The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 9, April 2000, Panel Publishers, New York, NY.


By Robert W. Wood

[This article, in two parts (the second installment will be in your May 2000 issue) looks at the tough tax bite incident to stock buybacks.]

One of the inherent tensions in the corporate tax law concerns stock redemptions, 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. Obviously, 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.

So much for general rules. We all know that this redemption treatment, frequently involving considerable expenses, is not very good. 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. Sometimes, the seemingly simple Code provisions can be circumnavigated (to use a polite word).

Five Star Flap

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 reached the happy conclusion 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 dire circumstances that could produce this tax home run can be debated though, and certainly there has been much debate since Five Star was decided back in 1966.

Perhaps the facts in Five Star were truly extraordinary and are unlikely to be repeated. In Five Star, the corporation's sole asset was a license agreement. The holder of the licensed patent threatened to cancel the license, which would have forced a liquidation of Five Star if Five Star did not redeem the stock owned by a disruptive shareholder.

One does not have to think too far in advance to imagine taxpayers attempting to manipulate their own facts into this kind of fact pattern. Still, the courts have not looked favorably on this notion. In part, this is perhaps simply because virtually no other company has faced the kind of dramatic and seemingly inevitable annihilation that would have befallen Five Star.

Such factual differences aside, 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. (Remember, that was when tax acts were still labeled as tax acts, not given some euphemistic-or jargonistic-name.)

Kroy, Etc.

The Section 162(k) provision has generated at least a few cases, 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 pile of Tax Court Judges log on to the opinion to make really clear that the losing argument is at the bottom of the dog pile.

In fact, 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.

Not to be outdone by courts, 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.

[Part Two of this article will examine some of the more recent authority dealing with redemptions and the tax treatment of redemption expenses, especially attempted end-runs around the IRS' no-tax-benefit mantra for redemptions]

Deduction on Stock Buybacks? (Part I), Vol. 8, No. 9, M&A Tax Report (April 2000), p. 7.