IBM would not have been willing to take back the 3090 if West One had not leased the 580, there was no evidence that IBM would have been unwilling to lease the 580 if West One had wanted to continue renting the 3090 as well.)
In any event, the Court held that the favorable line of authority relating to "pure" cancellations of leases did not apply where the rollover charge, in the Court's view, resulted in the realization of future benefits over the term of the lease of the 580. Moreover, the similarity between the 3090 and the 580 was sufficient to bring the case within the ambit of the unfavorable rules relating to cancellations and new leases of the same property. Accordingly, the Court was unwilling to allow any current deduction or to permit West One to make an allocation under which even a portion of the $2,500,000 cost might be currently deducted.
The Tax Court's application of some well-established rules to the facts of this case may perhaps be criticized; however, our criticism will not change the legal framework applicable to lease cancellation and modification transactions. It is important that lessees be aware of the fact that their payments in such transactions may in some cases not be deductible, so that they can appropriately weigh the after-tax economic cost of all of their alternatives.