IRS to concede capitalization of loan origination costs under prop. regs.

• Author: O'Connell, Frank J., Jr.

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 Circuit's reversal of the Tax Court in PNC Bancorp, Inc., 212 F3d 822 (3rd Cir. 2000), which restored a taxpayer's 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...