The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 10, May 2001, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

In this post-INDOPCO era, it hardly takes a microscope to spot deduction vs. capitalization issues in any acquisition. One fear is always that a variety of types of costs will be required to be capitalized rather than deducted. In the context of stock options that are canceled as part of the deal (either ISOs or NSOs), one question is whether the payment attributable to such a cancellation is deductible.

The amount at stake would be the amount of cash or property used to cancel the options. Assuming that the company issues a W-2 form (treating the cancellation payment as wages) to each pertinent employee, there is little question that the payment is properly deductible. Happily, the gremlins of INDOPCO have apparently not reached this particular area.

Indeed, in a surprising show of largesse, the IRS even has ruled in letter rulings that the following items can also be deducted notwithstanding INDOPCO:

All these result in deductible expenditures (not capital expenditures). Of course, don't get carried away with this logic. If the options were issued as a result of the sale or acquisition of the business, or in connection with some other transaction that is by its nature capital, then the payments may not be currently deductible. This is our old friend the origin of the claims doctrine (which applies in litigation recoveries, among other areas) raising its head again. See, e.g., U.S. v. Gilmore, 372 U.S. 39 (1963).

To Deduct or Capitalize Option Deal Costs, Vol. 9, No. 10, M&A Tax Report (May 2001), p. 3.