                                                MEDIA SPACE, INC., PETITIONER v. COMMISSIONER
                                                     OF INTERNAL REVENUE, RESPONDENT

                                                        Docket No. 25696–08.                   Filed October 18, 2010.

                                                 P’s charter granted its preferred shareholders redemption
                                               rights which if exercised triggered obligations by P to pay
                                               interest on the redemption amount if P was not able to
                                               pay the redemption amount. P and its shareholders entered
                                               into several consecutive forbearance agreements by which the
                                               shareholders agreed to forgo the redemption elections if they
                                               received payments resembling the interest payments. P
                                               deducted these payments, and R disallowed the deductions for
                                               2004 and 2005. Held: The payments in question were not
                                               interest and therefore were not deductible under sec. 163,
                                               I.R.C. Held, further, all payments in 2004 were deductible
                                               under sec. 162, I.R.C., and the 12-month rule of sec. 1.263(a)–
                                               4(f)(5)(i), Income Tax Regs. However, payments in 2005 were
                                               not deductible to the extent that sec. 1.263(a)–4(d)(2)(i),
                                               Income Tax Regs., requires capitalization.

                                           Dustin F. Hecker and Steven A. Meyer, for petitioner.
                                           William T. Derick, for respondent.

                                                                                   OPINION

                                         GOEKE, Judge: Respondent determined deficiencies in peti-
                                      tioner’s income tax for the taxable years 2004 and 2005. The
                                      issue for decision is whether payments petitioner made to
                                      shareholders to delay redemption of their preferred shares
                                      are deductible under section 162 or 163. 1 For the reasons
                                        1 Unless otherwise indicated, all section references are to the Internal Revenue Code (Code)

                                      in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice
                                      and Procedure.


                                      424




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       425


                                      stated herein, we find that the payments are deductible in
                                      part under section 162.

                                                                               Background
                                        Some of the facts have been stipulated and are so found.
                                      Petitioner is a Delaware corporation whose principal place of
                                      business at the time it filed its petition was Norwalk, Con-
                                      necticut. Since its incorporation in 1999 petitioner has con-
                                      ducted business in the field of media advertising sales.
                                        Petitioner raised startup capital by issuing shares of stock.
                                      Petitioner had authority to issue shares of common stock,
                                      series A preferred stock, series B preferred stock, and
                                      undesignated preferred stock. In or before 2000 petitioner
                                      issued 5,197,176 shares of series A preferred stock and
                                      231,389 shares of series B preferred stock to eCOM Partners
                                      Fund I, L.L.C. (the series A investor), for total consideration
                                      of $5 million. Also in or before 2000, petitioner issued
                                      1,145,926 shares of series B preferred stock to E-Services
                                      Investments Private Sub, L.L.C. (the series B investor), for
                                      consideration of $11.9 million.
                                        Article IV of petitioner’s ‘‘Fourth Amended and Restated
                                      Certificate of Incorporation’’ (the charter) provided for divi-
                                      dends to be paid on the series A and B preferred stock at a
                                      rate of 8 percent per year. The charter also provided certain
                                      redemption rights to the series A investor and the series B
                                      investor (collectively, the investors). The investors had the
                                      right to require petitioner to redeem the preferred stock on
                                      September 30, 2003, or anytime thereafter. The investors
                                      were allowed to demand that petitioner ‘‘redeem, out of funds
                                      legally available therefor, up to one hundred percent (100%)
                                      of the originally issued and outstanding shares’’ of each
                                      series held by the investors.
                                        The charter required that investors making redemption
                                      elections give to other holders of the preferred stock series
                                      and to petitioner ‘‘not less than fifteen (15) days prior written
                                      notice’’. Petitioner was required to redeem a series (in part
                                      or in whole) only if a majority of the holders of the specific
                                      series elected redemption.
                                        The series A redemption price was defined in the charter
                                      as:




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                                      426                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      an amount in cash, equal to (i) $0.577237 per share of Series A Convertible
                                      Preferred Stock held by such holder (adjusted appropriately for stock
                                      splits, stock dividends, recapitalizations and the like with respect to the
                                      Series A Convertible Preferred Stock), plus (ii) any accumulated but
                                      unpaid dividends to which such holder of outstanding shares of Series A
                                      Convertible Preferred Stock is then entitled, if any, plus (iii) any interest
                                      accrued pursuant to Section A.5(e) hereof to which such holder of Series
                                      A Convertible Preferred Stock is entitled.

                                      The series B redemption price was defined identically except
                                      that the cash amount was $8.6399988 per share and the
                                      interest accrued was pursuant to section B.5(e) of the
                                      charter.
                                         Sections A.5(e) and B.5(e) of the charter addressed the
                                      possibility that petitioner could be prohibited from redeeming
                                      the shares under Delaware general corporation law because
                                      of an impairment of petitioner’s capital or that petitioner
                                      could otherwise fail to redeem the shares as required by the
                                      charter. In such a case, petitioner was required to pay
                                      interest to the investors at the rate of 4 percent per annum,
                                      which would increase by 0.5 percent at the end of each 6-
                                      month period until paid in full, subject to a maximum rate
                                      of 9 percent per annum. Petitioner was also required to con-
                                      tinue paying the 8-percent dividend on any shares it could
                                      not redeem. In addition, petitioner was required to ‘‘redeem
                                      such shares on a pro-rata basis among the holders * * * in
                                      proportion to the full respective redemption amounts to
                                      which they are entitled hereunder to the extent possible and
                                      shall redeem the remaining shares to be redeemed as soon
                                      as the Corporation is not prohibited from redeeming some or
                                      all of such shares’’.
                                         Before September 30, 2003, petitioner and the investors
                                      recognized that petitioner would not have the funds to
                                      redeem all of the series A or series B preferred shares. Peti-
                                      tioner’s auditors stated that if the redemption rights were
                                      able to be exercised before September 30, 2004, the auditors
                                      would need to issue a going concern statement on petitioner’s
                                      financial statements. A going concern statement is issued
                                      when there are material doubts due to financial constraints
                                      as to whether a corporation will be able to operate. At the
                                      time, petitioner was attempting to negotiate a new financing
                                      agreement with Fleet Bank. A going concern statement could
                                      have caused Fleet Bank to back out of the financing arrange-




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       427


                                      ment with petitioner and negatively affected petitioner’s
                                      financial relationships with vendors.
                                         Petitioner and the investors had several discussions in
                                      2003 regarding redemption. The series A investor wished to
                                      exercise its redemption rights but realized doing so would not
                                      be feasible because petitioner would not be able to redeem
                                      the shares. The series A investor also wished not to forfeit
                                      its redemption right. The series B investor was short on cash
                                      and expressed its desire to have petitioner redeem its shares
                                      as soon as possible. Neither investor ever gave petitioner a
                                      written notice that it was electing to have shares redeemed.
                                         Petitioner and the investors entered into negotiations
                                      regarding a forbearance agreement by which the investors
                                      would agree to forbear temporarily from exercising their
                                      redemption rights. Petitioner proposed a 1- to 2-year forbear-
                                      ance, but the investors limited the agreement to 1 year,
                                      wishing to regain their redemption rights as soon as possible
                                      while also enabling petitioner to avoid issuance of a going
                                      concern statement.
                                         Petitioner and the investors entered into the forbearance
                                      agreement on September 30, 2003. The investors agreed to
                                      forbear from exercising their redemption rights until Sep-
                                      tember 30, 2004. In exchange, petitioner agreed to pay the
                                      investors a ‘‘Forbearance Amount’’ on September 30, 2004.
                                      The ‘‘Forbearance Amount’’ was defined as:
                                      with respect to the Series A Investor and the Series B Investor, as
                                      applicable, an amount equal to interest accruing at 4.0% per annum on the
                                      Redemption Amount applicable to such Investor commencing on September
                                      30, 2003 and ending on the Termination Date, which interest rate shall
                                      increase by an additional 0.5% at the end of each six-month period there-
                                      after, not to exceed 9.0% per annum (calculated on the basis of the actual
                                      number of days elapsed and a 360-day year and compounded annually).

                                      The forbearance                  agreement            also       defined        ‘‘Redemption
                                      Amount’’ as:
                                      The sum of the Series A Convertible Redemption Price and the Series B
                                      Convertible Redemption Price then payable to the Series A investor or the
                                      Series B investor, as the case may be, assuming the Series A Convertible
                                      Redemption Date and the Series B Convertible Redemption Date had
                                      occurred on September 30, 2003 and such Investor had duly elected to
                                      require the Company to redeem all of its respective shares of Preferred
                                      Stock as of such date.




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                                      428                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      The forbearance amount payments (the forbearance pay-
                                      ments) for the first year were thus equal to the amounts peti-
                                      tioner would have been required to pay the investors as
                                      interest under sections A.5(e) and B.5(e) of the Charter had
                                      the investors elected to have their shares redeemed and peti-
                                      tioner been unable to redeem them. Communication between
                                      the investors and petitioner made it clear that both parties
                                      believed and intended the forbearance payments to constitute
                                      interest as compensation for the investors’ forbearance from
                                      receipt and use of the redemption amount.
                                         The forbearance agreement was a contract separate from
                                      the charter. While the forbearance agreement did not provide
                                      for amendment of the charter in regard to the date on which
                                      the investors would gain the redemption right or the amount
                                      paid to the investors in return for deferral, it did provide for
                                      other amendments to the charter. While most of these
                                      amendments appear to be superficial, at least one of
                                      these amendments was substantive—removal of section
                                      1.A.8(d)(ii). Removal of this section gave the holder of each
                                      series of preferred stock the power to block by majority vote
                                      ‘‘the redemption of * * * Common Stock from employees,
                                      officers, or Directors of, or consultants, advisors or inde-
                                      pendent contractors to, the Corporation or any of its subsidi-
                                      aries’’.
                                         As September 30, 2004, approached petitioner still did not
                                      have the funds to redeem the preferred shares. Petitioner
                                      and the investors began discussing an extension of the
                                      forbearance agreement. The series B investor again
                                      expressed its desire to have petitioner redeem its shares.
                                      After negotiations an 8-month extension was agreed upon,
                                      extending the expiration date to May 31, 2005. In reaching
                                      the 8-month agreement, the investors again rebuffed a pro-
                                      posal by petitioner to extend the forbearance agreement for
                                      more than a year. The investors wished to regain their
                                      redemption right as soon as possible, in case petitioner
                                      became able to redeem the shares.
                                         The terms of the extension continued to track sections
                                      A.5(e) and B.5(e) of the charter for the length of this forbear-
                                      ance agreement extension. The initial payment rate of the
                                      September 30, 2004, extension was 5 percent per annum,
                                      which increased to 5.5 percent per annum after 6 months.




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                                      (424)                   MEDIA SPACE, INC. v. COMMISSIONER                                                429


                                        In advance of the new May 31 expiration date, petitioner
                                      was still unable to redeem the shares of stock. Another
                                      extension was agreed upon, extending the forbearance agree-
                                      ment expiration date to May 31, 2006. Since then the
                                      forbearance agreement has been extended four additional
                                      times, the latest extension lasting through May 31, 2010.
                                      The payment rate in each extension from May 31, 2005, has
                                      been 6.5 percent per annum, differing from the rate that
                                      would have been required by sections A.5(e) and B.5(e) of the
                                      charter.
                                        Pursuant to the original forbearance agreement and the
                                      extensions, petitioner accrued and deducted $874,955 and
                                      $1,229,367 in 2004 and 2005, respectively. Petitioner
                                      deducted the 2004 forbearance payment on its 2004 corporate
                                      tax return as an interest expense under section 163 and
                                      deducted the 2005 amount on its 2005 return as a forbear-
                                      ance expense under section 162. The investors declared the
                                      payments as taxable interest on their own tax returns.
                                        Petitioner had cashflow of negative $677,582 in 2003,
                                      $1,019,597 in 2004, and negative $1,428,554 in 2005. The
                                      reduction in cashflow in 2005 coincided with a $5 million
                                      increase in accounts receivable.
                                        On August 26, 2008, respondent issued the notice of defi-
                                      ciency to petitioner, determining the following deficiencies:

                                              Year                                                                                Deficiency

                                              2004 ............................................................................    $19,035
                                              2005 ............................................................................     22,127

                                      Petitioner timely petitioned this Court contesting respond-
                                      ent’s determinations. A trial was held on November 3, 2009,
                                      in Boston, Massachusetts. At trial petitioner introduced an
                                      expert report which stated that forbearance agreements of
                                      various sorts are common in almost any business.

                                                                                      Discussion
                                      I. Burden of Proof
                                        Deductions are a matter of legislative grace, and a tax-
                                      payer bears the burden of proving entitlement to any claimed
                                      deductions. Rule 142(a)(1); INDOPCO, Inc. v. Commissioner,




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                                      430                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering,
                                      292 U.S. 435, 440 (1934).
                                      II. Arguments of the Parties
                                         Petitioner argues that the forbearance payments deferred
                                      the payment of an obligation and thus may be deducted as
                                      interest under section 163. Petitioner also contends that the
                                      payments may be deducted under section 162 as ordinary
                                      and necessary business expenses.
                                         Respondent argues that petitioner is prohibited from
                                      deducting the forbearance payments as interest under sec-
                                      tion 163 because petitioner did not make the payments on
                                      indebtedness. Respondent also contends that a number of
                                      Code sections as construed by regulations preclude petitioner
                                      from deducting the payments as ordinary and necessary busi-
                                      ness expenses under section 162.
                                      III. Whether the Payments Were Deductible Under Sec-
                                           tion 163
                                        Respondent argues that the payments may not be deducted
                                      under section 163 because they were not made on indebted-
                                      ness. Respondent contends that no indebtedness existed
                                      because the investors did not exercise the redemption right.
                                        Petitioner argues the payments were made on indebted-
                                      ness and that even a conditional obligation may give rise to
                                      indebtedness. Petitioner also contends that respondent’s
                                      argument elevates form over substance because the result of
                                      the forbearance agreement was, in petitioner’s view, the
                                      same as if the investors had made a redemption election.
                                        For the reasons stated below, we find that although the
                                      parties intended the forbearance payments to constitute
                                      interest, the payments were not made on an existing indebt-
                                      edness and therefore may not be deducted under section 163.
                                           A. Section 163 in General
                                        Section 163(a) provides that ‘‘There shall be allowed as a
                                      deduction all interest paid or accrued within the taxable year
                                      on indebtedness.’’ This Court has previously stated that in
                                      order for payments to constitute interest under section 163:
                                      (1) The parties must intend the payments to be interest, and
                                      (2) the law must give effect to this intention. Midkiff v.




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       431


                                      Commissioner, 96 T.C. 724, 738 (1991), affd. sub nom.
                                      Noguchi v. Commissioner, 992 F.2d 226 (9th Cir. 1993);
                                      Dunlap v. Commissioner, 74 T.C. 1377, 1421 (1980), revd. on
                                      other grounds 670 F.2d 785 (8th Cir. 1982).
                                           B. Intent of the Parties
                                         The testimony and other evidence make it clear that the
                                      parties intended the forbearance payments to constitute
                                      interest. In the forbearance agreement the forbearance pay-
                                      ments were identified and calculated as ‘‘interest’’ on the
                                      redemption amount. On their tax returns the investors
                                      declared the payments as taxable interest. Communications
                                      between petitioner and the investors indicated that all par-
                                      ties considered the forbearance payments to be interest pay-
                                      ments. Respondent has offered no evidence that the parties
                                      did not intend the forbearance payments to constitute
                                      interest.
                                         We find that the parties intended the payments to con-
                                      stitute interest. We must next determine whether the law
                                      will give effect to the intention of the parties.
                                           C. Whether the Law Gives Effect to the Intent of the Parties
                                           1. Whether the Forbearance Payments Were Made on
                                              Indebtedness as Defined in Howlett
                                        Section 163(a) permits a deduction for ‘‘all interest paid
                                      * * * on indebtedness.’’ Indebtedness is ‘‘an existing,
                                      unconditional, and legally enforceable obligation for the pay-
                                      ment of a principal sum.’’ Howlett v. Commissioner, 56 T.C.
                                      951, 960 (1971); see also Midkiff v. Commissioner, supra at
                                      734–735; Indeck Energy Servs., Inc. v. Commissioner, T.C.
                                      Memo. 2003–101.
                                        Indebtedness must be genuine in substance, not merely in
                                      form. Knetsch v. United States, 364 U.S. 361, 365–366 (1960).
                                      Interest on indebtedness for purposes of section 163(a)
                                      requires more than ‘‘interest’’ labels or computations based
                                      on a percentage. Williams v. Commissioner, 47 T.C. 689, 692
                                      (1967), affd. 409 F.2d 1361 (6th Cir. 1968). Therefore, the
                                      fact that petitioner and the investors characterized the
                                      forbearance payments as ‘‘interest’’ in their dealings is not
                                      dispositive.




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                                      432                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                         Petitioner argues that the redemption right creates an
                                      indebtedness because it is ‘‘an existing, unconditional, and
                                      legally enforceable obligation for the payment of a principal
                                      sum.’’ See Howlett v. Commissioner, supra at 960 (defining
                                      ‘‘indebtedness’’). Petitioner is mistaken. The redemption right
                                      itself does not create the obligation to pay a principal sum
                                      (the redemption amount); rather the exercising of the
                                      redemption right by the shareholders’ written election cre-
                                      ates the obligation to pay. Without a written election, no
                                      obligation for payment existed. No redemption election was
                                      made during the years at issue. Indeed, as of May 2010
                                      (when the most recent forbearance agreement extension
                                      ended) the investors had yet to make a redemption election.
                                         Petitioner’s obligation to pay the redemption amount was
                                      predicated upon the preferred shareholders’ making a writ-
                                      ten election to have petitioner redeem their shares. As of
                                      May 2010 no such election had been made. Therefore, peti-
                                      tioner had no obligation to pay the redemption amount. As
                                      petitioner had no obligation to pay a principal sum, there
                                      was no indebtedness as defined in Howlett. See Howlett v.
                                      Commissioner, supra at 960 (indebtedness requires an
                                      existing obligation for payment of a principal sum).
                                           2. The Conditional Obligation Exception
                                        Petitioner notes that in some circumstances conditional
                                      obligations may be treated as indebtedness. See Halle v.
                                      Commissioner, 83 F.3d 649, 653 (4th Cir. 1996), revg.
                                      Kingstowne v. Commissioner, T.C. Memo. 1994–630. The
                                      Court of Appeals for the Fourth Circuit in Halle v. Commis-
                                      sioner, supra at 653, stated:
                                      even if materially conditional, an existing, legally enforceable obligation
                                      may still give rise to indebtedness, so long as (1) the contingency on which
                                      the obligation rests is beyond the control of the party seeking the interest
                                      deduction, (2) the amount of the indebtedness on which the interest
                                      accrued was fixed as of the date that the interest began to accrue, and (3)
                                      the payor’s liability to the payee is primary and direct. * * *

                                      See, e.g., Journal Co. v. Commissioner, 125 F.2d 349, 350–
                                      351 (7th Cir. 1942), revg. 44 B.T.A. 460 (1941); Midkiff v.
                                      Commissioner, supra at 739–745; Dunlap v. Commissioner,
                                      supra at 1424; Kaempfer v. Commissioner, T.C. Memo. 1992–
                                      19.




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       433


                                         In Dunlap, the corporate taxpayer entered into a contract
                                      with a seller to purchase stock. The taxpayer provided
                                      promissory notes as part of the purchase price. The agree-
                                      ment was subject to approval by a third party. While
                                      approval was pending, interest accrued on the purchase
                                      price. The Court allowed a deduction for interest accrued
                                      while third-party approval was pending, even though the
                                      obligation was materially conditional during this period.
                                         Petitioner argues that the obligation to pay the redemption
                                      amount exists and is legally enforceable but is conditioned
                                      upon the redemption election of the shareholders. We dis-
                                      agree, again finding that the obligation to pay the redemp-
                                      tion amount did not exist.
                                         Unlike the interest in Dunlap, the ‘‘interest’’ in this case
                                      was not accrued in a period during which the obligation to
                                      pay the debt was conditional. Petitioner had no obligation
                                      to pay the redemption amount during the period of ‘‘interest’’
                                      accrual because the investors had not elected to have their
                                      shares redeemed. The ‘‘interest’’ payments deferred the
                                      investors’ receipt of the redemption right; they did not relate
                                      to deferred payment of an existing but conditional debt as in
                                      Dunlap.
                                         Petitioner has no obligation to pay the redemption amount
                                      until the investors make a redemption election. Until such an
                                      election occurs, no debt exists. Therefore the Halle condi-
                                      tional debt exception does not apply. See Halle v. Commis-
                                      sioner, supra at 653 (requiring ‘‘an existing, legally enforce-
                                      able obligation’’ (emphasis added)).
                                           3. Whether Respondent’s Argument Elevates Form Over
                                              Substance
                                        Petitioner argues respondent’s position elevates form over
                                      substance. Petitioner contends the forbearance agreement
                                      was merely a formality and that the substantive result of the
                                      forbearance agreement is that petitioner has an obligation to
                                      pay the redemption amount to the investors.
                                        As petitioner’s principal place of business is in Connecticut,
                                      the Court of Appeals for the Second Circuit has appellate
                                      jurisdiction. See sec. 7482(b)(1)(B). The Tax Court will gen-
                                      erally defer to the rule adopted by the Court of Appeals for
                                      the circuit to which appeal would normally lie, if that Court




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                                      434                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      of Appeals has ruled with respect to the identical issue. See
                                      Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd. 445
                                      F.2d 985 (10th Cir. 1971); Becker v. Commissioner, T.C.
                                      Memo. 2006–264 (discussing a similar issue in the context of
                                      precedent of the Court of Appeals for the Fifth Circuit). The
                                      Court of Appeals for the Second Circuit has adopted the
                                      ‘‘strong proof ’’ rule, stating: ‘‘when the parties to a trans-
                                      action such as this one have specifically set out the cov-
                                      enants in the contract * * * strong proof must be adduced
                                      by them in order to overcome that declaration.’’ Ullman v.
                                      Commissioner, 264 F.2d 305, 308 (2d Cir. 1959), affg. 29 T.C.
                                      129 (1957). We look to the facts to determine whether ‘‘strong
                                      proof ’’ exists to support petitioner’s argument that the sub-
                                      stantive result of the forbearance agreement is the same as
                                      if the investors had actually made a redemption election.
                                      See, e.g., id. at 308–309; Croyle v. Commissioner, T.C. Memo.
                                      1980–501.
                                         In 2003 and 2004 the investors made clear their desire to
                                      have petitioner redeem their shares upon their receipt of the
                                      redemption right. The series B investor told petitioner it
                                      intended to exercise the redemption right as soon as possible.
                                      Petitioner argues that these statements show that the inves-
                                      tors were undoubtedly going to make a redemption election
                                      as soon as they gained the redemption right. As a result,
                                      petitioner contends that the redemption amounts are in sub-
                                      stance its obligation to the investors, even though no actual
                                      election was made. We disagree.
                                         Comparing the results of the forbearance agreement and
                                      the results that would have occurred had a redemption elec-
                                      tion been made reveals a glaring difference: petitioner would
                                      not be legally bound to redeem the investors’ shares as a
                                      result of the forbearance agreement. If the investors had
                                      made a redemption election, petitioner would have been
                                      bound to redeem the shares pro rata as petitioner became
                                      financially able to redeem them. Under the redemption elec-
                                      tion scenario the investors are entitled to redemption, but
                                      under the forbearance agreement the investors retain the
                                      choice of whether or not to have their shares redeemed.
                                         While the investors had expressed their desire to have
                                      their shares redeemed as soon as possible, such statements
                                      are not legally binding. Indeed, nearly 7 years after the first
                                      forbearance agreement was signed the investors still have




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       435


                                      not elected to have a single one of their shares redeemed. By
                                      the time the forbearance agreements cease to be extended
                                      (whenever that may be), the investors may unilaterally
                                      decide to hold their shares instead of having them redeemed.
                                        We find that petitioner has not met the ‘‘strong proof ’’
                                      standard. Both formal and substantive differences exist
                                      between the terms of the forbearance agreement and the
                                      terms which would have applied had the investors made a
                                      redemption election. The mere fact that the investors made
                                      nonbinding statements indicating they wished to have their
                                      shares redeemed as soon as possible does not create a sub-
                                      stantive indebtedness.
                                           D. Conclusion Regarding Section 163
                                        The caselaw relating to instances in which interest accrues
                                      on a conditional debt is not well defined. See generally Hill,
                                      Casenote, ‘‘Darkening the Already Murky Waters of I.R.C. §
                                      163: Halle v. Commissioner’’, 15 T.M. Cooley L. Rev. 49
                                      (1998). However, all courts dealing with interest issues have
                                      held that an actual indebtedness must exist in order for
                                      interest payments to be deductible. See, e.g., Halle v.
                                      Commissioner, 83 F.3d 649 (4th Cir. 1996); Howlett v.
                                      Commissioner, 56 T.C. 951 (1971); Bowater Inc. v. Commis-
                                      sioner, T.C. Memo. 1995–164 (‘‘The question whether pay-
                                      ments to a shareholder represent interest or dividends has
                                      long been vexatious. Critical to the answer is whether an
                                      actual indebtedness exists.’’). We will not depart from this
                                      clear standard. We find petitioner may not deduct the
                                      forbearance payments as interest under section 163.
                                      IV. Whether the Payments Were Deductible Under Section 162
                                        Petitioner argues the forbearance payments may be
                                      deducted as ordinary and necessary business expenses.
                                      Respondent argues that regulations and Code sections pre-
                                      vent petitioner from deducting the payments under section
                                      162. For the reasons stated below, we find the forbearance
                                      payments are partially deductible under section 162.
                                           A. Business Expenses in General
                                        Section 162(a) provides: ‘‘There shall be allowed as a
                                      deduction all the ordinary and necessary expenses paid or




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                                      436                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      incurred during the taxable year in carrying on any trade or
                                      business’’. A number of other Code sections and regulations
                                      differentiate deductible ordinary and necessary expenses
                                      from payments made to reacquire stock, distributions to
                                      shareholders, and capital expenditures. See, e.g., secs. 162(k),
                                      301, 361, 263; sec. 1.263(a)–4, Income Tax Regs. Our analysis
                                      must first determine whether the requirements of section
                                      162(a) have been satisfied. We will then determine whether
                                      any other Code sections or regulations preclude a deduction
                                      under section 162(a).
                                           B. Whether the Payments Met the Requirements of Sec-
                                              tion 162(a)
                                         To be deductible under section 162(a), an expense must be
                                      ‘‘ordinary and necessary’’ and ‘‘paid or incurred during the
                                      taxable year in carrying on any trade or business’’.
                                      Respondent does not contest the fact that the forbearance
                                      payments were paid during the taxable year in carrying on
                                      a business. We must determine whether such payments were
                                      ordinary and necessary.
                                         ‘‘Ordinary has the connotation of normal, usual, or cus-
                                      tomary. To be sure, an expense may be ordinary though it
                                      happen but once in the taxpayer’s lifetime. * * * Yet the
                                      transaction which gives rise to it must be of common or fre-
                                      quent occurrence in the type of business involved.’’ Deputy v.
                                      du Pont, 308 U.S. 488, 495 (1940); see also United Title Ins.
                                      Co. v. Commissioner, T.C. Memo. 1988–38.
                                         Petitioner produced an expert report by Richard A. Clarke,
                                      an expert in investment business. Mr. Clarke has 32 years
                                      of experience in banking, during which time he has partici-
                                      pated in hundreds of forbearance arrangements. Mr. Clarke’s
                                      report states that forbearance agreements, such as the one in
                                      this case, are common in almost any business, including peti-
                                      tioner’s line of business. Mr. Clarke knew of ‘‘at least five’’
                                      advertising agencies participating in forbearance agreements
                                      during his time in banking. Respondent has introduced no
                                      evidence contesting that such forbearance agreements are
                                      common in the type of business petitioner conducts. We find
                                      the payments were ordinary.
                                         ‘‘[T]he term ‘necessary’ imposes ‘only the minimal require-
                                      ment that the expense be ‘‘appropriate and helpful’’ for ‘‘the




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       437


                                      development of the [taxpayer’s] business’’ ’ ’’. INDOPCO, Inc.
                                      v. Commissioner, 503 U.S. at 85 (quoting Commissioner v.
                                      Tellier, 383 U.S. 687, 689 (1966)). The forbearance payments
                                      allowed petitioner to avoid issuance of a going concern state-
                                      ment on petitioner’s financial statements. This helped peti-
                                      tioner gain financing and maintain good financial relation-
                                      ships with its vendors. We therefore find the payments were
                                      necessary.
                                         We conclude that the forbearance payments are ordinary
                                      and necessary under section 162(a). We now must determine
                                      whether the payments were nondeductible payments made to
                                      reacquire stock, nondeductible distributions to shareholders,
                                      or capital expenditures (which either are nondeductible or
                                      must be capitalized).
                                           C. Whether Section 162(k) Precludes a Deduction Under
                                              Section 162(a)
                                         Section 162(k)(1) prohibits a deduction ‘‘for any amount
                                      paid or incurred by a corporation in connection with the
                                      reacquisition of its stock’’.
                                         Respondent argues that petitioner in substance exchanged
                                      the forbearance payments and new preferred stock with
                                      deferred redemption rights for old preferred stock with non-
                                      deferred redemption rights. Respondent has cited no caselaw
                                      in support of this assertion.
                                         We agree with respondent that petitioner’s tax liability is
                                      determined by the substance of the transaction. See Gregory
                                      v. Helvering, 293 U.S. 465, 469–470 (1935); Pinson v.
                                      Commissioner, T.C. Memo. 2000–208. However, we disagree
                                      with respondent that the transaction is in substance a
                                      reacquisition of petitioner’s stock. A taxpayer may ‘‘decrease
                                      the amount of what otherwise would be his taxes, or
                                      altogether avoid them, by means which the law permits
                                      * * * But the question for determination is whether what
                                      was done, apart from the tax motive, was the thing which
                                      the statute intended.’’ Gregory v. Helvering, supra at 469. We
                                      find that section 162(k) was not intended to cover such a
                                      situation and that the transaction in substance is not a
                                      reacquisition of stock.
                                         We do not believe deferring the redemption right by a year
                                      or less at a time is such a significant change in the nature




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                                      438                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      of the investment as to amount to a new investment. The
                                      nature and structure of petitioner’s business did not change
                                      as a result of the forbearance agreement, and the preferred
                                      stock retained all other rights, including receipt of the 8-per-
                                      cent dividend. Petitioner would not likely have been able to
                                      redeem the investors’ shares even had the investors gained
                                      and exercised the redemption right, and the investors had
                                      previously agreed to be paid compensation should they make
                                      a redemption election and petitioner be unable to redeem.
                                        Considering the facts of the case, we find that the forbear-
                                      ance agreement between petitioner and the investors was not
                                      in form or in substance a reacquisition of stock and section
                                      162(k) does not preclude a deduction under section 162(a).
                                           D. Whether Section 361(c)(1) Precludes a Deduction Under
                                              Section 162(a)
                                         Section 361(c)(1) provides that ‘‘no gain or loss shall be rec-
                                      ognized to a corporation a party to a reorganization on the
                                      distribution to its shareholders of property in pursuance of
                                      the plan of reorganization.’’ Under section 368(a)(1)(E), a
                                      reorganization includes a recapitalization.
                                         The Supreme Court has defined a recapitalization as a ‘‘re-
                                      shuffling of a capital structure, within the framework of an
                                      existing corporation’’. Helvering v. Sw. Consol. Corp., 315
                                      U.S. 194, 202 (1942); see also Microdot, Inc. v. United States,
                                      728 F.2d 593, 596 (2d Cir. 1984). Respondent contends that
                                      a reshuffling of petitioner’s capital structure occurred
                                      because petitioner in substance exchanged the forbearance
                                      payments and new preferred stock with deferred redemption
                                      rights for old preferred stock with nondeferred redemption
                                      rights.
                                         For the same reasons stated hereinabove, we find that no
                                      exchange of stock occurred in form or in substance. See supra
                                      pp. 437–438. Therefore, we find that there was no reorga-
                                      nization and that section 361(c)(1) does not preclude a deduc-
                                      tion under section 162(a).
                                           E. Whether the Payments Were Distributions, Precluding a
                                              Deduction Under Section 162(a)
                                        Under section 311(a) a corporation generally does not rec-
                                      ognize gain or loss on a distribution of property with respect




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       439


                                      to its stock. The term ‘‘property’’ includes money. Sec. 317(a).
                                      Section 301 treats the distribution as either a dividend, a
                                      reduction of basis, or a gain from the sale or exchange of
                                      property. See sec. 301(a), (c).
                                         Section 1.301–1(l), Income Tax Regs., provides that a ‘‘dis-
                                      tribution to shareholders with respect to their stock is within
                                      the terms of section 301 although it takes place at the same
                                      time as another transaction if the distribution is in substance
                                      a separate transaction whether or not connected in a formal
                                      sense.’’ The regulation provides the following example:
                                      if a corporation having only common stock outstanding, exchanges one
                                      share of newly issued common stock and one bond in the principal amount
                                      of $10 for each share of outstanding common stock, the distribution of the
                                      bonds will be a distribution of property * * * to which section 301 applies,
                                      even though the exchange of common stock for common stock may be
                                      pursuant to a plan of reorganization under the terms of section
                                      368(a)(1)(E) (recapitalization) and even though the exchange of common
                                      stock for common stock may be tax free by virtue of section 354. [Id.]

                                         Respondent argues that the forbearance payments were in
                                      substance nondeductible distributions to the investors with
                                      respect to their stock, regardless of the fact that the pay-
                                      ments were connected in a formal sense to the deferral of the
                                      redemption right. Respondent contends these distributions
                                      were given to provide the investors with a return on their
                                      investment in petitioner.
                                         We agree that petitioner’s tax liability is determined by the
                                      substance of the transaction. See sec. 1.301–1(l), Income Tax
                                      Regs. However, we disagree that the forbearance payments
                                      were in substance distributions with respect to the investors’
                                      stock in petitioner.
                                         ‘‘Distribution of profits is neither the purpose nor effect of
                                      the action taken by the corporation’’ in this case. See Palmer
                                      v. Commissioner, 302 U.S. 63, 73 (1937). Here the corpora-
                                      tion received valuable deferral rights in return for the
                                      forbearance payments. Respondent did not allege, and we
                                      have found nothing to suggest, that the amounts petitioner
                                      paid to the investors to defer the redemption rights were in
                                      excess of the fair market value of deferral of those rights.
                                      See, e.g., Evans v. Commissioner, T.C. Memo. 1992–276
                                      (citing Palmer v. Commissioner, supra) (where the Commis-
                                      sioner argued ‘‘that a bargain sale by a corporation to its
                                      shareholder is a distribution to the shareholder that is sub-




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                                      440                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      ject to section 301’’ when a corporation allegedly sold assets
                                      to the shareholder below fair market value).
                                         We find that petitioner paid the investors to defer the
                                      redemption election, not to give the investors a return on
                                      their investment. The payments were not distributions in
                                      substance under section 301 or section 1.301–1(l), Income
                                      Tax Regs., such as would preclude their deduction under sec-
                                      tion 162(a).
                                           F. Whether Section 263 Precludes a Deduction Under Sec-
                                              tion 162(a)
                                         Under section 263(a)(1), ‘‘No deduction shall be allowed
                                      for—(1) Any amount paid out for * * * permanent improve-
                                      ments or betterments made to increase the value of any
                                      property or estate.’’ Section 1.263(a)–4, Income Tax Regs.,
                                      ‘‘provides rules for applying section 263(a) to amounts paid
                                      to acquire or create intangibles.’’ It applies to amounts
                                      paid or incurred on or after December 31, 2003. Sec.
                                      1.263(a)–4(o), Income Tax Regs.
                                         Petitioner cites several cases as authority for the propo-
                                      sition that section 263(a)(1) does not apply. However, the
                                      cases petitioner cites do not deal with improvements such as
                                      the ones in this case.
                                           1. Section 1.263(a)–4(c), Income Tax Regs.
                                        Section 1.263(a)–4(c)(1), Income Tax Regs., provides: ‘‘A
                                      taxpayer must capitalize amounts paid to another party to
                                      acquire any intangible from that party in a purchase or
                                      similar transaction.’’ The term ‘‘intangible’’ includes an
                                      ownership interest in a corporation. Sec. 1.263(a)–4(c)(1)(i),
                                      Income Tax Regs. Respondent argues that petitioner in sub-
                                      stance exchanged the forbearance payments and new pre-
                                      ferred stock with deferred redemption rights for old preferred
                                      shares with nondeferred redemption rights. Respondent con-
                                      tends that as a result, petitioner paid the investors to
                                      acquire an ownership interest in a corporation (itself) and
                                      that section 1.263(a)–4(c)(1), Income Tax Regs., therefore
                                      requires capitalization of the amount paid.
                                        For the same reasons stated hereinabove, we again find
                                      that no exchange of stock ownership occurred in form or in




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       441


                                      substance. See supra pp. 437–438. We therefore find that
                                      section 1.263(a)–4(c)(1), Income Tax Regs., does not apply.
                                           2. Section 1.263(a)–4(d), Income Tax Regs.
                                         Section 1.263(a)–4(d)(2)(i), Income Tax Regs., provides: ‘‘A
                                      taxpayer must capitalize amounts paid to another party to
                                      create, originate, enter into, renew or renegotiate with that
                                      party * * * [certain] financial interests’’. A financial interest
                                      includes an ownership interest in a corporation (stock). Sec.
                                      1.263(a)–4(d)(2)(i)(A), Income Tax Regs.
                                         Respondent first contends that section 1.263(a)–4(d)(2)(i),
                                      Income Tax Regs., requires capitalization of the forbearance
                                      payments because a financial interest (stock) was created.
                                      Respondent argues petitioner in substance exchanged
                                      forbearance payments and newly created preferred stock
                                      with deferred redemption rights for old preferred stock with
                                      nondeferred redemption rights. Yet again, for the same rea-
                                      sons stated hereinabove, we find that no exchange of stock
                                      ownership occurred in form or in substance. See supra pp.
                                      437–438. Therefore, no financial interest was created.
                                         Respondent also contends that section 1.263(a)–4(d)(2)(i),
                                      Income Tax Regs., requires capitalization of the forbearance
                                      payments because the terms of a financial interest (stock)
                                      were modified. See sec. 1.263(a)–4(d)(2)(iii), Income Tax
                                      Regs. (‘‘A taxpayer is treated as renegotiating a financial
                                      interest if the terms of the financial interest are modified.’’).
                                      While the forbearance agreement did not in form amend the
                                      charter provision regarding the date on which the investors
                                      would gain the redemption right, respondent argues that
                                      petitioner in substance paid the investors to modify this
                                      term. We agree with respondent.
                                         Before the forbearance agreement was entered into, the
                                      investors could have exercised their redemption right on Sep-
                                      tember 31, 2003; afterwards they were not able to exercise
                                      their redemption right until September 31, 2004. Such a pat-
                                      tern of deferral continued in each extension to the forbear-
                                      ance agreement. A change of the charter’s provision
                                      regarding the date on which the investors could exercise
                                      their redemption rights was the aim of the parties and was
                                      effectively the result accomplished by the forbearance agree-
                                      ment.




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                                      442                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                         Petitioner has argued that it and the investors were
                                      attempting to follow, not modify, the provisions of the charter
                                      by entering into the forbearance agreement. However, as dis-
                                      cussed supra pp. 434–435, substantive differences exist
                                      between the results of the forbearance agreement and the
                                      results that would have occurred had an investor made an
                                      actual redemption election. The forbearance agreement did
                                      not follow the provisions of the charter; it modified the
                                      charter term identifying the date on which the investors
                                      would receive the redemption right. Payments resembling
                                      interest were made to the investors to effect this modifica-
                                      tion.
                                         We also note that the forbearance agreement provided for
                                      some amendments to the charter itself. While none of these
                                      amendments related to the date on which the investors
                                      would gain the redemption right, at least one of the amend-
                                      ments (removal of section 1.A.8(d)(ii), which allowed the
                                      investors to bar petitioner from redeeming employees’
                                      common stock) was substantive.
                                         The forbearance agreement was a contract meant to modify
                                      the rights of the parties under the charter. Some terms it
                                      modified by actually amending the charter (i.e., removal of
                                      section 1.A.8(d)(ii)). Other terms it modified by acting as an
                                      external contract (i.e., the date on which the investors gained
                                      the redemption right). We must ‘‘[disregard] the mask and
                                      [deal] with realities.’’ Helvering v. Minn. Tea Co., 296 U.S.
                                      378, 385 (1935). The reality here is that the forbearance
                                      agreement modified the charter provision identifying the
                                      date on which the investors would gain the redemption right.
                                      We therefore find that section 1.263(a)–4(d)(2)(i), Income Tax
                                      Regs., requires capitalization of the forbearance payments.
                                           3. The 12-Month Rule of Section 1.263(a)–4(f)(1), Income
                                              Tax Regs.
                                        As we have found that section 1.263(a)–4(d)(2)(i), Income
                                      Tax Regs., requires capitalization of the payments, we must
                                      additionally determine whether the ‘‘12-month rule’’ applies
                                      in this case. Section 1.263(a)–4(f)(1), Income Tax Regs., pro-
                                      vides the 12-month rule:




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       443


                                      a taxpayer is not required to capitalize under this section amounts paid
                                      to create * * * any right or benefit for the taxpayer that does not extend
                                      beyond the earlier of—
                                        (i) 12 months after the first date on which the taxpayer realizes the
                                      right or benefit; or
                                        (ii) The end of the taxable year following the taxable year in which the
                                      payment is made.

                                      The original forbearance agreement and the extensions each
                                      meet these requirements. However, two other subparagraphs
                                      of the regulation may prevent petitioner from taking advan-
                                      tage of the 12-month rule.
                                         Section 1.263(a)–4(f)(3), Income Tax Regs., provides that
                                      the 12-month rule does not apply to amounts paid to create
                                      a section 197 intangible or amounts paid to create an intan-
                                      gible described in section 1.263(a)–4(d)(2), Income Tax Regs.
                                      Although we have previously found that the terms of the
                                      investor’s redemption rights were modified by the forbear-
                                      ance agreement, no intangible (stock) was created by the
                                      forbearance agreement. See supra pp. 441–442. Therefore,
                                      section 1.263(a)–4(f)(3), Income Tax Regs., does not prevent
                                      the 12-month rule from applying.
                                         Section 1.263(a)–4(f)(5)(i), Income Tax Regs., provides that
                                      ‘‘the duration of a right includes any renewal period if all of
                                      the facts and circumstances in existence during the taxable
                                      year in which the right is created indicate a reasonable
                                      expectancy of renewal.’’ If any two deferral periods are
                                      considered together in this case, they last longer than 12
                                      months. Thus, if there was a reasonable expectancy of
                                      renewal (extension) of the forbearance agreement, the 12-
                                      month rule would not apply, and petitioner would be forced
                                      to capitalize the forbearance payments.
                                         Section 1.263(a)–4(f)(5)(ii), Income Tax Regs., provides five
                                      factors that are ‘‘significant in determining whether there
                                      exists a reasonable expectancy of renewal’’. We consider each
                                      of these factors, as well as other factors specific to the facts
                                      and circumstances.
                                           a. Renewal History
                                         The fact that similar rights have been renewed in the past
                                      is evidence of a reasonable expectancy of renewal. When the
                                      taxpayer has no experience with similar rights, this factor is




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                                      444                135 UNITED STATES TAX COURT REPORTS                                        (424)


                                      less indicative of a reasonable expectancy of renewal. Sec.
                                      1.263(a)–4(f)(5)(ii)(A), Income Tax Regs.
                                        There is no evidence that petitioner had any prior experi-
                                      ence with similar arrangements at the time of the original
                                      forbearance agreement. However, as the forbearance agree-
                                      ment continued to be extended, petitioner naturally gained
                                      experience with similar arrangements. We find this factor is
                                      neutral in regard to the September 2003 agreement but
                                      begins to indicate a reasonable expectancy of renewal in
                                      regard to the September 2004 agreement. We also find this
                                      factor strongly indicates a reasonable expectancy of renewal
                                      in regard to the May 2005 agreement.
                                           b. Economics of the Transaction
                                        The fact that renewal is necessary for the taxpayer to earn
                                      back its investment in the right is evidence of a reasonable
                                      expectancy of renewal. For example, if a taxpayer pays
                                      $14,000 for a 9-month contract which earns the taxpayer
                                      $1,000 per month, the fact that renewal is necessary for the
                                      taxpayer to earn back its investment is evidence that a
                                      reasonable expectancy of renewal existed. Sec. 1.263(a)–
                                      4(f)(5)(ii)(B), Income Tax Regs.
                                        In this case, there was no investment comparable to the
                                      example found in the regulations. The only investment was
                                      that of the investors in petitioner’s stock, and extension of
                                      the forbearance agreement was not necessary for them to
                                      earn back their investment. We find this factor is neutral.
                                           c. Likelihood of Renewal by Other Party
                                        Evidence that indicates a likelihood of renewal to a right,
                                      such as a bargain renewal right or similar arrangement, is
                                      evidence of a reasonable expectancy of renewal. Sec.
                                      1.263(a)–4(f)(5)(ii)(C), Income Tax Regs.
                                        There was no bargain renewal provision or similar
                                      arrangement in the forbearance agreement. We find this
                                      factor is neutral.
                                           d. Terms of Renewal
                                        The fact that material terms of the right are subject to
                                      renegotiation at the end of the initial term is evidence of a
                                      lack of a reasonable expectancy of renewal. For example, if




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       445


                                      the parties must renegotiate price, this is evidence that no
                                      reasonable expectancy of renewal existed. Sec. 1.263(a)–
                                      4(f)(5)(ii)(D), Income Tax Regs.
                                         Petitioner and the investors renegotiated the amount of
                                      the forbearance payments, the length of the deferral at the
                                      end of the original agreement, and the extensions. The
                                      amount paid increased as a result of the September 2004 and
                                      May 2005 extensions, and the length was reduced to 8
                                      months in the September 2004 extension (down from 12
                                      months in the September 2003 original agreement) but then
                                      again pegged at 12 months in the May 2005 agreement. We
                                      find the fact that material terms were renegotiated is evi-
                                      dence that no reasonable expectancy of renewal existed.
                                           e. Terminations
                                        The fact that similar rights are typically terminated before
                                      renewal is evidence of a lack of a reasonable expectancy of
                                      renewal. Sec. 1.263(a)–4(f)(5)(ii)(E), Income Tax Regs.
                                        There is no evidence that petitioner ever previously had
                                      experience with a similar right or terminated such a right.
                                      The parties have supplied, and we have found, no evidence
                                      that rights similar to those in this case are typically termi-
                                      nated within the industry. We find this factor is neutral.
                                           f. Petitioner’s Financial Condition
                                        The likelihood of renewal was also partially dependent on
                                      petitioner’s financial health. While no provisions of the
                                      forbearance agreement prevented its extension past the point
                                      at which petitioner became financially able to redeem the
                                      shares, we believe that petitioner would be less likely to
                                      agree to a further extension as its financial condition
                                      improved.
                                        Petitioner’s cashflow increased from negative $677,582 in
                                      2003 to $1,019,597 in 2004, an increase of $1,697,179. When
                                      the original forbearance agreement expired on September 30,
                                      2004, petitioner did not demand a yearlong extension of the
                                      forbearance agreement but instead negotiated a shorter 8-
                                      month extension. The fact that the length of the extension
                                      was cut as cashflow was improving may well indicate that
                                      petitioner believed it would be able to redeem the shares
                                      without further extensions.




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                                        However, in 2005 petitioner’s cashflows deteriorated to a
                                      loss of $1,428,554, representing a $2,448,151 decline from
                                      2004. With the forbearance agreement extension set to expire
                                      on May 31, 2005, petitioner negotiated a 1-year extension.
                                      The May 31, 2005, extension was increased to 1 year (from
                                      the 8-month September 30, 2004, extension) at the same
                                      time cashflows were plummeting. This may well indicate that
                                      petitioner believed its ability to redeem was weakening, and
                                      that further extensions past May 2006 could be necessary
                                      before petitioner could redeem the shares.
                                           g. Conclusion Regarding the 12-Month Rule
                                        Weighing the factors in the light of the facts and cir-
                                      cumstances, we find that no reasonable expectancy of
                                      renewal existed at the time the September 2003 and Sep-
                                      tember 2004 agreements were created. Thus, petitioner may
                                      take advantage of the 12-month rule for the September 2003
                                      and September 2004 agreements. However, we find that a
                                      reasonable expectancy of renewal existed at the time the
                                      May 2005 agreement was created. We therefore consider the
                                      term of the May 2005 agreement to be combined with
                                      the term of the May 2006 agreement. Combined, the terms
                                      of those agreements extend beyond 12 months, and con-
                                      sequently, petitioner may not take advantage of the 12-
                                      month rule for the May 2005 agreement.
                                           h. Conclusion Regarding Section 162
                                         We have found that the forbearance payments satisfy the
                                      ‘‘ordinary and necessary’’ test of section 162(a). We have also
                                      determined that section 1.263(a)–4(d)(2)(i), Income Tax Regs.,
                                      requires capitalization of the forbearance payments, but that
                                      the 12-month rule of section 1.263(a)–4(f)(5)(i), Income Tax
                                      Regs., removes the original September 2003 agreement and
                                      the September 2004 extension from the purview of section
                                      1.263(a)–4(d)(2)(i), Income Tax Regs. The forbearance pay-
                                      ments which accrued during 2005 as a result of the May
                                      2005 extension must be capitalized under section 1.263(a)–
                                      4(d)(2)(i), Income Tax Regs. The forbearance payments
                                      relating to the September 2003 and September 2004 agree-
                                      ments are deductible as business expenses under section 162.




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                                      (424)                 MEDIA SPACE, INC. v. COMMISSIONER                                       447


                                      V. Conclusion
                                        We find petitioner may not deduct the forbearance pay-
                                      ments as interest under section 163. However, we find that
                                      petitioner may deduct the forbearance payments relating to
                                      the September 2003 and September 2004 agreements as
                                      business expenses under section 162. The forbearance pay-
                                      ments relating to the May 2005 agreement must be capital-
                                      ized under section 263.
                                        To reflect the foregoing,
                                                                         Decision will be entered under Rule 155.

                                                                               f




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