Long-term contract costs ruled capital expenditures.

• Author: Zarzar, Robert

Continuing its scrutiny of the deductibility of internal costs, in Letter Ruling (TAM) 9952069, the IRS ruled that employee compensation and travel costs incurred in obtaining and entering into long-term service contracts should be capitalized.

In the TAM, the taxpayer obtained several long-term contracts, each for an initial 10-year term, by either solicitation or direct contact from a prospective customer's proposal request. Beginning when the taxpayer first communicated with a prospective customer, its employees attempted to develop relationships with the prospect's employees through both informal and professional meetings and presentations, which occurred during the solicitation, evaluation and negotiation process and continued throughout the engagement with the customer.

The Service held that employee compensation and travel costs incurred by the taxpayer in obtaining five long-term contracts should be capitalized, because the expenditures resulted in the acquisition of an asset (i.e., a long-term contract) and a significant long-term benefit for the taxpayer. To support its position, the IRS relied on Lincoln Sav. & Loan Ass'n, 403 US 345 (1971), and PNC Bancorp, 110 TC 349 (1998) (recently reversed by the Third Circuit), as well as Stewart Title Guaranty Co., 20 TC 630 (1953), in which the court held that an expenditure to acquire a contract "which is expected to be income-producing over a series of years is in the nature of a capital expenditure which must be amortized ratably over the life of the asset or the period of the contract." Because each contract in the TAM was for a minimum duration of 10 years and was expected to produce future revenues throughout its life, the Service (relying on INDOPCO, Inc., 503 US 79 (1992)) concluded that the salary and travel expenditures should be capitalized under Sec. 263.

Taxpayer Arguments

The taxpayer presented four arguments for deductibility of the costs. First, it argued that the expenditures were selling expenses deductible under Regs. Sec. 1.162-1 (a), which states that selling expenses generally are business expenses; Regs. Sec. 1.451-3(d)(5)(iii)(A), which includes bidding expenses as a type of selling expense; and RJR Nabisco, TC Memo 1998-252, which held that advertising expenses were deductible under Regs. Sec. 1.162-1(a), notwithstanding INDOPCO. The IRS's primary authority for rejecting this contention was Regs. Sec. 1.451-3(d)(6)(ii)(S), which states that bidding expenses...