Deductibility of forbearance payments.

• Author: Dabrowska, Anita

In Media Space, Inc., 135 T.C. No. 21, the Tax Court held that a corporation's payments to its shareholders to delay redemption of their preferred shares were generally deductible under Sec. 162. However, the court further held that a company would be required to capitalize forbearance agreement payments under the 12-month rule in Regs. Sec. 1.263(a)-4(f)(1) if there was a reasonable expectancy of the agreement's renewal.

In 2000, Media Space, Inc., a C corporation, raised its startup capital by issuing two series of preferred stock. The corporate charter provided for dividends on both series of the preferred stock as well as redemption rights to the preferred stockholders (the investors). The investors had the right to require Media Space to redeem the preferred stock on September 30, 2003, or anytime thereafter by making a written redemption election. If the company was unable to redeem the stock because of an impairment of the corporation's capital or other reasons, Media Space was required to pay interest to the investors as provided in the corporate charter.

Before September 30, 2003, the corporation and the investors recognized that the corporation lacked the financial ability to redeem all the preferred shares. The company's auditors advised the company that they would need to issue a going concern statement on the company's financial statements if the redemption rights were able to be exercised. At that time, Media Space was negotiating a new financing agreement, and a going concern statement could have negatively affected the negotiations.

Although the investors wanted to redeem their shares as soon as possible, after negotiations they entered into a forbearance agreement with the company by which the investors agreed to forbear from exercising their redemption rights for a period of one year. In exchange, the company agreed to make the forbearance payments equal in amount to the interest payments it would have been required to make under the terms of the charter if the investors had made the redemption election and Media Space had been unable to redeem the stock. However, the forbearance agreement was a contract separate from the charter.

The company and the investors subsequently extended the agreement several times. Both parties intended the forbearance payments to constitute interest as compensation for the investors' forbearance from receipt and use of the redemption amount. Media Space accrued and deducted the forbearance...