Update on loan origination costs.

• Author: Tapajna, Joseph J.
• Position: Expenses

For more than a decade, the IRS has focused on the treatment of loan origination costs, which are expenses a lender incurs when making loans. They can include both internal and external expenses (such as employee salaries), the cost of credit reports and fees for collateral appraisals. According to the Service, these should be capitalized into the lender's basis in a loan, while most taxpayers have always deducted these expenses.

To resolve this issue, the INS has pursued a course of litigation. So far, it has litigated two cases. The first resulted in a taxpayer-favorable decision issued last year by the Third Circuit in PNC Bancorp, Inc., 212 F3d 822 (2000), rev'g 110 TC 349 (1998). The second case, Lychuk, 116 TC No. 27 (2001), represented something of a victory for the Service. It is unclear whether the taxpayers in Lychuk will appeal to the Sixth Circuit. The IRS's strategy appears to be to continue litigating the issue until there is a split in the circuits, inviting Supreme Court review. If Lychuk is not appealed, the Service will need to develop another case.

In PNC, the IRS argued that loan origination costs should be capitalized, because they were incurred in connection with the creation of separate and distinct assets (the loam the bank made). The Tax Court agreed with the Service, holding that PNC should have capitalized the expenses. The Third Circuit, however, rejected the IRS's argument. According to the court, the expenses should have been deducted, because they were recurring, routine expenses associated with PNC's day-to-day business of making loans. The Third Circuit also criticized the Service for pursuing the capitalization of a wide range of expenses in the wake of INDOPCO, Inc., 503 US 79 (1992), which held that expenses should be capitalized if they resulted in a significant future benefit, even if not related to the creation or acquisition of a separate asset.

At the time the Third Circuit issued its decision in PNC, Lychuk was pending in Tax Court. Lychuk involved loan acquisition costs, which were the same type of costs that a secondary purchaser incurs in evaluating whether to purchase a loan. The taxpayers in Lychuk were shareholders of an S corporation that specialized in purchasing auto loans made to consumers with poor credit. Under arrangements in place with several local car dealers, the company evaluated prospective loans and determined whether to acquire them. On average, the corporation acquired less...