Technical correction clarifies sec. 162(k) limit on stock reacquisition expenses.

• Author: Diamond, Mark L.

Section 1704(p) of the Small Business Job Protection Act of 1996 (SBJPA) provides much-needed clarification on the Sec. 162(k) limitation on stock reacquisition expenses. First, the SBJPA added new Sec. 162(k)(2)(A)(ii), effective as of the effective date of the Tax Reform Act of 1986 (TRA), clarifying that financing costs are not subject to disallowance. Second, the SBJPA clarified that Sec. 162(k) applies to any reacquisition of previously outstanding stock, regardless of whether the transaction is treated for tax purposes as a redemption, a sale of stock, a dividend, a reorganization or any other transaction. This second "clarification" applies only to amounts paid or incurred after Sept. 13, 1995.

Legislative History of Sec. 162(k) Prior to 1996, there was no authority that would allow a corporation to deduct, either currently or through amortization, costs associated with a redemption of its stock other than at the end of the corporations life. However, in Five Star Manufacturing Co., 355 F2d 724 (1966), the Fifth Circuit allowed a corporation to deduct expenditures related to the redemption of a shareholder's stock, including the cost of the redeemed shares. The peculiar facts in Five Star involved a shareholder who threatened liquidation of the corporation unless his stock was repurchased. In allowing a deduction for the redemption, the court noted that the liquidation of the corporation was imminent without the removal of the shareholder.

Limited by its facts and questioned as to its validity, Five Star was an isolated case whose main contribution to the world of tax was the creation of uncertainty as to the proper treatment of costs incurred by a corporation to redeem a problem shareholder.

During the leveraged buyout boom of the early 1980s, many corporations were the targets of hostile takeovers. Noting the decision in Five Star, these corporations started deducting the substantial expenditures incurred to repurchase stock from hostile shareholders (so-called "greenmail" payments). Obviously, this did not please the government. As a result, Congress added Sec. 162(1).

Reclassified as subsection (k) in 1988, Sec. 162 (k) codified the general rule of case law that a redemption of stock is a capital transaction and, as such, stock redemption expenses are not deductible. The legislative history of Sec. 162(k) specifically refers to Five Star and indicates that Sec. 162(k) was enacted to clarify, by way of an express statutory...