Tax Court Requires Capitalization of Loan Acquisition Costs

In 1998, the Tax Court broadened the definition of a capital expenditure when it ruled that loan origination costs incurred by a financial institution were to be capitalized and amortized over the life of the loan (PNC Bancorp, 110 TC 349). The taxpayer had to capitalize both payments to third parties for various credit reports, as well as a portion of the salaries of employees involved in granting loans. The court opined that such costs were incurred in connection with the acquisition of a capital asset and therefore required capitalization under Sec. 263(a).

Many commentators noted that this result could have broad-reaching implications beyond the financial services industry, requiring employers to consider whether they might have to capitalize salaries of any employees involved in transactions contributing to a benefit lasting more than one year for the employer. PNC Bancorp was appealed to the Third Circuit, which overturned the case in 2000 (212 F3d 822), much to the relief of many taxpayers.

However, in May 2001, in David J. Lychuk, 116 TC No. 27, the Tax Court reiterated its position that taxpayers must capitalize such costs. This decision may be an important indicator of the Tax Court's position in the continuing controversies between taxpayers and the IRS since INDOPCO, Inc., 503 US 79 (1992).

Facts

Mr. and Mrs. Lychuk and five other shareholders owned Automotive Credit Corporation (ACC), a cash-basis S corporation engaged in the business of providing alternate financing to purchasers of automobiles with marginal credit histories. The company's sole business operation was the acquisition and servicing of installment contracts from automobile dealers who had sold autos to high-credit-risk individuals. Typically, ACC paid dealers 65% of the face amount of the loan for the contracts. The length of repayment ranged from 12 to 36 months and typically carried a 22% interest rate. ACC had nine employees over the periods covered, each of whom was at least partially responsible for credit-analysis activities during that time. After analyzing the applications and other applicant credit information, ACC rejected approximately 66% of the notes that it reviewed.

ACC claimed a current deduction for the credit-analysis expenses that it incurred, which included payroll expenses for the nine employees and all related overhead costs, such as printing, rent, telephone, utilities and computer costs. The IRS disallowed these deductions and held that ACC had to capitalize the salaries and the portion of the overhead relating to acquisitions of the installment notes. The Service argued that such expenditures were solely related to the acquisition of the installment contracts, which were new assets providing future benefits to the taxpayer. On the other hand, ACC argued that such costs were routine recurrent business expenses, arising from the employment relationship, rather than from a capital transaction. ACC's position relied on the Third Circuit rationale in PNC Bancorp, which found such routine expenditures to be deductible. Second, ACC asserted that the installment-contract expenditures were deductible because they were not described in either Sec. 263(a) or the related regulations.

Court Opinion

The Tax Court agreed partially with the respondent and partially with the petitioners. It relied on the decisions in Idaho Power Co., 418 US 1 (1974), Honodel, 76 TC 351 (1981), and Woodward, 397 US 572 (1970), in holding that ACC incurred the expenses in connection with the acquisition of a capital asset and, therefore, was required to capitalize them. The court reasoned from Woodward that ACC should capitalize the expenditures related directly to the acquisition. Further, the court rebutted any presumption that salaries and wages were exempt from capitalization due to their routine nature, quoting the Supreme Court in Idaho Power:

Of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income...But when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and are then entitled to be amortized over the life of the capital asset so acquired.

The court went to great lengths in the opinion to rebut the Third Circuit's arguments in reversing the Tax Court's earlier decision in PNC. The Third Circuit had disagreed with the Tax Court that the salaries and third-party payments PNC made to acquire loans were part of the creation of a separate asset, concluding that the loan acquisition costs met the definition of current expense under Sec. 162, because they were normal and routine to the bank. In Lychuk, the Tax Court rejected the Third Circuit's reasoning, stating, "We do not believe that the 'normal and routine' nature of the expenses in question dictates their deductibility."

The court, using the same reasoning cited for capitalization of the wages, sided with the taxpayer on the overhead expenses. It found that the expenses for rent, utilities and other overhead items would have been incurred even if the taxpayer limited its business to the servicing of installment contracts. Such indirect expenses could not be directly tied to the acquisition of the installment notes. Therefore, ACC could deduct such items under Sec. 162. The court also ruled that expenses incurred for loan applications ultimately rejected could be currently deducted, because they did not directly result in the acquisition of a capital asset. In the absence of direct substantiation of the time spent on rejected applications, the court allowed ACC to apply its overall rejection rate of 62% to total salaries in determining the portion of salary expenditures currently deductible.

Ramifications to Taxpayers

Lychuk once again muddies the waters for companies involved in the financial services industry. Assuming the case is appealed to the Sixth Circuit, there is the chance that, if affirmed, a split in the circuits would exist on this issue. It is possible therefore that this case will find its way to the Supreme Court. In the meantime, financial services companies outside the Third Circuit continue to take a risk when they do not capitalize loan origination costs.

Lychuk also raises the wider question of whether companies should capitalize salaries expended for any corporate employee who works on acquiring or creating assets into the cost of those assets. The Service may be encouraged by this case on its position that taxpayers must capitalize wages and benefits paid whenever those wages contribute to some long-term result. Taxpayers can only wait and see what will be the ultimate resolution of this issue when (and if) the Sixth Circuit reviews it.

From Louis J. Miller, CPA, South Bend, IN