Originally published on Forbes.com June 19th, 2014
The ABC Beverage Corporation makes and distributes soft drinks for Dr. Pepper Snapple Group. It was subject to an onerous lease on its bottling plant in Hazelwood, Missouri. So the company decided to buy the building, which it reckoned to be worth about $2.75 million for $9 million. It recorded an expense of $6.25 million on its 1997 return as a cost of terminating the lease. The IRS maintained that the amount should be capitalized as a cost of acquiring the real estate.
Battle was joined and now we have the result. The Sixth Circuit has ruled that it already answered this question before all but the oldest of the baby boomers were born and that nothing that has happened since, not even the Red Sox finally breaking the curse, makes the answer any different. Like the Cleveland Allerton Hotel in 1948, ABC Beverage Corporation is entitled to deduct the premium portion of the price it paid for the real estate as a cost of terminating the lease.
The decision has caught a bit of interest. Lew Taishoff calls the decision a “heartwarmer for an elderly chap”. Apparently Lew is not quite old enough to remember the Cleveland Allerton precedent. He walks through the various legislative changes and Supreme Court decisions that the IRS argued should dictate a different result, but which left the Sixth Circuit sticking to its guns as Bloomberg puts it. It is all rather lawyerly, which makes me inclined to skip it, but there is a planning opportunity that I see here that might be worth considering.
When a real estate is appraised there are three approaches used that are then reconciled in the summary. The approaches are comparable sales, income and replacement cost. Comparable sales is the most favored, but in the case of many types of property, there are not enough sales that are comparable enough. For the sake of my possible planning opportunity, let’s assume that we have a company leasing real estate in a hot enough market that there are sufficient comparable sales. Let’s make the further assumption that the facility is well set up for its function. More importantly, assume that the location is ideal for the function.
Beverage bottling and distribution might be a good example of the type of business where you might have those types of conditions. You have your trucks fanning out from the facility with product that does not have that high a value to weight ratio. If you have the distributorship rights for a particular area, you would probably pay a premium to have just the right road access. Unlike a national accounting firm preparing tax returns, you don’t have the option of siting your bottling operation for Manhattan in Bangalore. At any rate, if there is a location-dependent business that is surrounded by other facilities that are not so location-dependent, it might find that its existing facility, which it is leasing, is worth more to its business than the “fair market value” of the property.
Many older leases were written during periods of much higher interest rates. It would seem that there might be an opportunity here for owners of location-dependent businesses to pay something of a premium over fair market value, based on comparables, while coming out ahead on replacement cost with an immediate tax deduction sweetening the deal.
Of course we need to get back to being lawyerly again. BNA notes that the Sixth Circuit is putting itself at odds with the Second Circuit and the Tax Court. So the fast write-off is shaky if you are outside of Kentucky, Michigan, Ohio and Tennessee. Still, it might be worth running some numbers.
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