Copyright (c) 1992 Tax Analysts

Tax Notes

 

JUNE 1, 1992

 

LENGTH: 1491 words 

 

DEPARTMENT: Letters to the Editor (LTE) 

 

CITE: 55 Tax Notes 1281 

 

HEADLINE: 55 Tax Notes 1281 - LETTERS TO THE EDITOR: EXPENSES PAID WITH STOCK ARE LEGITIMATE DEDUCTIONS. 

 

TEXT:

 

 To the Editor: 

 

   Lee Sheppard, 'The Tax Treatment of Silicon Valley Discounts,' 55 Tax Notes 871 (May 18, 1992), argues that a corporation should not be entitled to a tax deduction when it uses its own stock to pay a business expense. Section 1032 provides that a corporation does not recognize gain in dealings in its own stock. 'Corporate taxpayers who deal in their own stock,' Sheppard argues, 'cannot have it both ways.' If unrealized appreciation is not recognized as a gain, the argument apparently goes, neither should the appreciation be recognized as a cost. This letter defends the legitimacy of deductions for expenses paid with the payor's own stock on the ground that the value of the stock is a fair proxy for the future payments the issuer will make for the expense. 

 

   In general, there is something to the argument that appreciation should not be deducted as a cost if it has not been recognized as gain. If an item has never been included in tax, there is no need, in general, for a tax deduction to take the item out of tax. Thus, cash method taxpayers can not deduct their economic loss when their customers or clients do not pay their bills. They never included the receivable in taxable income, so they cannot deduct the receivable that goes bad. Casualty loss deductions do not include the unrealized appreciation that has been destroyed in the casualty; the deduction is limited to basis. Section 165(b). When appreciated property is used as an expense, the fair market value of the property may be deducted, but only because the appreciation is gain to the payor at the same time. International Freighting Co. v. Commissioner, 135 F.2d 310 (2d Cir. 1943). Section 170(e)(1), when it seeks neutral accounting, takes unrealized appreciation out of the charitable deduction. Disallowance of deduction of unrealized appreciation is, in general, a sound principle. 

 

   The deduction when stock is issued, however, legitimately rests on another ground, which is that the fair market value of the stock is a fair proxy for future payments by the corporation. By using its own stock, the issuing corporation is not selling an appreciated asset, but rather, taking on a burden or detriment that has a family resemblance to a corporate liability. Stock has value in the market place solely because it represents the discounted present value of future cash that the corporation will pay out as dividends or liquidation proceeds. By using stock for an expense, the corporation has committed itself to pay a great deal of cash for the expense. Giving the corporation a tax deduction upon the issuance of stock gives the corporation advanced credit for future payments, but it gives the corporation no tax advantage. Only the discounted value of future payments is deducted when the value of the stock is deducted. The discounting process takes away all tax advantage. 

 

   Stock is treated less well than debt, although both debt and stock represent future payments by the corporation. Debt is deducted before paid by accrual method taxpayers and is part of basis before paid for both cash and accrual taxpayers. For debt, tax law gives not only advanced credit for the principal portion of the debt, but also gives the added advantage of deducting interest. The corporation avoids tax on the earnings used to pay the interest. When stock is issued, by contrast, dividends (the interest equivalent for stock) are not deductible and the corporation must pay tax on its earnings used to pay the dividends. The nondeductibility of dividends is the source of the double tax on corporate earnings. For debt, the present-value discount is deducted eventually when interest is paid. For stock, the discount from the future value is never deducted. 

 

   Stock does not represent a necessary obligation as debt does, but that is reflected in the discount rate. The market place discounts corporate distributions on stock at very high discount rates to reflect considerable risks about the amount and timing of the distributions. Corporate managers often find that their stock is grossly undervalued because of the skepticism of the market. Those large discounts imposed by market skepticism are never deducted. Using stock is thus commonly a very expensive tax way for the corporation to pay its expenses. 

 

   That stock is a proxy for future payments is also the best explanation as to why a corporation can sell stock to the public and to noncontrolling shareholders without tax. Under sections 351 and 362, corporations get to carry over the basis of transferors of property only if the transferors own 80 percent of the corporation. The corporation gets credit for the tax paid by controlling shareholders and thus does not have to pay tax again when the transfer to them occurs. But, noncontrolling shareholders cannot give their basis and  posttax position to the corporation. Noncontrolling shareholders are strangers to the corporation and their cash paid into the corporation could be viewed as improving the net worth of the corporation and its pre-existing controlling shareholders. (See, e.g., section 362(c) refusing to give the corporation basis for cash from nonshareholders.) But, the corporation selling stock, in fact, achieves no improvement in net worth of itself or its controlling shareholders because the cash the corporation receives for the newly issued stock is perfectly offset by the discounted present value of the distributions that the corporation will make to the new shareholders. Just as debt issued for cash prevents the corporation from having net gain from borrowed cash, so stock issued for cash prevents the corporation from having gain from cash from the sale of stock. Stock in sum fairly reflects future payments by the corporation (see also Johnson,'The Legitimacy of Basis from a Corporation's Own Stock,' 9 American J. of Tax Policy 155 (Fall 1991) for a further exposition of the argument). 

 

   In the cases that Lee Sheppard looked at, however, the corporation sought tax deductions not upon issuing stock but upon issuing warrants, that is, options to buy its stock. Sun Microsystems, Inc. v. Commissioner, T.C. Dkt. No. 8976-91; Convergent Technologies, Inc. v. Commissioner, T.C. Dkt. No. 29655-91. Allowing the corporate deduction upon the issuance of warrants would probably be a mistake, unless the warrants are traded daily on a broad market. The issuance of the stock itself (i.e., exercise of the warrant) seems a better date for measuring both the deduction and the related income to the expense-payee. 

 

   Warrants commonly expire without any corporate payments, and hence commonly do not represent future payments by the corporation. If the valuation of the warrant is correct, deduction of warrants that expire will be balanced in cases in which the warrant is exercised by large nondeductible corporate payments on appreciated stock. But, we need the valuation of the warrant to be correct. Warrants are another step removed from corporate payments than the stock is, so that the opportunity for error is that much greater. One of the better assurances that the value claimed for the option is not overstated is bargaining between adverse parties. Thus, we need to be symmetrical in including the warrants in the expense-payee's income at the same time that the corporation deducts the warrants. With different measurement dates, moreover, the parties can and will whipsaw the government just because of fluctuating values. Tax law has always been appropriately skeptical about valuing nonmarket options. Baumer v. United States, 580 F.2d 863 (5th Cir. 1978) (dividend from option on corporation property was to be measured when option exercised rather than when option issued); Treas. Reg. section 1.83-7 (1978) (compensation in unmarketed compensatory options is measured when option exercised unless options have clearly ascertainable value). Thus, unless the warrant is traded on an established market, it seems the better part of wisdom to use the stock issuance as the measurement date for both the corporate payor and expense-payee. 

 

   Still, while the measurement date is an important issue that needs to be settled consistently, the underlying deduction that Sheppard worried about seems perfectly legitimate if the stock is appropriately valued. Expenses paid with the corporate issuer's own stock are legitimate deductions.

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                                   Sincerely yours,

                                   Calvin H. Johnson

                                   Arnold, White & Durkee

                                     Centennial

                                   Professor of Law

                                   The University of Texas at Austin

                                   May 26, 1992

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