IRS to Concede Capitalization of Loan Origination Costs under Prop. Regs.

After a long and tumultuous battle with financial institutions over the capitalization of loan origination costs, the IRS now appears willing to concede the issue. This conclusion is based on the language of Sec. 263(a) proposed regulations (REG-125638-01), issued Dec. 19, 2002, which do not require taxpayers to capitalize employee compensation, overhead and certain de minimis costs in acquiring or creating an intangible asset (including a loan).

As the vast majority of loan origination costs at issue for financial institutions fall into the above categories, the proposed regulations would allow a current deduction for these costs. This development follows the Third Circuits reversal of the Tax Court in PNC Bancorp, Inc., 212 F3d 822 (3rd Cir. 2000), which restored a taxpayers current deduction for its loan origination costs.

Background

In 1986, the Financial Accounting Standards Board (FASB) adopted Statement of Financial Accounting Standards (SFAS) No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (an amendment of FASB Statements No. 13, 60 and 65 and a rescission of FASB Statement No. 17), effective for fiscal years beginning after Dec. 15, 1987. SFAS No. 91 requires financial institutions to defer certain loan origination costs for book purposes and to recognize them as an adjustment to the loan yield (i.e., a reduction in interest income) over the underlying loans anticipated lives.

These costs include amounts paid for property and credit reports, appraisals, processing charges and employee compensation allocations. Before the adoption of SFAS No. 91, financial institutions recognized these loan origination costs, for book purposes, through current expensing.

While SFAS No. 91 significantly changed the financial accounting treatment of loan origination costs, many financial institutions continued to deduct these costs currently for tax purposes as Sec. 162(a) ordinary and necessary business expenses. However, the IRS had historically taken the position that taxpayers should capitalize these costs under Sec. 263(a) and recover them through amortization over the underlying loans anticipated lives (similar to book treatment).

The financial accounting deferral of these costs under SFAS No. 91 gave the IRS a convenient argument and numeric support for applying these capitalization principles to taxes. Interestingly, in PNC, the Service relied heavily on the taxpayers financial accounting calculations under SFAS No. 91 to support the audit adjustments described below.

PNC. In PNC Bancorp, 110 TC 349 (1998), the Tax Court directly ad-dressed the current deductibility of loan origination costs. It issued an IRS-favorable decision, concluding that the taxpayer had to capitalize and amortize the costs for tax purposes. It reached its conclusion on two bases: (1) it agreed that the costs created a separate and distinct asset (i.e., the loan) that warranted capitalization; see Lincoln Savings & Loan Assn, 403 US 345 (1971); and (2) it determined that the loans income stream produced a significant long-term benefit; see INDOPCO, Inc., 503 US 79 (1992). These arguments outweighed the taxpayers position that the costs were recurring Sec. 162(a) ordinary and necessary business expenses.

Two years later, the Third Circuit reversed the Tax Courts decision and rendered PNCs loan origination costs deductible. After a thorough analysis of the distinction between capital outlays (Sec. 263(a)) and ordinary and necessary business expenses (Sec. 162(a)), it sided with the taxpayer.

It found the loan origination costs to be an integral part of the banks current income-generation activities, and the costs to have only an indirect relationship to the loans. Thus, requiring capitalization would be an overly broad application of Lincoln Savings and INDOPCO.

Lychuk. The Tax Court rendered another taxpayer-adverse decision on an issue closely related to loan origination costs. In Lychuk, 116 TC 374 (2001), it determined that the taxpayer had to capitalize employee compensation for activities related to the acquisition of installment obligations issued by another taxpayer, and recover these costs through amortization over the lives of the acquired obligations. In issuing its opinion, the court defended its original decision in PNC and again upheld its position that the normal and routine nature of an expenditure does not mean that it falls outside of Sec. 263(a), when it relates to the acquisition of a long-term asset.

Ann. 93-60. Since the advent of SFAS No. 91 in the late 1980s, the IRS has routinely pursued the loan origination cost issue during examinations. In facing potentially large IRS audit adjustments, many taxpayers filed voluntary accounting-method-change requests with the National Office to switch to the cost-capitalization method and gain more favorable treatment on the resulting Sec. 481(a) adjustment.

To attain conformity in reporting loan origination costs, the National Office issued Ann. 93-60, in anticipation of forthcoming guidance, and provided that it would: (1) not accept any voluntary requests for accounting-method changes for loan origination costs; and (2) treat taxpayers faced with this issue on examination no less favorably than those not under examination for these costs, if such taxpayers made a protective filing under Ann. 93-60.

When Ann. 93-60 was issued, taxpayers anticipated that National Office guidance was imminent and that Ann. 93-60 would become obsolete (i.e., the guidance would establish a uniform accounting method that the Service would enforce under examination). However, the National Office never issued this guidance and Ann. 93-60 still applies.

Over the years, Ann. 93-60 has evolved into an administrative procedure that virtually guarantees audit protection from loan-origination-cost adjustments if taxpayers make the protective filing referred to above, within the first 90 days of an examination. As long as Ann. 93-60 continues to apply, taxpayers under examination should consider filing this protective claim at the start of any examination in which loan origination costs may be at issue.

Sec. 263(a) Prop. Regs.

Faced with appellate court reversals of PNC and several other high-profile cost-capitalization cases, in which the courts restored a taxpayers deductions (e.g., Wells Fargo & Co., 224 F3d 874 (8th Cir. 2000)), Treasury issued an advance notice of proposed rulemaking on Jan. 24, 2002, describing forthcoming Sec. 263(a) proposed regulations. Based on comments received, it issued the regulations on Dec. 19, 2002.

The proposed regulations offer substantial guidance on certain costs related to the acquisition, creation or enhancement of intangible assets and certain transaction costs; they also provide numerous definitions, examples, concessions and rules of administrative convenience, aimed at reducing the level of disagreement between taxpayers and the IRS over whether these costs should be capitalized. They provide several concessions that would eliminate the loan-origination-cost issue for many financial institutions.

For example, Prop. Regs. Sec. 1.263(a)-4(e)(3) does not require taxpayers to capitalize employee compensation, overhead and de minimis costs related to the acquisition, creation or enhancement of an intangible asset. Thus, the employee compensation and overhead components of the SFAS No. 91 costs at issue in PNC would be fully deductible for tax purposes. Likewise, compensation allocable to loan acquisition activities (such as those at issue in Lychuk) would also be deductible.

The proposed regulations set a de minimis threshold for expenses (other than compensation and overhead) at $5,000 per transaction. Taxpayers would determine these costs either on an individual loan basis or under an average pooled cost allocation for similar transactions. Either way, except in extreme circumstances, a financial institutions loan origination costs will fall below the de minimis threshold and will be currently deductible.

The proposed regulations would be effective for amounts taxpayers pay or incur on or after the date that Treasury publishes final regulations in The Federal Register, according to Prop. Regs. Sec. 1.263(a)-4(o).

For many financial institutions, these regulations support the existing method of accounting for loan origination costs and would not require an accounting-method change. However, for taxpayers capitalizing loan origination costs, the finalization of these regulations would require them to change their method.

The new rules would apply only to costs taxpayers incur on or after the date that Treasury finalizes the regulations. Thus, the change would apply on a cut-off basis and only to new loan origination costs (i.e., no Sec. 481(a) adjustment). Previously capitalized loan origination costs would be amortized into taxable income under the taxpayers former accounting method. However, Treasury requested comments on whether to apply these rules retroactively in certain situations.

Conclusion

After many years of disagreement over the current deductibility of loan origination costs, the issue appears to be headed for a favorable resolution in the near future. The Sec. 263(a) proposed regulations would eliminate this issue prospectively for most loan originations, by allowing a current deduction for these costs. However, these regulations are not effective until finalized. Taxpayers should continue to monitor this issue during the examination process and consider taking advantage of the protective filing available under Ann. 93-60.

From David A. Thornton, CPA, Columbus, OH