Lychuk v. Commissioner: another skirmish in the INDOPCO wars.

• Author: Grigsby, McGee

In a continuation of the apparently endless series of disputes between taxpayers and the Internal Revenue Service over whether expenditures may be currently deducted or must be capitalized, the Tax Court in Lychuk v. Commissioner, 116 T.C. 27 (May 31, 2001),(1) upheld the Commissioner's position requiring the capitalization of employee compensation expenses incurred by a company whose main business consisted of the acquisition and servicing of high risk installment sales contracts for automobiles. At the same time, the Tax Court determined that the company's overhead expenses (utilities, rent, telephone and computer charges, etc.) could be currently deducted.(2)

Confronted by two recent reversals of Tax Court decisions requiring capitalization of expenses, Judge Laro distinguished the decision of the Eighth Circuit in Wells Fargo & Co. & Subsidiaries v. Commissioner, 224 F.3d 874 (8th Cir. 2000), affirming in part and reversing in part, Norwest v. Commissioner, 112 T.C. 89 (1999), and simply rejected the analysis and conclusions of the Third Circuit in PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822 (3d Cir. 2000), reversing 110 T.C. 349 (1998).

Although the Lychuk decision invites comment on a number of significant INDOPCO-related issues,(3) the primary focus of this article is consideration of the Lychuk decision in the context of Rev. Rul. 99-23, 1999-1 C.B. 998, which held that expenses incurred by an ongoing business to investigate whether to acquire another business are currently deductible under section 162 of the Internal Revenue Code.(4)

1. Facts

   The expenses at issue were incurred by Automotive Credit Corporation (ACC), an S corporation. The primary business activity of ACC was the acquisition and servicing of high-risk installment sales contracts from automobile dealers. As described by the Tax Court, ACC's acquisition of installment sales contracts followed an established procedure.

   [1] ACC would contact dealers and advise them that it was in the business of acquiring installment contracts on an ongoing basis. [2] ACC would enter into the independent agreement with each dealer.... [3] [T]he dealer ... would alert the buyer to ACC's financing business. [4] IA] buyer who wanted to finance the purchase with ACC would complete a detailed credit application.... [5] ACC would ... perform its credit review process. [6] [T]o the extent that ACC decided favorably on a credit application, and the buyer accepted ACC's financing arrangement, ACC would issue the dealer a check for the [purchase] amount. 116 T.C. No. 27, *7-8. The contracts' terms generally ranged from 12 to 36 months.(5) Id. at *7. ACC's daily business consisted mainly of reviewing credit applications, reviewing the terms of contracts submitted by dealers, and various other activities relevant to determining whether to purchase installment contracts. According to the Tax Court's findings, ACC reviewed 1,824 applications in 1993, of which it acquired 693; and it reviewed 2,158 applications in 1994, of which it acquired 820.

   ACC deducted $267,832 on its federal income tax return in 1993, and $288,911 on its 1994 return. The 1993 deduction represented the total cost of employee salaries and benefits (salary expenses), and overhead expenses, associated with ACC's credit analysis activities in that year. The 1994 deduction represented the same costs for 1994, less $50,300.(6) On audit, the IRS disallowed $198,626 of ACC's 1993 deduction of salary expenses and overhead.(7)

2. The Tax Court's Analysis

   The taxpayer argued that the expenses in question should be currently deductible because they were ordinary and necessary business expenses deductible under section 162. In so arguing, the taxpayer emphasized the primacy of the employment relationship and the routine and recurring nature of the expenditures. The taxpayer also argued that the installment sales contracts acquired by ACC were not "capital assets" within the meaning of section 263 of the Code or the Supreme Court's decisions in Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971), and INDOPCO.

   Writing for the court, Judge Laro rejected the taxpayer's arguments as they applied to employee compensation but simultaneously ruled that the nexus between overhead expenses and the acquisition of the installment sales contracts was too tenuous to require capitalization. Seven judges dissented from the holding that the overhead expenses may be deducted currently.

   1. ACC's Salary Expenses Are Not Deductible Merely Because They Are Ordinary, Routine, and Recurring in the Context of ACC's Business

      The taxpayer's primary argument in favor of deducting the expenses in question was that the salary expenses were, in the context of ACC's business, "routine and ordinary" and, as such, deductible currently. Specifically, the taxpayer argued that, because ACC was in the business of acquiring and servicing installment sales contracts, expenses incurred in acquiring installment contracts were, for ACC, "ordinary and necessary business expenses," and, hence, deductible under section 162(a). The court disagreed.

      We do not believe that "the `normal and routine' nature of the expenses in question dictates their deductibility.... [P]ayments made with a sufficiently direct connection to the acquisition, creation, or enhancement of a capital asset must be capitalized even when those payments are made in the course of the payee's regular business operations. 116 T.C. No. 27, *57. 2. ACC's Installment Contracts Are Capital Assets

      An essential but lightly treated element of the court's analysis is the finding that the installment sales contracts were "capital assets." A significant portion of the taxpayer's briefs was devoted to arguments that the installment sales contracts were not "capital assets" within the...