We have come to expect that taxpayers and their advisers, on the one hand, and the Internal Revenue Service, on the other, will have differing views regarding various questions of tax law. Usually, each side can discern at least a kernel of rationality in the position taken by the other. Occasionally, though, the Service takes a bizarre position that is very difficult for commentators to justify. Such a situation is presented by a private letter ruling recently issued by the Service that deals with the question of whether a lessee may deduct payments made to a lessor to obtain a release from an onerous lease. Private Letter Ruling 9607016 (Nov. 20, 1995).

It is often the case when a strange result is reached in the tax world that we are dealing with a taxpayer who is seeking an atypical result. Taxpayers normally seek to accelerate their deductions; in the case of a lessee buying its way out of a lease, so that the lessee can relocate to new premises, it would normally be advantageous to the lessee to deduct the full amount of the payment when the lease is terminated. Only if the lessee otherwise had some unusual tax attributes would the lessee want to "capitalize" the amount paid to its old lessor as a cost of obtaining a lease on the new premises. Apparently, however, the taxpayer that sought Private Letter Ruling 9607016 was in just such a situation and, when it sought a ruling that capitalization, rather than current deduction, was required, the Service was only too happy to grant it!

There is a constant tension in the tax law between the rule that a taxpayer may deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business" and the rule that no deduction is allowed for "capital expenditures," including "any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." As a theoretical matter, capitalization of an expenditure is viewed as the norm, while current deduction is viewed as an exception that is available only when the Internal Revenue Code makes specific provision for it. As a practical matter, though, certain categories of payments which might conceivably have found their way to the "capitalization" side of the line have been accepted as deductible.

Among these deductible payments have historically been lease termination payments made by a lessee. The courts have held and the Service has accepted that such payments merely effect reductions to future expenses, rather than an acquisition of a future benefit which would require capitalization. By contrast, when a lessor makes a payment to a lessee to induce the lessee to vacate the premises early, capitalization is required, since the lessor is reacquiring a significant property right - the right to possession. Similarly, if a lessee is already amortizing its cost of acquiring a lease and then agrees to cancel the lease and to enter into a new lease with the lessor, the lessee may not deduct the remaining unamortized cost in the year of cancellation.

What happens, though, when the lessee makes a lease termination payment to the lessor so that the lessee will be free to enter into a new lease at a new location with a lessor unrelated to its existing landlord? Is there a sufficient connection between the making of the payment and entering into the new lease to justify capitalization of the payment and its amortization over the term of the new lease, in lieu of current deduction?

This was the situation presented to the Service in Private Letter Ruling 9607016, where the taxpayer sought a ruling that it could not deduct the payment currently. A few facts are presented in the ruling which might distinguish the payment in question from an ordinary, deductible lease termination payment. The lessee in the ruling had the right to be released from its obligation to lease its new premises if it was unable to obtain a release from its old lease. Conversely, its lease termination agreement with respect to the old premises had as a condition to the lessee's exercise of its rights to terminate the old lease that it acquire the new premises. It is difficult to know, though, why the old lessor would have cared about the taxpayer's new premises, and one is left wondering which of the parties had the right to waive that condition. Based on these facts, the Service concluded that the lease termination payment was part of a single overall plan" involving the acquisition of an affirmative benefit, i.e. the new premises, that went beyond a mere reduction of future expenses. Therefore, the taxpayer was required to capitalize the lease termination payment.

The taxpayer that sought and obtained this ruling may be very pleased, but most other taxpayers will be outraged at the Service's analysis. The taxpayer may, in some sense, have been motivated to make the payment by its desire to move to new premises, but making the payment did not really confer any benefit on the taxpayer with respect to that move - the move did not become any cheaper or easier as a result. The Service cited no cases in which a lessee making a lease termination payment had been required to capitalize the payment, and the authorities which the Service did cite, relating to lessor's payment and the write-off of unamortized costs from prior transactions, are clearly distinguishable. We are left to marvel at the Service's creativity in accommodating the taxpayer who sought this ruling!