Termination of Burdensome Lease

The Tax Court addressed application of Sec. 167(c)(2) to an acquisition of leased property that resulted in termination of a burdensome lease agreement (Union Carbide Foreign Sales Corp., 115 TC 423 (2000)). The case involved a long-term lease of a specialized seagoing vessel that the taxpayer had operated as lessee for approximately 10 years. However, the lease terms became extremely burdensome to the taxpayer.

Under the agreement, the taxpayer could terminate the lease by making a significant termination payment or by purchasing the leased vessel. The taxpayer determined that the cost of exercising the purchase option was about 20% less than the termination payment and would have the effect of terminating the lease. Therefore, the taxpayer exercised its $107,748,925 purchase option. At exercise, the taxpayer determined the vessel's fair market value to be $13,865,000. Accordingly, the taxpayer deducted the remaining $93,883,925 as a payment for termination of a burdensome lease. The IRS disallowed the taxpayer's deduction on the basis that Sec. 167(c)(2) prohibits such an allocation.

Tax Court Decision

Under Sec. 167(c)(2)(A), "[i]f any property is acquired subject to a lease—no portion of the adjusted basis shall be allocated to the leasehold interest...." Accordingly, the primary issue centered on the definition of property "subject to a lease." The Tax Court found "no direct assistance" from the legislative history of Sec. 167(c)(2), which was enacted for the purpose of clarifying the application of Sec. 197. Nonetheless, the court concluded that under the statute's plain language, the vessel was acquired "subject to a lease" and, therefore, Sec. 167(c)(2) prohibited allocation of any amount as a deductible contract termination payment. The court also rejected the taxpayer's alternative argument that the acquisition should be characterized as two separate transactions, one attributable to acquisition of the vessel and the other attributable to cancellation of the burdensome lease.

Although the Union Carbide decision is troubling, there are a number of issues in the court's analysis that may limit the case's application outside of its specific facts and holding. For example, in rejecting the taxpayer's alternative argument, the court relied on an interpretation of the Supreme Court's analysis in Millinery Center Building Corp., 350 US 456 (1956), that conflicts with a recent Service interpretation of this seminal case.

In Letter Ruling 9842006, the IRS concluded that the Supreme Court's decision in Millinery Center was consistent with the Sixth Circuit's analysis in Cleveland Allerton Hotel, Inc., 166 F2d 805 (1948). Specifically, the ruling stated:

Although it might be argued that Millinery Center does not permit an allocation of a portion of Taxpayer's payment to a deductible contract termination payment..., the above analysis demonstrates not only that such an allocation is permissible but that it is consistent with cases such as Cleveland Allerton, Stuart, and Troc.

In the ruling, the Service permitted the taxpayer to allocate a portion of the purchase price of a power-generating facility as a deductible contract termination payment. Likewise, in Field Service Advice 9918022, the IRS reaffirmed its interpretation of the primary case law in this area, noting:

We have taken the position, as set out in PLR 9842006, that an allocation may be appropriate under certain circumstances where it is clear that a portion of the payment was for the purpose of terminating an unprofitable contract and where the amount paid to terminate the contract is ascertainable. This interpretation of Millinery Center reconciles it with Cleveland Allerton Hotel, which was not expressly disapproved.

Although the Tax Court in Union Carbide recognized that "these administrative discussions give the [taxpayer] some solace," it gave the Service's interpretation no weight. The court dismissed these administrative pronouncements because they were issued subsequent to the transaction at hand and had no precedential value. Instead, the Tax Court relied on a sharply different interpretation of the Supreme Court's decision in Millinery Center to prohibit the taxpayer's allocation, concluding that, although not expressly stated, the Supreme Court's holding in Millinery Center had the effect of overruling the Sixth Circuit's decision in Cleveland Allerton Hotel.

In this regard, the Tax Court stated:

[given the Supreme Court's holding in Millinery Center] it would appear that the approach of the Court of Appeals for the Sixth Circuit was rejected. Accordingly, the vitality of the holding in Cleveland Allerton Hotel, Inc....is questionable.

In dismissing Cleveland Allerton Hotel, the Tax Court concluded that, even under case law existing prior to Sec. 167(c)(2), no such allocation would be permitted.

However, this interpretation of the case law conflicts with the IRS's position that Millinery Center and Cleveland Allerton Hotel illustrate a consistent application of the general rule permitting taxpayers to separately characterize portions of a lump-sum payment if the allocation can be supported. Further, the Tax Court's opinion recognizes the uncertainty surrounding the proper interpretation of the primary authorities in this area and specifically notes that any appeal of the case would be made to the Second (rather than the Sixth) Circuit.

The Tax Court's decision in Union Carbide may be troubling for taxpayers that wish to terminate a burdensome lease through acquisition of the leased property. However, taxpayers should recognize that Union Carbide was an issue of first impression and conflicts with the IRS National Office's apparent interpretation of the primary authorities addressing this issue. In addition, taxpayers should be aware of the Tax Court's own recognition of the uncertainty underlying its reading of the relevant case law, and may wish to take these factors into consideration in analyzing the application of the case to their particular circumstances.

From Dennis Tingey, J.D., CPA, Washington, DC