Lychuk v. Commissioner: another skirmish in the INDOPCO wars.

In a continuation of the apparently endless series of disputes between taxpayers and the Internal Revenue Service over whether expenditures may be currently deducted or must be capitalized, the Tax Court in Lychuk v. Commissioner, 116 T.C. 27 (May 31, 2001),(1) upheld the Commissioner's position requiring the capitalization of employee compensation expenses incurred by a company whose main business consisted of the acquisition and servicing of high risk installment sales contracts for automobiles. At the same time, the Tax Court determined that the company's overhead expenses (utilities, rent, telephone and computer charges, etc.) could be currently deducted.(2)

Confronted by two recent reversals of Tax Court decisions requiring capitalization of expenses, Judge Laro distinguished the decision of the Eighth Circuit in Wells Fargo & Co. & Subsidiaries v. Commissioner, 224 F.3d 874 (8th Cir. 2000), affirming in part and reversing in part, Norwest v. Commissioner, 112 T.C. 89 (1999), and simply rejected the analysis and conclusions of the Third Circuit in PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822 (3d Cir. 2000), reversing 110 T.C. 349 (1998).

Although the Lychuk decision invites comment on a number of significant INDOPCO-related issues,(3) the primary focus of this article is consideration of the Lychuk decision in the context of Rev. Rul. 99-23, 1999-1 C.B. 998, which held that expenses incurred by an ongoing business to investigate whether to acquire another business are currently deductible under section 162 of the Internal Revenue Code.(4)

A. Facts

The expenses at issue were incurred by Automotive Credit Corporation (ACC), an S corporation. The primary business activity of ACC was the acquisition and servicing of high-risk installment sales contracts from automobile dealers. As described by the Tax Court, ACC's acquisition of installment sales contracts followed an established procedure.

   [1] ACC would contact dealers and advise them that it was in the business
   of acquiring installment contracts on an ongoing basis. [2] ACC would enter
   into the independent agreement with each dealer.... [3] [T]he dealer ...
   would alert the buyer to ACC's financing business. [4] IA] buyer who wanted
   to finance the purchase with ACC would complete a detailed credit
   application.... [5] ACC would ... perform its credit review process. [6]
   [T]o the extent that ACC decided favorably on a credit application, and the
   buyer accepted ACC's financing arrangement, ACC would issue the dealer a
   check for the [purchase] amount. 116 T.C. No. 27, *7-8. The contracts'
   terms generally ranged from 12 to 36 months.(5) Id. at *7.

ACC's daily business consisted mainly of reviewing credit applications, reviewing the terms of contracts submitted by dealers, and various other activities relevant to determining whether to purchase installment contracts. According to the Tax Court's findings, ACC reviewed 1,824 applications in 1993, of which it acquired 693; and it reviewed 2,158 applications in 1994, of which it acquired 820.

ACC deducted $267,832 on its federal income tax return in 1993, and $288,911 on its 1994 return. The 1993 deduction represented the total cost of employee salaries and benefits (salary expenses), and overhead expenses, associated with ACC's credit analysis activities in that year. The 1994 deduction represented the same costs for 1994, less $50,300.(6) On audit, the IRS disallowed $198,626 of ACC's 1993 deduction of salary expenses and overhead.(7)

B. The Tax Court's Analysis

The taxpayer argued that the expenses in question should be currently deductible because they were ordinary and necessary business expenses deductible under section 162. In so arguing, the taxpayer emphasized the primacy of the employment relationship and the routine and recurring nature of the expenditures. The taxpayer also argued that the installment sales contracts acquired by ACC were not "capital assets" within the meaning of section 263 of the Code or the Supreme Court's decisions in Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971), and INDOPCO.

Writing for the court, Judge Laro rejected the taxpayer's arguments as they applied to employee compensation but simultaneously ruled that the nexus between overhead expenses and the acquisition of the installment sales contracts was too tenuous to require capitalization. Seven judges dissented from the holding that the overhead expenses may be deducted currently.

1. ACC's Salary Expenses Are Not Deductible Merely Because They Are Ordinary, Routine, and Recurring in the Context of ACC's Business

The taxpayer's primary argument in favor of deducting the expenses in question was that the salary expenses were, in the context of ACC's business, "routine and ordinary" and, as such, deductible currently. Specifically, the taxpayer argued that, because ACC was in the business of acquiring and servicing installment sales contracts, expenses incurred in acquiring installment contracts were, for ACC, "ordinary and necessary business expenses," and, hence, deductible under section 162(a). The court disagreed.

   We do not believe that "the `normal and routine' nature of the expenses in
   question dictates their deductibility.... [P]ayments made with a
   sufficiently direct connection to the acquisition, creation, or enhancement
   of a capital asset must be capitalized even when those payments are made in
   the course of the payee's regular business operations. 116 T.C. No. 27,
   *57.

2. ACC's Installment Contracts Are Capital Assets

An essential but lightly treated element of the court's analysis is the finding that the installment sales contracts were "capital assets." A significant portion of the taxpayer's briefs was devoted to arguments that the installment sales contracts were not "capital assets" within the meaning of section 263 or the Supreme Court's decisions in Lincoln Savings or INDOPCO.

The taxpayer's argument that the installment contracts were not capital assets was based on the language of Treas. Reg. [sections] 1.263(a)-2, which provides that capital expenditures include "the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year." (Emphasis added.) Specifically, the taxpayer argued that, even if the installment contracts have a useful life substantially beyond the taxable year, they are not "similar" to the assets listed and, therefore, should not be considered capital assets.

Responding in footnotes, the Tax Court gave short shrift to the taxpayer's arguments that the installment sales contracts are not capital assets, stating in one that it was adopting the accounting definition of "capital asset" that encompasses "any asset with a useful life exceeding 1 year." 116 T.C. 27, *18, n.10. See 116 T.C. No. 27, *36, n.20 ("We understand the word `similar' to encompass any property that, like the examples, has a useful life extending substantially beyond the taxable year of the related expenditure.... [T]he Supreme Court has consistently taken a wider view as to capital expenditures.").

3. ACC's Salary Expenses Are Sufficiently Related to Acquiring the Contracts to Be Capital Expenses

Having concluded that the installment contracts were "capital assets," the court discussed whether the costs ACC incurred in acquiring them must be capitalized. In explaining the relationship between sections 162 and 263, the court noted that, although employee wages and overhead expenses may, in some cases, be deductible pursuant to section 162(a) and Treas. Reg. [subsections] 1.162-1(a) and 1.1627(a), the fact that these expenses appear to fall under section 162 is not determinative. See 116 T.C. No. 27, *20 ("The fact that a payment falls within a literal reading of section 162(a) does not necessarily mean that the payment is deductible."). The court then cited several cases, including Commissioner v. Idaho Power Co., 418 U.S. 1 (1974); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982); Stevens v. Commissioner, 46 T.C. 492 (1966), aff'd, 388 F. 2d 298 (6th Cir. 1968); and X-Pando Corp. v. Commissioner, 7 T.C. 48 (1946), for the proposition that "expenditures incurred `in connection with' the acquisition of a capital asset are considered capital expenditures includible in the acquired asset's tax basis." 116 T.C. 27, *23.

The court then turned to Woodward v. Commissioner, 397 U.S. 572 (1970), where it found a "process of acquisition" test, to determine whether ACC's salary expenses were sufficiently connected with the acquisition of the installment contracts to be considered part of their cost. Under that test, "an acquisition-related expenditure is a capital expenditure when its origin `is in the process of acquisition itself.'" 116 T.C. No. 27, *18. Finding that ACC's salary expenses were "inexorably tied" to the acquisition of the installment contracts(8), the court held that these expenses should be capitalized. In contrast, the Tax Court held that ACC's overhead expenses did not have a similarly direct and but-for connection with the process of acquiring the installment contracts: "None of these routine and recurring expenses originated in the process of ACC's acquisition of installment contracts, nor, in fact, in any anticipated acquisition at all. ACC would have continued to incur most of these expenses in the ordinary course of its business." Id. at *29.

4. Capitalizing ACC's Salary Expenses More Clearly Reflects ACC's Income

Finally, the court asserted, among other things, that its characterization of the expenses at issue is consistent with the purpose of the capitalization requirement in section 263, namely, "to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income." INDOPCO, 503 U.S at 84.

5. Overhead Expenses

As previously noted, the Tax Court allowed the taxpayer to deduct overhead expenses because it found that: (1) "ACC's payment of the overhead expenses was not directly related to the anticipated acquisition of any of the installment contracts," and (2) "any future benefit that ACC received from the overhead expenses was incidental to its payment of them," 116 T.C. No. 27, *18. In support of these findings, the court reasoned that ACC's overhead expenses "were generally fixed charges which had no meaningful relation to the number of credit applications analyzed (of the number Of installment contracts acquired)," id. at *29, and that "ACC would have continued to incur most of these expenses in the ordinary course of its business had its business only been to service the installment contracts." Id.

In his dissent, Judge Ruwe criticized the majority's finding that ACC's overhead expenses were not sufficiently related to its acquisition of the installment contracts to be capital expenditures. First, Judge Ruwe pointed out that the majority's reliance on the fact that ACC would have incurred the overhead expenses even if its business consisted only of the servicing of the installment contracts is inconsistent with the majority's finding that none of the expenses which the taxpayer identified as overhead expenses for 1993 and 1994 included any post-acquisition or servicing expenditures. See 116 T.C. 27, *80. Second, Judge Ruwe found that a large percentage of ACC's overhead expenses "related exclusively to ACC's credit analysis activities." Id. at *81. Judge Ruwe did not directly attack the majority's point that overhead expenses may be deducted currently because they are fixed, rather than incremental, costs.

Judge Halpern's dissent began by criticizing the notion of distinguishing between "direct" and "indirect" expenses, because that analysis "risks confusion with existing law (and accounting principles) that distinguish `direct' costs from `indirect' costs." Id. at *86. Judge Halpern then suggested that the majority did in fact confuse these two concepts in holding that the overhead costs are indirectly related because they are fixed as opposed to incremental. Judge Halpern noted that, by definition, overhead expenses are indirect and not identifiable with individual costing units. Not all overhead expenses, however, are deductible. Therefore, he concluded, "It is . paradoxical that the majority's approach should be that all inquiry ends once it is determined that an overhead cost is only indirectly related to the purchase of a capital asset." Id. at *91.

C. Commentary

There are a number of aspects of the Lychuk decision that invite comment. For example, the dissenters' argument that the overhead expenses should be capitalized is at once troubling in its implications and forceful in its logic.

One must also question whether the court's recitation of the hallowed matching principle incantations contributes to the analysis. After all, the expenses in question were incurred on a regular basis year after year. These were not expenses that were 10x in year one and 2x for the next five years. Similarly, the installment sales contracts purchased by ACC were not assets that would produce an income stream over many years to come. In fact, for the years at issue the contracts had actual average lives of 17.5 months (1993 contracts) and 19.5 months (1994 contracts). In short, in the context of this case and many other INDOPCO-related controversies, discussion of the "matching" principle may be much ado about nothing.

Also worth considering is the Tax Court's response to the two reversals by the Third and Eighth Circuits of decisions on INDOPCO-related issues. Clearly, the message of Lychuk is that the Tax Court is holding firm. One wonders whether the Tax Court should reconsider.

Arguably, each of these questions is addressed directly Or indirectly in the Lychuk opinion itself. But the one question that appears to have been completely ignored is whether the decision in Lychuk can be reconciled with Rev. Rul. 99-23, which holds that certain preacquisiton investigatory costs are currently deductible under section 162, and with the IRS concession in Wells Fargo that due diligence costs incurred prior to a decision to participate in a corporate acquisition are currently deductible.

Rev. Rul. 99-23, was issued by the IRS after the Tax Court's decision in Norwest v. Commissioner, 112 T.C. 89 (1999), reversed in part sub nom. Wells Fargo & Co. and Subsidiaries v. Commissioner, 224 F.3d 874 (8th Cir. 2000), but before the appellate briefs were filed. In the ruling, the IRS addressed section 195 of the Code, which allows a taxpayer to amortize certain "start-up expenditures." One of the requirements for qualifying as a "start-up expenditure" is that the expenditure be one that would be currently deductible under section 162 if the business incurring the expense were an existing business rather than one in the process of starting up.

The specific issue addressed in Revenue Ruling 99-23 was whether certain investigatory costs incurred by a taxpayer in preparing for and consummating the acquisition of a business would be currently deductible under section 162 if incurred by an existing business. Rev. Rul. 99-23 answered this question in the affirmative:

   Expenditures incurred in the course of a general search for, or
   investigation of, an active trade or business in order to determine whether
   to enter a new business and which new business to enter (other than costs
   incurred to acquire capital assets that are used in the search or
   investigation) qualify as investigatory costs that are eligible for
   amortization as start-up expenditures under [sections] 195. However,
   expenditures incurred in the attempt to acquire a specific business do not
   qualify as start-up expenditures because they are acquisition costs under
   [sections] 263.

The Tax Court's decision in Norwest considered the current deductibility of investigatory costs incurred by a bank prior to entering into a transaction in which the bank was acquired by another bank. The expenses at issue were incurred prior to the time the bank agreed to participate in the transaction. The IRS challenged the current deductibility of the expenses, and the Tax Court held the expenses should be capitalized. Between the time of the Tax Court decision and the filing of the government's brief on appeal, the IRS issued Rev. Rul. 99-23. Subsequently, the government, citing Rev. Rul. 99-23, conceded the current deductibility of the investigatory costs.

Surprisingly, the Lychuk decision acknowledges the existence of Rev. Rul. 99-23 and the concession in Wells Fargo but does not analyze their implications when considering the deductibility of costs incurred by ACC.

A comparison of the expenditures at issue in Lychuk and those considered in both Rev. Rul. 99-23 and Wells Fargo reveals many similarities.

Using the statistical information in the Lychuk opinion, it appears that ACC employees reviewed approximately 7.4 applications a day in 1993 and 8.9 applications a day in 1994. There is nothing in the opinion to suggest that any of the applications were pre-wired so that ACC knew the instant the application was received that a purchase offer would be made. Similarly, the opinion in no way intimates that ACC was in any way obligated even to review, much less purchase, any given installment contract. Thus, when initially received, the applications were simply potential investment opportunities that ACC could consider.

Analogously, the fact patterns described in Rev. Rul. 99-23 (Situation 1) involve expenses incurred (1) to evaluate the possibility of acquiring a trade or business unrelated to the taxpayer's trade or business, (2) to research several industries, (3) to evaluate several companies within an industry, and (4) to evaluate a specific business and that business's competitors. Situation 2 in the ruling involved expenses incurred to evaluate three specific businesses. In both Situation 1 and Situation 2, the taxpayer incurring the expenses eventually acquired one of the businesses evaluated. Rev. Rul. 99-23 holds that a significant portion of the expenses described in both Situation I and Situation 2 are currently deductible under section 162 as long as the expenses are incurred before the taxpayers decide both whether to make an acquisition and which acquisition it is going to attempt.

The Wells Fargo concession related to investigatory expenses incurred by the target bank prior to the time the target decided to cooperate with the proposed acquisition.

Thus, from a chronological perspective in each of the three instances, the expenses appear to have been incurred at a similar time. Most of the expenses incurred by ACC were incurred prior to the time ACC made a decision to make an offer to purchase a specific installment sale contract. The expenses deemed currently deductible in Rev. Rul. 99-23 were those occurring prior to the time the taxpayer decided whether to enter a new business and which business to acquire. In Wells Fargo the target bank's deductible investigatory expenses were those incurred prior to its decision to participate in the acquisition.

Although there are obvious differences among the precise investigatory activities conducted by, ACC, the hypothetical taxpayer in Rev. Rul. 99-23 and the target bank in Wells Fargo, these differences do not appear to dictate different tax treatment.

According to the Tax Court, ACC's expenses were incurred primarily to evaluate the buyer's credit worthiness, including a review of the credit application, obtaining credit reports on the potential buyer, verifying job status, salary, and residence, and evaluating various aspects of the buyer's credit history. The hypothetical taxpayers in Rev. Rul. 99-23, in Situation 1, hired an investment banker to conduct research on several industries, evaluate publicly available financial information relating to several businesses, evaluate several businesses within a specific industry, and eventually commissioned an appraisal of a specific business; and in Situation 2, hired an investment banker to evaluate three potential businesses. In Wells Fargo, the expenses at issue were general investigatory expenses incurred by the target prior to deciding to participate in the acquisition.

Thus, although there are differences in the specifics, in all three cases, the entity conducting the investigation is examining and evaluating factors relevant to making a decision whether to participate in an acquisition and which specific acquisition to undertake. In all three cases, a substantial element of such an investigation is a review of relevant financial data. ACC evaluated essential financial and economic data related to the potential purchaser. Undoubtedly, for both the hypothetical taxpayer in Rev. Rul. 99-23 and the target bank in Wells Fargo, the investigations considered similar financial and economic data related to the industry and business that might be acquired and the acquiring bank, respectively. Other information might also be considered. ACC might consider whether a particular job appears to be secure. The taxpayer considering an acquisition in Rev. Rul. 99-23 would look at trends for an industry. Surely, the target bank in Wells Fargo considered whether it should combine with a regional or a national bank.

These differences would not appear to have legal significance notwithstanding an assertion to the contrary by the IRS. In its briefs to the Tax Court in Lychuk, the IRS took the position that its position in Lychuk was consistent with the Wells Fargo concession and Rev. Rul. 99-23 because the revenue ruling was distinguishable. According to the IRS, the critical distinction was that Rev. Rul. 99-23 applied to investigatory costs associated with acquiring a "business" whereas the issue in Lychuk was the acquisition of a "capital asset." ("The Service has also consistently recognized the distinction between investigating the purchase of an asset and investigating the acquisition of a business." Respondent's Brief at 52.)

To paraphrase Judge Laro, "Is this a distinction with a difference?" 116 T.C. No. 27, *37. Surely, a "business" is a "capital asset."

D. Conclusion

The question that remains is how Rev. Rul. 99-23 and the IRS's concession in Wells Fargo can coexist with the Lychuk "process of acquisition" analysis. If the test for capitalization is a direct, but-for connection with the acquisition of a capital asset, none of the expenses described in Situation I or Situation 2 of Rev. Rul. 99-23 or those incurred by the target bank in Wells Fargo would be currently deductible under section 162.(9) In both Situation 1 and Situation 2 of Rev. Rul. 99-23 and in Wells Fargo, the anticipated acquisition, in fact, occurred. Beginning at the end and proceeding to the beginning of the chain of events, as Judge Laro does in Lychuk, the "process of acquisition" analysis will inevitably result in the capitalization of substantial expenditures that, it would appear, would be deductible under Rev. Rul. 99-23.

The proposition that investigatory expenses incurred prior to the time a taxpayer makes the "whether and which decision" are currently deductible under section 162 is not difficult to support. Surely, there is no immutable or sacrosanct tenet of tax law that is violated or even offended by such a proposition. Moreover, the "process of acquisition" analysis of Lychuk proves too much. As argued by the dissent, there is no logical stopping point. ACC was in the business of purchasing and servicing installment sales contracts. The logical conclusion mandated by the Lychuk analysis would be that the salary of every employee should somehow be prorated and capitalized to reflect that portion of ACC's business that constitutes the acquisition of installment sales contracts.

By contrast, the logic of Rev. Rul. 99-23 is both rational and practical. Capitalization is not required until the taxpayer has decided to attempt the acquisition of a specific asset. In the case of ACC, that event did not occur until a prospective credit application had been approved. All expenses incurred prior to that time would be currently deductible under section 162.

(1) The pagination for the Tax Court's decision is not yet available. Therefore, the case is cited as "116 T.C. No. 27, *" followed by a page number from 1, the first page of the opinion as it appears on the Tax Court's web page (http://www.ustaxcourt.gov/InOpHistoric/LYCHUK.TC.WPD.pdf), to 102, the last page of the opinion.

(2) The case also involved contested deductions related to securities offerings, which are not relevant to this discussion.

(3) All references to "INDOPCO" relate to the Supreme Court's 1992 decision, INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992).

(4) All references to "sections" and the "Code" are to sections of the Internal Revenue Code.

(5) The face term of the contracts acquired by ACC in 1993 and 1994 averaged 23.89 months and 29 months, respectively. The actual duration of the contracts ACC acquired in 1993 and 1994, however, averaged 17.5 months and 19.5 months, respectively.

(6) ACC claimed, before the Tax Court, that it omitted this amount in error, and that it was entitled to deduct the full $339,211 in salary expenses it incurred in 1994.

(7) The IRS made no adjustments to ACC's installment contract expenditures for 1994.

(8) See id. at *28 ("Each of the employees spent a significant portion of his or her time working on credit analysis activities, ... and, but for ACC's anticipated acquisition of installment contracts, ACC would not have incurred the salaries and benefits attributable to those activities.").

(9) It would seem that a deduction under section 165 would be available in respect of the expenses were associated with evaluating potential acquisitions that ultimately did not materialize.

McGEE GRIGSBY is a partner in the Washington, D.C., office of Latham & Watkins, and chairs the firm's tax controversy practice. He has participated in numerous TEI meetings at both the chapter and Institute level, and is a regular contributor to The Tax Executive. He expresses his appreciation to Daniel Lopez, a summer associate at the firm.