Sixth Circuit OKs Deduction for Lease Termination Costs.
(Parker Tax Publishing July 9, 2014)

A recent appellate court decision has potentially set the stage for a showdown in the Supreme Court over the deductibility of lease termination costs. In ABC Beverage Corporation v. U.S., 2014 PTC 287 (6th Cir. 6/13/14), the Sixth Circuit affirmed a district court and held that a lessee who buys property it is leasing for a price greater than the property's fair market value can immediately deduct as a business expense the excess purchase price as a lease termination expense. While this is great news for taxpayers, the decision is at odds with an earlier Second Circuit decision denying such a deduction as well as a subsequent Tax Court decision that relied on that Second Circuit decision to also deny a similar deduction. Thus, whether a taxpayer may deduct such costs, or must capitalize them as part of the purchase price of the building, may ultimately depend upon the circuit court jurisdiction in which the taxpayer lives.

Practice Tip: The issue of whether the excess purchase price of a building being leased is fully deductible or must be capitalized as part of the building purchase presents a planning opportunity for practitioners. One option that may be available depending on the circumstances is to instead of purchasing a building for more than its fair market value to get out of an onerous lease separately negotiate a payment to terminate the lease. The termination of a contract right is generally a deductible business expense under Code Sec. 162.

Facts

ABC Beverage (ABC) has a bottling plant in Hazelwood, Missouri where it makes and distributes soft drinks and other non-alcoholic beverages. ABC leased the facility at first, but after concluding that its rent under the lease was too high, it exercised an option to buy the property. Appraisals valued the property without the lease at $2.75 million, and ABC determined that the fair market value of the property with the lease would be at least $9 million. ABC eventually bought the property for approximately $9 million. On its tax return, ABC reported $2.75 million as its cost of acquiring the property and deducted $6.25 million as a business expense for terminating the lease. The IRS disallowed the deduction and assessed a tax deficiency of $2.5 million. ABC paid the deficiency and sued for a refund in district court.

District Court's Decision

In the district court, the IRS primarily argued that Code Sec. 167(c)(2) prohibited ABC from categorizing any part of the purchase price as a distinct business expense for terminating the lease. Code Sec. 167(c)(2), which was enacted in 1993, provides that if any property is acquired subject to a lease, no portion of the adjusted basis can be allocated to the leasehold interest, and the entire adjusted basis is taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease.

Whether Code Sec. 167(c)(2) governs the issue is a question of statutory construction and interpretation, the district court said. The first step, the court said, requires a determination of whether the statute is ambiguous. The district court concluded that the statute was not ambiguous, that it plainly and unambiguously outlines what happens, for the purposes of depreciation, when property is acquired subject to a lease. After reviewing the legislative history of Code Sec. 167(c)(2), the district court rejected the IRS's argument that Code Sec. 167(c)(2) applied to the transaction at issue. According to the district court, if a party does not acquire the property as a lessor or a lessee, then Code Sec. 167(c)(2) doesn't apply.

Instead, the district court said it was obliged to follow the Sixth Circuit's opinion in Cleveland Allerton Hotel, Inc. v. IRS, 166 F.3d 805 (6th Cir. 1948). In Cleveland Allerton, a taxpayer owned and operated a hotel on leased premises. When there was roughly 80 years left on the lease term, the taxpayer was paying $25,000 per year in rent. However, the taxpayer determined the rent was excessive by $15,000 per year. After negotiations, the taxpayer purchased the property for $441,250 and took a business expense deduction based on the difference between the purchase price and $200,000, the fair market value of the real estate. The taxpayer characterized the difference as a deductible cost of buying out a burdensome lease, even though there was no specific designation of the amount paid for the purchase of the leasehold. The Tax Court rejected the taxpayer's arguments but was reversed by the Sixth Circuit.

The Sixth Circuit found support for the taxpayer's claim that the value of the land was no more than $200,000, not counting the value of the lease. The Sixth Circuit pointed out the difference between the taxpayer who was buying out its own lease (as in the instant case) and a third-party investor who buys real estate subject to a long-term profitable lease. The court agreed that the taxpayer could take a business expense deduction for amounts paid to escape a burdensome lease. The Sixth Circuit also concluded the deduction must be taken during the year when made.

In ABC Beverage, the district court also rejected the IRS's argument that the Supreme Court's decision in Millinery Center Bldg. Corp. v. IRS, 350 U.S. 456 (1956), had effectively overruled the Cleveland Allerton decision. In Millinery Center, the taxpayer leased land and, under the terms of the lease, erected a 22-story building. Subsequently, the taxpayer exercised its option to extend the lease for another 21 years. Title to the building was in the taxpayer's name, but at the eventual termination of the lease it would vest, without payment, in the lessor, at the lessor's option. In May 1945, the taxpayer paid $2.1 million to the owner to purchase the land and be released from the obligations of the renewed lease. On its tax return, the taxpayer deducted $1,440,000 the difference between the purchase price under the May 1945 agreement and the 1945 value of the unimproved land as an ordinary and necessary business expense.

The Tax Court held that the difference could not be deducted, that the difference could not be amortized over the remaining term of the cancelled lease, and that no annual depreciation could be taken because the cost of the building had already been fully depreciated and the purchase price could not be separated between the purchase price for the building and purchase price for the land. The Second Circuit affirmed the refusal to permit a deduction, but reversed the holding that no amount could be added to the asset value of the building for purposes of depreciation. While rejecting the taxpayer's argument that it should be allowed to amortize the $1,440,000 over the unexpired term of the cancelled lease, the Second Circuit accepted the taxpayer's alternative argument that depreciation over the remaining useful life of the building should be allowed.

Because of the apparent conflict between the Second Circuit's holding in Millinery Center and the Sixth Circuit's holding in Cleveland Allerton, the Supreme Court granted certiorari. The Supreme Court's opinion turned on the taxpayer's lack of evidence that the rent under its lease was actually burdensome. Absent such evidence, the Court concluded, the taxpayer had to capitalize the entire purchase price. The Court did not decide whether a taxpayer could deduct the cost of buying out a burdensome lease because, in the facts before it, there was no burdensome lease. Accordingly, the district court found that the situation in ABC Beverage was distinguishable on that point which formed, in part, the basis of the ultimate Supreme Court decision.

The district court also dismissed the IRS's claim that ABC's deduction was barred by Code Sec. 263(a)(1), which prohibits the deduction of capital expenditures. Because the court found, however, a genuine dispute about when ABC could take the deduction, the case went to a jury which found that ABC could deduct the payment in the year made. The IRS appealed to the Sixth Circuit

Sixth Circuit's Decision

In its appeal to the Sixth Circuit, the IRS cited several authorities as supporting its position that ABC had to capitalize the entire amount paid for the building. First, the IRS reiterated its argument that Code Sec. 167(c)(2) prohibits any allocation of the purchase price of the property to the leasehold interest. Second, the IRS asked the Sixth Circuit to revisit its holding in Cleveland Allerton.

The Sixth Circuit agreed with the district court's holding and held that a lessee who buys the property it is leasing for a price greater than the value of the property can immediately deduct as a business expense the portion of the purchase price attributable to the unexpired lease.

While agreeing with the district court's holding that Code Sec. 167(c)(2) did not apply, the Sixth Circuit did take issue with the district court's statement that the text of Code Sec. 167(c)(2) was unambiguous. The Sixth Circuit found the statute's text ambiguous because the phrase "subject to a lease" might modify "acquired," as the taxpayer in ABC Beverage argued, in which case the statute applies only if the purchased property remains subject to a lease after the purchase. However, the Sixth Circuit said, the phrase might also modify "property," as the IRS argued, in which case Code Sec. 167(c)(2) would apply to deny a deduction so long as the property is subject to a lease when acquired. The only other court to have parsed Code Sec. 167(c)(2), the Sixth Circuit noted, was the Tax Court in Union Carbide Foreign Sales Corp. v. Comm'r, 115 T.C. 423 (2000). And the Tax Court came to the opposite conclusion as the Sixth Circuit, holding that Congress did not intend for Code Sec. 167(c)(2) to limit the statute's reach and that the point of Code Sec. 167(c)(2) is to prevent taxpayers from allocating to a lease any part of the cost of acquiring tangible property. In reaching its decision, the Tax Court also cited the Second Circuit's decision in Millinery Center. Thus, the Tax Court in Union Carbide concluded that Code Sec. 167(c)(2) prevented the taxpayer from deducting any portion of its cost to acquire an asset to the termination of a burdensome lease.

With respect to its prior holding in Cleveland Allerton, the Sixth Circuit said the decision still applied because nothing had changed since that opinion was issued. A published prior panel decision remains controlling authority, the court observed, unless an inconsistent decision of the U.S. Supreme Court requires modification of the decision or unless the Sixth Circuit sitting en banc overrules the prior decision. Since nothing like that had occurred, there was no reason to modify the Cleveland Allerton decision. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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