Deduction of loan origination costs.

• Author: O'Connell, Frank J., Jr.

Financial institutions recently achieved a significant victory over the IRS in their ongoing battle to deduct loan origination costs as ordinary and necessary business expenses. In PNC Bancorp, Inc., 5/19/00, the Third Circuit reversed the previous taxpayer-adverse decision of the Tax Court on this issue. While the original Tax Court ruling required the taxpayer to capitalize its loan origination costs and amortize them over the lives of the underlying loans, the appellate court decision permits the taxpayer to deduct these costs currently. The financial institution community now awaits the Service's response to this reversal.

Background

In 1986, the Financial Accounting Standards Board adopted Statement of Financial Accounting Standards (SFAS) No. 91, effective for fiscal years beginning after Dec. 15, 1987. SFAS No. 91 requires financial institutions to defer both fees and certain costs associated with loan originations and recognize these deferred amounts as an adjustment to the loan yield (i.e., interest income) over the expected lives of the underlying loans. Before the adoption of SFAS No. 91, financial institutions recognized loan fee income and origination costs at the time of origination for both financial accounting and tax purposes.

While the implementation of SFAS No. 91 significantly changed the financial accounting treatment of loan origination costs, many financial institutions continue to deduct these costs currently for tax purposes as ordinary and necessary business expenses under Sec. 162(a). However, the IRS's position on loan origination costs is that these costs should be capitalized under Sec. 263(a) and recovered through amortization over the useful lives of the underlying loans.

The IRS has been at odds with financial institution taxpayers over the treatment of loan origination costs since the adoption of SFAS No. 91. Presumably, the financial accounting standard of capitalizing these costs drew the Service's attention, as it provided a convenient argument and numeric support for applying these capitalization principles for tax purposes. Interestingly, the IRS relied heavily on the taxpayer's financial accounting calculations under SFAS No. 91 to support the audit adjustments in PNC.

Tax Court

The Tax Court's decision in PNC directly addressed whether loan origination costs represent ordinary and necessary business expenses under Sec. 162(a), or whether a taxpayer must capitalize them under Sec. 263(a) and recover the costs through amortization.

The taxpayer was principally engaged in the banking business; the costs at issue consisted of the loan origination costs, which the taxpayer deferred for financial accounting purposes pursuant to SFAS No. 91. These costs included (1) payments made directly to third parties for property reports, credit reports, appraisals...