Loan purchase commitment fees upheld as option premiums.

A recent taxpayer victory in Tax Court is the latest development in a long series of tax authorities addressing amounts paid in connection with credit and loan market transactions. In this case, the taxpayer treated loan purchase commitment fees it received as option premiums; see Federal Home Loan Mortgage Corp. (Freddie Mac), 125 TC No. 12 (2005).The taxpayer successfully argued that receipt of the fees did not trigger their inclusion in gross income.

Commitment Fees

In Freddie Mac, the question was whether the taxpayer properly treated certain payments it received from mortgage sellers. A mortgage originator could either commit to selling a mortgage to Freddie Mac at a specific price and pay a small application fee, or obtain pre-approval for a later purchase of a mortgage at a variable price (along with a degree of interest-rate risk protection) and pay a larger "commitment fee."

The commitment fee included both refundable and nonrefundable portions. Only the latter was at issue in the case. During the years in question (1985-1990), approximately 99% of the mortgage originators paying the commitment fee consummated a sale transaction by delivering a mortgage loan to Freddie Mac. Only approximately 1% failed to deliver a mortgage loan and forfeited the fee's refundable portion.

Fee Income vs. Option Premium

The IRS argued that the nonrefundable portion of the commitment fees should have been included in Freddie Mac's income in the year of receipt, because the taxpayer had met the Sec. 451 "all events" test during that year. This is the rule for accrual-method taxpayers; they generally must include amounts in gross income when "all the events have occurred which fix the right to receive" income, and the amount "can be determined with reasonable accuracy"; see, e.g., Charles Schwab Corp., 161 F3d 1231 (9th Cir. 1998), aff'g 107 TC 282 (1996), cert. den.

Freddie Mac countered that a mortgage originator received an option to sell a mortgage to it in return for the commitment fee; thus, the fee was an option premium. Option premiums are generally not taxable on receipt. Instead, according to Rev. Rul. 58-234, they are tax-deferred until they either are exercised or lapse; see also Old Harbor Native Corp., 104 TC 191 (1995) and Rev. Rul. 78-182.When a taxpayer writes (grants) a put option (an option the holder may exercise, requiring the option writer to purchase something), either (1) the option is exercised, with the option premium being included in the purchaser's basis for the property purchased; or (2) the option lapses, with the option premium constituting ordinary income to the option writer. (Conversely, if an option premium is received in exchange for the grant of a call option (an option the holder may exercise, requiring the option writer to sell something), generally either (1) the option is exercised, with the option premium being included in the seller's amount realized on sale of the property; or (2) the option lapses, with the option premium constituting ordinary income to the option writer; see Rev. Rul. 58-234.)

Option in Form and Substance

The IRS presented two alternative arguments. First, it contended that the transaction did not involve granting put options to the mortgage originators that paid commitment fees to Freddie Mac. Second, even if the contractual arrangements contained options in form, the options lacked sufficient substance to be respected for tax purposes.

Under the taxpayer's contracts, the mortgage originator had the choice of delivering a mortgage loan in return for consideration, or delivering nothing. A mortgage originator that delivered a loan could choose from alternate purchase price computation methods. This choice gave them a degree of protection against increases in prevailing interest rates. If a mortgage originator chose to deliver nothing, it would forfeit the nonrefundable portion of the commitment fee paid to Freddie Mac. The Tax Court characterized this arrangement as an option to sell a mortgage loan in form; using a formula to compute the loan purchase price did not change this result.

In addressing whether the arrangement was an option in substance, the court noted that mortgage originators could choose not to pay the commitment fee by committing to sell a mortgage loan to Freddie Mac at a specific price. If they had done so but failed to deliver a mortgage loan, they would be subject to sanctions, including disqualification from further dealings with Freddie Mac. In paying the commitment fee, they were protected from the risk of not being able to close the subject mortgage. This weighed in favor of the court finding the arrangement to be an option in substance as well as form. Even though approximately 99% of the options were exercised, this did not turn the grant of the options into completed sales.

Because the arrangement was an option in form and substance, Freddie Mac had properly deferred including the commitment fees in gross income until the date the options were exercised or lapsed; see Old Harbor Native Corp. and Rev. Rul. 58-234.

Conclusion

Freddie Mac illustrates the principle that receipt of a payment is treated in accordance with the rights, property or services provided in return, and is not governed by the payment's denomination or label (e.g., a "commitment fee"). It also serves as a reminder that receipt of an option premium is generally not taxable to the recipient until the option is exercised or lapses.

FROM STEFAN GOTTSCHALK, J.D., LL.M., CPA, WASHINGTON, DC

Editor: Stefan Gottschalk, J.D., LL.M., CPA Senior Manager Grant Thornton LLP Washington, DC