The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 9, April 2002, Panel Publishers, New York, NY.


By Robert W. Wood

It is no secret that stock redemption payments are nondeductible. Still, sometimes where there is a will, there is a way. The well-watched Kansas City Royals tax case, recently decided by the Tenth Circuit, is worth noting. The Tenth Circuit has affirmed the district court, dismissing a refund suit brought by the Kansas City Royals' owner who had claimed a bad debt deduction or a business expense deduction (ok, so it was a multiple choice tax case) for a loan from the team to a co-owner. The Tenth Circuit agreed with the district court that this "loan" really was a stock redemption. See Robert B. Rogers, et al. v. U.S., No. 00-3013 and 00-3030 (10th Cir., Feb. 25, 2002), Tax Analysts Doc. No. 2002-4781, 2002 TNT 38-14.

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

This redemption treatment, frequently involving considerable expenses, is quite unattractive. 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).

Home Run?

One of the seminal 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 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.

Royal Flush

Robert B. Rogers, et al. v. U.S., No. 00-3013 and 00-3030 (10th Cir., Feb. 25, 2002), Tax Analysts Doc. No. 2002-4781, 2002 TNT 38-14, 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 (or is that a baseball?) 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 District Court case is at 85 A.F.T.R.2d ¶2000-465, Tax Analysts Doc. No. 2000-4917, 2000 TNT 37-8 (Dist. Kansas 1999).

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 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.

The court emphasized (in a footnote), 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).

Whatever it was called, then, the court found that the transaction was a redemption. Perhaps expecting this conclusion, the Kauffman Estate had also argued in the alternative that Five Star applied. Thus, said the Kauffman Estate, the $34 million payment was deductible as an ordinary and necessary business expense. Why? The Royals risked losing their franchise if the team did not buy out Fogelman (the now crumbling real estate magnate). Much like other courts presented with Five Star arguments, the court was not persuaded. The court referred 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.

Seventh Inning Stretch

The Tenth Circuit Court of Appeals has now hit a homerun here (or a foul ball, depending upon your perspective). The circuit court concluded that the district court applied the correct standard — our old friend substance over form — in granting summary judgment. Indeed, the court concluded that the clearest discussion of the differences between the sham doctrine (or economic substance) and substance over form doctrine was in the district court's opinion. The Tenth Circuit concluded that the transaction must be treated by the Code under objective standards. Thus, the appellate court found that the district court had correctly identified the substance over form doctrine as the legal standard which governs the transaction for tax purposes.

The circuit court went on to say that no reasonable fact finder could have found in favor of the taxpayer here. The transaction was a sale, according to the court, and summary judgment was appropriate. The court also dismissed the argument for equitable recruitment, noting that there was no inconsistent tax treatment, and that the doctrine does not apply in situations involving two unrelated taxpayers. Lastly, noting that the expert witness' testimony was used solely to value the Kansas City Royals on the date of the loan, the court found that this testimony was not relevant. The transaction, after all, was a sale (said the court), not a loan.

Nondeductible Stock Redemption Payments, Vol. 10, No. 9, M&A Tax Report (April 2002), p. 4.