Tax Court issues split decision on capital vs. deductible expenditures.

• Author: Moore, Philip E.

Taxpayers and Treasury have had numerous contests over whether certain expenditures were deductible as ordinary and necessary business expenses under Sec. 162 or expenditures that required capitalization under Sec. 263. Despite Supreme Court guidance (e.g., INDOPCO, Inc., 503 US 79 (1990), Idaho Power Co., 418 US 1 (1974), Lincoln Savings & Loan Assn., 403 US 345 (1971), and Woodward, 397 US 572 (1970)), no bright-line test exists to resolve the issue. Lychuk, 116 TC No. 27 (2001), illustrates the uncertainties that taxpayers face in this area. In Lychuk, five separate opinions resulted in the taxpayers being allowed to deduct certain contested expenditures while being required to capitalize others.

Mr. Lychuk was a shareholder in Automotive Credit Corporation (ACC), an S corporation that provided financing to used auto purchasers with marginal credit. ACC acquired installment-loan contracts from auto dealers for approximately 65% of their face value and serviced these contracts. ACC was not obligated to purchase any loan contract offered for sale by a dealer, but decided whether to purchase each contract based on a review of the applicant's credit bureau files and an analysis of the applicant's debt-to-income ratio, employment history and other relevant factors. In fact, during the two years covered by the case, ACC purchased only 38% of the contracts that it reviewed.

The contracts had an average original duration of more than two years, and their actual average duration, due to prepayments and defaults, was approximately 18 months. More than 25% of the contracts had an actual duration of one year or less.

ACC deducted all of the salaries, benefits and overhead related to the acquisition of the loan contracts. The IRS determined that these amounts represented capital expenditures, because they were related to ACC's acquisition of separate and distinct assets (i.e., the installment-loan contracts) and because, the expenditures provided ACC with significant future benefits (i.e., the income stream from the installment loans). The taxpayer argued that the expenditures were fully deductible because they were routine, recurring business expenses, arising from an employment relationship rather than from a capital transaction.

The majority opinion held that the taxpayer was allowed to deduct the salaries and benefits related to the loan contracts that it investigated but did not acquire, but it was required to capitalize the salaries and...