Deductibility of Forbearance Payments

By Anita Dabrowska, CPA, MST

Editor: Greg Fairbanks, J.D., LL.M.

Expenses & Deductions

In Media Space, Inc., 135 T.C. No. 21, the Tax Court held that a corporation’s payments to its shareholders to delay redemption of their preferred shares were generally deductible under Sec. 162. However, the court further held that a company would be required to capitalize forbearance agreement payments under the 12-month rule in Regs. Sec. 1.263(a)-4(f)(1) if there was a reasonable expectancy of the agreement’s renewal.

In 2000, Media Space, Inc., a C corporation, raised its startup capital by issuing two series of preferred stock. The corporate charter provided for dividends on both series of the preferred stock as well as redemption rights to the preferred stockholders (the investors). The investors had the right to require Media Space to redeem the preferred stock on September 30, 2003, or anytime thereafter by making a written redemption election. If the company was unable to redeem the stock because of an impairment of the corporation’s capital or other reasons, Media Space was required to pay interest to the investors as provided in the corporate charter.

Before September 30, 2003, the corporation and the investors recognized that the corporation lacked the financial ability to redeem all the preferred shares. The company’s auditors advised the company that they would need to issue a going concern statement on the company’s financial statements if the redemption rights were able to be exercised. At that time, Media Space was negotiating a new financing agreement, and a going concern statement could have negatively affected the negotiations.

Although the investors wanted to redeem their shares as soon as possible, after negotiations they entered into a forbearance agreement with the company by which the investors agreed to forbear from exercising their redemption rights for a period of one year. In exchange, the company agreed to make the forbearance payments equal in amount to the interest payments it would have been required to make under the terms of the charter if the investors had made the redemption election and Media Space had been unable to redeem the stock. However, the forbearance agreement was a contract separate from the charter.

The company and the investors subsequently extended the agreement several times. Both parties intended the forbearance payments to constitute interest as compensation for the investors’ forbearance from receipt and use of the redemption amount. Media Space accrued and deducted the forbearance payments on its tax returns. Similarly, the investors declared the payments as taxable interest on their tax returns.

This case raises several interesting points with respect to deductibility of the forbearance payments. First, the corporation argued that forbearance payments constitute interest under Sec. 163. The IRS responded, and the court agreed, that the payments were not deductible under Sec. 163 because no indebtedness existed between the investors and the company so the payments were not “interest paid or accrued . . . on indebtedness,” as required by Sec. 163(a).

The Tax Court, using a two-pronged test to determine whether the payments were Sec. 163 deductions, agreed with the IRS. Under this test, payments will constitute interest if the parties intend the payments to be interest and the law supports the intended treatment. Although all parties to the forbearance agreement intended to treat the payments as interest, the law did not give effect to their intention. According to the court, the redemption right does not create “an existing, unconditional, and legally enforceable obligation for the payment.” Instead, the exercising of the redemption right by the shareholders’ written election creates the obligation to pay. Since no redemption election was made by the preferred shareholders, there was no indebtedness and hence no interest payment.

The second argument raised by Media Space is that the payments were deductible as ordinary and necessary business expenses under Sec. 162. Based on an expert report stating that forbearance agreements are common in the business the corporation conducts, the court found the payments ordinary. In addition, based on the fact that the forbearance payments allowed Media Space to avoid a going concern statement on its financial statements, the court found the payments necessary. Consequently, the Tax Court found the forbearance payments ordinary and necessary as required by Sec. 162(a).

The IRS then argued that the forbearance payments were nondeductible as incurred in connection with the reacquisition of the company stock under Sec. 162(k)(1). According to the IRS, Media Space in substance exchanged the forbearance payments and new preferred stock with deferred redemption rights for old preferred stock with nondeferred redemption rights. The court disagreed, stating that deferring the redemption right is not a significant enough change in the nature of the investments to amount to a new investment. Consequently, the court found that the forbearance agreement was not in form or in substance a reacquisition of stock and so Sec. 162(k) was not applicable.

Another IRS argument was that Media Space engaged in a reorganization under Sec. 368(a)(1)(E), defined as a recapitalization or “reshuffling of a capital structure, within the framework of an existing corporation.” Once again, the court found that no exchange of stock occurred in form or in substance, making the nonrecognition provision of Sec. 361(c)(1) inapplicable.

The court also considered whether the forbearance payments were nondeductible distributions to shareholders with respect to their stock under Sec. 301. Based on the fact that the company paid the investors to defer the redemption election, not to give them a return on their investment, the court found that the payments were not distributions in substance.

Finally, the IRS argued for capitalization of the forbearance payments under Sec. 263. It was partially successful with respect to certain forbearance payments paid on subsequent extensions of the forbearance payments. The court held that under the 12-month rule in Regs. Sec. 1.263(a)-4(f)(1), the company would be required to capitalize the payments if there was a reasonable expectancy of renewal of the forbearance agreement at the time the agreement was created. According to the court, a reasonable expectancy of renewal did not exist at the time of the original agreement and the first extension. However, a reasonable expectancy of renewal did exist at the time of the second extension. Therefore, the payments made under the original agreement and the first extension could be deducted, and the payments under the third extension must be capitalized.

Given the financial position of many companies, forbearance agreements of the type involved in Media Space are not uncommon. Clearly, there is a way to make the forbearance payments deductible. Based on the Tax Court’s analysis, the Sec. 162(a) ordinary and necessary requirements need a rather low threshold to satisfy them. The key is to avoid any provision that would preclude a deduction under Sec. 162(a).

The court stressed the significance of the magnitude of the change in the nature of the investment before and after the forbearance agreement. A simple deferral of the redemption rights, without any other changes affecting the preferred stock, did not constitute an exchange in substance for purposes of Secs. 162(k) or 368(a)(1)(E). The fact that the forbearance agreement was a contract separate from the charter may also be helpful.

Finally, the forbearance payment should not be in excess of the fair market value of the redemption rights deferral to avoid Sec. 301 classification. The Tax Court did not seem to focus on the fact that the forbearance terms were part of the corporate charter.

EditorNotes

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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