Expenses & Deductions
The Tax Court held that payments by a company to investors for agreeing to temporarily forgo making an election to redeem stock were not interest payments; however, it further held that some of the payments were deductible ordinary and necessary business expenses.
Background
Media Space, Inc., is a media advertising corporation based in Connecticut. It was incorporated in 1999, and in 2000 it issued over 5 million shares of series A preferred stock and over 1 million shares of series B preferred stock to two investment LLCs.
Media Space’s corporate charter provided for dividends to be paid on the series A and B preferred stock at a rate of 8% per year. The charter also gave the investors the right to require Media Space to redeem all of both series of stock on September 30, 2003, or anytime thereafter. A formula for determining the redemption price for the stock was included in the charter. In addition, the charter also addressed the possibility that Media Space might not be able to redeem the shares when the investors elected redemption. If Media Space was prohibited from redeeming the shares under state corporation law because of an impairment of its capital or otherwise failed to redeem the shares as required by the charter, the company was required to pay interest to the investors at the rate of 4% per year, increasing by 0.5% at the end of each six-month period until paid in full, up to a maximum rate of 9%.
Before September 30, 2003, Media Space and the investors recognized that the company would not have the funds to redeem all the series A or series B preferred shares without causing its financial auditors to include a going concern statement on the company’s financial statements. Therefore, although all the investors wanted to redeem their Media Space shares on September 30, they entered into an agreement with the company to forgo exercising their redemption rights for one year. In return, Media Space agreed to pay the investors an amount equal to the interest that they would have received if they had exercised their redemption rights and Media Space had been unable to redeem their shares. The forbearance agreement, however, was a separate contract from the company charter.
In 2004, Media Space was again in a position where it would not be favorable for the company to redeem the investor’s shares. Therefore, although the investors still wanted to redeem their shares, they extended the forbearance agreement under the same terms. This scenario has repeated itself every year up to the present, except that for 2005 and later years the interest rate paid under the extensions of the agreement was increased to an amount above that required by the charter in the event of a failure of the company to redeem shares upon request by the investors.
In 2004, Media Space deducted the 2004 forbearance payments under the agreement on its corporate return as an interest expense under Sec. 163. In 2005, it deducted the forbearance payment as an ordinary and necessary business expense under Sec. 162. The investors included the payments on their returns as interest. The IRS disallowed Media Space’s deductions for the payments for both years (which included payments made under the forbearance agreements from 2003, 2004, and 2005). Media Space challenged the IRS’s determination in Tax Court.
The Payments as Interest Expense
Media Space advanced three alternative arguments to support treatment of the forbearance payments as payments of interest on a debt. It first argued that it was the parties’ intent that the payments be treated as interest and that the redemption right itself created a debt. The company’s second argument was that the obligation to pay the redemption amount existed and was enforceable but was conditioned upon a redemption election by the investors so the company had a conditional obligation that should be treated as a debt. The third argument was that the substance of the forbearance agreement was that Media Space had an obligation to pay the redemption amount, and, elevating the substance of the agreement over its form, it was a debt of the company. The Tax Court rejected all three arguments and held that the payments were not deductible as interest.
With regard to the first argument, the Tax Court found that the redemption rights did not constitute a debt and that a debt would be created only if the investors exercised their redemption rights. The investors had not exercised their redemption rights, so it was immaterial whether the parties intended that the payments be interest because no debt obligation existed. Likewise, the Tax Court rejected the conditional obligation argument because a debt obligation did not exist and would not exist until the investors had exercised their rights and created an obligation for Media Space to pay the redemption amount.
Finally, the Tax Court rejected the substance over form argument because the results of the forbearance agreement were not the same as the results that would have occurred if the investors had exercised their redemption rights. The court stated:
Comparing the results of the forbearance agreement and the results that would have occurred had a redemption election been made reveals a glaring difference: petitioner would not be legally bound to redeem the investors’ shares as a result of the forbearance agreement. If the investors had made a redemption election, petitioner would have been bound to redeem the shares pro rata as petitioner became financially able to redeem them. Under the redemption election scenario the investors are entitled to redemption, but under the forbearance agreement the investors retain the choice of whether or not to have their shares redeemed. [Media Space, Inc., slip op. at 17–18]
The Tax Court further noted that although the investors had expressed their desire that Media Space redeem their shares as soon as possible, their nonbinding statements were not enough to create a substantive debt.
The Payments as Sec. 162 Expenses
Media Space fared better, at least in the short term, in its argument that the payments were ordinary and necessary business expenses. The Tax Court held that the payments were ordinary and necessary expenses and that the company could deduct some of the payments for the years at issue.
The IRS initially contended that the payments were not ordinary and necessary and were therefore not deductible at all under Sec. 162, but Media Space presented expert testimony that persuaded the Tax Court that forbearance payments like the ones at issue were common in business in general and in advertising businesses like Media Space. The IRS then fell back on several arguments that Media Space should have capitalized the payments instead of deducting them. The Tax Court dismissed several of these out of hand but agreed with the IRS’s argument that the 12-month rule in Regs. Sec. 1.263(a)-4(f) might work to deny Media Space a deduction for the forbearance payments.
Under the 12-month rule, a taxpayer is not required to capitalize payments to create any right or benefit that does not extend beyond the earlier of (1) 12 months after the first date on which the taxpayer realizes the right or benefit or (2) the end of the tax year following the tax year in which the payment is made. If the right in question is subject to renewal, the duration of the right includes any renewal period if all the facts and circumstances in existence during the tax year in which the right is created indicate a reasonable expectancy of renewal. Courts apply a five-factor test in determining whether a reasonable expectancy of renewal exists.
The Tax Court concluded that if it considered the forbearance agreements separately, the payments would fall under the 12-month rule and would be deductible. It further concluded that if it took the renewal period for each agreement into account, the 12-month rule would not apply, and Media Space would be forced to capitalize the forbearance payments. Therefore, the court applied the five-factor test to the three agreements at issue to determine if it should take the renewal period for each agreement into account.
The court determined that it should not take the renewal period for the 2003 and 2004 agreements into account and that the 12-month rule applied, making the forbearance payments made under those agreements deductible. However, it determined that it should take the renewal period into account for the 2005 agreement and that the 12-month rule did not apply. Thus, the payments made under the 2005 agreement were not deductible and had to be capitalized under Sec. 263.
Reflections
The Tax Court pointed to two principal reasons why it considered there to be a reasonable expectancy of renewal at the time of the third forbearance agreement but not at the time of the first two. First, at the time of the third agreement, the company and the investors already had extended the forbearance period once. According to the court, this renewal history (which was not present at the time of the first or second agreements) was a strong indicator that the company and the investors expected that they would extend the forbearance period again at the end of the third agreement. Second, during the second forbearance period, Media Space’s financial condition deteriorated significantly. This indicated that the company would be unable to redeem the shares at the end of the third forbearance period and that another renewal of the forbearance agreement would be necessary.
Although the Tax Court properly did not address the forbearance agreements after the 2005 agreement, it would seem likely that based on the renewal history, the court would not allow a deduction for the forbearance payments in the later years unless the financial condition of the company improved dramatically. Because the investors would presumably elect to redeem their shares if it did, the company would effectively be prevented from deducting the forbearance payments under the 12-month rule as long as the forbearance agreement was in effect because there would always be a reasonable expectancy of its renewal.
Media Space, Inc., 135 T.C. No. 21 (2010).
