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

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 benefits related to the loan contracts that it did acquire. The court did not require the taxpayer to capitalize any portion of the overhead expenses related to either group of contracts.

The value of Lychuk is not the establishment of a clear rule for characterizing an expenditure as a deductible or a capital expense. Instead, the case is valuable because of the discussion and analysis of prior Supreme Court and circuit court holdings in this area. The majority opinion interpreted prior Supreme Court holdings to require capitalization when the expenditure satisfies one of three alternative tests. The expenditure must create or enhance a separate and distinct asset, produce a significant future benefit or be incurred in connection with the acquisition of a capital asset. The court interpreted the phrase "in connection with" to mean that the expenditure must be directly related to the acquisition.

Relying on Woodward, the court held that the appropriate test is whether an expenditure originated in the "process of acquisition" of the capital assets acquired. The court then concluded that the salaries and benefits related to the loan contracts actually acquired had to be capitalized because, "but for ACC'S anticipated acquisition of installment contracts, ACC would not have incurred the salaries and benefits attributable to those activities." The company admitted that it could service its current portfolio of contracts with only three employees, including the company president. Eight of the 15 employees in dispute spent all of their time working on the acquisition of installment-loan contracts, and the amount of compensation paid to the employees hinged directly on the number of contracts acquired. These facts distinguished Lychuk from Wells Fargo & Co., 224 F3d 874 (8th Cir. 2000), in which a bank was not required to capitalize any portion of the salaries of officers involved in the investigation of the bank's acquisition by another corporation. Unlike the ACC officers, the Davenport officers (the bank that was acquired) received no increase in their compensation as a result of the investigative work, and the time spent by the officers on the capital transaction was a small portion of their overall duties.

In allowing ACC to deduct all of the overhead expenses in the year paid, the court distinguished these items from salaries and benefits. Unlike the compensation costs, the overhead expenses did not originate in the process of ACC's acquisition of installment contracts and generally had no meaningful relationship to the number of credit applications analyzed. The court rejected the IRS's argument that INDOPCO required capitalization of these expenses, concluding that any future benefit was so incidental as not to require capitalization on that theory.

In view of the continuing uncertainty over the scope of Secs. 162 and 263, Congress should step in and enact some bright-line rules that will provide guidance to the business community and the Service.

FROM BARRY NAGLER, CPA, J.D., LL.M., HOLTZ RUBENSTEIN & CO., LLP, MELVILLE, NY