Warrants issued to customers.

During the 1980s and 1990s, some equity prices became severely inflated; consequently, many companies looked for ways to capitalize oil their increased share price by using their stock as currency. One idea was to issue customers warrants to motivate them to purchase a certain amount of product. This effectively gave the customer the potential to realize a significant discount on products purchased and provided a seller the means to offer a purchase incentive. The IRS and taxpayers have disputed the appropriate tax treatment of these warrants--while taxpayers argue they should be treated as sales discounts, the IRS claims they should be capitalized.

Purchase/Sales Discount

The primary issue is whether the issued warrants constitute (1) a sales discount or allowance excludible from gross sales; (2) an ordinary and necessary business expense deductible under Sec. 162; or (3) an investment by the customer that is neither excludible from income nor deductible. Clearly, amounts excludible from gross income or deductible as ordinary and necessary business expenses may be paid in terms other than cash. For example, warrants issued in connection with debt often create original issue discount deductible under Sec. 163; see Coscia, Tax Clinic, "Debt Issued with Warrants," p. 666, this issue. Employees are often offered stock options as compensation and third-party consultants are often paid via stock, which can be deductible depending on the services rendered.

Cases: Two court cases examined the deductibility of warrants issued to customers. In Sun Microsystems, Inc., TC Memo 1993-467, the taxpayer issued warrants to a customer that were grouped with a note and debentures representing capital transactions, mainly to comply with Federal and state securities laws. The warrants were contingent on the customer purchasing a certain level of product from the taxpayer.

The Tax Court concluded that the negotiations between the two parties clearly showed the warrants were included as an incentive to purchase product, not as a capital item. The court rejected the argument that the warrants were included in an agreement with a note and debentures, as this merely facilitated securities law requirements. Additionally, the customer did not ultimately own any stock; the warrants were sold to a third party who immediately exercised them. The court noted that the customer "did not intend to purchase or hold the stock of...[Sun]...if the Stock Warrants became...