Long-Term Contract Costs Ruled Capital Expenditures

Continuing its scrutiny of the deductibility of internal costs, in Letter Ruling (TAM) 9952069, the IRS ruled that employee compensation and travel costs incurred in obtaining and entering into long-term service contracts should be capitalized.

In the TAM, the taxpayer obtained several long-term contracts, each for an initial 10-year term, by either solicitation or direct contact from a prospective customer's proposal request. Beginning when the taxpayer first communicated with a prospective customer, its employees attempted to develop relationships with the prospect's employees through both informal and professional meetings and presentations, which occurred during the solicitation, evaluation and negotiation process and continued throughout the engagement with the customer.

The Service held that employee compensation and travel costs incurred by the taxpayer in obtaining five long-term contracts should be capitalized, because the expenditures resulted in the acquisition of an asset (i.e., a long-term contract) and a significant long-term benefit for the taxpayer. To support its position, the IRS relied on Lincoln Sav. & Loan Ass'n, 403 US 345 (1971), and PNC Bancorp, 110 TC 349 (1998) (recently reversed by the Third Circuit), as well as Stewart Title Guaranty Co., 20 TC 630 (1953), in which the court held that an expenditure to acquire a contract "which is expected to be income-producing over a series of years is in the nature of a capital expenditure which must be amortized ratably over the life of the asset or the period of the contract." Because each contract in the TAM was for a minimum duration of 10 years and was expected to produce future revenues throughout its life, the Service (relying on INDOPCO, Inc., 503 US 79 (1992)) concluded that the salary and travel expenditures should be capitalized under Sec. 263.

Taxpayer Arguments

The taxpayer presented four arguments for deductibility of the costs. First, it argued that the expenditures were selling expenses deductible under Regs. Sec. 1.162-1(a), which states that selling expenses generally are business expenses; Regs. Sec. 1.451-3(d)(5)(iii)(A), which includes bidding expenses as a type of selling expense; and RJR Nabisco, TC Memo 1998-252, which held that advertising expenses were deductible under Regs. Sec. 1.162-1(a), notwithstanding INDOPCO. The IRS's primary authority for rejecting this contention was Regs. Sec. 1.451-3(d)(6)(ii)(S), which states that bidding expenses incurred in the successful solicitation of an extended period long-term contract must be capitalized over its life.

The taxpayer next argued that the costs were recurring in nature. The Service responded that the recurring nature of an expenditure does not automatically permit a current deduction. It relied on the Tax Court's PNC Bancorp decision, in which the Tax Court found no authority, "which stands for the proposition that expenses incurred in the creation of separate and distinct assets are currently deductible if such expenses are incurred regularly." Because the expenditures resulted in the creation of several long-term contracts, the IRS concluded that they had to be capitalized, despite their recurring nature.

Third, the taxpayer looked to Sec. 197 and its legislative history for the proposition that the contracts were self-created intangibles (e.g., goodwill or customer lists) and, hence, the costs to create them were currently deductible. In rejecting this position, the Service stated that Congress did not intend Sec. 197 to change the existing treatment of capitalizing costs incurred to create or acquire assets. Also, because specific newly acquired assets could be identified, the costs incurred did not result in the acquisition of intangibles in the nature of goodwill or customer lists.

Finally, the taxpayer asserted that expenditures incurred before it was actually awarded a contract were investigatory in nature and, therefore, deductible. Rejecting this contention, the Service relied on Norwest, 112 TC 89 (1999), which held that costs incurred in investigating the expansion of a business before the time a taxpayer formally decided to proceed with the transaction had to be capitalized.

Impact of Rev. Rul. 99-23

Subsequent to Norwest, the IRS released Rev. Rul. 99-23, holding that costs incurred by a taxpayer in investigating whether to enter a new business and which new business to enter are eligible for amortization as start-up expenditures under Sec. 195. As discussed in the item, "Government Clarifies Position on Investigatory Costs," the Justice Department (in a brief filed in conjunction with the taxpayer's appeal of Norwest) has conceded that the investigatory costs involved in that case should be deductible. However, because the treatment of investigatory costs in Norwest was in the context of Sec. 195, this concession should not affect the Service's reliance on Norwest for purposes of TAM 9952069, as the expenditures in the TAM were not incurred because of the acquisition of a trade or business within the scope of Sec. 195.

From George A. Manousos, CPA, Washington, DC