Section 249: Tax Rules for Stock Redemption Costs
Gain insight into the tax principles governing corporate stock redemption costs. Understand the distinction between capital transaction fees and deductible expenses.
Corporations sometimes buy back, or redeem, their own stock from shareholders for reasons such as restructuring ownership, settling disputes, or defending against a hostile takeover. When a company undertakes a stock redemption, it incurs costs beyond the price paid for the shares.
Publicly traded corporations are also subject to a 1% excise tax on the value of stock they repurchase. This tax applies to the fair market value of the repurchased shares, though this amount can be reduced by the value of any new stock the company issues during the same year. Associated redemption expenses are subject to specific rules that govern whether they can be deducted. The Internal Revenue Code (IRC) establishes that these expenses are capital in nature, not ordinary business expenses, and cannot be used to reduce a company’s current-year tax liability.
The General Rule of Non-Deductibility
The guiding principle for the tax treatment of stock redemption costs is found in IRC Section 249. This rule disallows a deduction for any amount a corporation pays or incurs “in connection with” the reacquisition of its stock. This language is interpreted broadly by the IRS and the courts, capturing many expenses beyond the direct purchase price of the shares. These costs are viewed as capital expenditures related to the company’s financial structure rather than its day-to-day operations.
The phrase “in connection with” extends the rule of non-deductibility to a list of related expenses. Professional fees paid to facilitate the redemption are non-deductible, including legal fees for drafting agreements, accounting fees for valuing the stock, and brokerage commissions paid to intermediaries. This rule also applies to special payments made to selling shareholders, such as “greenmail,” which is a premium price paid to a corporate raider to repurchase stock and thwart a hostile takeover.
Exceptions to the General Rule
While the default rule is restrictive, there are exceptions that permit deductions for certain costs. The most significant of these is for interest expenses. Under the IRC, interest paid on debt is generally deductible, and this extends to debt a corporation takes on to finance the repurchase of its own stock. The loan used to fund the redemption is treated as a separate transaction, allowing the interest payments to be deducted.
Deductions may also be permitted for costs related to certain employee benefit plans. For example, payments made to terminate stock options held by employees as part of a redemption may be deductible as compensation. The distinction is often analyzed using the “origin of the claim” doctrine, which separates deductible business expenses from non-deductible capital costs. This doctrine examines the underlying reason for the expense.
If a payment originates from a pre-existing obligation, such as a compensation agreement with an employee or a separate consulting contract, it may be deductible even if paid at the same time as the stock redemption. The corporation must demonstrate that the expense is not a disguised part of the stock purchase price. For this to apply, the separate payment must be for a legitimate business purpose and its amount must be reasonable.
Application in Corporate Transactions
The rules governing stock redemption costs are best understood through common corporate scenarios. In a friendly redemption where a corporation buys out a retiring shareholder, the legal fees to draft the purchase agreement and the appraisal fees to value the shares are directly connected to the reacquisition. Consequently, these costs must be capitalized.
The rules are also relevant in a hostile takeover defense. If a company pays a premium, or “greenmail,” to a potential acquirer to buy back its shares and end the takeover threat, that entire payment is non-deductible because its origin is the reacquisition of stock.
A leveraged buyout (LBO) illustrates how the exceptions work. In an LBO, a significant amount of debt is used to finance the acquisition of a company’s stock. While the fees paid to lawyers and investment bankers for structuring the buyout are non-deductible capital expenses, the interest paid on the acquisition debt is a different matter. Due to the exception for interest, the substantial expenses generated by the LBO financing can be deducted, providing a tax shield for the company.