A business exercising an option to buy property that it was already leasing may deduct a portion of the amount tendered in the transaction as a lease termination payment, the Court of Appeals for the Sixth Circuit ruled, affirming an earlier district court decision.

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The court rejected the IRS’s argument that the entire amount had to be capitalized as part of the purchase price of the property (ABC Beverage Corporation v. U.S., CA 6, June 13, 2014).

In 1987, Corporate Property Associates (the landlord) leased a building to ABC Beverage Corporation. The initial lease period lasted 25 years and provided for five successive five-year renewal options.

The lease contained a clause allowing ABC the option to purchase the property. On Dec. 10, 1996, ABC notified the landlord that it was exercising its purchase option. However, the parties could not agree on the purchase price.

Three appraisals obtained by ABC determined a fair market value (FMV) of $2.75 million. The landlord’s appraisals indicated a FMV of $14.1 million, including the value of the unexpired lease.

The parties remained at an impasse. On Oct. 2, 1997, the landlord notified ABC that it was exercising its remedies under the lease and requested that ABC make an offer to purchase the property.

In January 1999, the parties entered into an agreement in which they agreed that the FMV of the property would be no less than $9 million and no greater than $11.5 million. Later in 1999, they agreed on a purchase price of $11 million.

On its 1997 tax return, ABC claimed a deduction for $6.25 million as a lease termination expense and capitalized the property for $2.75 million. ABC apparently based the deduction on its calculation that the minimum it would have to pay to acquire the property was $9 million. Using the minimum purchase price and subtracting the appraisals it had obtained for the property, ABC concluded that the cost of buying out the lease was $6.25 million.

In 2005, the IRS assessed an income tax deficiency against ABC. The dispute over the lease termination payment deduction wound up in district court.

In the original district court proceeding, the IRS argued that ABC could not claim any of the cost of terminating the leasehold as a business expense. Alternatively, it argued that, if a deduction was allowable, the proper year for the deduction was 1999, not 1997.

The district court held that ABC was entitled to claim as a business expense the cost associated with buying out an onerous lease. However, it put off deciding on the proper year for the deduction. In a subsequent proceeding, a jury agreed that 1997 was the proper year for the deduction.

Now the Sixth Circuit has agreed with the district court. In reaching its conclusion, the court upheld its earlier decision in Cleveland Allerton Hotel v. Commissioner and rejected the Tax Court’s decision in Union Carbide Foreign Sales Corp. v. Commissioner. The ABC Beverage case may not be the last word on this topic.