The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 6, January 2001, Panel Publishers, New York, NY.

STOCK ACQUISITIONS GIVEN UNATTRACTIVE REDEMPTION TREATMENT

By Robert W. Wood

In this heyday of acquisitions, asset acquisitions outnumber stock acquisitions, at least with smaller companies. However, it is still true that stock acquisitions have been on the rise for years, both taxable and tax-free acquisitions. One of the continually puzzling rules to business people is that a company receives no tax benefit on redeeming its own stock, or as the popular press likes to call them, stock buybacks. The corporation simply purchases the stock much like a third party would. The basic rule is that the redemption of a corporation's stock is not a taxable event to the corporation.

Of course, it is a taxable event to the shareholder, but the corporation receives neither a deduction nor capital treatment on a payment for its own stock. As a consequence (however unfortunate) the expenses incurred in a redemption are often not deductible. Section 311 of the Code states plainly that no gain or loss is recognized on distributions with respect to stock. Section 162(k) of the Code states, equally clearly, that there is no deduction earned by a company for stock reacquisition expenses.

Five Star Authority

Corporations (and the tax advisors that corporations engage) have a considerable incentive to push the envelope of these Code sections to try to achieve some tax advantage. One of the classic cases on this question is Five Star Manufacturing Co. v. Commissioner, 355 F.2d 724 (5th Cir. 1966). In Five Star, the Fifth Circuit Court of Appeals concluded that a deduction should be available where a stock buyback was necessary to the survival of the corporation, and the redemption expenditures were needed to save the company from the brink of ruin. Just how one defines the needed dire circumstances can be debated, and there has been much debate since Five Star was decided. Perhaps the facts in Five Star were truly extraordinary and are unlikely to be repeated. Anyway, the interpretation of Five Star today may largely be moot. After all, Section 162(k) of the Code disallows any deduction for amounts paid or incurred by a corporation in connection with a redemption of its stock. This provision was added relatively recently in our tax history, by the Tax Reform Act of 1986.

Kroy, Etc.

The Section 162(k) provision has generated case law, though it has hardly been a controversial provision. One of the significant cases was In Re Kroy (Europe), Ltd., et al., 27 F.3d 367 (9th Cir. 1994). In this case, the Ninth Circuit Court of Appeals ruled that Section 162(k) did not disallow the amortization of investment banking fees incurred by a corporation to borrow money to finance a redemption of its own shares. Unfortunately, shortly after the Ninth Circuit issued this important opinion, the Tax Court issued a reviewed decision disagreeing with the Ninth Circuit's view. In a reviewed decision, a plethora of Tax Court Judges endorse the opinion to make clear that the losing argument is at the bottom of the dog pile.

Then, the Tax Court issued a veritable diatribe on the subject in Fort Howard Corp. v. Commissioner, 103 T.C. No. 18 (1994). The Tax Court in Fort Howard considered a set of circumstances similar to those in Kroy, involving large fees paid to investment bankers for arranging financing for a management-led LBO. Just as in Kroy, the loan in Fort Howard was conditioned on the use of the funds to repurchase the company's stock. The Tax Court found Section 162(k) squarely applicable, concluding that it would not follow the Ninth Circuit's decision in Kroy.

The legislature attempted to tinker with Section 162(k) in the Revenue Reconciliation Act of 1995. Cast as a technical correction, the 1995 change amended Section 162(k) to permit the deduction of expenses associated with borrowing to finance a redemption of the issuing corporation's equity. See Section 162(k)(2)(ii), as amended by Section 13402 of the Revenue Reconciliation Act of 1995. Of course, this provision indicates that the exception applies to interest and to those costs allocable to indebtedness that would be properly amortized over the term of the indebtedness.

End Runs to Tax Benefits

If the Five Star route seems to be a difficult path to follow for tax deductions, then a couple of other alternatives may be worth considering. Robert B. Rogers, Successor Executor for the Estate of Ewing M. Kauffman v. United States, 85 A.F.T.R.2d ¶2000-465, Tax Analysts Doc. No. 2000-4917, 2000 TNT 37-8 (Dist. Kansas 1999), represents an interesting twist on the redemption/deduction dilemma. The case involved the corporate ownership of the Kansas City Royals baseball club. The S corporation that owned the club faced serious creditors' claims. The 50% owner (Ewing Kauffman) was concerned that the American League would revoke the team's franchise if ownership was taken over by creditors. The other 50% owner was a real estate magnate who had serious financial problems and creditors were circling like jackals.

The solution was for Mr. Kauffman to loan $34 million to the Royals. The Royals, in turn, then owed the real estate magnate (Fogelman) $34 million on a nonrecourse note. The collateral for the loan was Fogelman's stock, plus the option Fogelman held to acquire Kauffman's stock. The loan transaction also involved Fogelman granting the Royals an option to acquire both his stock and his option on Kauffmann's stock (confused yet?). The purchase price under the option that Fogelman granted to the Royals was, not surprisingly, the balance Fogelman owed the Royals on its loan to him.

When a suitable buyer for 100% of the company's stock did not surface, Mr. Fogelman defaulted on his loan. The Royals took the collateral in lieu of foreclosure, and Mr. Kauffman regained his 100% ownership of the corporate stock (something that he had owned before the real estate magnate, Mr. Fogelman, had entered the picture for 50% of the stock in the first place).

Obviously, this whole ball of wax (here, horsehide?) amounted to a redemption transaction. A tax case arose, though, not focusing on the redemption rules, but rather on the bad debt rules. The Royals claimed the $34 million (plus accrued interest) as a bad debt, deducting it on the Royals' Form 1120S for 1991. Mr. Kauffman had plenty of basis to utilize the pass-through of this bad debt loss on his personal return (because of the $34 million loaned to the S corporation). The IRS disallowed the $34 million plus bad debt deduction. Kauffman paid the deficiency (no small matter here!) and then sued for a refund. The IRS and the Estate of Kauffman (who had expired by this point, much like the end of a baseball season) each filed motions for summary judgment.

The Kauffman Estate's argument was that the stock was merely collateral for the note, having only nominal value as of the date of foreclosure (in 1991). Support for this "nominal value" argument was in the form of an opinion from Morgan Guaranty & Trust Company of New York that (and we quote) "the Royals' equity was of nominal value." The IRS responded that the value of the stock as collateral was irrelevant. The substance of this mess, said the IRS, was that the corporation redeemed Fogelman's stock and option for $34 million in a step transaction. As a matter of law, said the IRS, there was no bad debt because there was no debt in the first place!

The district court in Kansas found that a bona fide debt is a debt which arises from a debtor/creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. Here, said the court, a part of the transaction involved Mr. Fogelman granting the Royals an option to purchase his stock, and the option was for a price equal to the outstanding balance of his "alleged" Royals loan.

What's a Redemption?

If some readers find this summary of the judge's view unduly harsh, perhaps an explanation of the option here is in order. The court emphasized (in a footnote-maybe so all of remember that we really have to read the footnotes), that the option exercise price decreased with every dollar that Fogelman paid upon the "purported" loan. In other words, had Mr. Fogelman repaid the loan completely, the Royals evidently would have obtained Mr. Fogelman's interest for nothing. This option provision caused the court to give no weight whatsoever to Mr. Fogelman's statement that the transaction was structured as a loan because of his intense desire to one day regain his prior position as the sole owner of the Royals. According to the court, this alleged subjective desire was absolutely and irrevocably unattainable under the very terms of the deal (which the court found simply was not a loan).

Regardless of moniker, the court found the transaction to be a redemption. Yet, the Kauffman Estate had argued in the alternative that Five Star applied. The Kauffman Estate argued that the $34 million payment was deductible as an ordinary and necessary business expense. After all, the Royals risked losing their franchise if the team did not buy out Fogelman (the now crumbling real estate magnate). The court was not persuaded, referring to the limiting authorities since Five Star, particularly U.S. v. Houston Pipeline Co., 37 F.3d 224 (5th Cir. 1994). Houston Pipeline made clear that the Five Star exception applied only where the redemption was absolutely necessary for the survival of the company. Here, that argument simply didn't fly (at least not into the outfield).

Riverton Investment Decision

Recently, in Riverton Investment Corp. v. United States, No. 5:99CV00089 (W. Dist. Va., Oct. 26, 2000), Tax Analysts Doc. No. 2000-29412, 2000 TNT 222-4, a U.S. magistrate judge held that payments a holding company made to managers to acquire the outstanding stock in their company were payments in redemption of the stock. Therefore the payments were not deductible by the holding company as employee compensation expenses.

Riverton Investment Corp. was a holding company organized to acquire all of the stock of Riverton Corp. from its then parent company, Investment Corporation of Florida. Seeking to gain management support for this transaction, Riverton's president developed a plan denominated the "Management Stockholders Agreement" ("MSA") to encourage management participation in the potential growth of the company, while insulating their investment from devaluation risks. According to the plan, management acquired Riverton shares. On their termination, the participants sold their Riverton stock back to Riverton for 60% of book value as of their termination date. The participants in this plan reported ordinary income on the difference between what Riverton paid for the stock and their original purchase price. Riverton claimed the corollary amounts as deductible business expenses. The IRS looked at this situation and determined that Riverton's payments for the stock were really stock redemption payments, therefore not deductible by Riverton as employee compensation. Riverton paid the tax and then sued for refund.

In district court, the U.S. Magistrate recommended that the government be granted summary judgment. The court noted that under the MSA, the participants and Riverton had a buy-sell agreement that basically worked as a covenant that ran with the stock. The parties agreed that under Section 83, if the stock were transferred to the participants only in connection with the performance of services, the payments made to those shareholders under the buy-sell agreement would be income to the participant. A deductible business expense would therefore be available to Riverton. They also agreed that if the stock transfer was not under Section 83, the participants' stock acquisitions would be an ordinary stock transfer and Riverton's acquisition would be a stock redemption.

Under the Section 83 regulations, the court noted, a transfer of property occurs when a person acquires beneficial ownership interest in the property, disregarding any lapsing restrictions. The court found that the transfer was subject to a lapse restriction as it called for Riverton's acquisition of stock as a redemption. Because the stock transfer was a redemption, Riverton could not deduct the amounts as business expenses. The court rejected Riverton's reliance on an IRS letter ruling on a similar issue, citing the notion that letter rulings cannot be cited as precedent.

On the last point, recall the U.S. Supreme Court cited letter rulings in Rowan Companies, Inc. v. U.S., 452 U.S. 247 (1981)!

Stock Acquisitions Given Unattractive Redemption Treatment, Vol. 9, No. 6, The M&A Tax Report (January 2001), p. 1.