Contract Cancellation Payments

Contract Cancellation Payments

April 01, 2005
CONTRACT CANCELLATION PAYMENTS can normally be deducted, but the IRS told one US company on audit that it had to treat such a payment as a cost of a new contract the company signed around the same time.

The IRS action is described in a “technical advice memorandum,” or ruling, that the agency released in March. The ruling is TAM 200512021.

Inability to deduct a cancellation payment makes terminating a contract more expensive. As a general rule, payments to get out of a contract can be deducted, but not if the payment is to modify the contract or replace it with another agreement. In the case under audit, a company entered into a merger agreement to be sold to a suitor, but later changed its mind after receiving a better offer from another suitor. It paid to terminate the original merger agreement and signed a new agreement to be bought by the new suitor. The IRS said the termination payment could not be deducted as it was a cost of the new agreement.

Keith Martin