Deducting a $225,000 Termination Commission Payment

If your business pays out large lump-sum commissions when ending a salesperson or vendor relationship, you may be able to deduct that full amount in the year you pay it rather than capitalizing it over several years.

Here’s how it works in a real-world example.

For business owners: What you need to know

You operate an investment advisory firm that reports income on the cash method. You charge clients a 1 percent annual fee on assets under management and pay your originating vendor or salesperson a commission split of 25 percent of what you collect.

Under your agreement, if you terminate the vendor, you must pay a lump-sum termination amount equal to the vendor’s commissions for the last 3 years. In your case, that’s $225,000.

The key question: Can you deduct that $225,000 right now, or must you capitalize and amortize it over time?

Why do you deduct it now

You’re paying this $225,000 to settle an existing contractual obligation for past services the vendor already performed, not to buy a new business asset. It’s similar to a large catch-up commission or dismissal wage.

Under Section 162, it makes it an ordinary and necessary business expense deductible in full in the year paid.

In other words, you’re paying to end a relationship, not to acquire something new.

For Tax Pros: Technical Annotations

This is an ordinary deduction under IRC Section 162(a) for amounts paid as compensation for past services.
It is supported by Potter (termination payments characterized as ordinary income for prior services).
Rev. Rul. 94-77 holds that severance payments are deductible even if they produce incidental future benefits such as reduced operating costs.

Why Section 197 Amortization Doesn’t Apply

Tax code Section 197 requires 15-year amortization for certain intangibles you acquire when buying a business, such as goodwill or customer lists. But you don’t acquire anything new here. The payment arose from your ongoing commission agreement.

You’re simply extinguishing an existing obligation, not buying a business or an intangible.

For Tax Pros Technical Annotations

Section 197(d)(1) applies only to acquired intangibles in connection with a purchase of a trade or business.
This termination payment does not fall within Section 197(d)(1)(E) (customer-based intangibles) because there’s no acquisition, just termination of an internal contractual relationship.

Why not capitalize under Section 263

Tax code Section 263 generally requires capitalization for costs that create or enhance a separate and distinct intangible asset-something that can be sold, transferred, or pledged independently.

Your $225,000 payment doesn’t do that. It doesn’t create a new right; it eliminates an old obligation. Functionally, it’s no different from paying severance to a departing employee.

For Tax Pros: Technical Annotations

See IRS Reg. Section 1.263(a)-4(b)(3), which defines “separate and distinct intangible asset.”
IRS Reg, Section 1.263(a)-4(b)(3)(ii) states that amounts paid to terminate an agreement do not create a distinct intangible.
Rev. Rul. 94-77 confirms that severance-like payments are deductible even though they may offer future business benefits, such as lower costs.

Possible IRS Argument

The IRS could argue that the termination payment creates a long-term benefit, such as removing a profit-sharing obligation, and therefore constitutes a capital expenditure. If the IRS were to win that argument, you would amortize the payment over the shorter of 15 years or your average customer relationship life.

This is a minor but possible risk, especially if the payment substantially increases your firm’s long-term profitability or was a condition to keep certain client accounts.

For Tax Pros: Supporting Commentary

Reg. Section 1.263(a)-4(d)(7) lists transactions that must be capitalized, such as acquiring or creating certain contractual rights. The termination payment described in this article does not fall under this section of the regulation.
The “significance future benefit” test from INDOPCO was narrowed by later guidance-see Reg. Section 1.263(a)-4(b)(1)(iv) – removing capitalization where a payment isn’t enumerated in the regulations.

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