Author: By Dean L. Surkin
DEAN L. SURKIN is a tax
manager with Rosen Seymour Shapss Martin & Company, LLP, CPAs, in New York
City. He is also an attorney and an adjunct professor at the Pace University
School of Business, the NYU School of Professional Studies, and Hunter College.
Increasingly common in economic downturns is the problem of a burdensome lease, whether of real estate or other property. A solution for the lessee might be to buy out the lease or, as in the Union Carbide case, to acquire the lessor. Unfortunately, the case law and the Code do not permit the cost of eliminating the lease burden to be currently deducted.
EDITED BY LEWIS R. KASTER, LL.B.
Union Carbide Foreign Sales Corporation, 115 TC 423, illustrates a refinement of the typical situation that arises when a taxpayer acquires more than one asset in a single transaction. In general, if a taxpayer acquires the assets of a business, the consideration paid must be allocated among the various assets; some will be depreciable, some amortizable, and others will be ineligible for cost recovery until sold. 1 If the taxpayer acquires improved real estate, the consideration must be allocated between the nondepreciable land and the depreciable improvements.
What the taxpayer in Union Carbide acquired was a vessel that it had been leasing, and it attempted to allocate the purchase price between depreciable basis for the ship and a deduction for a lease cancellation (as a cost of doing business). The IRS argued, however, that the entire amount paid was for the vessel. The taxpayer failed to convince the Tax Court otherwise.
Union Carbide had ordered a tanker built to its specifications in 1983 and leased the vessel under a "bareboat charter." By the early 1990s, the lease terms had become burdensome. The lease permitted Union Carbide to cancel only if it made a termination payment, which by the end of 1993 would have amounted to about $135 million. Instead, the taxpayer purchased, for about $108 million, the grantor trust that held title to the vessel. In June 1994, Union Carbide cancelled the lease and acquired title to the vessel. The tanker was worth about $14 million at the time the taxpayer paid $108 million, the difference being the premium value of the future lease payments.
The taxpayer treated the transaction as $14 million paid for the vessel and $94 million paid for terminating the burdensome lease. Not surprisingly, the Service contended that the entire $108 million had to be capitalized and recovered through depreciation. Either way, the total ultimately deductible was $108 million, but there is a significant timing difference in the positions of the parties. As shown by Exhibit 1, if the taxpayer's position had been upheld there would have been a saving of over $8 million due to the time value of money.
The purchase of what appears to be one asset may be treated, for tax purposes, as the purchase of several assets. In that event, the purchaser must allocate the purchase price among the several assets according to their FMVs. For example, in Newark Morning Ledger Co., 71 AFTR 2d 93-1380, 507 US 546, 123 L Ed 2d 288, 93-1 USTC ¶50228 , the Supreme Court held that the purchaser of a newspaper could include subscriber lists and goodwill in the assets among which the purchase price was allocated. The amount allocated to the subscriber lists, having a limited useful life and a determinable value, could be depreciated, while the amount allocated to goodwill was nondepreciable. 2
In Selig, 54 AFTR 2d 84-5784, 740 F2d 572, 84-2 USTC ¶9696, the taxpayer spent $10.8 million to purchase the baseball team that became the Milwaukee Brewers. The franchise itself did not have a determinable useful life, and therefore could not be depreciated. The taxpayer, however, allocated 95% of the purchase price to the player contracts, which were depreciable over five years. The IRS argued that a baseball team does not exist without its players, and therefore the taxpayer could not separate the player contracts from the value of the team. In an opinion both thorough for its examination of the various grounds for the experts' valuations and amusing in its references to baseball lore, the Seventh Circuit held that it was reasonable for the taxpayer to allocate 95% of the purchase price to the quickly depreciable player contracts.
The Tax Court also held that a taxpayer could allocate a portion of a purchase price for a business to the value of a franchise, as a separate and distinct asset, with its own amortization period. In Triangle Publications Inc., 54 TC 138, the asset was a franchise to publish TV Guide, given by Triangle to an unrelated company (Tele Views). A subsidiary of Triangle later bought the franchise from Tele Views. Triangle subsequently granted an extension of the franchise to the subsidiary, which amortized the cost of the franchise over five years. Afterwards, Triangle and the subsidiary merged, and the court held that Triangle could continue to amortize the franchise over what was left of the five years.
The same case also involved another franchise, this one granted by Triangle to a different unrelated company (TNI). After offering (but never implementing) a three-year extension, Triangle offered to buy back the franchise. After negotiations, it wound up buying TNI instead. Triangle liquidated TNI, and thus the franchise agreement was extinguished. Triangle allocated $489,000 to the non-existent three-year franchise offer and then immediately deducted that amount since it cancelled the franchise. The Tax Court held that only $55,000 was allocable to the franchise, because Triangle never actually granted the three-year extension. In a holding favorable to the taxpayer, however, the court allocated the rest of the purchase price to customer lists, which were deductible under Section 173 .
Suppose a taxpayer inherits improved real estate, and receives a step-up in basis to FMV, 3 to be allocated between nondepreciable land and depreciable improvements. Alternatively, the taxpayer might inherit property subject to a lease calling for an above-market rent. The income stream expected from the lease would cause the estate tax value of the property to be inflated above the free-and-clear value of the asset. Can the taxpayer apportion part of the basis to the lease, analogous to the way Bud Selig apportioned a part of the baseball team's purchase price to the player contracts?
Apparently not, according to the Tax Court's decision in Moore, 15 TC 906, rev'd and remanded 44 AFTR 470, 207 F2d 265, 53-2 USTC ¶9563, on remand TC Memo 1955-219 , PH TCM ¶55219, 14 CCH TCM 869 . The Ninth Circuit reversed, holding that the lease was an exhaustible asset that could be separately valued and amortized. The Tax Court disagreed with the Ninth Circuit's reasoning, however, and continued to hold—with the approval of the Third and Fourth Circuits—that the acquisition of real estate subject to a lease could not be bifurcated into two parts, i.e., the premium lease value and the value of the reversion. 4
More recently, the Tax Court again held that the value of a lease could not be separated from the value of the underlying property, in Moores, TC Memo 1995-52, RIA TC Memo ¶95052, 69 CCH TCM 1797 . There, the taxpayer purchased a building that was subject to a lease at an above-market rent, and thus the lease had a premium value. The taxpayer allocated the purchase price between the building ($933,000) and the lease ($1 million). 5 The taxpayer amortized the lease over its remaining life, 32 months. The court held that the right to receive rent is an incident of ownership, and that the taxpayer could not separate the right to receive rent from other rights possessed by the owner. The lease, therefore, could not be separately valued and amortized.
Prior to the events in Union Carbide, Congress appeared to address this allocation issue by amending Section 167(c) as part of RRA ’93. Under a "special rule for property subject to lease" in Section 167(c)(2), "if any property is acquired subject to a lease ... no portion of the adjusted basis shall be allocated to the leasehold interest, and ... the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease." (Emphasis added.)
In Union Carbide, however, the acquiring taxpayer was the lessee at the time it acquired the underlying property that was subject to the lease. Union Carbide contended that Section 167(c)(2) therefore did not apply to its situation, reasoning that the property was not "acquired subject to a lease" because the lease merged with the fee interest the moment lessor and lessee were the same person, i.e., the moment Union Carbide acquired the property. The Service said that the vessel was subject to a lease when the taxpayer acquired it, and therefore Section 167(c) applied.
The parties engaged in grammatical arguments and counter-arguments, seeking to determine whether or not Section 167(c)(2) applies where a lease terminates or merges on acquisition of the fee interest by the lessee.
Union Carbide, in its grammatical argument, contended that the phrase "subject to a lease" modified "acquired," and that meant the property had to remain subject to the lease after the acquisition for Section 167(c)(2) to apply. The taxpayer said that if Congress meant what the IRS contended, the statute should read "if any property subject to a lease is acquired."
The Service contended that "acquired subject to a lease" denoted the gaining of possession. The IRS asserted that use of "acquired" placed the phrase in the past tense, without any reference to present or future tense. The Service reasoned that this use of the past tense had great significance, citing 1 U.S.C. section 1 1 U.S.C. section 1, which provides that "words used in the present tense include the future as well as the present." The IRS argued that this necessarily implied that words used in the past tense do not include the future. Accordingly, the Service argued that Section 167(c)(2) applied to transactions in which the lease existed in the past, and not in the future, and therefore covered the taxpayer's situation. Both sides appear to be wrong: "is acquired" is the present tense in the passive voice, and has nothing to do with past tense. 6
The court did not base its decision on grammatical nuance. In determining whether Congress intended Section 167(c)(2) to apply to an acquisition where the lease merges into the lessee's new property ownership interest, the court looked first to the legislative history. The only example given in the Conference Report dealt with leases to third parties. 7 The court determined that the example was illustrative and not all-inclusive, and it stated that the legislative history did not offer guidance. The court next turned to the case law, and found only two cases in which the lessor and lessee became the same party.
In Cleveland Allerton Hotel, 36 AFTR 862, 166 F2d 805, 48-1 USTC ¶9218, the taxpayer constructed and owned a hotel on leased land. At some point thereafter, the taxpayer purchased the reversionary interest for approximately $440,000. Based on the taxpayer's credible evidence, the Tax Court held that the rent under the lease was excessive, and that the value of the land without the lease was $200,000. The Sixth Circuit noted that the parties considered the reversionary value of the land to be nominal; therefore, the amount paid in excess of the $200,000 value of the land must be for the cancellation of the onerous lease.
The taxpayer in Millinery Center Bldg. Corp., 49 AFTR 171, 350 US 456, 100 L Ed 545, 56-1 USTC ¶9391, aff'g 47 AFTR 448, 221 F2d 322, 55-1 USTC ¶9377, also owned a building on leased land, and also asserted that the lease was onerous. The Second Circuit upheld the Service's position that the taxpayer could not bifurcate the basis between real estate and rent. The Supreme Court granted certiorari because of an apparent conflict with the Sixth Circuit's decision in Cleveland Allerton Hotel. The Court concluded that the taxpayer, which had introduced evidence concerning the rent for unimproved land, failed to prove that the rent it paid for the land with the building was excessive. Thus, while the Supreme Court upheld the Second Circuit's ruling that the taxpayer could not deduct the cost of relief from the lease, it limited its holding to the failure of proof and explicitly held that it was not ruling on the issue of deductibility of payments for relief from a lease. It would appear, therefore, that the Supreme Court never resolved the apparent conflict between Cleveland Allerton Hotel and Millinery Center Bldg. Corp.
The Tax Court in Union Carbide also stated that Congress enacted Section 167(c)(2) in order to codify the holding in Millinery Center. This may or may not be true, since the legislative history did not mention Millinery Center, and 37 years had elapsed between the Supreme Court's opinion and the enactment of Section 167(c)(2) in 1993.
In reaching its holding that Section 167(c)(2) applied, the Tax Court said that Union Carbide's position would eviscerate Section 167(c)(2) . It would be too simple for taxpayers to avoid the special rule for leases by simultaneously acquiring tangible property, cancelling the lease, and negotiating a new lease.
Union Carbide's alternative argument was that in acquiring the tanker, it really acquired two assets – the vessel and the lease. The Tax Court rejected this as well.
The court observed that if an unrelated party had purchased the tanker it would have acquired not only the vessel but also an income stream from the favorable lease, and therefore would have been willing to pay $108 million for the combination of assets and rights. A sale to such an unrelated party would not result in the merger of ownership and lease interest. Without the attendant cancellation of the lease, the unrelated party would ascribe the full $108 million purchase price to the basis of the vessel. The Tax Court stated that the taxpayer should be held to the same standard.
In Idaho Power Co., 34 AFTR 2d 74-5244, 418 US 1, 41 L Ed 2d 535, 74-2 USTC ¶9521, a case involving capitalization of construction period depreciation, the Supreme Court held that a taxpayer capable of constructing its own plant should be placed on an equal footing with a taxpayer who engaged a contractor to construct its plant. Idaho Power had purchased its own construction equipment, and was deducting depreciation on the equipment it was using to construct its plant. A contractor, however, would incorporate its depreciation expenses into the final cost for the plant. A taxpayer dealing with a contractor would pay such expenses as part of its purchase price, which clearly would be capitalized and subject to depreciation (over a much longer period than the recovery period applicable to the equipment). If the Tax Court in Union Carbide had followed the logic of Idaho Power, it could have held that the tax law should be construed to equalize the treatment of taxpayer-lessee purchasers and unrelated third-party purchasers, and therefore Union Carbide could not bifurcate its purchase into vessel and leasehold interests.
Even if Union Carbide had been successful in convincing the court that Section 167(c)(2) did not apply to its situation, and that it had acquired two separately valued assets, it would have come up against a line of cases holding that a cancelled lease can be deemed to have a continuing existence. The effect would be to require amortization of the cost of the lease over its remaining deemed life, which in Union Carbide's case would have been longer than the recovery period for the vessel.
In Wolan, 39 AFTR 1025, 184 F2d 101, 50-2 USTC ¶9424, the taxpayer's shareholders had to amortize lease expenses over the original life of the lease even after the taxpayer itself liquidated. The taxpayer had owned real estate that it leased to Sevenorm in 1936 for 20 years. Sevenorm incurred advance rent and other lease expenses that it amortized over the lease term. Three years later, the taxpayer acquired all of Sevenorm's stock and liquidated it. In 1941, the taxpayer leased the property to an unrelated party and incurred costs that it amortized over the term of the new lease. In 1944, the taxpayer liquidated, and deducted the remaining unamortized lease expenses from both leases. The court held that just as the Sevenorm lease had a fictionalized existence after Sevenorm's liquidation, both leases continued to have a fictionalized existence after taxpayer's liquidation. Therefore, the shareholders, as successors in interest, could continue to take the yearly amortization expenses formerly taken by the taxpayer.
This argument is troubling. The taxpayer, as successor to Sevenorm, acquired Sevenorm's assets in a tax-free transaction (the liquidation of a subsidiary). Taxpayer's shareholders, on the other hand, acquired taxpayer's assets in a taxable liquidation. Since the shareholders recognized gain or loss on the liquidation, the corporation's tax attributes should not have carried over to the shareholders.
In Action Distributing Co., Inc., 64 AFTR 2d 89-5016, 876 F2d 534, 89-1 USTC ¶9348, aff'g per cur. TC Memo 1987-377, PH TCM ¶87377, 53 CCH TCM 1490, the court considered the deductibility of leasehold improvements, where an acquisition caused the leases to be cancelled.
There, Byrne owned 100% of stock of United, and owned the buildings that United leased for its business. United made leasehold improvements, and depreciated the improvements straight line over their useful life. Later, United adopted a plan of liquidation pursuant to which United would sell its business to an unrelated buyer and distribute the rest of its assets to its shareholder. Action bought United's stock from Byrne, so when United liquidated, Action received its assets. At the time of the liquidation, Byrne and United cancelled the leases, and Byrne entered into new leases with the buyer of United's business. Action claimed a deduction for unamortized leasehold improvements, as United's transferee.
The court noted that when the lessor and lessee are related, there is no assurance that the lease term reflects arm's-length negotiations. Related parties could choose to terminate a lease early, in order to accelerate amortization or depreciation deductions. Citing Wolan with approval, the court held that when the lessor acquired the lessee, and liquidated the lessee, there was a fictional continuance of the lease. The lessor had continued use of the property, as if the lease continued, and thus the lessor had to take the amortization deductions over the term of the lease that no longer existed.
Any appeal in Union Carbide would lie to the Second Circuit, and it is highly likely that taxpayer would not prevail. In its opinion in Millinery Center, the Second Circuit did not focus on the taxpayer's failure of proof (as did the Supreme Court in affirming). Therefore, it is reasonable to conclude that the Second Circuit could view a possible Union Carbide appeal as a vehicle for deciding the issue when the lease is burdensome, which was the issue in Millinery Center that the Supreme Court left open.
The taxpayer in Union Carbide made a bad economic bargain with respect to its lease of the tanker. It bought its way out at a savings of $27 million (the difference between the $135 million cancellation fee and the $108 million it paid to take over the trust that held title to the vessel). What it could not do was generate a further savings—to the detriment of the Treasury—by taking an immediate deduction for the $94 million lease premium.
The following comparison of the economic results of the taxpayer's and the Service's positions in Union Carbide Foreign Sales Corp. uses a present value (P.V.) computed at 8%.
Deductible Depreciable
expense basis in vessel
------------ ---------------
Taxpayer position: $94,000,000 $ 14,000,000
IRS position: $108,000,000
Taxpayer position IRS position
--------------------------------- --------------------------------
Depre-
ciation
percen- Tax Tax
Yr tage Deduction saving P.V. Deduction saving P.V.
-- ----- ----------- ----------- ----------- ----------- ---------- ----------
0 10.00% $95,400,000 $33,390,000 $33,390,000 $10,800,000 $3,780,000 $3,780,000
1 18.00 2,520,000 882,000 747,458 19,440,000 6,804,000 5,766,102
2 14.40 2,016,000 705,600 539,146 15,552,000 5,443,200 4,159,128
3 11.52 1,612,800 564,480 406,996 12,441,600 4,354,560 3,139,684
4 9.22 1,290,800 451,780 317,481 9,957,600 3,485,160 2,449,142
5 7.37 1,031,800 361,130 253,075 7,959,600 2,785,860 1,952,291
6 6.55 917,000 320,950 219,339 7,074,000 2,475,900 1,692,047
7 6.55 917,000 320,950 205,856 7,074,000 2,475,900 1,588,031
8 6.56 918,400 321,440 193,351 7,084,800 2,479,680 1,491,564
9 6.55 917,000 320,950 181,324 7,074,000 2,475,900 1,398,788
10 3.28 459,200 160,720 116,388 3,542,400 1,239,840 897,849
------------ ----------- ----------- ----------- ---------- ----------
Totals 108,000,000 37,800,000 36,570,415 108,000,000 37,800,000 28,314,626
============ =========== =========== =========== ========== ==========
The difference in present value between the taxpayer's position and the Service's position is $36,570,415 − $28,314,626, or $8,255,788.
It is doubtful that taxpayers can structure their deals to get around the Union Carbide holding. Suppose the buyer and seller had negotiated a contract that provided for the purchase of two separate assets, the vessel and the lease, with a separate price given for each. Theoretically, the IRS should respect this as an arm's-length contract between adverse parties. The cancellation cost for a lease is deductible in full in the year of cancellation (see Cassatt, 31 AFTR 576, 137 F2d 745, 43-2 USTC ¶9579 ). The cost of the vessel would be depreciable over its recovery period. Nevertheless, there is a danger that the IRS could apply the step-transaction doctrine. If the taxpayer can show that it gets an independent business benefit from the buyout of the lease, e.g., relief from the onerous lease that burdened Union Carbide, then the first step could have an independent life apart from the second step, and the step-transaction doctrine may not apply. (see G.M. Trading Corp., 103 TC 59, supp. opn. 106 TC 257, rev'd on other issue 80 AFTR 2d 97-6402, 121 F3d 977, 97-2 USTC ¶50658 ).
See generally MacNeil, Sargent, and Wegener, "Final Regs. on Allocation of Purchase Price to Assets Affect Actual and Deemed Sales," 95 JTAX 15 (July 2001) .
See Levy, MacNeil, and Young, "Supreme Court's Decision on Amortizing Intangibles Removes One Barrier," 79 JTAX 4 (July 1993) .
The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16, 6/7/01; EGTRRA) modifies the stepped-up basis rules for the estates of decedents dying after 2009 in favor of a modified carryover basis regime—which, unless the law is changed, will expire after 2010 under EGTRRA's sunset provisions. See generally Blattmachr and Detzel, "Estate Planning Changes in the 2001 Tax Act—More Than You Can Count," 95 JTAX 74 (August 2001) .
Midler Court Realty, Inc., 61 TC 590, aff'd 36 AFTR 2d 75-5567 , 521 F2d 767, 75-2 USTC ¶9650 ; Schubert, 33 TC 1048, aff'd 7 AFTR 2d 550, 286 F2d 573, 61-1 USTC ¶9217.
At trial, the parties agreed that the premium value for the lease had been overvalued, and it should be $765,000 rather than $1 million.
In active rather than passive voice, the statute might have said "if a person acquires property subject to a lease...." In this construction, the Service's argument fails because the sentence is in the present tense; the taxpayer's argument fails because the phrase "subject to a lease" modifies the noun "property" rather than the verb "acquired."
H. Rep't No. 103-213, 103d Cong., 1st Sess. 681-682 (1993).