The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 10, May 2000, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

[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.]

Other Routes to Tax Benefits

If the Five Star route seems like a difficult path to follow for tax deductions, indeed it is. But at least a couple of other alternatives should be considered. The recent case of 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 (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 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.

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).

Whatever it was called, 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.

Deduction on Stock Buybacks? (Part II), Vol. 8, No. 10, M&A Tax Report (May 2000), p. 5.