The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 7, February 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

It is well-known that Section 162(k) of the Code restricts the deductibility of expenses paid or incurred in connection with a stock redemption. Basically, Section 162(k) disallows any amount paid or incurred by a corporation in connection with the redemption of its stock. The only exceptions to this general no-deduction rule are for deductions allowable under Section 163 (relating to interest) or deductions for dividends paid (within the meaning of Section 561). There are special rules that relate to redemptions of stock in certain regulated investment companies. However, in general Section 162(k) provides a fairly tight net on redemption expenses.

Recent FSA

In a recently released Field Service Advice (1998-410), the IRS has advised on the deductibility of various expenses incurred in connection with a redemption. This FSA notes that a variety of types of expenses can be considered. It is an instructive Field Service Advice, since many of these types of expenses are incurred in a typical redemption by a corporation of its own stock:

Scope of Restrictions

The types of transactions that are considered redemptions and hence subject to the Section 162(k) nondeductibility gauntlet may seem rather narrow. By its terms, Section 162(k) only applies to stock redemptions by a corporation of its own stock. However, other authorities suggest that the reach of Section 162(k) can be broader than this.

For example, in another 1993 Field Service Advice (recently released in 1998 as FSA 1998-419), the IRS advised that an acquiring corporation's purchase of a target corporation's stock followed by its merger into a target corporation should be treated for tax purposes as a redemption of the target corporation's stock.

Under the merger agreement, the acquiring corporation offered cash for all outstanding target shares. The acquiring corporation borrowed some of the money used to acquire those shares, and then merged into the target, with the target corporation assuming its debts. The IRS here concluded that the target bears the economic burden to repay the loans used to acquire its stock. Therefore, said the IRS, the acquiring corporation should be considered the conduit of the target. The IRS also advised that:

Watch Out for Redemption Characterization

Although most practitioners are sensitive to the Section 162(k) restrictions on redemptions and the expenses made in connection therewith, probably most practitioners would not easily see the redemption issue in Field Service Advice 1998-419 (discussed immediately above). The fact that a purchase of target stock, followed by its merger into the acquiring corporation, would be viewed as a redemption might surprise some practitioners.

Nonetheless, at least in the Service's view, this allows it to employ one of its more effective devices to whittle down what otherwise may be a long list of deductions in the transaction.

Redemption Expenses Nondeductible: Avoiding Redemption Characterization, Vol. 7, No. 7, The M&A Tax Report (February 1999), p. 7.