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Capitalization of loan organization costs?

Since the introduction of SFAS 91 in 1988, lenders have been capitalizing loan origination costs for financial purposes. These costs, however, have historically been deductible under Sec. 162 as ordinary and necessary expenses incident to the business of lending, which is required of a bank under Sec. 581. In several recent IRS exams, however, the Service has asserted that these origination costs should be capitalized for tax purposes. One response to this IRS exam risk has been to voluntarily change tax accounting methods to conform with SFAS 91. This approach, however, could eliminate a lender's ability to ever contest the validity of the Service's position.

Prior to 1988, the costs associated with, or allocated to, originating loans were regularly expensed for financial purposes. For tax purposes, lenders generally deducted these costs as ordinary and necessary business expenses.

Historically, the IRS did not challenge the deductibility of these expenses. More importantly, Congress has not changed the treatment of these costs recently. Yet the Service apparently feels that these costs should now be capitalized, but only since 1988. Evidently, the IRS'S response is attributable to the introduction of SFAS 91, and the resulting tax adjustments on lenders' tax returns.

In some recent IRS exams, the Service has asserted that loan origination costs, capitalized under SFAS 91, should also be capitalized for tax purposes under Sec. 263(a). The IRS is using Letter Ruling (TAM) 9024003, dealing with out-of-pocket costs of setting up home equity lines of credit, to support its position. IRS exam officials have also suggested that this issue could become a coordinated exam issue, and that a coordinated issue paper is currently being prepared. To date, however, the Service has issued nothing justifying its position with regard to SFAS 91 or loan origination costs.

One suggested response to the threat of an IRS exam involves voluntarily changing accounting methods to conform with SFAS 91 by filing a Form 3115 in accordance with new Rev. Proc. 92-20. It is unclear, however, whether the GAAP. method is appropriate for tax purposes. According to the Supreme Court, in Thor Power Tool Co., 439 US 522 (1979), there is no presumption that GAAP is valid for tax purposes.

In addition, SFAS 91 not only requires the capitalization of costs of originating loans, but also requires the deferral of point and fee income over the life of the loans. In contrast, the IRS requires current recognition of points and fees received in cash, according to Rev. Rul. 70-540. Therefore, if the Service does advocate SFAS 91, it appears to only advocate a part of it.

Because the IRS has not issued any guidance on this issue, simply following the rules of SFAS 91 to capitalize loan origination costs for tax purposes would appear inappropriate. Therefore, before lenders can file accounting method changes, some guidance from the Service will be necessary to ensure that taxpayers are requesting a change to an accounting method that will be approved.

The potential benefit of requesting a change in accounting method is partially based on new Rev. Proc. 92-20. This revenue procedure generally provides that if a taxpayer voluntarily changes from an improper method to a proper one, the change can be made on a prospective basis, and the IRS will not retroactively apply the method on examination. For Category B method changes requested before an IRS examination, however, there are no more benefits under Rev. Proc. 92-20 than there were under old Rev. Proc. 84-74. Both revenue procedures give protection from retroactive audit assessments, and both allow prospective accounting treatment. Therefore, for lenders not under examination, this option of changing accounting methods has long existed.

However, if a lender has already been contacted by the Service for an examination, there is a new benefit under Rev. Proc. 92-20. As long as the request for change is filed within 90 days of IRS contact, the lender can still receive prospective treatment.

Letter Ruling 9024003 held that the costs incurred to create home equity lines of credit were not deductible, but instead should be capitalized under Sec. 263(a). A bank had paid the out-of-pocket costs of making the loans, which are normally reimbursed by the customer on closing of the loan. The bank maintained that it could deduct the costs under Sec. 162.

The TAM concluded that the expenses related to the acquisition of a mortgage loan should be capitalized, citing Lincoln Savings & Loan Association, 403 US 345 (1971); the position of the Service was that an expenditure must be capitalized under Sec. 263 if the expenditure created, enhanced or was part of the cost of acquiring or defending a tangible or intangible asset with a useful life greater than one year.

The TAM noted that although Sec. 263(a) refers only to tangible capital assets, it may also be applied to intangible assets, citing Briarcliff Candy Corp., 475 F2d 775 (2d Cir. 1973). It noted that "any expense |incurred in acquiring an asset or economic interest, benefit or advantage - whether tangible or intangible with an income producing life extending beyond the taxable year' must be capitalized."

The costs mentioned in the TAM, however, are ordinary and necessary expenses incurred in the business of lending. in fact, the costs referred to in this TAM do not create loans at all, but instead create a line of credit which may, or may not, be extended in the form of a loan.

The facts and circumstances in this TAM are limited, and generally inconsistent with SFAS 91. The ruling dealt with unreimbursed direct out-of-pocket costs; the vast majority of costs capitalized under SFAS 91 are allocations of indirect costs.

In Notice 88-86, the IRS held that the origination of a loan for resale should be treated under Sec. 263A as the production of intangible property, as opposed to the acquisition of intangible property for resale. Accordingly, Sec. 263A does not apply to loan origination costs either.

Before the uniform capitalization rules were enacted, the Service concluded, in GCM 3568 1, that a mortgage company was required to capitalize expenses incurred in originating mortgage loans to the extent they were directly attributable to the mortgage. The GCM, however, also concluded that indirect administrative expenses for salaries, rent and overhead should not be capitalized, but instead were currently deductible under Sec. 162. The bulk of the costs required to be capitalized under SFAS 91 are these types of indirect administrative expenses.

It seems inappropriate to use the limited conclusions in the TAM as a basis for requiring the use of SFAS 91 for tax purposes. The TAM deals with direct out-of-pocket expenses, while SFAS 91 deals mainly with allocations of indirect expenses, and the IRS has already held, in GCM 35681, that indirect administrative costs are in fact deductible under Sec. 162.
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Author:Bryant, W. Michael
Publication:The Tax Adviser
Date:Feb 1, 1993
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