Lease Cancellation Expenditures

By Schnee, Edward J. | Journal of Accountancy, February 1999 | Go to article overview

Lease Cancellation Expenditures


Schnee, Edward J., Journal of Accountancy


If a corporate taxpayer decides to cancel a lease--even for a valid business purpose--it may be required to pay a cancellation fee. If a fee is paid, may the taxpayer deduct it or must it be capitalized? The Tax Court considered this question in a recent case.

U.S. Bancorp leased a computer for five years under a noncancelable lease. One year later, the company decided it needed a more powerful computer. U.S. Bancorp negotiated with the lessor the right to cancel the lease early in exchange for a $2.5 million payment. The cancellation contract provided for an increased payment if the company did not lease another computer from the lessor. The contract also said that the payment was due in installments over the life of the new lease. U.S. Bancorp deducted the $2.5 million payment on its tax return. The IRS rejected the deduction, saying the company had to capitalize the payment and amortize it over the life of the new lease. The company appealed.

Result: For the IRS. The Tax Court said the tax treatment of a typical lease cancellation payment is well established. A taxpayer can deduct a payment made to cancel a lease if the payment does not produce income but instead is a penalty for terminating an existing contract. However, if the taxpayer negotiates a new lease for property covered by an old lease, the cancellation payment should be capitalized and amortized over the life of the new lease. This payment is, in effect, a modification payment that generates benefits over the life of the new lease. …

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