Tax Court requires capitalization of loan acquisition costs.

• Author: O'Connell, Frank J., Jr.

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 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...