David J. Lychuk and Mary K. Lychuk v. Commissioner , 116 T.C. No. 27 ( 2001 )

116 T.C. No. 27
UNITED STATES TAX COURT
DAVID J. LYCHUK AND MARY K. LYCHUK, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 11794-99, 11855-99, Filed May 31, 2001.
11863-99.
A acquires and services multiyear installment
contracts as its sole business operations. A acquires
each contract at 65 percent of its face value and is
entitled to all principal and interest payments. A’s
employees perform various credit review services in
order to decide whether to acquire each contract
offered to A and, as to the contracts which A chooses
to acquire, perform additional services in paying the
sellers. R determined that all of A’s salaries,
benefits, and overhead (printing, telephone, computer,
rent, and utilities) relating to its acquisition (and
not to its service) operation were capital
expenditures. R also determined that A had to
capitalize professional fees and commissions
1
Cases of the following petitioners are consolidated
herewith: Edward C. and Virginia M. Blasius, docket No. 11855-
99; James E. and Mary Jo Blasius, docket No. 11863-99.
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(collectively, offering expenditures) relating to its
offering of notes in 1993 and a second offering that
was planned in 1993 and abandoned in 1994.
Held: The salaries and benefits are capital
expenditures; A’s payment of these items was directly
related to its anticipated acquisitions of assets with
expected useful lives exceeding 1 year.
Held, further, The overhead expenses may be
deducted currently under sec. 162(a), I.R.C.; A’s
payment of these items was not directly related to the
anticipated acquisitions, and any future benefit that A
received from these expenses was incidental to its
payment of them.
Held, further, sec. 165(a), I.R.C., allows A to
deduct the portion of the capitalized salaries and
benefits that was attributable to installment contracts
which it never acquired; A may deduct those amounts for
the respective years in which it ascertained that it
would not acquire the related contracts.
Held, further, A must capitalize all of the
offering expenditures; A’s payment of these
expenditures was anticipated to provide A with
significant future benefits.
Held, further, sec. 165(a), I.R.C., allows A to
deduct in 1994 the portion of the capitalized offering
expenditures that was attributable to the abandoned
offering.
Oksana O. Xenos, for petitioners.*
Eric R. Skinner, for respondent.
LARO, Judge: Petitioners petitioned the Court to
redetermine deficiencies attributable primarily to adjustments
which respondent made to their income from a subchapter S
*
Briefs of amici curiae were filed by Robert A. Rudnick, B.
John Williams, Jr., James F. Warren, and Richard J. Gagnon, Jr.,
as counsel for Federal Home Loan Mortgage Corporation (FHLMC),
and by Felix B. Laughlin and Anna-Liza Harris as counsel for
Federal National Mortgage Association (FNMA).
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corporation, Automotive Credit Corporation (ACC). Respondent
determined a $1,202 deficiency in the 1993 Federal income tax of
David J. and Mary K. Lychuk. Respondent determined $2,149 and
$11,461 deficiencies in the 1993 and 1994 Federal income taxes,
respectively, of Edward C. and Virginia M. Blasius. Respondent
determined $23,683 and $89,609 deficiencies in the 1993 and 1994
Federal income taxes, respectively, of James E. and Mary Jo
Blasius.2 Both Blasius couples alleged in their respective
petitions that they had an overpayment for 1994 on account of
costs which ACC failed to deduct for that year.
Following concessions, we must decide whether ACC must
capitalize certain expenditures made during 1993 and 1994. The
expenditures were generally ACC’s payment of (1) salaries,
benefits, and overhead (printing, telephone, computer, rent, and
utilities) relating to its acquisition of retail installment
contracts (installment contracts) in the ordinary course of its
business (installment contracts expenditures) and (2)
professional fees and commissions relating to a private placement
offering of notes that ACC accomplished in 1993 and a second
offering that ACC planned in 1993 and abandoned in 1994
(collectively, PPM expenditures). We hold that ACC must
capitalize both groups of expenditures to the extent described
herein. We must also decide whether ACC may deduct the portion
2
James Blasius is Edward Blasius’ son.
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of the capitalized installment contracts expenditures relating to
installment contracts which it never acquired. We hold it may
deduct that portion under section 165(a).3 We must also decide
whether ACC may deduct the portion of the PPM expenditures
relating to the abandoned offering. We hold it may deduct that
portion for 1994 under section 165(a).
FINDINGS OF FACT
The parties have stipulated many of the facts. We
incorporate herein the parties’ stipulation of facts and the
exhibits submitted therewith. We find the stipulated facts
accordingly. Each petitioning couple is a husband and wife who
resided in Michigan when their petition was filed. Each
petitioning couple filed a joint Federal income tax return for
the relevant years.
ACC is a cash method taxpayer that was incorporated in 1992
and elected shortly thereafter to be taxed as an S corporation
for Federal income tax purposes. It was formed to provide
alternate financing for purchasers of used automobiles or light
trucks (collectively, automobiles) who have marginal credit. Its
sole business operation is (1) the acquisition of installment
contracts from automobile dealers (dealers) who have sold
automobiles to high credit risk individuals and (2) the servicing
3
Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the relevant years. Rule
references are to the Tax Court Rules of Practice and Procedure.
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of those contracts. Its primary business activities are credit
investigation, credit evaluation, documentation, and the
monitoring of collections on installment contracts. Its business
is conducted out of space that it rents in Bingham Farms,
Michigan, pursuant to a 5-year lease that began on October 22,
1992. Under the lease, ACC pays monthly rent of $3,137.50 during
the first 24 months and $3,250 afterwards.
ACC’s shareholders and their respective ownership interests
are as follows:
1993 1994
James and Mary Jo Blasius 77% 86%
Edward and Virginia Blasius 13 14
Donald Terns 5 0
David Lychuk 5 0
None of the shareholders, except James Blasius, works in ACC’s
daily business. The other male shareholders serve as the
directors of ACC’s board.
ACC’s key management personnel includes its president, James
Blasius, its vice president and chief financial officer, Steven
Balan, its credit manager, Cass Budzynowski, and its credit
investigator, Hope McGee. During the relevant years, each of
these individuals performed services in connection with ACC’s
acquisition of installment contracts. James Blasius managed
ACC’s overall operation and handled personally all contracts with
dealers. Steven Balan supervised and oversaw ACC’s day-to-day
management and its financial and general office management. Cass
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Budzynowski analyzed credit applications and supervised credit
investigations. Hope McGee analyzed credit reports and verified
all information provided by credit applicants, e.g., by directly
contacting employers, banks, and creditors.
ACC pays each of its key management personnel a base salary.
Each of these individuals is also entitled to receive an annual
bonus at the sole discretion of ACC’s board of directors. The
bonuses are paid from a “bonus pool” established by ACC and in
which ACC places funds in an amount up to 16.25 percent of its
pretax net profits. Except in the case of James Blasius, no
restrictions exist as to the amount of compensation that ACC may
pay to its officers or key employees. James Blasius’ bonus is
limited to 55 percent of the pool.
Under the terms of each installment contract, an individual
buys an automobile from a dealer at a set price to be paid (with
interest) in monthly installments. The average rate of interest
charged to the buyers is approximately 22 percent. The length of
repayment ranges from 12 to 36 months.
ACC and the dealers have an independent agreement under
which the dealers sell some of the installment contracts (and the
right to the corresponding payments of principal and interest) to
ACC at a price equal to 65 percent of each contract’s principal
amount (i.e., at a 35-percent discount). As of April 30, 1993,
ACC acquired the installment contracts from 13 dealers, 3 of
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which sold to ACC 69.4 percent of the installment contracts which
ACC acquired. ACC is not obligated to acquire all of the
installment contracts offered to it by the dealers but generally
must decide on whether it will acquire a particular installment
contract before the related automobile sale is finalized. ACC
rests its decision as to the acquisition of an installment
contract on its analysis of the buyer’s credit worthiness. That
analysis generally includes ACC’s review of the buyer’s credit
application, ACC’s obtaining of one or more credit reports on the
buyer, ACC’s verifying of the buyer’s job status, salary, and
residence, and ACC’s evaluation of various aspects of the buyer’s
credit history such as payment history and financial stability.
If ACC acquires an installment contract, the dealer generally
assigns its rights under that contract to ACC as part of the
automobile sale, and ACC pays the dealer the 65-percent amount
upon ACC’s receipt of all of the documents relating to the
installment contract. The automobile buyer pays ACC all amounts
due under the installment contract, and the automobile buyer
collateralizes his or her obligation to make those payments with
the purchased automobile.4 ACC may repossess and sell the
automobile if the buyer defaults on the installment contract.
ACC’s acquisition of installment contracts generally
followed an established procedure. First, ACC would contact
4
ACC services all of the installment contracts it acquires.
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dealers and advise them that it was in the business of acquiring
installment contracts on an ongoing basis. Second, ACC would
enter into the independent agreement with each dealer that
decided to sell its installment contracts to ACC, and the dealer
would provide ACC with its sellers license. Third, the dealer,
when faced with a prospective automobile buyer who did not
qualify for traditional financing, would alert the buyer to ACC’s
financing business. Fourth, a buyer who wanted to finance the
purchase with ACC would complete a detailed credit application
that the dealer would transmit to ACC by facsimile. Fifth, ACC
would record the application in its daily log and perform its
credit review process. Sixth, to the extent that ACC decided
favorably on a credit application, and the buyer accepted ACC’s
financing arrangement,5 ACC would issue the dealer a check for
the 65-percent amount on the next Friday, or, if ACC had not yet
received the requisite documentation from the dealer, on the
first Friday after it received that documentation. One piece of
documentation required by ACC was the fully executed installment
contract that was printed on a form that bore ACC’s name, logo,
address, and telephone number. Upon receipt of this contract,
ACC assigned the applicant an account number and entered all
applicable information into its computerized collection system.
5
ACC’s approval of an application did not always result in
its acquisition of the related installment contract. An
applicant sometimes decided for one reason or another not to
accept ACC’s financing arrangement.
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ACC’s credit review process generally included six steps,
all of which ACC could perform within 3 to 4 hours. First, ACC
would access electronically credit bureau reports on the
applicant and assign points to certain items shown on the
reports. Second, ACC would measure the total points either
against preestablished levels for approval or denial or against
an arbitrary level of approval or denial that was ascertained
intuitively. Third, ACC would analyze through debt-to-income and
loan-to-value ratios an applicant’s ability to pay the debt,
taking into account his or her disposable income and income per
dependent. ACC would sometimes perform in connection with this
step a budgetary analysis to suggest changes to the loan terms
(e.g., by decreasing the monthly payment over a longer time
frame) so as to meet preestablished target ratios. Fourth, ACC
would conditionally approve or deny an applicant on the basis of
all of the information that it had as of yet accumulated. Fifth,
as to applications that received a conditional approval, ACC
would perform an additional review as to the applicant by
verifying (mainly by telephone) his or her employment, residency,
and personal references, and by interviewing the applicant by
telephone. Sixth, as to the applicants who passed this
additional level of review, ACC would communicate to the dealer
ACC’s approval of the applicant. In some instances, ACC would
inform the dealer that it was unwilling to finance the purchase
under the terms offered to it but would finance a lesser amount
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of principal and/or would finance the purchase over a shorter
repayment term.
In 1993 and 1994, ACC paid installment contracts
expenditures totaling $267,832 and $339,211, respectively. These
expenditures, which were attributable to ACC’s obtaining of
credit reports and screening of credit histories, related
primarily to the portion of ACC’s payroll and overhead expenses
that was attributable to its credit analysis activities.6 None
of these expenditures included any postacquisition or servicing
expenses. ACC ascertained the amount of these expenditures at
the request of its independent auditors. The parties agree that
these expenditures are “related” to ACC’s credit analysis
activities and that the breakdown of specific expenditures is as
set forth below. The parties dispute whether any or all of the
expenditures is “directly related” to ACC’s credit analysis
activities, as contended by respondent, or is “indirectly
related” to those activities, as contended by petitioners.
6
We use the term “credit analysis activities” to refer to
ACC’s credit review services and its funding services (i.e.,
ACC’s issuance of the checks to dealers in consideration for the
installment contracts).
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Breakdown of Specific Expenditures1
1993
Salary Percentage of Total Expenses Amount
And Benefits Related to ACC’s Credit In
Employee Wages FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue
Steve Balan $69,359 $4,504 $313 $4,062 $78,238 50 $39,119
James Blasius 89,769 4,713 313 4,062 98,857 75 74,143
Cass Budzynowski 43,500 3,213 313 1,790 48,816 100 48,816
Hope McGee 16,248 1,216 313 3,692 21,469 100 21,469
Kelly 16,100 1,193 313 1,790 19,396 100 19,396
Stacey 10,280 767 313 2,086 13,446 75 10,085
245,256 15,606 1,878 17,482 280,222 213,028
Overhead Items
Printing 9,412 75 7,059
Telephone 12,454 75 9,341
Computer 19,598 95 18,618
Rent 34,413 50 17,207
Utilities 5,162 50 2,581
81,039 54,806
2
361,261 267,832
1994
Salary,
Wages, and Percentage of Total Expenses Amount
Estimated Benefits Related to ACC’s Credit In
Employee Bonus FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue
Steve Balan $95,820 $4,886 $218 $4,932 $105,856 40 $42,342
James Blasius 139,216 5,776 218 4,932 150,142 50 75,071
Cass Budzynowski 52,846 3,813 218 2,177 59,054 100 59,054
Hope McGee 11,508 842 218 4,932 17,500 100 17,500
Kelly 22,200 1,584 218 2,177 26,179 100 26,179
Sue 24,500 1,760 218 4,932 31,410 100 31,410
Kathy 16,921 1,256 218 4,932 23,327 75 17,495
Stacey 1,218 93 32 411 1,754 75 1,316
Kirsten 2,438 167 57 181 2,843 100 2,843
366,667 20,177 1,615 29,606 418,065 273,210
Overhead Items
Printing 8,663 75 6,497
Telephone 15,133 60 9,080
Computer 25,919 95 24,623
Rent 37,875 60 22,725
Utilities 5,126 60 3,076
92,716 66,001
510,781 339,211
1
The record does not indicate the surname of each of
the listed employees. Nor does the record indicate the
job titles of the employees listed without a surname or
describe their daily duties.
2
The parties agree than this column equals $267,832.
Actually, it equals $267,834. Because the $2
unexplained difference is immaterial to our analysis,
we use the parties’ figure of $267,832.
ACC deducted the installment contracts expenditures of
$267,832 on its 1993 Federal income tax return, and it deducted
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$288,911 of the $339,211 in installment contracts expenditures on
its 1994 Federal income tax return. ACC now claims that it was
entitled to deduct for 1994 the remaining $50,300 of installment
contracts expenditures ($339,211 - $288,911). As to the
respective years, ACC deducted officers’ compensation of $158,099
and $217,036 and salaries/wages of $126,464 and $194,306. The
portion of the officers’ compensation, salaries/wages, and
overhead which was deducted but not in issue is attributable to
ACC’s servicing of the installment contracts.
For financial accounting purposes, ACC separately listed the
installment contracts as assets on its 1993 and 1994 balance
sheets. In addition, ACC initially deducted the installment
contracts expenditures of $267,832 for 1993 but amended that
year’s financial statements to amortize the expenditures over the
expected life of the related installment contracts. ACC’s
independent auditors required the amendment and related
amortization in order to comply with Statement of Financial
Accounting Standards No. 91 (SFAS 91), Accounting for
Nonrefundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases.7 ACC
7
The record does not indicate why ACC’s auditors believed
that the amendment was required under SFAS 91. Whereas SFAS 91
provides explicitly for the deferral of “direct loan origination
costs”, it does not provide similarly as to the direct costs of
acquiring loans. SFAS 91 provides as to the acquisition of loans
that “15. The initial investment in a purchased loan or group of
loans shall include the amount paid to the seller plus any fees
(continued...)
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amortized the installment contracts expenditures of $339,211 over
the expected lives of the related installment contracts for 1994.
ACC performed its credit review services as to approximately
1,824 credit applications in 1993 and approximately 2,158 credit
applications in 1994. As to those applications, ACC acquired 693
installment contracts in 1993 and 820 installment contracts in
1994; in other words, ACC acquired in each year approximately 38
percent of the installment contracts which were offered to it.
The original terms of the 1993 installment contracts averaged
23.89 months, and their actual duration averaged 17.5 months.
The original terms of the 1994 installment contracts averaged 29
months, and their actual duration averaged 19.5 months. Of the
693 installment contracts acquired in 1993, 182 had an actual
duration of 12 months or less. Of the 820 installment contracts
acquired in 1994, 217 had an actual duration of 12 months or
less.
ACC issued a private placement memorandum (PPM) on April 30,
1993, offering up to $2.4 million of its subordinated asset
7
(...continued)
paid or less any fees received. * * * All other costs incurred
in connection with acquiring purchased loans or committing to
purchase loans shall be charged to expense as incurred.” We note
in passing, however, that rules such as SFAS 91 which are
compulsory for financial accounting purposes do not control the
proper characterization of an item for Federal income tax
purposes. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522,
542-543 (1979); see also Old Colony R.R. Co. v. Commissioner, 284
U.S. 552, 562 (1932).
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backed notes (Notes). ACC intended through the offering to raise
funds for its current operation, including the acquisition of
installment contracts which would be (and were) pledged to secure
ACC’s obligations under the Notes. The Notes matured in 36
months but could be redeemed by the noteholders at 12 or 24
months. The Notes bore interest at 12 percent during the first
year, 13 percent during the second year, and 14 percent during
the final year. The Notes were purchased by approximately 50
investors, and approximately five of these investors redeemed
their Notes before maturity.
East-West Capital Corporation (East-West) sold the Notes on
ACC’s behalf and was paid a commission equal to 4 percent of the
principal amount of the Notes sold, plus 1 percent of the
principal outstanding at 12 months, plus 1 percent of the
principal outstanding at 24 months. Included in East-West’s
commission was a 1 percent due diligence fee.
ACC deducted $29,647, $38,239, and $33,783 of offering
expenses, commissions, and professional fees, respectively, for
1993. ACC deducted $36,251, $74,361, and $110,432 of offering
expenses, commissions, and professional fees, respectively, for
1994. The deductions for 1993 and 1994 included costs
attributable to a second private placement offering that was
planned in 1993 and abandoned in 1994.
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Respondent audited ACC’s 1993 and 1994 taxable years. As to
1993, respondent disallowed $198,626 of installment contracts
expenditures deducted by ACC, determining that these expenses
were capital expenditures relating to assets having a life
exceeding one year.8 Respondent also disallowed $55,027 and
$66,652 of PPM expenditures deducted by ACC for 1993 and 1994,
respectively, determining that these expenditures were capital
expenditures which had to be amortized over the terms of the
Notes. The $55,027 included legal fees of $7,274 and a
registration fee of $1,250 paid in 1993 for the private placement
offering that ACC abandoned in 1994. The $66,652 included legal
fees of $21,792 paid in 1994 for the private placement offering
that ACC abandoned in 1994. The remaining adjustments as to the
PPM expenditures consisted of legal fees and commissions paid in
connection with the PPM.
OPINION
We must decide whether ACC may expense any of the disputed
costs or must capitalize them as expenditures to be deducted in
later years. Income tax deductions are a matter of legislative
grace, and petitioners bear the burden of proving ACC’s
entitlement to the claimed deductions. See Rule 142(a); INDOPCO,
Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Interstate Transit
8
Respondent made no adjustment to ACC’s deduction of
installment contracts expenditures for 1994.
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Lines v. Commissioner, 319 U.S. 590, 593 (1943). For Federal
income tax purposes, the principal difference between classifying
a payment as a deductible expense or a capital expenditure
concerns the timing of the taxpayer’s recovery of the cost. As
the Supreme Court has observed:
The primary effect of characterizing a payment as
either a business expense or a capital expenditure
concerns the timing of the taxpayer’s cost recovery:
While business expenses are currently deductible, a
capital expenditure usually is amortized and
depreciated over the life of the relevant asset, or,
where no specific asset or useful life can be
ascertained, is deducted upon dissolution of the
enterprise. * * * Through provisions such as these,
the Code endeavors 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 for tax purposes. * * *
[INDOPCO, Inc. v. Commissioner, supra at 83-84.]
Our inquiry begins with the installment contracts
expenditures. Respondent determined and maintains that ACC must
capitalize these expenditures to the extent stated herein.
Respondent argues primarily that these expenditures are capital
expenditures because they were related to ACC’s acquisition of
separate and distinct assets; i.e., the installment contracts.
Respondent argues secondly that ACC’s payment of the installment
contracts expenditures provided it with significant future
benefits in that it was able to acquire the installment contracts
which produced income for it in later years. Petitioners
maintain that the installment contracts expenditures are
currently deductible. Petitioners agree that the expenditures
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are related to the acquisition of the installment contracts but
argue primarily that the expenditures are deductible as routine,
recurring business expenses arising primarily from an employment
relationship rather than from a capital transaction. Petitioners
argue secondly that the installment contracts expenditures are
deductible because they are not described in either section
263(a) or the related regulations.
We agree with respondent in part and with petitioners in
part. We agree with respondent that ACC must capitalize the
installment contracts expenditures to the extent of the salaries
and benefits.9 We conclude that ACC’s payment of the salaries
and benefits was directly related to its acquisition of the
installment contracts. We agree with petitioners that ACC may
9
We allow ACC to deduct under sec. 165(a) the portion of
those expenditures that was attributable to the installment
contracts which it never acquired. ACC may deduct those amounts
for the respective years in which it ascertained that it would
not acquire the related contracts. See Ellis Banking Corp. v.
Commissioner, 688 F.2d 1376, 1382 (11th Cir. 1982), affg. in part
and remanding in part T.C. Memo. 1981-123. See generally PNC
Bancorp, Inc. v. Commissioner, 110 T.C. 349, 359, 362 (1998)
(Commissioner allowed banks to deduct loan origination costs
expended in connection with loans which were not successfully
approved), revd. on other grounds 212 F.3d 822 (3d Cir. 2000).
Respondent argues that petitioners have failed to prove the
portion of the expenditures attributable to the installment
contracts which it never acquired. We disagree. We have found
as a fact that ACC did not acquire approximately 62 percent of
the installment contracts which were offered to it in each of the
subject years. We hold that ACC may deduct for 1993 and 1994 62
percent of the installment contracts expenditures attributable to
installment contracts which in those years it decided not to
acquire. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d
Cir. 1930).
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currently deduct the installment contracts expenditures to the
extent of the overhead expenses. We conclude that ACC’s payment
of the overhead expenses was not directly related to the
anticipated acquisition of any of the installment contracts. We
also conclude that any future benefit that ACC received from the
overhead expenses was incidental to its payment of them. As
discussed in detail below, we believe that the Supreme Court’s
mandate as to capitalization requires that an expenditure be
capitalized when it: (1) Creates or enhances a separate and
distinct asset, see Commissioner v. Lincoln Sav. & Loan
Association, 403 U.S. 345, 354 (1971), (2) produces a significant
future benefit, see INDOPCO, Inc. v. Commissioner, supra at 87-
89, or (3) is incurred “in connection with” the acquisition of a
capital asset,10 Commissioner v. Idaho Power Co., 418 U.S. 1, 13
(1974); see Woodward v. Commissioner, 397 U.S. 572, 575-576
(1970). Given the Supreme Court’s pronouncement in Woodward v.
Commissioner, supra at 577, that an acquisition-related
10
We, like the Court of Appeals for the Eleventh Circuit in
Ellis Banking Corp. v. Commissioner, supra at 1379, understand
the term “capital asset” to be used for this purpose in its
accounting sense to encompass any asset with a useful life
exceeding 1 year. See also United States v. Akin, 248 F.2d 742,
744 (10th Cir. 1957) (“it may be said in general terms that an
expenditure should be treated as one in the nature of a capital
outlay if it brings about the acquisition of an asset having a
period of useful life in excess of one year”. Such an
understanding is directly consistent with the Secretary’s
interpretation set forth in sec. 1.263(a)-2(a), Income Tax Regs.,
of examples of property for which the costs of acquisition are
capital expenditures.
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expenditure is a capital expenditure when its origin “is in the
process of acquisition itself”, we understand the phrase “in
connection with” in the third situation to mean that the
expenditure must be directly related to the acquisition.
Our analysis begins with the relevant statutory text. We
apply that text in accordance with the related Treasury income
tax regulations, the validity of which has not been challenged by
either party, and the interpretation of that text and those
regulations primarily by the United States Supreme Court.
Section 162(a) provides that “There shall be allowed as a
deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or
business”. The Treasury regulations specify that ordinary and
necessary business expenses include “the ordinary and necessary
expenditures directly connected with or pertaining to the
taxpayer’s trade or business”, sec. 1.162-1(a), Income Tax Regs.,
such as “a reasonable allowance for salaries or other
compensation for personal services actually rendered”, sec.
1.162-7(a), Income Tax Regs. The Supreme Court has explained
that a cash method taxpayer such as ACC may deduct an expenditure
under section 162(a) if the expenditure is: (1) An expense,
(2) an ordinary expense, (3) a necessary expense, (4) paid during
the taxable year, and (5) made to carry on a trade or business.
See Commissioner v. Lincoln Sav. & Loan Association, supra at
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352-353. The Supreme Court has stated that a necessary expense
is an expense that is appropriate or helpful to the development
of the taxpayer’s business, see Commissioner v. Tellier, 383 U.S.
687, 689 (1966); Welch v. Helvering, 290 U.S. 111, 113-115
(1933), and that an ordinary expense is an expense that is
“normal, usual, or customary” in the type of business involved,
Deputy v. du Pont, 308 U.S. 488, 495-496 (1940); see also Welch
v. Helvering, supra at 113-115. The Supreme Court has observed
that the need for an expenditure to be ordinary serves, in part,
to “clarify the distinction, often difficult, between those
expenses that are currently deductible and those that are in the
nature of capital expenditures, which, if deductible at all, must
be amortized over the useful life of the asset.” Commissioner v.
Tellier, supra at 689-690.
The fact that a payment falls within a literal reading of
section 162(a) does not necessarily mean that the payment is
deductible. Sections 161 and 261, for example, except certain
payments from the current deductibility provision of section
162(a). See INDOPCO, Inc. v. Commissioner, 503 U.S. at 84.
Section 161 provides that “there shall be allowed as deductions
the items specified in * * * [section 162(a)], subject to the
exceptions provided in * * * sec. 261 and following, relating to
items not deductible”. Section 261 provides that “no deduction
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shall in any case be allowed in respect of the items specified in
this part”; i.e., part IX (Items Not Deductible).
Section 263 is included in part IX. Section 263(a)
provides, in language that dates back to the Revenue Act of 1864,
sec. 117, 13 Stat. 282, see United States v. Hill, 506 U.S. 546,
556 n.6 (1993) (“section 263(a)(1) has one of the longest
lineages of any provision in the Internal Revenue Code.”), that
“No deduction shall be allowed for--(1) Any amount paid out for
new buildings or for permanent improvements or betterments made
to increase the value of any property or estate.” The Treasury
regulations interpret this text by listing the following item as
an example of a capital expenditure: “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.” Sec. 1.263(a)-2(a),
Income Tax Regs.
The determination of whether an expenditure is deductible
under section 162(a) or must be capitalized under section 263(a)
is not always a straightforward or mechanical process. “[E]ach
case ‘turns on its special facts’”, and “the cases sometimes
appear difficult to harmonize.” INDOPCO, Inc. v. Commissioner,
supra at 86 (quoting Deputy v. du Pont, supra at 496).
In accordance with the current law on capitalization, an
expenditure may be deductible in one setting but capitalizable in
- 22 -
a different setting. For example, in Commissioner v. Idaho Power
Co., 418 U.S. at 13, the Supreme Court observed the following as
to wages paid by a taxpayer in its trade or business:
Of course, reasonable wages paid in the carrying on of
a trade or business qualify as a deduction from gross
income. * * * But when wages are paid in connection
with the construction or acquisition of a capital
asset, they must be capitalized and are then entitled
to be amortized over the life of the capital asset so
acquired. * * *
Similarly, in Ellis Banking Corp. v. Commissioner, 688 F.2d 1376,
1379 (11th Cir. 1982), affg. in part and remanding in part T.C.
Memo. 1981-123, the Court of Appeals for the Eleventh Circuit
observed as to business expenses in general:
an expenditure that would ordinarily be a deductible
expense must nonetheless be capitalized if it is
incurred in connection with the acquisition of a
capital asset.6
6
We do not use the term “capital asset” in
the restricted sense of section 1221.
Instead, we use the term in the accounting
sense, to refer to any asset with a useful
life extending beyond one year.
Accord American Stores Co. & Subs. v. Commissioner, 114 T.C. 458(2000) (taxpayer required to capitalize legal fees incurred to
defend against State antitrust suit arising out of, and connected
to, prior stock acquisition); cf. Stevens v. Commissioner, 46
T.C. 492, 497 (1966) (otherwise deductible business expenses are
capital expenditures when paid to acquire a capital asset), affd.
388 F.2d 298 (6th Cir. 1968); X-Pando Corp. v. Commissioner, 7
T.C. 48, 51-53 (1946) (salary, rent, advertising, and traveling
- 23 -
expenses which would ordinarily be deductible may be a capital
expenditure if made to cultivate or develop business, the
benefits of which will be realized in future years).
The just-quoted observations of the Supreme Court and the
Court of Appeals for the Eleventh Circuit in the Idaho Power Co.
and Ellis Banking Corp. cases, respectively, reflect a
longstanding, firmly established body of law under which
expenditures incurred “in connection with” the acquisition of a
capital asset are considered capital expenditures includable in
the acquired asset’s tax basis.11 Commissioner v. Idaho Power
Co., supra at 13; see Woodward v. Commissioner, 397 U.S. at 575
(“It has long been recognized, as a general matter, that costs
incurred in the acquisition or disposition of a capital asset are
to be treated as capital expenditures”); see also Johnsen v.
Commissioner, 794 F.2d 1157, 1162 (6th Cir. 1986) (“costs
incurred in connection with the acquisition or construction of a
capital asset are capital expenditures”), revg. on other grounds
83 T.C. 103 (1984); Ellis Banking Corp. v. Commissioner, supra at
11
The Commissioner has had a similar longstanding view.
See, e.g., Rev. Rul. 73-580, 1973-2 C.B. 86 (portion of
compensation paid by corporation to its employees that is
attributable to services performed in connection with corporate
acquisitions is a capital expenditure); Rev. Rul. 69-331, 1969-1
C.B. 87 (bonuses and commissions paid by gas distributor to
secure long-term leases for hot water heaters are capital
expenditures); Rev. Rul. 57-400, 1957-2 C.B. 520 (commissions
paid by bank to brokers and other third parties for introduction
of acceptable applicants for mortgage loans are capital
expenditures).
- 24 -
1379 (“an expenditure that would ordinarily be a deductible
expense must nonetheless be capitalized if it is incurred in
connection with the acquisition of a capital asset”); cf. A.E.
Staley Manufacturing Co. & Subs. v. Commissioner, 119 F.3d 482,
489 (7th Cir. 1997) (costs are capital expenditures if they are
“associated with” facilitating a capital transaction), revg. on
other grounds and remanding 105 T.C. 166 (1995); Central Tex.
Sav. & Loan Association v. United States, 731 F.2d 1181, 1184
(5th Cir. 1984) (“expenditures incurred in the acquisition of a
capital asset must generally be capitalized”); Commissioner v.
Wiesler, 161 F.2d 997, 999 (6th Cir. 1947) (“well settled rule
that expenditures incurred as an incident to the acquisition or
sale of property are not ordinary and necessary business
expenses, but are capital expenditures which must be added to the
cost of the property”), affg. 6 T.C. 1148 (1946).
Capitalizable expenditures are not limited to the actual
price that the buyer pays to the seller for the asset but
include, for example, the payment of legal, brokerage,
accounting, appraisal and other “ancillary” expenses related to
the asset’s acquisition. Woodward v. Commissioner, supra at
576-577; see United States v. Hilton Hotels Corp., 397 U.S. 580(1970); see also Ellis Banking Corp. v. Commissioner, supra at
1379. Capitalizable expenditures also include compensation paid
for services performed in connection with an asset’s acquisition,
- 25 -
including “a reasonable proportion of the wages and salaries of
employees who spend some of their working hours laboring on the
acquisition”. Briarcliff Candy Corp. v. Commissioner, 475 F.2d
775, 781 (2d Cir. 1973), revg. on other grounds and remanding
T.C. Memo. 1972-43; see Commissioner v. Idaho Power Co., supra at
13; see also Cagle v. Commissioner, 539 F.2d 409, 416 (5th Cir.
1976), affg. 63 T.C. 86 (1974); Perlmutter v. Commissioner, 44
T.C. 382, 404 (1965), affd. 373 F.2d 45 (10th Cir. 1967); cf.
Strouth v. Commissioner, T.C. Memo. 1987-552 (costs of securing
potential leases, including checking the lessee’s credit,
reviewing the lease application, and drafting the lease documents
are capital expenditures).
When the Supreme Court was faced with the question as to the
capitalization of litigation costs incurred appraising the stock
of minority shareholders in connection with the majority
shareholder’s acquisition of that stock, the Court held that the
central inquiry was whether the expenditure originated in “the
process of acquisition”. Woodward v. Commissioner, supra at 577.
In other words, the Court set its focus on the directness of the
costs’ relationship to the acquisition and adopted a test under
which costs originating in the process of acquiring a capital
asset are considered capital expenditures.
- 26 -
We believe that the application of the “process of
acquisition” test is appropriate here.12 Both this Court and the
Court of Appeals for the Ninth Circuit applied the process of
acquisition test in Honodel v. Commissioner, 76 T.C. 351 (1981),
affd. 722 F.2d 1462 (9th Cir. 1984), to decide whether the
taxpayer/investors could deduct two types of fees which they paid
to an investment advisory and financial management company. The
first fee was a nonrefundable monthly retainer that the taxpayers
paid for investment counsel and advice. The amount of this fee
depended on the investor’s income level and the investor’s
financial planning, tax advice, and investment needs. The second
fee was a one-shot charge for services rendered in connection
with each investment acquired. The amount of this fee equaled a
specific percentage of the investment’s cost. We allowed the
taxpayers to deduct the monthly fees but required them to
capitalize the one-shot fees. We focused on whether the services
performed by the investment adviser were performed in the process
of acquisition or for investment advice. We concluded that the
services relating to the monthly fee did not arise out of that
process but that the services relating to the one-shot fee did.
See id. at 363-368. The Court of Appeals for the Ninth Circuit
agreed. See Honodel v. Commissioner, 722 F.2d 1462 (9th Cir.
12
This approach is consistent with a test suggested by the
amicus for FHLMC.
- 27 -
1984). Thus, while the monthly fees were connected to an
acquisition in the sense that they were required to be paid in
order to consummate any acquisition, both this Court and the
Court of Appeals for the Ninth Circuit acknowledged that the fees
were insufficiently connected with an acquisition to require
their capitalization. The process of acquisition test,
therefore, does not simply rest on whether an expenditure is
somehow connected to an asset acquisition but focuses more
appropriately on whether the expenditure was directly related to
that acquisition.
We apply the process of acquisition test to the facts at
hand. The salaries and benefits are a capital expenditure if the
underlying services were performed in the acquisition process,
or, in other words, were directly related to ACC’s anticipated
acquisition of installment contracts. See Woodward v.
Commissioner, 397 U.S. 572 (1970); Honodel v. Commissioner,
supra. We conclude that the underlying services were performed
in that process; i.e., the services were directly related to
ACC’s anticipated acquisition of installment contracts. Each of
the employees spent a significant portion of his or her time
working on credit analysis activities, which was the first (and,
in ACC’s business, an indispensable) step in ACC’s acquisition
process, and, but for ACC’s anticipated acquisition of
installment contracts, ACC would not have incurred the salaries
- 28 -
and benefits attributable to those activities.13 The credit
review activities were so inexorably tied to and such an integral
part of the acquisition process that the portion of the salaries
and benefits attributable thereto must be considered as part of
the cost of the installment contracts. To be sure, the Supreme
Court in Commissioner v. Idaho Power Co., 418 U.S. at 13, even
considered the tools and materials used by the construction
workers, in addition to the wages of the workers themselves, as
part of the capital asset’s cost, as did the court in Ellis
Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982),
with respect to office supplies, filing fees, travel expenses,
and accounting fees. We hold that the salaries and benefits are
capital expenditures to the extent that the parties have agreed
that those costs are attributable to the credit analysis
activities.14
13
As a matter of fact, ACC admitted as much in its PPM when
it stated:
In the event only a minimal amount of Notes are sold
pursuant to this Offering, the Company [ACC] would have
to downsize its operations and could, in fact, operate
with its current portfolio of retail installment
contracts with as few as three (3) individuals,
including the President of the Company, James Blasius.
14
To the extent that the specific work performed by each
individual as to the acquisition process is not contained in the
record, petitioners bear the consequences of any deficiency in
the record as they bear the burden of disproving respondent’s
determination that the costs of the services and benefits at
issue are capital expenditures.
- 29 -
As to the overhead expenses, we conclude and hold
differently. Those expenses are capital expenditures to the
extent that they originated in ACC’s acquisition process, or, in
other words, were directly related to ACC’s anticipated
acquisition of installment contracts. We are unable to find that
such was the case. 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 had its business only been to
service the installment contracts. The items of rent and
utilities, for example, were generally fixed charges which had no
meaningful relation to the number of credit applications analyzed
(or the number of installment contracts acquired) by ACC. Nor
did the printing expense have any such meaningful relation. In
fact, ACC’s printing costs were less in 1994 than in 1993, even
though ACC analyzed 18.3 percent more credit applications (and
acquired 18.3 percent more installment contracts) in 1994 than in
1993. Although ACC’s telephone and computer costs did increase
in 1994 from the prior year, we are unable to discern from the
record any direct relationship between that increase and the
increase from the prior year in credit applications analyzed
and/or installment contracts acquired so as to require
capitalization of those costs.
- 30 -
We recognize that the Court in Perlmutter v. Commissioner,
44 T.C. at 403-405, required the taxpayer there to capitalize a
portion of his utilities as sufficiently connected to a capital
transaction. In that regard, the Perlmutter case is
distinguishable from the case at hand in that the Perlmutter case
preceded Woodward v. Commissioner, supra, and the related process
of acquisition test. We also distinguish the printing costs at
hand from the printing costs in A.E. Staley Manufacturing Co. &
Subs. v. Commissioner, 119 F.3d at 492-493, the latter of which
we and the Court of Appeals for the Seventh Circuit considered as
associated with a capital transaction. The printing costs there,
unlike those here, were required to be incurred by the taxpayer
so as to facilitate communication with shareholders and others in
connection with the transaction. See A.E. Staley Manufacturing
Co. & Subs. v. Commissioner, 105 T.C. at 180, 197.
Respondent argues that ACC’s payment of the overhead
expenses produced for it a significant future benefit requiring
capitalization under INDOPCO, Inc. v. Commissioner, 503 U.S. 79(1992). We disagree. On the basis of our discussion above, we
conclude that any future benefit that ACC realized from these
expenses was incidental to its payment of them so as not to
require capitalization on that theory. See id. at 87-88.
Petitioners argue that the salaries and benefits are ipso
facto deductible because they are the routine, recurring expenses
- 31 -
of ACC’s business.15 Petitioners make three assertions in
support of this argument. Petitioners first assert that the
salaries and benefits are fixed costs which flow from an
employment agreement and are not dependent upon the occurrence of
a capital transaction. In this regard, petitioners contend, the
amounts of the salaries and benefits paid by ACC are unaffected
by the quantity, principal amount, or duration of the installment
contracts, and those items would have been incurred even without
the acquisition of an installment contract. Petitioners assert
secondly that the salaries and benefits are deductible under a
literal reading of section 1.162-1(a), Income Tax Regs. The
relevant text of that section allows a taxpayer to deduct
reasonable compensation that is “directly connected with or
pertaining to the taxpayer’s trade or business”. Petitioners
assert thirdly that the salaries and benefits are deductible
under the established jurisprudence of First Sec. Bank of Idaho,
N.A. v. Commissioner, 592 F.2d 1050 (9th Cir. 1979), affg. 63
T.C. 644 (1975); First Natl. Bank of South Carolina v. United
States, 558 F.2d 721 (4th Cir. 1977); Colorado Springs Natl. Bank
v. United States, 505 F.2d 1185 (10th Cir. 1974); and Iowa-Des
Moines Natl. Bank v. Commissioner, 68 T.C. 872 (1977), affd. 592
15
The amicus for FNMA also advances this argument.
- 32 -
F.2d 433 (8th Cir. 1979) (collectively, credit card cases).16
Petitioners assert that the credit card cases hold that recurring
expenses are deductible under section 162(a) whenever the
expenses are incurred in the ordinary course of business.
Petitioners also point to INDOPCO, Inc. v. Commissioner, supra,
and contend that the Supreme Court acknowledged there that an
expense’s recurring nature is critical to qualifying it as
deductible under section 162(a).
We disagree with petitioners’ argument that section 162(a)
allows ACC to deduct the expenses that recur in the ordinary
course of its business merely by virtue of the fact that the
expenses are everyday and/or routine in nature. In order for a
payment to be deductible under section 162(a), the underlying
expense must not only be “normal, usual, or customary” in the
type of business involved, Deputy v. du Pont, 308 U.S. at 495, it
must be realized and exhausted in the year of payment, see
Stevens v. Commissioner, 388 F.2d at 300. Although an employer’s
payment of salaries and benefits similar to the ones at issue
will usually generate for the employer benefits that will be
realized and exhausted in the year of payment, the same is not
true when those items are directly related to the employer’s
acquisition of a capital asset such as an installment contract.
16
Petitioners also rely on Bankers Dairy Credit Corp. v.
Commissioner, 26 B.T.A. 886 (1932).
- 33 -
The benefits which ACC will reap from the installment contracts;
namely, interest and excess principal income,17 will not be
realized and exhausted within the year of payment. ACC will
realize those benefits in each of the later years in which the
interest and excess principal are received. Given the Supreme
Court’s observation in INDOPCO, Inc. v. Commissioner, supra at
83-84, that our tax law endeavors to measure taxable income by
allowing expenses to be deducted in the taxable year in which the
related income is recognized, see also Newark Morning Ledger Co.
v. United States, 507 U.S. 546, 565 (1993); Hertz Corp. v. United
States, 364 U.S. 122, 126 (1960), it is only appropriate to defer
ACC’s deduction of its payment of any expenses directly related
to that interest or excess principal income to the years in which
ACC recognizes the income.18 Only then will ACC’s taxable income
be calculated more accurately for tax purposes than if ACC had
deducted those expenses currently.
We find instructive to our decision the case of Helvering v.
Winmill, 305 U.S. 79 (1938), revg. 93 F.2d 494 (2d Cir. 1937),
17
We use the term “excess principal” to refer to the
principal on the installment contracts that exceeded 65 percent
of their face value.
18
The salaries and benefits were instrumental to the
production of that income in that ACC would not have acquired any
of the installment contracts without performing its credit
analysis activities. In this regard, we disagree with the amicus
representing FNMA that all of ACC’s salaries and benefits are
indirect expenses to which sec. 263(a) does not apply in the
first place.
- 34 -
revg. and remanding 35 B.T.A. 804 (1937). There, the taxpayer
claimed that he could deduct as compensation brokerage
commissions paid to acquire securities in the ordinary course of
his business. The Commissioner had disallowed the deduction,
determining that the payments were capital expenditures. The
taxpayer argued that it could deduct the payments because, he
asserted, they were an ordinary and necessary business expense.
The taxpayer asserted that he was in the business of buying and
selling securities. A divided Board of Tax Appeals sustained the
Commissioner’s disallowance. See Winmill v. Commissioner, 35
B.T.A. 804 (1937). The Court of Appeals for the Second Circuit
disagreed with the Board, holding that the payments were
deductible if the taxpayer was in fact engaged in the business of
buying and selling securities. See Winmill v. Commissioner, 93
F.2d 494 (2d Cir. 1937). The Supreme Court held that the
payments were capital expenditures. The Supreme Court noted that
the Treasury regulations (Regs. 77, art. 282 (1932)19) set forth
a longstanding position that commissions paid in acquiring
securities are considered part of the securities’ cost and
stated: “The fact-–if it be a fact-–that * * * [the taxpayer]
was engaged in the business of buying and selling securities does
19
The substance of these regulations regarding commissions
paid to acquire securities has been carried forward into sec.
1.263(a)-2(e), Income Tax Regs.
- 35 -
not entitle him to take a deduction contrary to this provision.”
Helvering v. Winmill, 305 U.S. at 84.
Petitioners argue that Helvering v. Winmill, supra, is
irrelevant. Petitioners recognize that the taxpayer in the
Winmill case, similar to petitioners here, relied on a provision
in the regulations that provided specifically that compensation
paid in the ordinary course of business qualified as a deductible
expense. Petitioners distinguish the Winmill case by noting that
another provision in those regulations provided specifically that
“commissions paid in purchasing securities are a part of the cost
price of such securities.” Regs. 77, art. 282 (1932).
Petitioners conclude that the Supreme Court’s holding in the
Winmill case rested solely on the presence of the second
provision and assert that no similar provision exists here to
preclude explicitly its deduction of the salaries and benefits.
Petitioners also note that the instant facts are different than
Winmill in that ACC is not a securities dealer, the installment
contracts are not securities, and none of the installment
contracts expenditures are commissions.
We disagree with petitioners’ assertion that Helvering v.
Winmill, supra, is irrelevant. We, like the Supreme Court in the
Winmill case, focus on a specific, longstanding position set
forth in the Treasury regulations to conclude that the salaries
and benefits must be capitalized even though, in a different
- 36 -
setting, those costs may have qualified for deduction under a
more general regulatory provision. Specifically, whereas section
1.162-1(a), Treasury Income Tax Regs., provides generally that
“the ordinary and necessary expenditures directly connected with
or pertaining to the taxpayer’s trade or business” are deductible
expenses, section 1.263(a)-2(a), Income Tax Regs., provides
specifically that capitalized 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.” We
disagree with petitioners when they assert that this latter
provision does not preclude explicitly ACC’s deduction of the
salaries and benefits. The installment contracts, similar to the
buildings, machinery and equipment, and furniture and fixtures
listed specifically in section 1.263(a)-2(a), Income Tax Regs.,
have anticipated useful lives extending substantially beyond the
taxable year of the related expenditures.20 We also disagree
20
Petitioners argue that the installment contracts are not
"similar" to the examples in the regulations and, hence,
expenditures connected thereto need not be capitalized. We
disagree. 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.
Petitioners’ narrow interpretation of the regulations fails to
recognize that the Supreme Court has consistently taken a wider
view as to capital expenditures. See, e.g., Commissioner v.
Lincoln Sav. & Loan Association, 403 U.S. 345 (1971)
(contributions to depository reserve fund were capital
expenditures); Helvering v. Winmill, 305 U.S. 79 (1938) (taxpayer
(continued...)
- 37 -
with petitioners when they draw factual distinctions between the
two cases sufficient to warrant contrary results. The facts that
ACC is not a securities dealer, that the installment contracts
are not securities, and that none of the installment contracts
expenditures are commissions are, in our minds, merely
distinctions without a difference. Compare Woodward v.
Commissioner, 397 U.S. at 575, 577-578, wherein the Court stated:
The Court recognized [in Helvering v. Winmill, supra,]
that brokers’ commissions are ‘part of the
(acquisition) cost of the securities,’ Helvering v.
Winmill, supra, 305 U.S. at 84, 59 S.Ct. at 47, and
relied on the Treasury regulation, which had been
approved by statutory re-enactment, to deny deductions
for such commissions even to a taxpayer for whom they
were a regular and recurring expense in his business of
buying and selling securities.
* * * * * * *
in this case there can be no doubt that legal,
accounting, and appraisal costs incurred by taxpayers
in negotiating a purchase of the minority stock would
have been capital expenditures. See
Atzingen-Whitehouse Dairy, Inc. v. Commissioner, 36
T.C. 173 (1961). Under whatever test might be applied,
such expenses would have clearly been ‘part of the
acquisition cost’ of the stock. Helvering v. Winmill,
supra. * * *
Accord Commissioner v. Wiesler, 161 F.2d at 999 (“the Winmill
case * * * follow[s] the well settled rule that expenditures
incurred as an incident to the acquisition * * * of property are
not ordinary and necessary business expenses, but are capital
20
(...continued)
required to capitalize the regular and recurring costs incurred
in acquiring securities).
- 38 -
expenditures”); Ellis Banking Corp. v. Commissioner, T.C. Memo.
1981-123 (“Nor would the fact that petitioner was engaged in the
business of acquiring bank stock entitle it to deduct such
expenditures if the bank stock was a capital asset and the
expenditures were incurred in the acquisition thereof. Helvering
v. Winmill, supra.”).
We also apply the case of Commissioner v. Idaho Power Co.,
418 U.S. 1 (1974), revg. 477 F.2d 688 (9th Cir. 1973), revg. T.C.
Memo. 1970-83. There, the taxpayer was a public utility engaged
in the production, transmission, and sale of electricity.
Throughout its long existence, the taxpayer regularly and
routinely constructed additional transmission and distribution
facilities using its own equipment and hundreds of its own
employees. Respondent determined that the taxpayer had to
capitalize the depreciation on its equipment to the extent used
in the construction project. The Supreme Court agreed. The
Court noted that a goal of Federal income tax accounting is to
match income with the related expenses and observed that “‘It has
long been recognized, as a general matter, that costs incurred in
the acquisition * * * of a capital asset are to be treated as
capital expenditures.’” Id. at 12 (quoting Woodward v.
Commissioner, supra at 575; ellipsis in original). Further, the
Court noted: “there can be little question that other
construction-related expense items, such as tools, materials, and
- 39 -
wages paid construction workers, are to be treated as part of the
cost of acquisition of a capital asset.” Id. at 13. The Court
concluded that requiring the taxpayer to capitalize its
depreciation would maintain tax parity between it and another
taxpayer who retained an independent contractor to construct the
improvements and additions for it. In the latter case, the Court
stated, the depreciation on the equipment used by the independent
contractor would be part of the cost that the contractor charged
on the project. The Court believed it unfair to allow a taxpayer
to deduct the cost of constructing its facility if it has
sufficient resources to do its own construction work, while
requiring another taxpayer without such resources to capitalize
its cost including the depreciation charged by the contractor.21
See id. at 14. The Court expressed no opinion as to the fact
that the taxpayer in the Idaho Power Co. case had been regularly
and routinely improving its facilities throughout most of its
long existence, nor that these improvements had for the most part
been made by its employees. See id.; see also the opinions of
the lower courts at Idaho Power Co. v. Commissioner, 477 F.2d
688, 690 (9th Cir. 1973); Idaho Power Co. v. Commissioner, T.C.
Memo. 1970-83.
21
The amicus for FHLMC would limit the Supreme Court’s tax
parity rationale to cases of self-created assets. We read
nothing that would so limit that rationale.
- 40 -
The Court of Appeals for the Eleventh Circuit also applied
the case of Commissioner v. Idaho Power Co., supra, in Ellis
Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982), to
require capitalization of certain acquisition-related
expenditures. There, the taxpayer was a bank holding company
that, under State law, had to acquire the stock of other banks or
organize new banks in order to expand its business into new
geographic markets. The taxpayer agreed with another bank
(Parkway) and certain of Parkway’s shareholders to acquire all of
Parkway’s stock in exchange for taxpayer stock. The agreement
was contingent on the satisfaction of certain events. Prior to
consummation of the acquisition, but in connection therewith, the
taxpayer incurred various expenses conducting a due diligence
examination of Parkway’s books. These expenses were for office
supplies, filing fees, travel expenses, and accounting fees. The
taxpayer deducted these expenses, and respondent disallowed the
deduction. Respondent determined that the expenses had to be
capitalized.
We sustained respondent’s disallowance. We held that the
expenses were capital expenditures because they were incurred in
connection with the acquisition of a capital asset. The Court of
Appeals for the Eleventh Circuit agreed. The taxpayer had argued
that the expenses were "ordinary and necessary" because they were
incurred in connection with its decision to acquire the stock and
- 41 -
in evaluating the market in which Parkway was located. See id.
at 1381. The taxpayer noted that the expenses were incurred
before it was bound to buy Parkway’s stock. The Court of
Appeals, in rejecting the taxpayer’s claim to current
deductibility, stated:
Ellis also devotes a portion of its brief to arguing
that it is in the business of promoting banks, so that
the expenditures made in that business are deductible.
It is not enough to establish that expenditures are
incurred in carrying on a trade or business to qualify
for a deduction under section 162--all of the
requirements set out above [namely, the five
requirements for deductibility set forth in
Commissioner v. Lincoln Sav. & Loan Association, 403
U.S. at 352-353,] must be fulfilled. Indeed, if being
in the business sufficed, Ellis would be able to deduct
the purchase price of the Parkway stock. * * * [Id. at
1381 n.10.]
The Court of Appeals went on to say that
the expenses of investigating a capital investment are
properly allocable to that investment and must
therefore be capitalized. That the decision to make
the investment is not final at the time of the
expenditure does not change the character of the
investment; when a taxpayer abandons a project or fails
to make an attempted investment, the preliminary
expenditures that have been capitalized are then
deductible as a loss under section 165. * * * As the
First Circuit stated, ‘* * * expenditures made with the
contemplation that they will result in the creation of
a capital asset cannot be deducted as ordinary and
necessary business expenses even though that
expectation is subsequently frustrated or defeated.’
Union Mutual, 570 F.2d at 392 (emphasis in original).
Nor can the expenditures be deducted because the
expectations might have been, but were not, frustrated.
[Id. at 1382.]
Our opinion as to the salaries and benefits is further
supported by the cases of Godfrey v. Commissioner, 335 F.2d 82- 42 -
(6th Cir. 1964), affg. T.C. Memo. 1963-1, and Stevens v.
Commissioner, 388 F.2d 298 (6th Cir. 1968). Godfrey v.
Commissioner, supra, concerned deductions that the taxpayer
claimed as to a joint venture in two parcels of real estate known
as the Goose Pond and Adams Packing properties. Before taking
title to the Goose Pond property, the taxpayer and his associates
caused a use survey to be conducted on the property in order to
ascertain its best commercial use. They concluded from the
survey that the upper part of the tract was best suited for an
automobile dealership and that the lower portion could best be
used for a shopping center. They acquired the property and then
discovered that it lacked the zoning classification necessary to
use it in the manner indicated by the survey. They retained
attorneys to try to change the property’s classification. Their
attempt was unsuccessful. The taxpayer deducted his
proportionate share of the cost of the survey and the attorney’s
fee. The taxpayer also deducted travel and living expenses that
he had paid in connection with acquiring both the Goose Pond and
Adams Packing properties.
We denied the deductions, holding that all of the
expenditures were capital expenditures. We observed that the use
survey “represented their first step in the contemplated
development of the property; and its benefits were obviously
expected to extend beyond the year in which the survey was made.”
- 43 -
Godfrey v. Commissioner, T.C. Memo. 1963-1. We observed that the
attorney’s fee was part of the cost of the development of a
capital asset, in that it represented an unsuccessful attempt to
have the Goose Pond property rezoned for certain commercial use.
We observed that the travel and living expenses generally related
to the acquisition and development of the property.
The Court of Appeals for the Sixth Circuit agreed with us
that all of the expenditures were capital expenditures. The
court stated:
The Tax Court found that the cost of the “use
survey” was a capital expenditure. The court said: “It
represented their first step in the contemplated
development of the property; and its benefits were
obviously expected to extend beyond the year in which
the survey was made.” The test of an ordinary business
expense is whether it is of a recurring nature and its
benefit is generally exhausted within a year. An
expenditure is of a capital nature “where it results in
the taxpayer’s acquisition or retention of a capital
asset, or in the improvement or development of a
capital asset in such a way that the benefit of the
expenditure is enjoyed over a comparatively lengthy
period of business operation.” Louisiana Land &
Exploration Co. v. Commissioner, 7 T.C. 507, aff’d, 161
F.2d 842, C.A. 5 * * *. The purpose of the use survey
was to benefit the land in a permanent way so that the
owners could derive income from it on the basis of its
best use. We agree with the Tax Court that this was
properly a capital expenditure.
We are of the opinion that the same reasoning is
applicable to the expenditure for attorney’s fee.
Counsel for the * * * [taxpayer] concedes that if the
effort had been successful the expenditure would not
have been a deductible item. We think there can be no
distinction. The purpose of the expenditure was to
create a permanent benefit. The fact that it created
neither a permanent nor exhaustible benefit does not
- 44 -
change its character. * * * [Godfrey v. Commissioner,
335 F.2d at 85.22]
In Stevens v. Commissioner, 46 T.C. 492 (1966), the taxpayer
and another individual (Woody) entered into various joint
ventures each of which involved acquiring a race horse and
sharing that horse’s winnings or any proceeds from its sale.
Woody paid the purchase price of each horse, and the taxpayer
paid each horse’s maintenance and training expenses. We held
that one-half of the otherwise deductible maintenance expenses
were capital expenditures because they represented the taxpayer’s
cost of acquiring a one-half interest in the horses. We stated:
We agree with respondent to the extent that at
least some portion of these expenses, which would
otherwise be deductible as ordinary and necessary
business expenses, must be capitalized as petitioner’s
acquisition costs in the particular factual
circumstances here present. It is obvious that
petitioner had some acquisition cost for his interests;
these interests were not acquired for nothing.
Although Woody paid the entire purchase price for each
horse, he did not give petitioner a one-half interest
in each without consideration. * * *
* * * * * * *
In effect, Woody assumed petitioner’s half of the
purchase price and as consideration for this,
petitioner assumed Woody’s half of the expense burden.
* * * [Id. at 497.]
22
The court held that our findings as to the remaining
expenses were not clearly erroneous. See Godfrey v.
Commissioner, 335 F.2d 82, 86 (6th Cir. 1964), affg. T.C. Memo.
1963-1.
- 45 -
In affirming our decision, the Court of Appeals for the Sixth
Circuit held that the mere fact that the expenses were recurring
and otherwise deductible business expenses was not enough to make
the expenses deductible under section 162. The court noted that
“Section 162 was primarily intended to cover recurring
expenditures where the benefit derived from the payment is
realized and exhausted within the taxable year” and that the
benefit from the expenses would not be exhausted within the year.
Stevens v. Commissioner, 388 F.2d at 300; accord Perlmutter v.
Commissioner, 44 T.C. at 403-405 (taxpayer required to capitalize
portion of salaries, utilities, insurance, depreciation, legal
and audit expenses, office expenses, and vehicle and truck
expenses allocable to the construction of shopping center
buildings).
We also are mindful of Wells Fargo & Co. & Subs. v.
Commissioner, 224 F.3d 874 (8th Cir. 2000), affg. in part and
revg. in part Norwest Corp. v. Commissioner, 112 T.C. 89 (1999).
There, a bank (Davenport) entered into a transaction with another
bank (Norwest) that resulted in Norwest’s owning all the stock of
an entity of which Davenport was a part. Following the
taxpayer’s concession that section 263(a) required that Davenport
capitalize the costs which were directly related to the
transaction, we were left to decide whether section 162(a)
allowed Davenport to deduct investigatory costs of $87,570, due
- 46 -
diligence costs of $23,700, and officers’ salaries of $150,000
which respondent had determined were attributable to the
transaction. Most ($83,450) of the investigatory costs related
to services rendered by a law firm, before Davenport agreed to
participate in the transaction. The remaining ($4,120)
investigatory costs related to services performed by the law firm
in investigating whether, after the transaction, Norwest’s
director and officer liability coverage would protect Davenport’s
directors and officers for acts and omissions occurring before
the transaction. The due diligence costs related to services
performed by the law firm in connection with Norwest’s due
diligence review. The disallowed officers’ salaries were
attributable to services performed in the transaction.
We held that section 162(a) did not let Davenport deduct any
of the disputed costs. Our holding followed our conclusion that
all of the costs bore a sufficient nexus to a transaction
producing a significant long-term benefit to fall within the
rules of capitalization as set forth primarily in INDOPCO, Inc.
v. Commissioner, 503 U.S. 79 (1992). Upon appeal, the
Commissioner conceded that section 162(a) allowed Davenport to
deduct the investigatory costs of $83,450 because they were
attributable to the investigatory stage of the transaction. That
concession followed the Commissioner’s release of Rev. Rul. 99-
23, 1999-1 C.B. 998, 1000, which holds that
- 47 -
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 § 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 §
263. The nature of the cost must be analyzed based on
all the facts and circumstances of the transaction to
determine whether it is an investigatory cost incurred
to facilitate the whether and which decisions, or an
acquisition cost incurred to facilitate consummation of
an acquisition.[23]
As to the remaining fees of $27,820 ($4,120 + $23,700), all
of which were incurred after Davenport had made its final
decision as to the acquisition, the Court of Appeals for the
Eighth Circuit agreed with us that those amounts were capital
expenditures. The Court of Appeals disagreed with us, however,
as to the officers’ salaries and held that those costs were
currently deductible. The court reasoned:
23
The Commissioner’s position as to the deductibility of
investigatory expenditures incurred to acquire specific assets is
set forth in Rev. Rul. 74-104, 1974-1 C.B. 70. There, the costs
were “evaluation” expenditures which the taxpayer incurred in its
business of acquiring residential property to renovate and sell
to the public. Before acquiring the property, the taxpayer
evaluated certain localities to ascertain the feasibility of
selling the property in that locality. The taxpayer incurred a
cost to secure an initial report from an independent agent and
other costs to evaluate the report and the locality involved.
The ruling holds that the costs are capital expenditures because
they were incurred in connection with acquiring the residential
property and provide benefits beyond the current taxable year
through the sale of the renovated property.
- 48 -
the distinction between the case at hand, and the
INDOPCO case lies in the relationship between the
expense at issue and the long term benefit. In
INDOPCO, the expenses in question were directly related
to the transaction which produced the long term
benefit. Accordingly, the expenses had to be
capitalized. See INDOPCO, 503 U.S. 79, 112 S. Ct. 1039,
117 L. Ed. 2d 226. We conclude that if the expense is
directly related to the capital transaction (and
therefor, the long term benefit), then it should be
capitalized. * * * See e.g. INDOPCO, 503 U.S. 79, 112
S. Ct. 1039, 117 L. Ed. 2d 226 (1992). In this case,
there is only an indirect relation between the salaries
(which originate from the employment relationship) and
the acquisition (which provides the long term benefit *
* *).
Similarly, the instant case is distinguishable
from Acer Realty Co. v. Commissioner22, wherein this
Court held that the salaries paid to two officers for
"unusual, nonrecurrent services" had to be capitalized.
132 F.2d 512, 513 (8th Cir. 1942). The taxpayer was a
corporation whose only business was leasing real estate
to a related corporation. Its officers were paid no
salaries prior to their undertaking a large building
program, at which point the two officers began acting
as general contractors and "performed all the services
necessary to the management of the construction of the
buildings." Acer Realty, 132 F.2d at 514. Because the
salaries were clearly and directly related to the
capital project, this Court determined that most of the
salaries paid were extraordinary or incremental
expenses which had to be capitalized. Acer Realty Co.
v. Commissioner, 132 F.2d 512 (8th Cir. 1942).
22
Acer Realty is the only case in our
Circuit, that we are aware of, which denies
the taxpayer a deduction for salary expenses.
The instant case is easily distinguishable from
Acer Realty because Davenport’s officers had always
received salaries, even before the acquisition was a
possibility. There was no increase in their salaries
attributable to the acquisition, and they would have
been paid the salaries whether or not the acquisition
took place. Therefore, we determine that the salary
expenses in this case originated from the employment
relationship between the taxpayer and its officers.
- 49 -
Indirectly, the payment of these salaries provided
Davenport with a long term benefit. [Wells Fargo & Co.
& Subs. v. Commissioner, 224 F.3d at 887-888.]
Judge Bright wrote a concurring opinion in Wells Fargo & Co.
& Subs. to highlight the fact that the record did not allow for a
determination as to the portion of the salaries which were
directly related to the transaction. Judge Bright wrote:
I write separately to emphasize that the record in this
case is inadequate to show that the portion of the
salaries in question, $150,000, was directly or
substantially related to the acquisition. Moreover,
the tax court’s findings of fact on this issue does not
address the direct or indirect relationship of the work
of the officers to the acquisition. That finding
recited:
During 1991, DBTC [Davenport] had 9
executives and 73 other officers
(collectively, the officers). John Figge,
James Figge, Thomas Figge, and Richard Horst
worked on various aspects of the transaction,
as did other officers. None of the offices
were hired specifically to render services on
the transaction; all were hired to conduct
DBTC’s day-to-day banking business. DBTC’s
participation in the transaction had no
effect on the salaries paid to its officers.
Of the salaries paid to the officers in 1991,
$150,000 was attributable to services
performed in the transaction. DBTC deducted
the salaries, including the $150,000, on its
1991 Federal income tax return. Respondent
disallowed the $150,000 deduction; i.e., the
portion attributable to the transaction. * *
*
This finding does not address whether some
officers at any particular period of time devoted
substantial work to the acquisition or whether the
officers during the period of time in question only
incidentally worked on the acquisition while doing
regular banking duties.
- 50 -
In order to determine whether an allocation of
officers’ salaries to an acquisition-transaction such
as made here qualifies as a deduction from income or
should be capitalized, the taxing authorities should
require the taxpayer to show officers’ time devoted to
the acquisition as compared to time spent on regular
work during a particular and relevant time period.
The finding made by the tax court here does not justify
capitalization of the officers’ salaries. [Id. at 889-
890 (Bright, J., concurring).]
We do not believe that our view as to the salaries and wages
at hand is inconsistent with the Court of Appeals for the Eighth
Circuit’s view as to the salaries at issue in Wells Fargo & Co. &
Subs., supra. The cases are factually distinguishable. There,
some of Davenport’s 82 officers spent a portion of their time
performing services on a capital transaction; apparently, it was
a relatively small portion, since the total salary attributable
to work performed on the transaction by all of the officers was
$150,000. The services which they performed as to the capital
transaction were extraordinary in the daily course of their
employment, and the capital transaction was extraordinary to
their employer’s business. They would have been paid the same
salaries regardless of whether the transaction was consummated.
Here, by contrast, each of the disputed employees spent a
significant portion of his or her time (in fact, in 8 of the 15
cases, all of his or her time) working on capital asset
acquisitions which occurred in the ordinary course of ACC’s
- 51 -
business.24 The employees were paid specifically to perform work
as to the acquisitions, and the amount of the compensation that
ACC paid to the employees hinged directly on the number of
installment contracts that it acquired, e.g., at least some of
the employees were entitled to receive a bonus in profitable
years.25 Thus, whereas the officers in Wells Fargo & Co. &
Subs., supra, performed the typical services of bank employees,
services which could include work on a capital transaction as
part of the bank’s business in general, ACC’s employees were
hired and paid to perform services that necessarily would include
work on capital asset acquisitions.
The record here indicates specifically the portion of ACC’s
total compensation that was directly related to ACC’s acquisition
of the installment contracts, and, in accordance with Supreme
Court precedent (as well as jurisprudence from the Second
Circuit, Fifth Circuit, and this Court), we consider as capital
expenditures that “proportion of the wages and salaries of
employees who spend some of their working hours laboring on the
acquisition”. Briarcliff Candy Corp. v. Commissioner, 475 F.2d
at 781; see Commissioner v. Idaho Power Co., 418 U.S. at 13; see
24
Of the total compensation paid to the disputed employees
in 1993 and 1994, 76 percent ($213,028/$280,222) and 65.4 percent
($273,212/$418,065), respectively, was attributable to the
acquisition of installment contracts.
25
We also bear in mind the statement in ACC’s PPM discussed
supra note 13.
- 52 -
also Cagle v. Commissioner, 539 F.2d at 416; Perlmutter v.
Commissioner, 44 T.C. at 404.
Petitioners are mistaken when they assert that established
jurisprudence provides that section 162(a) always allows a
taxpayer to deduct the everyday, recurring costs of its business.
The primary cases upon which petitioners rely, i.e., the credit
card cases, did not merely rest on facts that the costs at issue
there were everyday and recurring in nature. All of those cases
involved costs which were incurred in the businesses’ startup
phase and which did not produce any separate or distinct asset.
In Colorado Springs Natl. Bank v. United States, 505 F.2d at
1192, for example, the Court of Appeals for the Tenth Circuit
noted that "The start-up expenditures here challenged did not
create a property interest. They produced nothing corporeal or
salable." Similarly, in First Natl. Bank of South Carolina v.
United States, 558 F.2d at 723, the Court of Appeals for the
Fourth Circuit noted that “Membership in ASBA is not a separate
and distinct additional asset created or enhanced by the payments
in question.” Likewise, in Iowa-Des Moines Natl. Bank v.
Commissioner, 68 T.C. at 879, we noted that the costs "did not
create or enhance a separate and distinct asset or property
interest."26 Cf. Central Tex. Sav. & Loan Association v. United
26
In First Security Bank of Idaho, N.A. v. Commissioner,
592 F.2d 1050 (9th Cir. 1979), affg. 63 T.C. 644 (1975), the
(continued...)
- 53 -
States, 731 F.2d at 1184-1185 (court distinguished the credit
card cases by virtue of the fact that the expense of the taxpayer
before it created a separate and distinct asset). Contrary to
petitioners’ assertion (and, as discussed infra, the view of the
Court of Appeals for the Third Circuit), we do not read any of
the credit card cases to hold that everyday, recurring expenses
are ipso facto deductible under section 162(a). In fact, as this
Court observed in Iowa-Des Moines Natl. Bank v. Commissioner, 68
T.C. at 879, costs are entitled to deduction when they are
“related to the active conduct of an existing business and * * *
[do] not create or enhance a separate and distinct asset or
property interest.” Nor do we understand the Supreme Court in
INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), to have
espoused the sweeping pronouncement proffered by petitioners as
to this issue.27
Petitioners also rely on PNC Bancorp, Inc., v. Commissioner,
212 F.3d 822 (3d Cir. 2000), revg. 110 T.C. 349 (1998). When
this case was tried, the Court of Appeals for the Third Circuit
had not yet released its opinion in that case, and petitioners
26
(...continued)
Court of Appeals for the Ninth Circuit adopted as the law of that
circuit the decision of the Tenth Circuit in Colorado Springs
Natl. Bank v. United States, 505 F.2d 1185 (10th Cir. 1974).
27
Nor do we read Bankers Dairy Credit Corp. v.
Commissioner, 26 B.T.A. 886 (1932), to hold that salaries and
benefits are ipso facto deductible when they are recurring costs.
- 54 -
took the view that our opinion there was inapplicable to this
case because, they claimed, the cases were factually
distinguishable. We held in PNC Bancorp, Inc., v. Commissioner,
supra, that loan origination costs were capital expenditures.
The Court of Appeals for the Third Circuit disagreed, holding
that the costs were deductible expenses. Petitioners now assert
that PNC Bancorp, Inc. is relevant to our inquiry.
We do not believe that PNC Bancorp, Inc. v. Commissioner,
supra, is so factually distinguishable from the instant case to
support contrary results. Although the cases are obviously
distinguishable by virtue of the fact that PNC (as defined below)
was a loan originator and ACC is a loan acquirer, we do not
believe that this bare distinction is meaningful enough to
support contrary results in the cases, especially given the
Supreme Court’s statements in Commissioner v. Idaho Power Co.,
supra at 12-13, to the effect that the creation of an asset is
subject to the same set of capitalization rules as the
acquisition of an asset. Given the additional fact that the
Court of Appeals for the Third Circuit disagreed with our view as
to the rules of capitalization applicable to the loan origination
costs in PNC Bancorp, Inc., we believe it appropriate to
reconsider our opinion there in light of the contrary view set
forth by the Court of Appeals for the Third Circuit in reversing
our decision. We have carefully done so, giving due regard to
- 55 -
the contrary view. For the reasons set forth below, we continue
to adhere to our view on the rules of capitalization as expressed
in PNC Bancorp, Inc., respectfully disagreeing with the contrary
view expressed by the Court of Appeals for the Third Circuit.
PNC was the successor in interest to two banks
(collectively, PNC) which had deducted expenditures paid to
market, research, and originate loans to PNC’s customers. These
expenditures included: (1) Amounts paid to record security
interests, (2) amounts paid to third parties for property
reports, credit reports, and appraisals, and (3) an allocable
portion of salaries and benefits paid to employees for evaluating
a borrower’s financial condition, evaluating guaranties,
collateral, and other security arrangements, negotiating loan
terms, preparing and processing loan documents, and closing loan
transactions. PNC capitalized and amortized these costs for
financial accounting purposes but deducted them for Federal
income tax purposes. PNC argued that the costs were deductible
for tax purposes because they (1) were recurring expenses in the
banking business, (2) were integral to PNC’s daily operation, and
(3) provided PNC with only short-term benefits.
We found that PNC incurred the costs to create separate and
distinct assets, i.e., the loans, and that the costs produced for
PNC long-term benefits in the form of the interest to be received
in later years. The Court of Appeals for the Third Circuit
- 56 -
disagreed with both of these findings. The Court of Appeals
focused primarily on the everyday meaning of the word “ordinary”
and, without any reference to Helvering v. Winmill, 305 U.S. 79(1938), and with only a passing reference to Commissioner v.
Idaho Power Co., 418 U.S. 1 (1974), which the Court of Appeals
cited for the proposition that capitalization prevents the
distortion of income in the case of depreciable property,
concluded that the loan origination costs were ordinary business
expenses for purposes of section 162(a) because the costs were
normal and routine to the business of a bank. See PNC Bancorp,
Inc., v. Commissioner, 212 F.3d at 828-829, 834-835. The court
saw no meaningful distinction between PNC’s loan origination
costs and the costs incurred as "ordinary expenses" by banks in
general. The court stated that PNC’s deduction of the loan
origination costs would not distort its income because it
incurred those costs regularly. See id. at 834-835.
The Court of Appeals for the Third Circuit also stated that
PNC’s costs did not create any separate and distinct asset within
the meaning of Commissioner v. Lincoln Sav. & Loan Association,
403 U.S. 345 (1971). Unlike the assets in Lincoln Sav. & Loan
Association, which were not used by the taxpayer in its everyday
business, PNC used its loans as part of its everyday business.
The Court of Appeals distinguished the respective assets in the
cases by this fact. The Court of Appeals also distinguished
- 57 -
PNC’s costs from the payments in Lincoln Sav. & Loan Association
by noting that the payments in Lincoln Sav. & Loan Association
had formed the corpus of the asset, whereas PNC’s costs were not
included in the principal of the loans. The Court of Appeals
analogized PNC’s costs to the expenditures at issue in the credit
card cases, concluding that the costs were deductible under that
line of cases. PNC Bancorp, Inc., v. Commissioner, 212 F.3d at
830-831.
We do not believe that the “normal and routine” nature of
the expenses in question dictates their deductibility. As
discussed above, payments 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.
See, e.g., Woodward v. Commissioner, 397 U.S. at 575, 577-578;
Helvering v. Winmill, supra. Nor do we believe that any of the
long line of cases addressing this acquisition-related
capitalization requirement supports a conclusion that a payment
is a capital expenditure only if it creates, enhances, or becomes
part of an asset that is unrelated to the taxpayer’s daily
business. An expense that recurs in a taxpayer’s business is a
capital expenditure when it is incurred in direct connection with
the acquisition, creation, or enhancement of a separate and
distinct asset, or provides the taxpayer with a significant
- 58 -
future benefit. See, e.g., INDOPCO, Inc. v. Commissioner, 503
U.S. 79 (1992); Commissioner v. Idaho Power Co., supra at 13;
Woodward v. Commissioner, supra; Helvering v. Winmill, supra; see
also Ellis Banking Corp. v. Commissioner, T.C. Memo. 1981-123
(citing Woodward v. Commissioner, supra) (fact that a taxpayer
"incurs expenditures * * * on a recurring basis does not ensure
their characterization as ‘ordinary’ if they are incurred in the
acquisition of a capital asset"). The mere fact that an expense
may have been deductible in the credit card cases (or any other
case for that matter) does not necessarily mean that the same
type of expense is ipso facto deductible in another setting such
as the one found in PNC Bancorp, Inc., v. Commissioner, 212 F.3d
822 (3d Cir. 2000). See, e.g., Commissioner v. Idaho Power Co.,
supra at 13.
We also do not believe that the fact that PNC’s loan
origination costs were recurring in nature means that PNC’s
current deduction of them would allow for an appropriate matching
of income and expense. See PNC Bancorp, Inc., v. Commissioner,
supra at 834-835. The Supreme Court stated explicitly in
INDOPCO, Inc. v. Commissioner, supra at 84, that our Federal
income tax system endeavors to match expenses with the related
revenue in the taxable period for which the income is recognized.
The Court stated in Commissioner v. Idaho Power Co., supra at 16,
that “The purpose of section 263 is to reflect the basic
- 59 -
principle that a capital expenditure may not be deducted from
current income. It serves to prevent a taxpayer from utilizing
currently a deduction properly attributable, through
amortization, to later tax years when the capital asset becomes
income producing.” The thrust of these statements, in our minds,
is that an expenditure must be deducted in accordance with its
own individual identity, regardless of the possible recurrence in
the taxpayer’s business of that type of expense. A taxpayer’s
income will be distorted if the taxpayer currently deducts a
recurring expense that should be capitalized and the amount of
that expense fluctuates meaningfully between taxable years. For
example, when the amount of such an expenditure increases
significantly from one year to the next, the deduction of the
expenditure may result in the taxpayer’s income being understated
in the first year and overstated in the second, and the profits
of the business may appear to be sinking, when in fact it is
enjoying great success, or rising, when in fact it may be
seriously diminished. See Electric & Neon, Inc. v. Commissioner,
56 T.C. 1324, 1332-1333 (1971), affd. without published opinion
496 F.2d 876 (5th Cir. 1974). Such an inaccurate reporting of
this fluctuation thwarts, rather than fosters, “a major objective
of efficient tax policy.” Cabintaxi Corp. v. Commissioner, 63
F.3d 614, 619 (7th Cir. 1995), affg. in part, revg. in part, and
remanding on another issue T.C. Memo. 1994-316.
- 60 -
Nor do we read anything in section 263 or the related
regulations that hinges section 263(a)’s applicability to an
expenditure on a finding that an asset acquired or created by the
expenditure was used outside of the taxpayer’s daily business.
In fact, if such was the case, the costs incurred to acquire
manufacturing equipment would arguably be deductible because that
equipment is indispensable to the daily operation of the
manufacturer’s business. Moreover, in the case of an appraisal,
the costs of which are clearly capital expenditures when incurred
in connection with the purchase of property, the appraisal
neither adds value to the appraised property nor has a long-term
life. We also note our disagreement with the concept that a cost
is a capital expenditure only if it becomes part of an asset. To
be sure, the depreciation of the equipment used to construct the
facilities in Commissioner v. Idaho Power Co., 418 U.S. 1 (1974),
did not become an actual part of those facilities.
Nor do we find persuasive PNC’s argument to the Court of
Appeals for the Third Circuit that our application of the
“separate and distinct asset test” of Commissioner v. Lincoln
Sav. & Loan Association, 403 U.S. at 354, was too expansive in
that it would require capitalization of costs incurred “in
connection with” or “with respect to” the acquisition of an
asset. PNC Bancorp, Inc. v. Commissioner, 212 F.3d at 830. Such
an argument conflicts directly not only with the Supreme Court’s
- 61 -
reasoning in Commissioner v. Idaho Power Co., supra at 12-14, and
Woodward v. Commissioner, 397 U.S. at 575-576, but with the
reasoning of various Courts of Appeals that have required
capitalization of amounts incurred “in connection with” the
acquisition of an asset. See, e.g., Johnsen v. Commissioner, 794
F.2d at 1162; Central Tex. Sav. & Loan Association v. United
States, 731 F.2d at 1184; Ellis Banking Corp. v. Commissioner,
688 F.2d at 1379.
Nor do we believe that the fact an expenditure is somehow
connected to the “needs of current income production” is enough
to qualify that expenditure as a current deduction. PNC Bancorp,
Inc. v. Commissioner, 212 F.3d at 829, 833-834 (citing National
Starch & Chem. Corp. v. Commissioner, 918 F.2d 426 (3d Cir.
1990), affd. sub nom. INDOPCO, Inc. v. Commissioner, 503 U.S. 79(1992). In our minds, an expenditure that produces both a
current and long-term benefit is neither 100 percent deductible
nor 100 percent capitalizable. Instead, regardless of whether
the expenditure’s primary or predominant purpose is to benefit
significantly the business’ current operation, on the one hand,
or its long-term operation, on the other hand, the expenditure is
a capital expenditure to the extent that it produces a
significant long-term benefit and deductible to the remaining
extent. See Woodward v. Commissioner, 397 U.S. at 577-579;
Commissioner v. Idaho Power Co., supra; Great N. Ry. v.
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Commissioner, 40 F.2d 372 (8th Cir. 1930), affg. on other grounds
8 B.T.A. 225 (1927); Southern Natural Gas Co. v. United States,
188 Ct. Cl. 302, 412 F.2d 1222, 1264-69 (1969).28
Having rejected petitioners’ first argument as to the
salaries and benefits, we now turn to petitioners’ second
argument that the salaries and benefits are outside the reach of
section 263 because, they contend, those items are not described
in that section. Petitioners make three assertions in support of
this argument. First, they assert that section 263(a) applies
only when an expenditure creates or adds value to a separate and
distinct capital asset29 and that ACC’s payment of the salaries
and benefits neither created nor added value to a capital asset.
According to petitioners, an expenditure is subject to section
263(a) only if it (1) is incurred to increase the value of
28
In Commissioner v. Idaho Power Co., 418 U.S. 1 (1974),
the Supreme Court held that the taxpayer must capitalize the
portion of depreciation on transportation equipment allocable to
part-time use in constructing improvements and other capital
facilities for the taxpayer. In Great N. Ry. v. Commissioner, 40
F.2d 372 (8th Cir. 1930), affg. on other grounds 8 B.T.A. 225(1927), the Court of Appeals for the Eighth Circuit held that a
railway had to capitalize the cost of operating its regular
trains to the extent it was attributable to the transportation of
the railway’s workmen and materials to construction sites. In
Southern Natural Gas Co. v. United States, 188 Ct. Cl. 302, 412
F.2d 1222, 1264-69 (1969), the Court of Claims held that
depreciation on automotive equipment used primarily for operating
and maintaining a pipeline system, but occasionally used in
construction operations, had to be capitalized to the extent it
was attributable to the construction.
29
The amici for FNMA also advance this argument.
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property and (2) concerns the permanent improvement or betterment
of that property. Petitioners also contend that the installment
contracts are ordinary (and not capital) assets in the hands of
ACC. Second, they assert that the salaries and benefits are
expansion costs as to an existing business which, they contend,
are deductible under a line of cases including PNC Bancorp, Inc.,
v. Commissioner, 212 F.3d 822 (3d Cir. 2000); Briarcliff Candy
Corp. v. Commissioner, 475 F.2d at 781; Bankers Dairy Credit
Corp. v. Commissioner, 26 B.T.A. 886 (1932); and the credit card
cases. Petitioners also point to the following excerpt from the
legislative history under section 195:
In the case of an existing business, eligible startup
expenditures do not include deductible ordinary and
necessary business expenses paid or incurred in
connection with an expansion of the business. As under
present law, these expenses will continue to be
currently deductible. [H. Rept. 96-1278, at 11 (1980),
1980-2 C.B. 709, 712.]
Third, they assert that the salaries and benefits did not
generate a future benefit to ACC. They contend that the salaries
and benefits are not directly related to the acquisition of any
specific installment contract. They contend that the salaries
and benefits were predecisional expenses which generated
predominately short-term benefit. They contend that the salaries
and benefits did not themselves generate future income but only
allowed ACC to decide whether it would acquire an installment
contract.
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We reject petitioners’ second argument. As to their first
assertion, we disagree with them that acquisition costs are
capitalizable under section 263(a) only if they create or add
value to a capital asset.30 In Dustin v. Commissioner, 467 F.2d
47, 49-50 (9th Cir. 1972), affg. 53 T.C. 491 (1969), the taxpayer
was a shareholder of an S corporation (Capitol) that agreed to
acquire the stock of a company that owned and operated radio
station KGMS. In 1961, Capitol incurred $12,460 of legal,
engineering, and accounting fees in connection with the transfer
to Capitol of control of station KGMS’ radio-broadcasting
license. The taxpayer deducted his proportionate share of these
expenses, and the Commissioner disallowed the deduction asserting
that the expenses were capital expenditures. The taxpayer argued
in this Court that he could deduct $10,960 of the expenses
because they were attributable to a hearing held by the Federal
Communications Commission on this matter and which did not add
any value to the acquired stock. We disagreed with the taxpayer
that any of these amounts were currently deductible. On appeal,
so did the Court of Appeals for the Ninth Circuit. According to
30
As mentioned above, we understand the term “capital
asset” to be used in its accounting sense and not in accordance
with its meaning under sec. 1221. We add to our prior discussion
that the term as applied to capitalization issues does not arise
from the Code but is a byproduct of judicial interpretation. On
the basis of our understanding of the meaning of the term, we
reject petitioners’ contention that costs related to an
“ordinary” asset under sec. 1221 can never be a capital
expenditure.
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that court: “The expenditures connected with the acquisition of
the broadcast license were no less capital in character because
they did not themselves contribute additional and specific
financial value to the license being sought. The important fact
is that the expenditures were made for the purpose of acquiring a
capital asset.” Dustin v. Commissioner, 467 F.2d at 50; accord
King Amusement Co. v. Commissioner, 44 F.2d 709 (6th Cir. 1930)
(fees paid to guarantors of rent under lease were capital
expenditures notwithstanding the fact that the fees added no
value to the lease or to the property leased thereunder), affg.
15 B.T.A. 566 (1929).
In making this assertion, petitioners focus solely on the
latter part of the text in section 263(a)(1); to wit, the phrase
“made to increase the value of any property”. We do not do
likewise. A proper reading of that section in full reveals that
the phrase relates to “permanent improvements or betterments” and
not to “new buildings”.31 Cf. Dustin v. Commissioner, 53 T.C. at
505. Here, we are dealing with salaries and benefits paid to
acquire capital assets (i.e., the installment contracts) and not
with expenditures made to improve or better property already
owned. We also bear in mind that the test for capitalization
31
Under the Treasury Department’s longstanding
interpretation of sec. 263(a) as set forth in sec. 1.263(a)-2(a),
Income Tax Regs., the cost of acquiring a long-term asset is an
example of a capital expenditure.
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does not hinge on the amount of value added to property but looks
at the nature of the expense itself. See Dominion Resources Inc.
v. United States, 219 F.3d 359, 371 (4th Cir. 2000). When the
nature of an expenditure bears a direct relation to the
acquisition of a capital asset, such as is the case here, the
expenditure must be capitalized.
The amicus for FNMA expands on petitioners’ first assertion
by reference to section 1.263(a)-1(b), Income Tax Regs. That
section provides: “In general, the amounts referred to in
paragraph (a) of this section include amounts paid or incurred
(1) to add to the value, or substantially prolong the useful
life, of property owned by the taxpayer * * * or (2) to adapt
property to a new or different use.” The amicus also references
the following passage from this Court’s Memorandum Opinion in
Mayer v. Commissioner, T.C. Memo. 1994-209: “It appears from the
record that these transaction fees consisted in large part of
general overhead rather than costs specifically allocable to
individual purchases and sales. These expenses are not
capitalizable under section 263.”32 The amicus for FNMA
concludes that the salaries and benefits are indirect costs
outside the realm of section 263(a).
32
This passage is likewise referenced by the amicus for
FHLMC.
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We disagree with the additional arguments set forth by the
amicus for FNMA as to petitioners’ first assertion. The rule of
section 1.263(a)-1(b), Income Tax Regs., upon which the amicus
relies is merely a general rule that is not intended to contain
the sole parameters of capitalization under section 263(a). Nor
do the amici rely correctly on our Memorandum Opinion in Mayer v.
Commissioner, supra. There, the taxpayer was an individual who
argued that he could capitalize his investment-related expenses.
We held he could not because he failed to meet his burden of
proof.
Nor are we persuaded by petitioners’ second assertion that a
body of law treats the salaries and benefits as deductible
expansion costs. As to the body of cases relied upon by
petitioners, we have discussed at length our disagreement with
their reading of these cases and adhere to our belief that none
of the cases supports the result that they desire. Nor does the
record at hand persuade us that any of the salaries and benefits
were incurred in expansion of ACC’s business.33 Even if they
could be construed to be expansion costs, which as just mentioned
we do not find that they are, petitioners would still not
prevail. Simply because a cost may qualify as an expansion cost
33
In fact, petitioners’ assertion that the costs were
related to an expansion of ACC’s business is inconsistent with
their primary argument that the expenditures were incurred
routinely in ACC’s everyday business.
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does not make it a deductible expense. See, e.g., FMR Corp. &
Subs. v. Commissioner, 110 T.C. 402, 429 (1998) (section 195 does
not require “that every expenditure incurred in any business
expansion is to be currently deductible”.34 Such is especially
true here where the salaries and benefits were incurred in
connection with the acquisition of a capital asset.
We also are unpersuaded by petitioners’ third assertion that
the salaries and benefits did not generate a significant future
benefit to ACC. These costs contributed directly to ACC’s
receipt in later years of interest and excess principal income.
This income significantly benefitted ACC in that it was the bread
and butter of its operation. Because ACC’s payment to its
employees of the disputed salaries and benefits provided ACC with
such a significant long-term benefit, they are capital
expenditures. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79(1992); see also Commissioner v. Idaho Power Co., 418 U.S. 1(1974); Woodward v. Commissioner, 397 U.S. 572 (1970); United
States v. Hilton Hotels Corp., 397 U.S. 580 (1970); cf. Colonial
Am. Life Ins. Co. v. Commissioner, 491 U.S. 244, 251 n.5 (1989)
(“the important point is * * * whether the taxpayer is investing
in an asset or economic interest with an income-producing life
that extends substantially beyond the taxable year”).
34
Nor is a cost deductible merely because it preceded the
final decision as to the acquisition of a specific asset.
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The amicus for FNMA concludes as to the salaries and
benefits that capitalizing these costs will administratively
burden ACC. We disagree. It was ACC that identified these costs
for its auditors in order to capitalize the costs for financial
accounting purposes. Contrary to the amicus’ assertion, under
the facts of this case, it is not “impossible” to identify the
portion of the salaries and benefits which are attributable to
each installment contract.35
We now turn to the PPM-related expenditures. Respondent
determined and argues that ACC must capitalize these
expenditures. Respondent points to the fact that the repayment
of the Notes extended beyond the year of their issuance.
Petitioners maintain that the PPM expenditures are currently
deductible. Petitioners repeat many of the same arguments which
we have rejected as to the salaries and benefits, stressing their
assertion that ACC issued the Notes in order to obtain funds to
acquire installment contracts in the ordinary course of its
business. Petitioners also add, with citations to Bonded
Mortgage Co. v. Commissioner, 70 F.2d 341 (4th Cir. 1934), revg.
and remanding 27 B.T.A. 965 (1933), and Franklin Title & Trust
Co. v. Commissioner, 32 B.T.A. 266 (1935), that financing
35
The amicus also raises an issue as to whether ACC’s
income was reflected clearly, within the meaning of sec. 446(b),
by its deduction of the salaries and benefits. This issue was
not raised by the parties and is not before the Court. We
decline the amicus’ invitation to address it.
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companies such as ACC may currently expense commissions connected
to the issuance of long-term debt.
We agree with respondent that the PPM expenditures are
capital expenditures.36 As to each of petitioners’ arguments
which we rejected above, we also reject them here as applied to
the PPM expenditures for the reasons stated above. As to
petitioners’ additional argument, we reject that argument as
well. The fact that ACC incurred the PPM expenditures in
borrowing funds means that the expenditures are capital
expenditures and must be amortized over the life of the debt.
See, e.g., Austin Co. v. Commissioner, 71 T.C. 955, 964-965
(1979); Enoch v. Commissioner, 57 T.C. 781, 794 (1972); Longview
Hilton Hotel Co. v. Commissioner, 9 T.C. 180, 182-183 (1947);
Lovejoy v. Commissioner, 18 B.T.A. 1179, 1181-1183 (1930); see
also S. & L. Bldg. Corp. v. Commissioner, 19 B.T.A. 788, 795-796
(1930), revd. on other grounds 60 F.2d 719 (2d Cir. 1932), revd.
sub nom. Burnet v. S. & L. Bldg. Corp., 288 U.S. 406 (1933);
compare Anover Realty Corp. v. Commissioner, 33 T.C. 671, 675
(1960), wherein we stated:
It is not the purpose for which the loan is made
that is important. It is the purpose of the
expenditure for loan discounts and expenses. That
36
In contrast with respondent, however, we allow ACC to
deduct for 1994, under sec. 165(a), the portion of those
expenditures that was attributable to the offering that was
abandoned in that year. See Ellis Banking Corp. v. Commissioner,
688 F.2d at 1382.
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purpose is to obtain financing or the use of money over
a fixed period extending beyond the year of borrowing.
When we analyze the reason behind the rule of
amortizing such debt expenses, the distinction between
this case and S. & L. Building Corporation and Longview
Hilton Hotel Co. vanishes. Here, as in the cited
cases, the mortgage discounts and expenses represent
the cost of money borrowed for a period extending
beyond the year of borrowing. It matters not that the
proceeds of the loans be used to build an income--
producing warehouse as in Julia Stow Lovejoy, or "to
purchase additional properties" as in S. & L. Building
Corporation or to buy the mortgaged premises, as in the
instant case. In all such cases the expenditure
represents an expenditure for the cost of the use of
money and not a capital expenditure for the cost of any
asset obtained by the use of the proceeds of the money
borrowed.
As to the two cases upon which petitioners rely to support their
additional argument, those cases are factually distinguishable
from the case at hand and require no further discussion.
We have considered each of the arguments made by the parties
and by the amici. We have rejected all arguments not discussed
herein as meritless.
Decisions will be entered
under Rule 155.
Reviewed by the Court.
WELLS, CHABOT, COHEN, GERBER, COLVIN, VASQUEZ, and THORNTON,
JJ., agree with this majority opinion.
CHIECHI, J., did not participate in the consideration of
this opinion.
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SWIFT, J., concurring: Although I would go further than the
majority and allow all of the salaries and overhead included in
the so-called installment contract expenditures to be currently
deductible, I do not dissent because I largely agree with the
result reached by the majority and with the movement reflected
therein away from the approach that would capitalize otherwise
routine business expenses.
In PNC Bancorp, Inc. v. Commissioner, 110 T.C. 349, 370
(1998), revd. 212 F.3d 822 (3d Cir. 2000), a case involving the
treatment of salary expenses very similar to those involved
herein (namely, salary expenses of credit institutions whose
officers and employees, among other things, investigate the
creditworthiness of potential borrowers), we concluded that a
portion of the salary expenses should be “assimilated” into the
capital costs of the loans that were approved.
The Court of Appeals for the Third Circuit disagreed and
held that the salaries and other expenses reflected “recurring,
routine day-to-day business” activities that did not produce
significant future benefits and therefore that the expenses were
currently deductible. PNC Bancorp, Inc. v. Commissioner, 212
F.3d at 834. The Court of Appeals resolved not to expand the
type of expenses that must be capitalized “so as to drastically
limit what might be considered as 'ordinary and necessary'
expenses.” Id. at 830.
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I believe the facts noted below reflect the noncapital,
ordinary and necessary nature of all of the salary and overhead
expenses that are in issue herein and should control resolution
of this fact issue.
(1) The salaries ACC paid were routine, reasonable and
recurring, and the amounts thereof, including increases and
bonuses thereto, were tied to overall net company profits, not to
the acquisition of specific installment loans. As the Supreme
Court explained:
Of course, reasonable wages [salaries] paid
in the carrying on of a trade or business
qualify as a deduction from gross income.
* * * [Commissioner v. Idaho Power Co., 418
U.S. 1, 13 (1974); emphasis added.]
(2) Generally, and for the most part, the specific benefits
initially received by ACC from the services of its employees
investigating proposed installment loans (namely, the receipt of
information needed to review the creditworthiness of potential
debtors on the installment loans) were exhausted or lost by ACC
almost simultaneously with the receipt of the benefits (i.e., for
various reasons the large majority of the proposed installment
loans that were investigated and considered by ACC were abandoned
within a day (majority op. p. 9)). In my opinion, this fact
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reflects strongly on the ordinary, noncapital nature of all of
ACC’s related salary and overhead expenses and rebuts the
appropriateness of some complicated and rather arbitrary
adjustment under which a portion of the expenses would be
capitalized.
As stated by the Court of Appeals for the Sixth Circuit in
Godfrey v. Commissioner, 335 F.2d 82, 85 (6th Cir. 1964), the
appellate venue for these cases:
The test of an ordinary business expense is
whether it is of a recurring nature and its
benefit is generally exhausted within a year.
* * * [Emphasis added.]
Generally, the benefits ACC received were exhausted within a few
hours after a majority of the prospective installment loans were
investigated and considered.
Under section 1.263(a)-2(a), Income Tax Regs., expenses are
to be capitalized where they produce benefits to a taxpayer with
a life substantially beyond a year. Computing the average life
of all of the installment loans investigated and considered by
ACC’s employees (including the loan applications rejected or
withdrawn as well as those approved) produces an average life for
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all of the installment loans investigated and considered of 6.6
months for 1993 and 7.4 months for 1994.1 Because a majority of
the installment loans investigated and considered by ACC were
never purchased and because the average life of all of the
installment loans (factoring in all installment loans
investigated and considered) was not beyond one year, I believe
it would be erroneous to conclude generally that the allegedly
related salaries and overhead provided benefits to ACC with a
life “substantially beyond” one year.
(3) The salaries and overhead were not paid by ACC in
connection with any specific installment loans. Note the Supreme
Court’s words, also from Commissioner v. Idaho Power Co., 418
U.S. at 13, linking expenditures to be capitalized to specific
capital assets:
But when wages [salaries] are paid in connection with
the construction or acquisition of a capital asset,
they must be capitalized and are then entitled to be
1
My computation of the average life of ACC’s installment
loans investigated and considered (including in the “Total” loans
those installment loans rejected or withdrawn) is shown below:
Number of Installment Loans
Rejected or Average Duration Average Duration
Year Withdrawn Accepted Total of Accepted Loans of All Loans*
1993 1,131 693 1,824 17.5 months 6.6 months
1994 1,338 820 2,158 19.5 months 7.4 months
* For 1993 [(1,131 V 0) + (693 V 17.5)] ÷ 1,824 = 6.6.
For 1994 [(1,338 V 0) + (820 V 19.5)] ÷ 2,158 = 7.4.
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amortized over the life of the capital asset so
acquired. * * * [Emphasis added.]
The point is not whether there is only one capital asset or many
capital assets to which expenses may be attached and capitalized.
Rather, the point is that to require capitalization of what are
otherwise routine and recurring ordinary and necessary expenses,
the expenses must be directly linked and associated with very
specific and identifiable capital assets.
(4) Services relating to ACC’s credit investigations that
were performed by ACC employees simply constituted investigatory
activities and as such the related salaries and overhead expenses
should be currently deductible. See Wells Fargo & Co. & Subs. v.
Commissioner, 224 F.3d 874, 887-888 (8th Cir. 2000), affg. in
part and revg. in part Norwest Corp. & Subs. v. Commissioner, 112
T.C. 89 (1999).
(5) Quite contrary to a possible reading of the majority
opinion (see Ruwe, J., concurring op. p.79), ACC’s primary and
underlying business activity is not the “purchase” of installment
loans. Rather, it is the “holding” of those loans and the
associated provision of funds to debtors and the credit
intermediation relating thereto (and all that is encompassed
within credit intermediation) that ACC provides that constitute
ACC’s primary, dominant, and underlying business activity.
Presumably, the amount of ACC’s income and profit in any one
year relates primarily to its annual cost of funds and to the
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losses associated with delinquent loan repayments, on the one
hand, as compared to the interest income ACC receives each year
on the installment loans, on the other hand. For Federal income
tax matching purposes, those expenses and income would appear to
be matched fully and completely on ACC’s annual Federal income
tax returns, as filed. To now require capitalization, as
respondent would, of a portion of ACC’s regular and routine
salary and overhead expenses, on the ground that they somehow
relate directly to the acquisition of specific installment loans
would, in my opinion, reflect a misunderstanding of the true
nature (1) of ACC’s underlying business activity, (2) of ACC’s
costs and expenses, and (3) of ACC’s income and profit.
As the majority opinion states (majority op. p. 4), ACC was
formed “to provide alternate financing”. ACC’s credit
investigations and its credit risk decisions relating thereto
represent just one of the steps (and certainly not the dominant
step) in ACC’s business of credit intermediation (i.e., of
providing “financing”).2
2
I acknowledge that the majority opinion (majority op. p.
4) is less than clear in its statement of the business purpose of
ACC. Nevertheless, the majority does acknowledge the important
role of ACC in providing “financing”, which in my opinion and
experience involves much more than just investigating loan
applicants and approving or rejecting the applications.
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Although the majority would allow most of ACC’s salary
expenses in issue to be currently deductible, I would go further
and hold all of such salaries to be currently deductible.
I also am puzzled by the majority's different treatment of
salaries and overhead expenses. I believe that on the particular
facts of this case both salaries and overhead expenses should
receive consistent treatment and, as indicated, be fully
deductible.
The concluding comments made by the Court of Appeals for the
Third Circuit in PNC Bancorp, Inc. v. Commissioner, 212 F.3d at
835, reflect much of my thinking on the issue before us. I quote
a portion thereof:
we find the case before us today to be much farther
from the heartland of the traditional capital
expenditure (a “permanent improvement or betterment”)
than are the scenarios at issue in INDOPCO and Lincoln
Savings. We will not mechanistically apply phrases
from those precedents in ignorance of the realities of
the facts before us. We see no principled distinction
between the costs at issue here and other costs
incurred as “ordinary expenses” by banks. [Id.]
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RUWE, J., concurring in part and dissenting in part: I
agree with the majority’s legal analysis and its application of
that analysis to ACC’s expenditures for salaries and benefits
(hereinafter “salaries”) that were incurred in connection with
the acquisition of installment contracts. The majority correctly
holds that the percentage of salaries related to credit analysis
activities must be capitalized. However, the majority then holds
that “overhead” expenditures need not be capitalized. I disagree
with the majority’s conclusion that the “overhead” expenses were
not directly related to the acquisition of installment contracts
because, in my opinion, that conclusion is inconsistent with the
majority’s specific findings of fact.
The following breakdown of specific expenditures appears on
page 11 of the majority’s findings of fact:
Breakdown of Specific Expenditures
1993
Salary Percentage of Total Expenses Amount
And Benefits Related to ACC’s Credit In
Employee Wages FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue
Steve Balan $69,359 $4,504 $313 $4,062 $78,238 50 $39,119
James Blasius 89,769 4,713 313 4,062 98,857 75 74,143
Cass Budzynowski 43,500 3,213 313 1,790 48,816 100 48,816
Hope McGee 16,248 1,216 313 3,692 21,469 100 21,469
Kelly 16,100 1,193 313 1,790 19,396 100 19,396
Stacey 10,280 767 313 2,086 13,446 75 10,085
245,256 15,606 1,878 17,482 280,222 213,028
Overhead Items
Printing 9,412 75 7,059
Telephone 12,454 75 9,341
Computer 19,598 95 18,618
Rent 34,413 50 17,207
Utilities 5,162 50 2,581
81,039 54,806
361,261 267,832
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1994
Salary,
Wages, and Percentage of Total Expenses Amount
Estimated Benefits Related to ACC’s Credit In
Employee Bonus FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue
Steve Balan $95,820 $4,886 $218 $4,932 $105,856 40 $42,342
James Blasius 139,216 5,776 218 4,932 150,142 50 75,071
Cass Budzynowski 52,846 3,813 218 2,177 59,054 100 59,054
Hope McGee 11,508 842 218 4,932 17,500 100 17,500
Kelly 22,200 1,584 218 2,177 26,179 100 26,179
Sue 24,500 1,760 218 4,932 31,410 100 31,410
Kathy 16,921 1,256 218 4,932 23,327 75 17,495
Stacey 1,218 93 32 411 1,754 75 1,316
Kirsten 2,438 167 57 181 2,843 100 2,843
366,667 20,177 1,615 29,606 418,065 273,210
Overhead Items
Printing 8,663 75 6,497
Telephone 15,133 60 9,080
Computer 25,919 95 24,623
Rent 37,875 60 22,725
Utilities 5,126 60 3,076
92,716 66,001
510,782 339,211
These expenditures were all incurred in ACC’s business. The
majority finds that ACC’s only business operation was the
acquisition of installment contracts and the servicing of those
contracts.1 With respect to the salaries and “overhead” expenses
found to be related to ACC’s credit analysis activities ($267,832
for 1993 and $339,211 for 1994),2 the majority makes the
following finding of fact:
In 1993 and 1994, ACC paid installment contracts
expenditures totaling $267,832 and $339,211,
respectively, * * * which were attributable to ACC’s
obtaining of credit reports and screening of credit
histories, related primarily to the portion of ACC’s
payroll and overhead expenses that was attributable to
its credit analysis activities.6 None of these
1
The majority finds: “Its sole business operation is (1) the
acquisition of installment contracts from automobile dealers * *
* and (2) the servicing of those contracts.” Majority op. pp. 4-
5.
2
The parties agree with the allocations in the above table.
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expenditures included any postacquisition or servicing
expenses. * * *
6
We use the term “credit analysis activities” to
refer to ACC’s credit review services and its funding
services (i.e., ACC’s issuance of the checks to dealers
in consideration for the installment contracts).
[Majority op. p. 10; emphasis added.]
From the majority’s findings of fact I conclude: (1) ACC’s
business operation consisted of the acquisition of installment
contracts and the postacquisition servicing of those contracts;
and (2) of the total expenses for salaries and overhead for 1993
and 1994, $267,832 for 1993 and $339,211 for 1994 were related to
credit analysis activities and were not related to any other
business operations of ACC.3 To me, the logical conclusion is
that both salaries and overhead expenses, totaling $267,832 for
1993 and $339,211 for 1994, were exclusively for ACC’s
acquisition of installment contracts and thus were “directly”
related to the acquisition of installment contracts.
The percentage of ACC’s salaries and “overhead” expenses
that related exclusively to ACC’s credit analysis activities
indicates that most of ACC’s business activity concerned the
acquisition of installment contracts. For example, 76 percent of
salaries and 68 percent of “overhead” expenses for 1993 were
related to ACC’s credit analysis activities. For 1994, the
3
The majority finds that “None of these expenditures
included any postacquisition or servicing expenses.” Majority
op. p. 10. ACC’s only business operation was the acquiring of
installment contracts and the postacquisition servicing of those
installment contracts.
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percentages were 65 percent and 71 percent, respectively. The
majority finds that “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.” Majority op. pp. 27-28.
Absent evidence to the contrary, it would seem to follow
logically that if ACC’s business operation had not included
credit analysis activities, ACC would never have incurred the
overhead expenses attributable to those activities.
The majority correctly states that the “overhead” expenses
would be capital in nature if they “originated” in ACC’s process
of acquiring installment contracts. Majority op. p. 29.
However, the majority reasons that the “overhead” expenses were
not directly related to the acquisition of installment contracts
because:
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
had its business only been to service the installment
contracts. * * * [Id.]
There is nothing in the majority’s specific findings of fact to
support the conclusion that overhead expenses related to credit
analysis activities did not “originate” in the process of ACC’s
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acquisition of installment contracts.4 Indeed, it would be
logical to conclude that the type and amount of these “overhead”
expenses did “originate” in ACC’s acquisition of installment
contracts. After all, this activity was ACC’s dominant activity.
If ACC had never engaged in acquiring installment contracts, most
of its expenditures for both salaries and overhead expenses would
have been unnecessary in the first place.
The majority reasons that rent and utilities were “generally
fixed charges which had no meaningful relation to the number of
credit applications analyzed (or the number of installment
contracts acquired) by ACC.” Majority op. p. 29. Again, with
the possible exception of rent,5 there are no specific findings
of fact to support this rationale. Logic would indicate that if
ACC no longer engaged in credit analysis activities, then its
need for office space would decrease, and it would take steps to
reduce its rental and utility costs. The same logic would apply
even more so to printing, telephone, and computer costs. There
is nothing in the majority’s findings to indicate that these were
4
It should be noted in this regard that petitioners bear
“the burden of clearly showing the right to the claimed
deduction”. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992).
5
The majority finds that ACC had a 5-year lease that began
in October 1992. There is no discussion of the specific terms of
the lease other than the amount of monthly rent.
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fixed costs.6 Approximately 75 percent7 of the printing and
telephone costs were attributable exclusively to ACC’s credit
analysis activities. Ninety-five percent of the expenses for
computers were related exclusively to ACC’s credit analysis
activities during the years in issue. One can only wonder how
the majority would have treated computer expenses if 100 percent
of such expenses were allocable to ACC’s credit analysis
activities.
The majority provides no legal basis for distinguishing
between expenditures for salaries and expenditures for “overhead”
expenses. Indeed, the majority correctly states that overhead
expenses “are capital in nature to the extent that they
originated in ACC’s acquisition process, or, in other words, were
directly related to ACC’s anticipated acquisition of installment
contracts.” Majority op. p. 29. Therefore, my disagreement with
the majority is based on what I view as the logical disconnect
between the majority’s specific findings of fact and the
majority’s rationale for concluding that the “overhead” expenses
6
The majority notes a variation in printing, telephone, and
computer costs from one year to another but does not identify the
cause. See majority op. pp. 29-30.
7
For 1993, 75 percent of printing and telephone costs were
attributable to ACC’s credit analysis activities. For 1994, 75
percent of printing costs and 60 percent of telephone costs were
attributable to ACC’s credit analysis activities.
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were not directly related to ACC’s credit analysis activities.
It is for that reason alone that I dissent.
WHALEN, HALPERN, BEGHE, FOLEY, GALE, and MARVEL, JJ., agree
with this concurring in part and dissenting in part opinion.
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HALPERN, J., concurring in part and dissenting in part:
I concur in most of the majority’s report, but, like Judge Ruwe,
whom I join, I dissent from the majority’s treatment of the
overhead items-–printing, telephone, computer, rent, and
utilities (overhead).
I. Introduction
Petitioners’ S corporation, Automotive Credit Corporation
(ACC), cannot deduct its expenditures for the installment
contracts here in question because such expenditures are capital
in nature. They are capital in nature because each such
expenditure purchases for ACC the right to receive monthly
payments for a term ranging from 12 to 36 months. With respect
to the overhead, the question is whether ACC may deduct its
overhead costs related (but, in the majority’s view, only
indirectly related) to such capital expenditures. Principally
for the reasons set forth by Judge Ruwe, I do not believe that
they may. I write separately, however, to make the following
points: (1) The majority distinguishes between directly related
and indirectly related costs without telling us how to draw that
distinction. In short, the majority uses the quality of
relatedness not in support of any analysis but only to express a
conclusion (i.e., the overhead was not directly related to ACC’s
capital expenditures). (2) The majority’s analysis also risks
confusion with existing law (and accounting principles) that
distinguish “direct” costs from “indirect” costs. Moreover,
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under that law (and those principles), indirect costs (including
overhead) are often required to be capitalized. (3) To the
extent the majority distinguishes directly related from
indirectly related costs, it seems to be saying that fixed costs
are period costs because they are only indirectly related to any
capital expenditure. That is also not an accurate statement of
current law (and accounting principles) that often require
absorption or full costing methods of accounting for fixed costs.
(4) The majority has ignored the proper mode of analysis, which
is to determine whether ACC’s accounting for overhead clearly
reflects its income.
II. Agreement of the Parties
The parties agree that the amounts identified by the
majority as ACC’s installment contract expenditures were
“related” to ACC’s credit analysis activities. Apparently, they
agree that overhead was related to ACC’s credit analysis
activities because items such as the telephone and computers
facilitated ACC’s obtaining of credit reports and screening of
credit histories. In turn, the credit reports and case histories
assisted ACC’s employees in determining that any particular
installment contract presented a sufficiently low expectation of
nonperformance to justify its purchase. ACC treated the
installment contract expenditures (including overhead)
disparately for financial accounting and Federal income tax
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purpose, matching such expenditures to the expected life of the
related installment contracts for financial accounting purposes
but deducting them for Federal income tax purposes, at least for
1993.
III. Majority’s Approach
According to the majority: Overhead expenses must be
capitalized only if they are directly related to the acquisition
of a capital asset, and such expenses are directly related to the
acquisition of a capital asset only to the extent that they
increase on account of such acquisition. For the reasons
discussed below, I do not believe that the majority’s limitation
of overhead costs subject to capitalization to (what I will refer
to as) incremental overhead costs is an accurate application of
the law, nor do I believe that it provides an improvement to the
law relating to the treatment of overhead costs.
IV. Overhead
Overhead is, by definition, an indirect cost. See, e.g.,
Kohler’s Dictionary for Accountants 366 (Cooper & Ijiri, eds.,
6th ed. 1983):
overhead 1. Any cost of doing business other than a
direct cost of an output of product or service.
2. A generic name for manufacturing costs of materials
and services not readily identifiable with the products
or services that constitute the main outputs of an
operation. * * *
A cost is an indirect cost, and, thus, overhead, if, at the time
the cost is incurred, it is not identifiable with an individual
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department, product, activity, or other object to be costed
(without distinction, costing unit). Because overhead costs are
not identifiable with a costing unit, some process is necessary
to allocate overhead among costing units:
Distinctions between overhead costs and direct
costs rest upon the methods of measuring unit costs.
Direct costs can be identified with units to be costed
(i.e., with departments, activities, orders, products)
at the time the cost is incurred. This is accomplished
by measuring quantities of materials and hours of labor
used for each costing unit. * * *
Overhead costs cannot, as a practical matter, be
traced directly to individual costing units, either
because the process of making direct measurements is
judged wasteful or because there is no acceptable
method of direct measurement available. As an example
of a too costly measurement, electric power used by
each department in a factory can be measured, but this
is not always done because management does not wish to
incur the expense of meters and records. Examples of
the lack of a method of distribution may be observed in
any endeavor to determine how much of the cost incurred
for plant protection, accounting, or the president’s
office applies to each unit of production.
Id. at 367. As other authorities on accounting state: “Indirect
expenses, by their very nature, can be assigned to departments
only by a process of allocation.” Meigs et al., Accounting, The
Basis for Business Decisions 820 (4th ed. 1977).
Although such process of allocation undoubtedly involves
many judgments and uncertainties, there are certain standards:
Accounting literature is generally consistent in
stating that indirect costs should be charged against
operations as incurred if they have no arguable cause-
and-effect relationship with future revenues (such as
the salary of a mailroom clerk). However, many
allocations of indirect costs affect future periods; an
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example is the allocation of factory overhead to units
of inventory produced during a period and remaining on
hand at period-end.
Minter et al., Handbook of Accounting and Auditing C2.06[4] (2001
ed.). One area of uncertainty concerns the treatment of fixed
overhead costs. In Belkaoui, the Handbook of Cost Accounting
Theory and Techniques 289 (1991), the author states: “The issue
of whether inventories should be costed at variable or full cost
remains a subject of debate in both academic and business worlds.
The controversy centers mainly on two inventory valuation
methods: the direct or variable costing method and the
absorption or full costing method.” That debate is relevant to
our analysis since, as Professor Belkaoui states: “The main
difference between product costing methods lies in the accounting
treatment of fixed manufacturing overhead. Under the direct
costing method, the fixed manufacturing overhead is regarded as a
period cost (that is, an expired cost to be immediately charged
against period sales). ” Id. at 291. Under the absorption
costing method, on the other hand, “all the manufacturing costs,
whether variable or fixed, are treated as product costs and hence
inventoried with the products.” Id.1 Fixed overhead, thus, is
only released to offset receipts as it flows into cost of goods
1
Professor Belkaoui adds: “Consequently, under absorption
costing, the period costs are limited to both selling and
administrative overhead.” Belkaoui, Handbook of Cost Accounting
Theory and Techniques, 291 (1991).
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sold (which may or may not be in the period such overhead is
incurred). See id. at 293.
Professor Belkaoui states that the central issue affecting
income determination is whether fixed manufacturing costs are
product or period costs. Id. at 299. He concludes: “From the
theoretical point of view, both methods [direct costing and
absorption] appear to be internally consistent. * * * From the
practical point of view as well, both methods have merit. Thus,
there is no absolute answer to whether a cost is a product or a
period cost.” Id. at 305.
For financial accounting purposes, the treatment of overhead
starts with the recognition that overhead costs are indirect and,
thus, in need of allocation, and it proceeds from there to
allocate such expenses pursuant to various standards, practices,
and judgments, in order to serve management’s (and other’s) needs
for information (including income determination). See Kohler’s
Dictionary for Accountants 366–370 (Cooper & Ijiri eds., 6th ed.
1983).
Overhead presents no different challenge for Federal income
tax purposes. It is, thus, 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.
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V. Clear Reflection of Income
A. Introduction
By characterizing the printing, telephone, computer, rent,
and utilities costs here in question as overhead, petitioner and
the majority do no more than identify that allocation is
required. In concluding that such costs need not be capitalized,
the majority accepts without question ACC’s allocation, which
allocates the costs to ACC’s postacquisition and servicing
activities (for which an immediate deduction is available). The
majority fails to apply any criteria to its acceptance of ACC’s
allocation. Notwithstanding that such allocation may be
acceptable (even required) for financial accounting purposes, see
majority op. p. 12 note 9, it still involves a method of
accounting. For Federal income tax purposes, the term “method of
accounting” “includes not only the over-all method of accounting
of the taxpayer but also the accounting treatment of any item.”
Sec. 1.446-1(a)(1), Income Tax Regs.; see also sec 1.446-
1(e)(2)(ii)(a), Income Tax Regs. (a change in method of
accounting includes any change in the treatment of any “material
item”: “A material item is any item which involves the proper
time for the inclusion of the item in income or the taking of a
deduction.” (Emphasis added.)). A taxpayer’s method of
accounting must clearly reflect income or the Secretary may
require the computation of taxable income under a method of
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accounting that does clearly reflect income. See sec. 446(b).
Notwithstanding the majority’s disclaimer that it is not passing
on whether ACC’s method of accounting clearly reflected its
income, see majority op. p. 69 note 37, that is precisely what it
is doing.
B. Clear Reflection and Section 263
We have previously addressed the interplay between the
clear-reflection standard and the requirements of section 263.
In Fort Howard Paper Co. v. Commissioner, 49 T.C. 275 (1967), the
core issue was how to treat overhead in determining the cost of
self-constructed assets. We rejected the Commissioner’s
principal argument that section 263 draws a clear line between
deductible expenses and capital expenditures. We stated that
consideration necessarily had to be given to whether the
taxpayer’s treatment of the overhead in question clearly
reflected income:
We reject as without merit respondent’s contention
that section 263 of the Code is in and of itself
dispositive of the issue before us. By requiring the
capitalization of amounts ‘paid out for new buildings
or for permanent improvements or betterments made to
increase the value of any property,’ such section begs
the very question we are asked to answer. We are
satisfied that, under the circumstances involved
herein, sections 263 and 446 are inextricably
intertwined. A contrary view would encase the general
provisions of section 263 with an inflexibility and
sterility neither mandated to carry out the intent of
Congress nor required for the effective discharge of
respondent’s revenue-collecting responsibilities.
Accordingly, we turn to a determination as to whether
petitioner’s method of accounting ‘clearly reflects
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income’ pursuant to the provisions of section 446.
* * *
Id. at 283–284.
In Fort Howard Paper Co., we found the taxpayer’s method of
accounting clearly to reflect income notwithstanding that the
taxpayer allocated no overhead to self-constructed property under
the “incremental cost” method of accounting adopted by him. The
Commissioner argued for the “full absorption cost” method, which
would have required an allocation of overhead to self-constructed
assets. We stated:
Under all the circumstances herein, we hold that
petitioner has satisfied its heavy burden and has
convinced us that it employed a generally accepted
method of accounting which ‘clearly reflects its
income.’ In so doing, we neither hold nor imply that,
under all circumstances, a taxpayer has a right to
choose between alternative generally accepted methods
of accounting or that respondent may not, under some
circumstances, require a taxpayer to accept his
determination as to a preferred selection among such
alternatives. We hold merely that where a taxpayer, in
a complicated area such as is involved herein, has over
a long period of time consistently applied a generally
accepted accounting method (which is considered
‘clearly to reflect’ income by competent professional
authority and is not specifically in derogation of any
provision of the Internal Revenue Code) and where this
method has been frequently applied by respondent in
making adjustments to the taxable income of the same
taxpayer (as distinguished from respondent’s mere
failure to object to its use by such taxpayer), the
taxpayer’s choice of method will not be disturbed.
* * *
Id. at 286–287 (citations omitted). In Coors v. Commissioner,
60 T.C. 368, 397 (1973), affd. 519 F.2d 1280 (10th Cir. 1975), we
distinguished Fort Howard Paper Co. and found the taxpayer’s
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method of accounting for the costs of self-constructed assets did
not clearly reflect income, in part because it expensed
incremental overhead costs.
In Dana Corp. v. United States, 174 F.3d 1344 (Fed. Cir.
1999), the taxpayer corporation paid a law firm an annual
retainer fee, which was paid to prevent the law firm from
representing parties adverse to the taxpayer in a takeover
attempt and for standing by to represent the taxpayer both if
subject to a hostile takeover and in other matters. Id. at 1346.
The law firm received the retainer whether it rendered legal
services during the retainer year or not. Id. at 1350. For some
years it rendered no legal services and, during others, it
rendered services in connection with deductible (non-capital)
matters. Id. During the year in question, the law firm rendered
services in connection with the taxpayer’s acquisition of a
capital asset and credited the year’s retainer amount against the
amount billed for those services. Id. For that year, the
taxpayer deducted the retainer amount and capitalized the
remaining fee. Id. The Court of Appeals disallowed the
taxpayer’s deduction of the retainer amount, stating: “Even
though the retainer fees were allowed as deductible expenses for
most of the years * * * [the taxpayer] paid them, the use of the
fee in a particular year determines the deductibility of the
expense in that year, and not the pattern of other years of
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paying it.” Id. at 1350-1351. Although that issue was not
decided on the basis of clear reflection of income, the taxpayer
was required to allocate a fixed cost incurred for multiple
purposes to a single, capital expenditure purpose.
C. Criticism of Majority
My criticism of the majority is not, per se, with its
finding that there were no incremental overhead costs
attributable to capital expenditures (although I doubt that that
is true). My criticism is with the majority’s uncritical
acceptance of the taxpayer’s method of accounting for overhead.
Judge Tannenwald’s nuanced analysis in Fort Howard Paper Co. v.
Commissioner, supra, exemplifies the considerations traditionally
given to clear reflection of income cases. Consider also Judge
Dawson’s’ analysis in Coors v. Commissioner, supra. The Supreme
Court cases that figure so prominently in the majority’s
analysis, see majority op. p. 18, are inapposite. Simply, they
do not address the accounting question here before us: Namely,
does it clearly reflect ACC’s income for Federal income tax
purposes for ACC to use a method of accounting that allocates
zero overhead to a costing unit (ACC’s credit analysis
activities) to which such overhead concededly relates? If ACC’s
accounting method is rejected, and some or all of the overhead is
allocated to ACC’s credit analysis activities, then, I suppose,
such overhead would, in the majority’s terminology, be directly
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related to those activities, and the Supreme Court cases would be
no bar to capitalization. The question here is not whether the
overhead directly or indirectly relates to ACC’s credit analysis
activities; the question is whether ACC has proven that its
method of accounting clearly reflects its income. It has not.
D. Majority’s Reasoning
Once the majority’s approach is stripped of the erroneous
notion that overhead can, without allocation, be identified to an
individual costing unit (e.g, a capital expenditure), what
remains is an approach that says that, for Federal income tax
purposes, overhead need not be allocated to a costing unit when,
if that costing unit were eliminated, the overhead would still be
incurred. Immediately, that approach raises analytic
difficulties. What if the overhead is incurred on account of two
costing units (one a capital expenditure and one not), and the
overhead would be incurred in the same amount if either (but not
both) were eliminated? Why is the default rule that the overhead
is allocated in total to the noncapital expenditure? Looked at
from a different perspective, what if there is not a linear
relationship between the taxpayer’s business activities and
overhead? The relationship may be step-wise, so that the
taxpayer’s business activities would have to increase by some
quantum before rent, for instance, would increase. Assume, for
example, that office space may only be rented in blocks of
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several thousand square feet. There is, thus, no incremental
cost in adding a capital activity to space not fully occupied by
a noncapital activity. Likewise, there is no decrement in cost
(once having added the capital activity) of completely
subtracting the noncapital activity. Must we conclude that the
rent still is not allocable to the capital activity? The fact
that a taxpayer would incur the same overhead costs should it
discontinue a capital activity may only be evidence that it is
amenable to an economically inefficient use of space or
equipment. Short of adopting the accounting concept of direct or
variable costing as normative for Federal income tax purposes,
that does not seem to me a sufficient reason to foreclose any
capitalization of fixed overhead. If the direct or variable
costing method is to be made normative for Federal income tax
purposes, that is a job for the Secretary or the Congress, not
for us.
Besides which, as Judge Ruwe points out, the majority has
made no specific findings of fact to support its conclusion that
ACC’s acquisition activities did not give rise to any incremental
overhead. Indeed, petitioner has proposed the following finding
of fact: “ACC’s payroll and overhead costs attributable to
credit review and other tasks relating to contract acquisition
were not materially affected by whether any given installment
contract was ultimately acquired by ACC from a dealership.”
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That, of course, is not to say that overhead would not be
materially affected if none of the contract acquisition activity
were continued.
VI. Conclusion
I am not here arguing for a rigid rule, requiring allocation
of overhead in all cases where overhead is related to a capital
activity. See, e.g, Dunlap v. Commissioner, 74 T.C. 1377, 1426
(1980) (no capitalization required for overhead where capital
activity (acquisition of banks) was incidental to taxpayer’s
principal business of holding and managing banks, revd. and
remanded on another issue 670 F.2d 785 (8th Cir. 1982)).2 I am,
2
The majority states: “[W]e conclude that any future
benefit that ACC realized from these expenses was incidental to
its payment of them so as not to require capitalization”.
Majority op. p. 30. The majority has failed, however, to explain
or quantify that finding. Without the overhead, the acquisition
activity would, at the least, have been substantially reduced.
Judge Swift, in his concurring opinion, suggests that any
benefit derived by ACC from both salaries and overhead associated
with the credit analysis activities was incidental to ACC’s
primary business activity: the holding of installment loans. He
would, therefore, permit a current deduction for both. Judge
Swift’s position is based upon his finding that any benefits
associated with the credit analysis activities “were exhausted or
lost by ACC almost simultaneously with the receipt of the
benefits”; i.e., most of the installment loans were immediately
rejected. Swift, J., concurring op., p. 73. He also views such
activities as “investigatory activities” the costs of which are
currently deductible.
I believe that all of the credit analysis activities related
to the purchased loans. Therefore, the costs of that activity
should be capitalized. The acquisition of installment loans was
an essential part of ACC’s business, and an unavoidable cost of
(continued...)
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however, arguing against what appears to be the rigid approach of
the majority that, if the taxpayer’s method of accounting for
overhead is to deduct all overhead that does not increase on
account of capital activities, such method of accounting clearly
reflects income and, thus, must be accepted by respondent.
I can do no better than to close with the majority’s own
words:
In our minds, an expenditure that produces both a
current and long-term benefit is neither 100 percent
deductible nor 100 percent capitalizable. Instead,
regardless of whether the expenditure’s primary or
predominant purpose is to benefit significantly the
business’ current operation, on the one hand, or its
long-term operation, on the other hand, the expenditure
is capital in nature to the extent that it produces a
significant long-term benefit and deductible to the
remaining extent. * * *
Majority op. p. 61.
WHALEN and BEGHE, JJ. agree with this concurring in part and
dissenting in part opinion.
2
(...continued)
such acquisitions was that associated with the need to
distinguish between acceptable and unacceptable risks; i.e., the
credit analysis activities. Put simply, the hunt was essential
to the capture.
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BEGHE, J., concurring in part and dissenting in part:
Having joined the side opinions of Judges Ruwe and Halpern, I
write on to empathize with the concerns that may underlie the
majority’s view on the treatment of the overhead costs, as
amplified by Judge Swift’s concurrence.
It bears observing that the oft-quoted passage in the
opinion of the Court of Appeals for the Seventh Circuit in
Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212, 217
(7th Cir. 1982), revg. T.C. Memo. 1981-255, which includes the
statement that “The administrative costs of conceptual rigor are
too great,” was uttered in the course of sustaining the
Commissioner’s determination that the costs in issue in that case
had to be capitalized. However, the Court of Appeals then
suggested that the distinction between recurring and nonrecurring
costs might provide the line of demarcation in some cases, but
went on to observe that the distinction wouldn’t make sense when
the taxpayer’s sole business was the creation or acquisition of
capital assets. Although ACC’s business includes the servicing
as well as the acquisition of capital assets, the relatively
short average time the acquired loans remain outstanding raises
questions about administrability, the costs of conceptual rigor,
and whether the exercise has been worth the candle.
These musings lead me to suggest the time has come to
request respectfully that the Congress step in and enact some
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bright-line rules that will provide guidance to the business
community and the Internal Revenue Service and reduce the burdens
of compliance and controversy on the public, the Service, and the
courts. Sections 195 and 197 come to mind as possible starting
points or models.
GALE, J., agrees with this concurring in part and dissenting
in part opinion.