Update on loan origination costs. (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 than 40% of all the loans it considered, and purchased these loans at a substantial discount from face value. Most of its employees' time was spent evaluating loans. They spent relatively little time servicing the loans once they were acquired.

On audit, the IRS challenged the deductibility of two types of expenses--employee salaries and overhead expenses (such as rent, utilities and printing) It argued that the corporation incurred these expenses in connection with the acquisition of separate assets. The Third Circuit issued its decision in PNC after the initial Tax Court briefs in Lychuk and asked the Service to clarify its position in the wake of the Third Circuit opinion. The IRS filed an additional brief in Tax Court, arguing that PNC had been wrongly decided (the Service's arguments are laid out in FSA 200109001).

The Tax Court decided in favor of the IRS, ruling that the corporation was required to capitalize many of its expenses. The majority opinion held that Lychuk had to capitalize the salaries that led to successful acquisitions. However, the court allowed it to write off the portion of the salaries that corresponded to loans Lychuk had considered but had not acquired. Because the company had acquired less than half of all the loans considered, it could deduct a substantial portion of the salary expenses. At the same time, the majority ruled that the company could deduct the overhead expenses, because they did not have a direct relationship to the loans acquired; however, this was not unanimous. On these issues, there were a number of concurring and dissenting opinions, making it difficult to draw much in the way of conclusions from the case, other than making it clear that most of the judges disagreed with the Third Circuit's reasoning in PNC.

It remains to be seen what will happen next in this area. The deadline for filing an appeal in Lychuk is later in the fall. It is unclear whether the taxpayers will appeal. The tax liability at issue was relatively small, and Lychuck could deduct a large proportion of the company's costs. The Service also has an opportunity to appeal the case, although there is as yet no indication that it will. If the taxpayers do not appeal, the IRS will need to find another case to litigate. In the meantime, most taxpayers under audit can rely on the protective procedures the Service provided in Ann. 93-60. Taxpayers can protect their deduction of loan origination costs on audit by filing under Ann. 93-60 within 90 days of being contacted for audit. Although the announcement does not specifically refer to loan acquisition costs, presumably taxpayers can also rely on the announcement to protect their deduction of loan acquisition costs.

The ultimate resolution of the treatment of loan origination costs could have collateral effects on other taxpayers. Loan origination costs can be analogized to other recurring-type costs incurred by taxpayers in other industries. Further, a government-favorable resolution of this issue could encourage the IRS to pursue other capitalization issues.

FROM HELEN S.YANCHISIN, J.D., WASHINGTON, DC