Deduction of loan origination costs.
In 1986, the Financial Accounting Standards Board adopted Statement of Financial Accounting Standards (SFAS) No. 91, effective for fiscal years beginning after Dec. 15, 1987. SFAS No. 91 requires financial institutions to defer both fees and certain costs associated with loan originations and recognize these deferred amounts as an adjustment to the loan yield (i.e., interest income) over the expected lives of the underlying loans. Before the adoption of SFAS No. 91, financial institutions recognized loan fee income and origination costs at the time of origination for both financial accounting and tax purposes.
While the implementation of SFAS No. 91 significantly changed the financial accounting treatment of loan origination costs, many financial institutions continue to deduct these costs currently for tax purposes as ordinary and necessary business expenses under Sec. 162(a). However, the IRS's position on loan origination costs is that these costs should be capitalized under Sec. 263(a) and recovered through amortization over the useful lives of the underlying loans.
The IRS has been at odds with financial institution taxpayers over the treatment of loan origination costs since the adoption of SFAS No. 91. Presumably, the financial accounting standard of capitalizing these costs drew the Service's attention, as it provided a convenient argument and numeric support for applying these capitalization principles for tax purposes. Interestingly, the IRS relied heavily on the taxpayer's financial accounting calculations under SFAS No. 91 to support the audit adjustments in PNC.
The Tax Court's decision in PNC directly addressed whether loan origination costs represent ordinary and necessary business expenses under Sec. 162(a), or whether a taxpayer must capitalize them under Sec. 263(a) and recover the costs through amortization.
The taxpayer was principally engaged in the banking business; the costs at issue consisted of the loan origination costs, which the taxpayer deferred for financial accounting purposes pursuant to SFAS No. 91. These costs included (1) payments made directly to third parties for property reports, credit reports, appraisals and recording of security interests and (2) an allocable portion of the taxpayer's salary and benefits costs for the time its employees spent to evaluate the financial condition of prospective borrowers; evaluate and record guarantees, collateral and other security arrangements; negotiate loan terms; prepare and process loan documents; and close loan transactions. The costs at issue did not include those incurred in connection with unsuccessful loan origination efforts.
The taxpayer made a number of arguments in favor of deducting its loan origination costs as ordinary and necessary business expenses. However, its primary argument was that these costs were both common and integral to the day-to-day operation of a banking business and provided only a short-term benefit. Based on this assertion, the taxpayer concluded that these costs fall outside the scope of Sec. 263(a) and represent ordinary and necessary expenses in carrying on a trade or business. In support of its arguments, the taxpayer pointed to Iowa-Des Moines Nat'l Bank, 592 F2d 433 (8th Cir. 1979); Colorado Springs Nat'l Bank, 505 F2d 1185 (10th Cir. 1974); and First Nat'l Bank of South Carolina, 558 F2d 721 (4th Cir. 1977), all of which allowed banks to deduct certain credit evaluation and recordkeeping costs related to issuing credit cards.
The Service focused its argument for capitalization on the rationale in Lincoln Savings & Loan Assn., 403 US 345 (1971). Lincoln Savings provided that, under Sec. 263(a), a taxpayer must capitalize costs that serve to create or enhance a separate and distinct asset. In support of its argument, the IRS focused on the relationship of the loan origination costs to the loan assets. By concluding that the loan origination costs served to create the underlying loans, the Service contended that the taxpayer should capitalize the costs under Sec. 263(a) and amortize them.
The Tax Court concluded that the loan origination costs did serve to create the loans and capitalization under Sec. 263(a) (and the Lincoln Savings rationale) was appropriate. The court rejected the taxpayer's argument that the costs provided only a short-term benefit, because the loam generally had a useful life of more than one year. Citing INDOPCO, Inc., 503 US 79 (1992), the court determined that the relationship of the loan origination costs to the loans required capitalization. This rationale was evident in the following language from the Tax Court's opinion:
Costs associated with the origination of the loans contribute to the generation of interest income and provide a long-term benefit that the banks realize over the lives of the underlying loans. The resulting stream of income extends well beyond the year in which the costs were incurred. It was this income benefit that was the primary purpose for incurring these expenditures. While the useful life of a credit report and other financial data may be of short duration, the useful life of the asset they serve to create is not.
While the court admitted that the credit-card expansion costs at issue in the cases cited by the taxpayer were similar to the loan origination costs at issue in PNC, the facts of these cases were different. Specifically, the court noted that none of these cases dealt with the creation or enhancement of separate and distinct assets or the creation of any significant future benefit.
In reversing the Tax Court, the Third Circuit found that the loan origination costs represent ordinary and necessary business expenses.
First, the court examined the fundamental distinction between deductible business expenses under Sec. 162(a) and capital outlays under Sec. 263(a). It analyzed the interrelationship of these provisions and considered them in conjunction with the Lincoln Savings rationale, to determine whether capitalization is appropriate. Specifically, the court acknowledged that capitalization of an expenditure (which is otherwise possibly an ordinary and necessary business expense) is appropriate if the expense falls within the purview of Sec. 263(a)(i.e., if it covers new buildings, permanent improvements or betterments that increase the value of any property or estate). Thus, for an expenditure to be currently deductible, it "must both be 'ordinary and necessary' within the meaning of section 162(a) and fall outside the group of capital expenditures envisioned by section 263(a)."
The appellate court found the loan origination costs routine to the banking business and part of current income production, thus constituting ordinary and necessary business expenses under Sec. 162(a). Further, these expenditures did not result in betterments made to increase a property's value. As a result, the court found the loan origination costs currently deductible. The court reasoned:
We cannot conclude that in performing credit checks, appraisals, and other tasks intended to assess the profitability of a loan, the banks 'stepped out of [their] normal method of doing business' so as to render the expenditures at issue capital in nature ... The facts before us demonstrate that loan operations are the primary method of income production for the subject banks. We have no doubt that the expenses incurred in loan origination were normal and routine 'in the particular business' of banking.
The court rejected the Tax Court's determination that the loan origination costs served to create the loans and therefore, had to be capitalized pursuant to the Lincoln Savings rationale. The costs at issue in Lincoln Savings consisted of payments made to a secondary reserve fund that the Federal Savings and Loan Insurance Corporation maintained. The payments Lincoln Savings made to this secondary reserve fund were refundable under certain circumstances and were carried on the books as an asset, because the taxpayer maintained an earmarked property interest in the secondary fund. The appellate court reasoned that PNC'S loan origination costs did not serve to create the loan, but were merely associated with creating the loans. These costs were distinguished from the secondary reserve payments in Lincoln Savings, because they were ordinary business expenses incurred in the production of income, rather than a capital outlay made to acquire an asset.
In addition, the court expressed some concern that to follow the Tax Court's reasoning would transform the Lincoln Savings rationale "from a test based on whether a cost 'creates' a separate and distinct asset, into a much more sweeping test that would mandate capitalization of costs incurred 'in connection with' or 'with respect to' the acquisition of an asset"
Finally, the appellate court addressed whether INDOPCO requires capitalization of the loan origination costs. The court focused on the significance of the term "future benefit" and whether such a benefit results from the taxpayer's loan origination costs. In concluding that no future benefit resulted, the Third Circuit pointed to the appellate decisions the taxpayer presented. The court likened the costs at issue in these cases (credit evaluation and recordkeeping costs related to the start-up of credit-card operations) to PNC's loan origination costs. The court found these cases pertinent to the taxpayer's argument, given its determination of no significant future benefit.
Announcement 93-60 and the Current IRS Audit Position
In the early 1990s, the Service began focusing on loan origination costs in its examination of financial institutions. Facing potentially large IRS audit adjustments, many institutions filed voluntary accounting-method change requests with the IRS National Office to switch to a method of cost capitalization and gain favorable treatment on the resulting Sec. 481 adjustment.
To attain conformity among financial institutions for the treatment of loan origination costs, the National Office issued Announcement 93-60, effectively suspending all voluntary accounting method requests for taxpayers electing a cost capitalization method, pending further guidance from a forthcoming revenue procedure. Although taxpayers anticipated the issuance of this guidance soon after the release of Announcement 93-60, the Service has not issued any guidance to date, and the PNC reversal is likely to delay its issuance even further.
Announcement 93-60 continues to represent the IRS's official position. As a result, taxpayers deducting their loan origination costs must continue to employ their current accounting methods. For those taxpayers capitalizing their loan origination costs, the Service is not likely to accept any requests to change accounting methods at this time.
Even though the IRS suspended all voluntary changes in the treatment of loan origination costs, field agents continue to raise this issue on examination. Announcement 93-60 offers protection in this area by allowing taxpayers under examination treatment of loan costs that is "no less favorable" than that granted to taxpayers not under examination. However, this protection is available only if the taxpayer files a protective Form 3115, Application for Change in Accounting Method, with the examining agent, within the first 90 days of the examination.
This protective procedure was formulated at a time when taxpayers believed that the guidance the Service promised in Announcement 93-60 was imminent. Both taxpayers and the IRS presently view the procedure as protection against any current audit adjustment for loan origination costs. As a result, all financial institutions deducting loan origination costs should consider filing the protective Form 3115, within the first 90 days of an Service examination, as long as Announcement 93-60 continues to apply.
The PNC reversal is a significant victory for financial institutions in the ongoing battle to deduct loan origination costs. However, the effect of the decision remains unclear, particularly in light of the IRS's current audit position on these costs. The onus is clearly on the Service to determine how it will respond to the Third Circuit decision. While the most common response would be litigation in other Federal circuits, the IRS already faces potentially adverse precedent in the other circuits. Therefore, the Service may ask the Supreme Court to hear the case. Until there is a final determination, taxpayers generally must continue with their current treatment of loan origination costs and be mindful of the audit protection offered in Announcement 93-60.
FROM DAVID A. THORNTON, CPA, COLUMBUS, OH
Frank J. O'Connell, Jr., CPA, J.D. Crowe Chizek Oak Brook, IL
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|Author:||O'Connell, Frank J., Jr.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2000|
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