                        T.C. Memo. 1998-317



                      UNITED STATES TAX COURT



       CUSTOM CHROME, INC. AND SUBSIDIARIES, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5530-96.                 Filed September 2, 1998.



     James J. Kelly, Jr. (an officer), and Harry J. Kaplan, for

petitioner.

     Lloyd T. Silberzweig, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   For the years in issue, respondent determined

deficiencies in and penalties to petitioner Custom Chrome, Inc.'s

and its consolidated subsidiaries' Federal income taxes as

follows:
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                                             Accuracy-Related Penalty
     Tax Year Ending      Deficiency               Sec. 6662(a)
      Jan. 31, 1992       $1,320,879                 $264,404
      Jan. 31, 1993        1,472,023                  294,244
      Jan. 31, 1994          778,098                  155,244


     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     Following concessions, the primary issues for decision are:

(1) Whether $5 million paid to a stockholder constitutes an

amortizable business expense for a covenant not to compete or a

nondeductible capital expenditure; (2) whether $1,199,000 paid to

employees constitutes currently deductible payments for services

rendered or nondeductible payments for a covenant not to compete

amortizable only in years not before the Court; (3) whether other

claimed business expenses constitute nondeductible capital

expenditures; and (4) the value of options issued on August 25,

1989, for purposes of calculating original issue discount

associated with a loan.


                          FINDINGS OF FACT

     Some of the facts are stipulated and are so found.     When the

petition was filed, petitioner's principal place of business was

located in Morgan Hill, California.
                               - 3 -


     In 1970, petitioner was incorporated by several individuals

to operate a small independent retail store selling motorcycle

parts and accessories.

     In 1975, two employees of petitioner, Tyrone A. Cruze, Sr.

(Cruze) and Ignatius J. Panzica (Panzica) purchased the stock of

petitioner.   In December of 1976, Cruze became sole owner of the

stock of petitioner,1 and Panzica stayed on as an employee.

     From 1976 until 1991, under Cruze's direction as sole

stockholder, president, and chief executive officer of

petitioner, petitioner's business thrived, and petitioner became

the largest independent worldwide supplier of Harley-Davidson

motorcycle parts and accessories.   Petitioner’s employees also

designed and manufactured many of the accessories that it sold

for Harley-Davidson motorcycles.

     Petitioner maintained warehouse facilities in California and

Kentucky.   In 1989, petitioner's combined domestic and foreign

sales exceeded $28 million.

     From 1976 until 1991, Cruze was involved in and maintained

final decision-making authority over all aspects of petitioner's

business operations.   Cruze established significant business

contacts with bankers, suppliers, and vendors who were important

to the business operations and success of petitioner.    Cruze was

1
      Cruze’s wife also purchased some of the stock in
petitioner. For convenience, we treat Cruze as sole owner of the
stock in petitioner.
                               - 4 -


well known and respected in the motorcycle parts business, and

his ideas, efforts, and management skills contributed

significantly to the growth and success of petitioner.

     From 1976 until 1991, Panzica served as petitioner's vice

president of operations.   In 1991, Panzica succeeded Cruze as

chief executive officer of petitioner.

     From approximately 1975 until the mid-1990's, Mario

Battistella managed warehouse operations for petitioner.

     From 1985 until August of 1989, Dennis B. Navarra was vice

president of finance for petitioner.   In 1989, Navarra became

chief financial officer and assistant secretary for petitioner.

     During the 1980's, Panzica, Battistella, and Navarra were

underpaid by petitioner for their significant services as

employees of petitioner.

     In 1988, Cruze began considering selling his stock in

petitioner.

     In late 1988 or early 1989, the Jordan Company (JC

Investors), a New York City investment firm, approached Cruze

regarding the potential purchase of his stock in petitioner.

JC Investors was in the business of purchasing private companies

and taking the companies public.   In 1989, JC Investors owned

substantial interests in over 25 private companies in various

industries with aggregate annual sales of $1.5 billion.

Generally, after acquiring controlling interests in companies,
                                - 5 -


JC Investors would retain existing management personnel of

acquired companies and would require key employees of the

companies to enter into covenants not to compete.

     In 1989, after significant negotiations, JC Investors agreed

to purchase from Cruze for $16.75 million all of the outstanding

stock in petitioner.    The stock purchase was structured as a

leveraged buyout (LBO).

     In order to carry out the LBO, JC Investors organized Custom

Chrome Holdings, Inc. (CC Holdings), as a wholly owned

subsidiary.   On May 24, 1989, a stock purchase agreement between

Cruze and CC Holdings was entered into under which Cruze was to

be paid $16.75 million in consideration for his stock in

petitioner.

     On August 15, 1989, JC Investors organized Custom Chrome

Acquisition Corp. (CC Acquisition), as a wholly owned subsidiary

of CC Holdings.    CC Acquisition was incorporated 10 days prior to

the LBO for the sole purpose of facilitating the LBO.     During its

10-day existence, CC Acquisition did not conduct any activities

unrelated to the LBO.

     In August of 1989, CC Acquisition obtained from First

National Bank of Boston (FNBB) a $26 million loan in order to

finance the LBO and to provide working capital for petitioner

after the LBO.    The $26 million obtained from FNBB by
                                 - 6 -


CC Acquisition was made available to CC Acquisition under 3 lines

of credit with various interest rates and terms, as follows:


  Lines of Credit     Amount              Interest Rate     Term
  Tranche I         $9,000,000           Prime Plus 2.0%   5 Years
  Tranche II         9,000,000           Prime Plus 1.5%   7 Years
  Working Capital    8,000,000           Prime Plus 1.5%   5 Years


     By selling debentures issued by CC Holdings to Mezzanine

Capital and Income Trust (Mezzanine Capital), CC Holdings

obtained an additional $7 million to assist in financing the LBO.

Prior to the LBO, CC Holdings contributed to CC Acquisition the

$7 million received from sale of the debentures along with an

additional $500,000 that CC Holdings had raised through sale of

its stock.

     The following schedule summarizes the source and amount of

funds obtained by JC Investors through its two controlled

corporations, CC Acquisition and CC Holdings, in connection with

the LBO:


                 Source of Funds                          Amount
     FNBB Line of Credit                               $26,000,000
     Sale of Debentures to Mezzanine Capital             7,000,000
     CC Holdings Contribution                              500,000
                                       Total           $33,500,000


     On August 25, 1989, pursuant to the plan of acquisition and

using the funds that had been obtained by CC Acquisition, CC

Holdings acquired Cruze’s stock in petitioner in an LBO that, for

Federal income tax purposes, took the form of a taxable reverse
                                - 7 -


subsidiary merger.    Simultaneous with the acquisition by CC

Holdings of Cruze's stock in petitioner, CC Acquisition was

merged into petitioner with petitioner surviving the merger.

     As a result of the reverse merger, CC Acquisition did not

remain in existence, and petitioner became a wholly owned

subsidiary of CC Holdings.

     According to the plan of acquisition and under the merger

agreement, petitioner became liable for debts of CC Acquisition,

including the $26 million loan obtained from FNBB.    The $16.75

million used to pay Cruze for the stock in petitioner was part of

the $26 million received as a loan from FNBB.

     After the LBO and under various supplemental agreements

relating to acquisition of the stock in petitioner and to the

continued employment of the senior employees of petitioner,

Mezzanine Capital and Panzica, Battistella, Navarra, and other

employees of petitioner acquired shares of stock in CC Holdings

for $500 per share.

     Further, on August 25, 1989, in connection with the $26

million loan made by FNBB, FNBB received from CC Holdings options

to purchase, over the course of 10 years, shares of stock in CC

Holdings representing up to 12.5 percent of the equity in CC

Holdings.   The options will expire on August 31, 1999, and the

exercise price was set at $500 per share, the same price per
                                - 8 -


share paid by investors who acquired stock in CC Holdings as part

of the LBO of petitioner.

     Terms of the agreement under which FNBB received options to

acquire stock in CC Holdings for $500 per share were hotly

negotiated between JC Investors, CC Holdings, and FNBB.

Financing the LBO posed significant risks for FNBB.

Approximately $9 million of the $26 million loan made available

by FNBB was not secured.    The LBO would change petitioner's

capital structure from primarily equity to primarily debt.      In

recognition of such risks, the options provided FNBB the

potential to earn significant additional income if the stock of

CC Holdings increased in value.    FNBB loan officers estimated

that the options might have a value in 5 years of approximately

$5 million.

     Immediately following the LBO transaction and under the

various supplemental agreements, the common stock (or in the case

of FNBB options to acquire common stock of CC Holdings) was owned

as follows:

                                          Percentage Ownership
             Stockholders                    In CC Holdings
     JC Investors                                28.500
     Mezzanine Capital                           28.500
     Cruze, Panzica,
       Battistella, and Navarra                  24.625
     FNBB (options)                              12.500
     Other Employees of Petitioner                5.375
     Miscellaneous                                 .500
                             Total              100.000
                               - 9 -


     Because of restricted voting rights associated with many of

the above shares, JC Investors controlled the board of directors

of petitioner.   Also, after the LBO and consistent with

JC Investors’ practice, petitioner's management team and senior

employees were asked to and did remain with petitioner.

     Further, consistent with JC Investors’ practice in acquiring

companies, Cruze, as key employee of petitioner, was requested to

enter into a covenant not to compete.   Under the covenant not to

compete that Cruze entered into with petitioner, for an

additional $5 million that was paid to Cruze in 1989 upon closing

of the LBO, Cruze was obliged for a 3-year period of time from

the date of the LBO not to enter into any business contract that

would compete directly or indirectly with petitioner’s business.

JC Investors likely would not have agreed to the purchase of the

stock in petitioner if Cruze had not signed this covenant not to

compete.

     On August 25, 1989, an additional $2,589,759 was paid to

Cruze to enable him to pay certain Federal income taxes that were

owed by petitioner and that related to years prior to the LBO

when petitioner had constituted an S corporation.

     The following schedule reflects total funds received by

Cruze on August 25, 1989, in connection with the LBO:
                              - 10 -


          Funds Received Relating To           Amount
          Outstanding Stock                 $16,750,000
          Covenant Not to Compete             5,000,000
          Petitioner’s Taxes                  2,589,759
                              Total         $24,339,759


     Also, upon closing of the LBO on August 25, 1989, under

separate agreements that were referred to as bonus and

noncompetition agreements, a total of $1.25 million was paid to

Panzica, Battistella, and Navarra.     As stated, in years prior to

the LBO, these individuals generally had been underpaid by

petitioner for their services to petitioner, and an understanding

existed between Cruze and these individuals that, if Cruze ever

sold his stock in petitioner, an effort would be made to pay

these individuals additional compensation for their prior

services rendered to petitioner.   Accordingly, in the

negotiations with JC Investors, Cruze emphasized that he wanted a

total of $1.25 million to be paid to Panzica, Battistella, and

Navarra in recognition for their services in prior years.     In the

negotiations, however, JC Investors was hesitant to pay the

employees $1.25 million.   Cruze then offered to have $1.25

million reduced from the $18 million that tentatively had been

agreed to be paid to him by JC Investors if this $1.25 million

would be paid to Panzica, Battistella, and Navarra for their

services in prior years.   Petitioner and JC Investors agreed to

this reduction and, as indicated, under the final agreement that
                              - 11 -


was entered into, Cruze was paid $16.75 million, instead of $18

million, for his stock in petitioner.

     The $1.25 million was paid to Panzica, Battistella, and

Navarra in the following respective amounts:


                 Employee                   Amount
               Panzica                    $1,000,000
               Battistella                   200,000
               Navarra                        50,000
                               Total      $1,250,000


     Of the $200,000 paid to Battistella, $51,000 ($20,000 in

principal and $31,000 in interest) in substance and in fact

related to and constituted repayments of principal and interest

on a $20,000 loan that in earlier years petitioner had received

from Battistella.

     Panzica, Battistella, and Navarra were regarded by Cruze as

key employees of petitioner and, at Cruze’s suggestion, they were

requested to enter into, and they did agree to, covenants not to

compete with petitioner for a period of 3 years which period was

not to begin until they left their employment with petitioner.

No dollar amount was allocated to the covenants not to compete

that were entered into by Panzica, Battistella, and Navarra.



     CC Acquisition incurred expenditures in connection with the

LBO totaling $1,342,347, for which petitioner became liable as

the successor corporation.   Of these total $1,342,347 in
                             - 12 -


expenditures, $692,347 constituted finance charges relating to

the financing provided by FNBB and Mezzanine Capital.   The

remaining $650,000 constituted legal and professional fees.

     On October 16, 1989, for $1,000, FNBB assigned the options

that it held in the stock of CC Holdings to Bank of Boston

Capital (Bank of Boston), a wholly owned subsidiary of FNBB.

Subsequently, on September 12, 1990, Bank of Boston assigned to

Security Pacific National Bank (SPNB) for an unspecified

consideration a portion of the options representing 5 percent of

the equity in CC Holdings, and Bank of Boston retained the

options with respect to the remaining 7.5 percent of the equity

in CC Holdings.

     On November 5, 1991, CC Holdings was merged into petitioner,

and petitioner’s stock was offered to the public in an initial

public offering (IPO) at $10 per share.   Most of petitioner's

debts were paid off using the $25 million in proceeds realized

from the IPO.

     On November 5, 1991, simultaneously with the IPO, the

options held by Bank of Boston and SPNB in CC Holdings’ stock

were exercised, and the banks received a total of 313,125 shares

of stock in petitioner with a combined total value of $3,131,250.

The combined net value of the stock in petitioner that the banks

realized in exercising the options equaled $3,068,750 ($3,131,250

less the $62,500 exercise price for the options).
                               - 13 -


     On July 22, 1993, a secondary public offering was held with

stock in petitioner selling for $17.50 per share.   Through this

secondary offering, JC Investors sold off all of its stock in

petitioner.

     During the years in issue, petitioner operated as an accrual

basis taxpayer with a tax year ending January 31.


Tax Returns and Audit

     On its corporate Federal income tax returns for each of its

taxable years 1990 through 1993, petitioner claimed a current

business expense deduction to amortize a ratable portion of the

$5 million paid to Cruze in 1990 under the 3-year covenant not to

compete, as follows:


              Tax Year Ending       Amortization Claimed
               Jan. 31, 1990            $ 694,444
               Jan. 31, 1991             1,666,667
               Jan. 31, 1992             1,666,666
               Jan. 31, 1993               972,223
                           Total        $5,000,000


     On its 1990 corporate Federal income tax return, petitioner

claimed an ordinary business expense deduction for the total

$1.25 million paid to Panzica, Battistella, and Navarra under the

bonus and noncompetition agreements.

     On its 1992 corporate Federal income tax return, petitioner

claimed a current business deduction of $1,342,347 for financing

charges allegedly incurred in connection with the LBO.
                             - 14 -


     On petitioner’s tax returns, no original issue discount

(OID) was claimed as a deduction relating to the options issued

to FNBB.

     For its financial accounting purposes, FNBB reported the

options it received in the stock of CC Holdings as an asset on

its books and records at a nominal value of $1,000, and for

Federal income tax purposes no OID was reported as income by FNBB

relating to the options.

     On audit of petitioner’s taxable years 1992, 1993, and 1994,

and of petitioner’s claimed net operating loss carryforwards from

petitioner’s taxable years 1990 and 1991, respondent disallowed

for 1990 through 1993 the claimed business expense deductions

relating to Cruze’s $5 million covenant not to compete.

Respondent also disallowed for 1990 the claimed business expense

deduction relating to the $1.25 million paid to Panzica,

Battistella, and Navarra in 1989 under the bonus and

noncompetition agreements.

     The basis for respondent’s disallowance for each year of the

claimed business expenses relating to Cruze’s $5 million covenant

not to compete was the determination that the payments to Cruze

constitute nondeductible capital expenditures.

     The basis for respondent’s disallowance for 1990 of the

$1.25 million paid to Panzica, Battistella, and Navarra

apparently was the determination that the $1.25 million relates
                              - 15 -


primarily to the noncompetition agreements each of these

individuals entered into, not to payments for services rendered

in prior years.   Because Panzica’s, Battistella’s, and Navarra’s

3-year noncompetition obligations were not triggered until they

left employment with petitioner and because, in 1990, Panzica,

Battistella, and Navarra still worked for petitioner, respondent

determined that no portion of the $1.25 million should be

deducted in 1990 or in later years before the Court.

     For 1992, respondent disallowed the $1,342,347 that

petitioner claimed as deductible financing charges on the grounds

that the expenses constitute nondeductible capital expenditures

relating to acquisition of the stock in petitioner.    Respondent

now agrees that $692,347 of the $1,342,347 was properly deducted

by petitioner as ordinary business expenses.   Only $650,000

remains in dispute as alleged nondeductible capital expenditures.

     Although not claimed on its 1990 through 1994 corporate

Federal income tax returns as filed, petitioner in its petition

affirmatively asserts beginning for 1990 (in order to increase or

to maintain the amount of the NOL claimed from 1990) and later

years, or beginning for 1992 and later years, that it is entitled

to amortize a portion of the claimed $3,068,750 as original issue

discount relating to the options that were issued to FNBB.

Alternatively, petitioner argues that the $3,068,750 should be
                             - 16 -


deductible as loan fees or compensation paid to FNBB under

section 83.2

                             OPINION

$5 Million Paid to Cruze as Covenant Not to Compete

     For the years in issue, amounts paid for covenants not to

compete generally are deductible over the useful life of the

covenants as current business expenses; whereas amounts paid for

goodwill or going concern value of a business generally are

treated as nondeductible capital expenditures.    Warsaw

Photographic Associates, Inc. v. Commissioner, 84 T.C. 21, 48

(1985).

     To be respected for Federal income tax purposes, covenants

not to compete should reflect economic reality.    Patterson v.

Commissioner, 810 F.2d 562, 571 (6th Cir. 1987), affg. T.C. Memo.

1985-53; Lemery v. Commissioner, 52 T.C. 367, 375 (1969), affd.

per curiam 451 F.2d 173 (9th Cir. 1971).   Where parties to

purported covenants not to compete do not have adverse tax

interests, the covenants will be strictly scrutinized.     Schulz v.

Commissioner, 294 F.2d 52, 55 (9th Cir. 1961), affg. 34 T.C. 235

2
      Also after trial, on June 2, 1997, petitioner filed under
Rule 41 a motion for leave to amend the petition for 1993 and
1994 in order to claim that capitalized costs of $586,236 and
832,706, respectively, should be allowed as deductible current
business expenses relating to petitioner’s mailing and shipping
operations. We deny petitioner's motion for leave to amend the
petition and to raise this new issue at this late date. Rule
41(a); Law v. Commissioner, 84 T.C. 985, 990 (1985); O'Rourke v.
Commissioner, T.C. Memo. 1990-161.
                               - 17 -


(1960); Buffalo Tool & Die Manufacturing Co. v. Commissioner,

74 T.C. 441, 447-448 (1980).   Further, taxpayers generally bear

the burden of proving entitlement to claimed deductions.    Rule

142(a).

     Respondent argues primarily that the covenant not to compete

by Cruze lacks economic reality and that the $5 million paid to

Cruze constitutes a nondeductible capital expenditure for the

goodwill or going concern value of petitioner.   Respondent

emphasizes that JC Investors, petitioner, and Cruze did not have

adverse tax interests and that the terms of the covenant were not

separately negotiated.   Respondent notes Cruze's testimony that

he would have been "pretty silly" to sell his company and then

spend his money trying to compete with it.

     If we conclude that the covenant not to compete should be

respected for Federal income tax purposes, respondent argues that

the proper amount to be allocated to the covenant is $2.3

million, not the $5 million claimed by petitioner.

     Petitioner argues that the covenant not to compete reflects

economic reality and that the entire $5 million paid to Cruze

with regard thereto should be respected.   Petitioner emphasizes

Cruze's management talents, knowledge of the industry, business

contacts, financial resources, and general ability to compete

with petitioner.
                               - 18 -


     As set forth in our findings of fact, the evidence

establishes the appropriateness and need for the 3-year covenant

not to compete between petitioner and Cruze.   In light of Cruze’s

extensive experience and contacts in the motorcycle parts

industry, petitioner's business would have been significantly and

adversely affected if Cruze had attempted to compete with

petitioner.   Further, JC Investors would not have consummated the

purchase of the stock in petitioner if Cruze had not agreed to

the covenant not to compete.

     We conclude that the covenant not to compete between

petitioner and Cruze had economic reality and that the agreement

is to be respected for Federal income tax purposes.

     Petitioner's expert valued Cruze's covenant not to compete

at $5 million.   Respondent's expert valued the covenant at $2.3

million using a discounted cash flow analysis of his estimate of

losses petitioner might suffer if Cruze established a business in

competition with petitioner.

     Based on our review of the expert witness reports and based

on our findings of fact that establish Cruze’s importance to the

business of petitioner and his experience and connections in the

motorcycle parts industry, we conclude that no discount should be

applied to the covenant not to compete and that the full $5

million represents payment to Cruze for his covenant not to

compete against petitioner.
                              - 19 -



$1.199 Million Paid to Panzica, Battistella, and Navarra

     Amounts paid by taxpayers to employees as compensation for

services rendered in the current or prior years are generally

deductible as ordinary and necessary business expenses.    Sec.

162(a); Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930).

Amounts paid for covenants not to compete are amortized as

deductions over the life of the covenants.   Warsaw Photographic

Associates, Inc. v. Commissioner, supra at 48.

     Petitioner argues that $1.199 million of the total $1.25

million paid to Panzica, Battistella, and Navarra ($1.25 million

less the $51,000 associated with the principal and interest

payments on the loan petitioner received from Battistella) should

be treated for Federal income tax purposes as compensation paid

to the three employees in 1990 for services rendered to

petitioner in prior years.   Petitioner argues that no portion of

the $1.199 million should be allocated to separate covenants not

to compete between petitioner and the employees.

     Respondent argues that the entire $1.199 million, or some

portion thereof, should be allocated to covenants not to compete

between petitioner and the employees and allowed as deductions

and amortized only after the covenants begin to run once the

employees stop working for petitioner (i.e., in years not before

the Court).

     We agree with petitioner.
                              - 20 -


     The evidence, although not extensive, is credible and

persuasive and establishes that the $1.199 million was paid to

Panzica, Battistella, and Navarra as consideration for services

rendered in prior years and not for covenants not to compete.

The $1.199 million was paid in 1990, not deferred until later

years after the employees terminated their employment with

petitioner and was based on a longstanding understanding between

Cruze, on the one hand, and Panzica, Battistella, and Navarra, on

the other, that Panzica, Battistella, and Navarra would be

compensated with additional compensation for services rendered if

Cruze’s stock in petitioner was sold.

     The bonus and noncompetition agreements did not specifically

allocate any of the $1.199 million to the covenants not to

compete.   See Annabelle Candy Co. v. Commissioner, 314 F.2d 1, 7

(9th Cir. 1962), affg. per curiam T.C. Memo. 1961-170; Major v.

Commissioner, 76 T.C. 239, 250 (1981); Rich Hill Ins. Agency,

Inc. v. Commissioner, 58 T.C. 610, 617 (1972).

     It also appears that because Panzica, Battistella, and

Navarra did not sell any stock in petitioner in connection with

entering into the bonus and noncompetition agreements, under

California law, the noncompetition clauses were unenforceable.

See Cal. Bus. & Prof. Code secs. 16600, 16601 (West 1997); Metro

Traffic Control Inc. v. Shadow Traffic Network, 27 Cal. Rptr. 2d

573 (Ct. App. 1994).
                               - 21 -


     For the above reasons, we conclude that the $1.199 million

paid to Panzica, Battistella, and Navarra should be treated as

compensation paid to the employees for services rendered in prior

years and as deductible by petitioner for 1990 as ordinary and

necessary business expenses.


$650,000 in Legal and Professional Fees

     Under section 162(k), amounts paid by a corporation in

connection with redemption of its stock are treated as

nondeductible capital expenditures.     Sec. 162(k); see United

States v. Hilton Hotels Corp., 397 U.S. 580 (1970); Woodward v.

Commissioner, 397 U.S. 572, 577-578 (1970).    Amounts that are to

be capitalized under section 162(k) include amounts paid in

consideration for the stock, fees incurred in connection with the

redemption of the stock, and legal, accounting, appraisal, and

brokerage fees, and any other expenses (except loan fees)

necessary or incidental to the redemption.    See H. Rept. 99-426,

at 248-249 (1985), 1986-3 C.B. (Vol. 2) 248-249; S. Rept. 99-313,

at 222-224 (1986), 1986-3 C.B. (Vol. 3) 222-224; Fort Howard

Corp. & Subs. v. Commissioner, 107 T.C. 187, 188-189 (1996),

supplementing 103 T.C. 395 (1994).

     Also, under various applications of the step transaction

doctrine, a series of formally separate steps may be collapsed

and treated as a single transaction.     Penrod v. Commissioner, 88

T.C. 1415, 1428 (1987).   A series of steps may be collapsed and
                              - 22 -


treated as one if at the time the first step was entered into,

there was a binding commitment to undertake the later step

(binding-commitment test), if the separate steps constitute

prearranged parts to a single transaction intended to reach the

end result (end-result test), or if the steps are so

interdependent that the legal relations created by one step would

have been fruitless without a completion of the series (mutual-

interdependence test).   Id. at 1429-1430.

     Respondent argues that the acquisition by CC Holdings of

Cruze’s stock in petitioner should be treated for Federal income

tax purposes as a redemption and that the $650,000 constituted

expenses incurred in connection with that redemption.

Alternatively, if the transaction is not treated as a stock

redemption, respondent argues that the expenses should be

capitalized due to significant long-term benefits to petitioner

and that no current deduction should be allowed in any year

before us.

     Petitioner argues that for Federal income tax purposes the

purchase of Cruze’s stock by JC Investors did not constitute a

stock redemption and that the expenses should be deductible

either for 1992 or for 1993, the year in which JC Investors

disposed of its interest in petitioner.

     We agree with respondent's primary argument.
                              - 23 -


     The evidence indicates that CC Acquisition was formed as a

subsidiary of CC Holdings solely to facilitate CC Holdings'

acquisition of the stock in petitioner.   CC Acquisition was

incorporated only 10 days prior to the LBO, and CC Acquisition

did not conduct any activities unrelated to the LBO during the

short period of its existence.

     The several integrated steps of the LBO involving

CC Acquisition -- its formation, its receipt of financing, its

merger into petitioner, and petitioner's assumption of its

liabilities -- constituted prearranged integrated steps to

facilitate the acquisition of the stock of petitioner, and these

steps were mutually interdependent.

     We note that other than the formation of CC Acquisition,

which occurred 10 days prior to the LBO, the remaining steps to

the transaction essentially occurred simultaneously on August 25,

1989.

     Because CC Acquisition was formed merely as a transitory

corporation to facilitate the LBO, we conclude that

CC Acquisition and the steps of the transaction involving

CC Acquisition should be disregarded for Federal income tax

purposes.   In effect, the transaction is to be treated for

Federal income tax purposes as if petitioner received loans

directly from FNBB and then used $16.75 million of the loan

proceeds to redeem the shares of stock that were held by Cruze.
                              - 24 -


See Bittker & Eustice, Federal Income Taxation of Corporations

and Shareholders, par. 5.04[6], at 5-29 (6th ed. 1997);

1 Ginsburg & Levin, Mergers, Acquisitions, and Buyouts, sec. 202,

at 2-15 (1998); 2 Ginsburg & Levin, Mergers, Acquisitions, and

Buyouts, sec. 1302.1.3, at 13-19 (1998).

     For 1992, the $650,000 in legal and professional fees that

petitioner incurred in connection with the redemption of Cruze’s

stock constitute under section 162(k) nondeductible capital

expenditures.


OID Associated With $26 Million Loan

     Original issue discount (OID) associated with a loan is

treated as interest and, ratably over the term of the loan, is

deductible by the debtor and taxable as ordinary income to the

creditor.   Secs. 163(e), 1272(a)(1).   Generally, OID is incurred

when the debtor, at the time the loan is obtained, receives from

the creditor less than the face amount of the loan.

     Where, in addition to the obligation to pay the creditor the

principal amount of the loan obligation and interest, a debtor

corporation grants to a creditor options to acquire stock in the

debtor corporation, in determining whether OID is associated with

the loan, the principal amount of the loan obligation and the

value of the options are considered together and are treated as a

single investment unit.   Sec. 1273(c)(2).   Typically, in this

situation, the amount of OID, if any, associated with the loan
                              - 25 -


will correspond to the amount or portion of the value of the

investment unit that is allocated to the options.   Secs.

1273(b)(2), 1273(c)(2), 1275(a)(2)(B).

     At trial and on brief, the parties herein agree that OID is

to be associated with the $26 million loan that was received from

FNBB to the extent that the options (to acquire stock in CC

Holdings) that were granted to FNBB had any ascertainable value

as of the date petitioner received the loan and the options were

issued to FNBB.3   The parties, however, disagree as to the value

of the options, and thus they disagree as to the existence and

amount of any OID associated with the loan.

     Petitioner values the options at or exceeding $2.6 million

and argues that it should be entitled to deduct at least $2.6

million as OID over the separate terms of the 3 loans that made

up the total $26 million loan.

     Respondent argues that no OID was associated with the $26

million loan, and, alternatively, if OID was incurred, the amount

thereof was no more than $31,850.

     The evidence establishes, and the parties agree, that the

options to acquire stock in CC Holdings that were granted to FNBB

were issued “at the money” with a $500 per share exercise price.


3
      As indicated, after the LBO, petitioner became liable for
the debts of CC Acquisition. For convenience, in discussing the
OID issue, we substitute petitioner for CC Acquisition as the
debtor on the loan.
                             - 26 -


This $500 per share exercise price was equal to the price paid,

at that time, by other investors for the stock of CC Holdings.

This constitutes strong evidence that the options had no premium

value to be associated with them at the time of issuance.     Thus,

any value that might attach to the options would be speculative

and would depend on the profits of petitioner and on appreciation

in the value of the underlying stock in subsequent years.

     On its original tax returns for its 1990 taxable year, the

taxable year in which the options were issued, and for its 1991

through 1994 taxable years, petitioner did not treat the $26

million loan as having any OID associated with it.    Similarly,

neither FNBB nor Bank of Boston treated the $26 million loan as

having any OID associated with it, and only a nominal $1,000

value was associated with the options by FNBB.    This also

constitutes significant evidence that the options had no premium

value to be associated with them at the time of issuance.

     Certainly, representatives of FNBB and Bank of Boston hoped

that the options, in subsequent years, would increase in value

and increase greatly the income their banks would receive in

connection with financing the LBO.    That speculative future

value, however, does not establish that OID is associated with

the $26 million loan.

     Petitioner relies on Monarch Cement Co. v. United States,

634 F.2d 484 (10th Cir. 1980), and the approach adopted therein
                             - 27 -


to argue that the $26 million loan was obtained by petitioner at

an interest rate discount and that the interest rate discount

gives rise to OID associated with the loan.    We decline to apply

the approach used in Monarch Cement Co.     The evidence in the

instant case does not establish that the $26 million loan was

obtained at a below-market interest rate.    Although bank

representatives testified that they would have liked to have

charged a higher interest rate on the $26 million loan, the

credible evidence does not establish that the parties to the $26

million loan actually negotiated and agreed to a discounted

interest rate as part of the compensation therefor.

     Because the options were issued at market, petitioner and CC

Holdings incurred no direct costs in issuance of the options.

Similarly, any income to be realized by the banks on exercise of

the options in subsequent years we regard as in the nature, not

of OID, but of capital appreciation in an equity investment.

     Petitioner makes numerous arguments as to why it should be

allowed OID deductions beginning either in the year the options

were issued or in the year the options were exercised.    As we

have explained, the evidence does not establish that any OID was

incurred in the year of issuance.

     With regard to 1992, the taxable year in which the options

were exercised, petitioner argues that it should be allowed a

deduction of $3.069 million as either OID, as loan fees, or as
                                - 28 -


compensation paid under section 83.      We disagree.   The existence

of OID is determined as of the date of issue of the investment

unit.     Secs. 1273(b)(2), 1273(c)(2), 1275(a)(2)(B).

     In support of the argument that it should be entitled to a

$3.069 million deduction for 1992 as loan fees with regard to the

$26 million loan, petitioner relies on cases where options were

issued as trade discounts in connection with long-term sales

contracts.     See Computervision Intl. v. Commissioner, T.C. Memo.

1996-131; Convergent Techs., Inc. v. Commissioner, T.C. Memo.

1995-320; Sun Microsystems, Inc. v. Commissioner, T.C. Memo.

1993-467.     Petitioner's reliance on these cases is misplaced.

The options in the instant case were not issued as trade

discounts but as part of a lending transaction.      Further, the

cases cited do not involve loan fees or loan charges.      No

credible evidence supports petitioner's claimed deduction for

loan fees.

        Further, under section 83 only upon exercise of stock

options received for services rendered may a corporation claim

deductions for compensation paid.     The options at issue herein

were not issued to FNBB in connection with services rendered.

         The evidence does not support, for any of the years in

issue, petitioner’s claim to a deduction of $3.069 million for

OID, loan fees, or compensation paid under section 83 relating to
                              - 29 -


the $26 million loan.   We reject petitioner’s arguments on this

issue.

     For each of the years in issue and for each adjustment

reflected in respondent’s notice of deficiency, respondent

determined an accuracy-related penalty under section 6662(a)

against petitioner for substantial understatements of tax.

     With regard to the disallowance for 1992 of the claimed

$650,000 in acquisition-related expenditures that we sustain

herein, petitioner has not demonstrated that it had substantial

authority to support this claimed deduction, and we sustain

imposition of this penalty.

     To reflect the foregoing,


                                      Decision will be entered

                                 under Rule 155.
