Payments under forbearance agreements held partially deductible.

The Tax Court held that payments by a company to investors for agreeing to temporarily forgo making an election to redeem stock were not interest payments; however, it further held that some of the payments were deductible ordinary and necessary business expenses.

Background

Media Space, Inc., is a media advertising corporation based in Connecticut. It was incorporated in 1999, and in 2000 it issued over 5 million shares of series A preferred stock and over 1 million shares of series B preferred stock to two investment LLCs.

Media Space's corporate charter provided for dividends to be paid on the series A and B preferred stock at a rate of 8% per year. The charter also gave the investors the right to require Media Space to redeem all of both series of stock on September 30, 2003, or anytime thereafter. A formula for determining the redemption price for the stock was included in the charter. In addition, the charter also addressed the possibility that Media Space might not be able to redeem the shares when the investors elected redemption. If Media Space was prohibited from redeeming the shares under state corporation law because of an impairment of its capital or otherwise failed to redeem the shares as required by the charter, the company was required to pay interest to the investors at the rate of 4% per year, increasing by 0.5% at the end of each six-month period until paid in full, up to a maximum rate of 9%.

Before September 30, 2003, Media Space and the investors recognized that the company would not have the funds to redeem all the series A or series B preferred shares without causing its financial auditors to include a going concern statement on the company's financial statements. Therefore, although all the investors wanted to redeem their Media Space shares on September 30, they entered into an agreement with the company to forgo exercising their redemption rights for one year. In return, Media Space agreed to pay the investors an amount equal to the interest that they would have received if they had exercised their redemption rights and Media Space had been unable to redeem their shares. The forbearance agreement, however, was a separate contract from the company charter.

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In 2004, Media Space was again in a position where it would not be favorable for the company to redeem the investor's shares. Therefore, although the investors still wanted to redeem their shares, they extended the forbearance agreement...