Tax Court Rejects Third Circuit’s Holding in PNC Bancorp

Lehman Brothers tax expert Robert Willens explains how to treat salaries for services performed in "the acquisition process."
Robert WillensJune 5, 2001

The hopelessly muddled issue of whether expenses may be currently deducted, or must be capitalized (and amortized over the life of the asset to which they relate), once again arose (in the context of a financial institution) in the recently-decided Lychuk v. Commissioner case.

The Tax Court–in material part–ruled against the taxpayer (which was engaged in the business of acquiring “high risk” retail installment contracts from automobile dealers) with respect to the question of whether salaries and benefits paid to the taxpayer’s credit analysts could be deducted. In the process, the court explicitly rejected the approach taken by the Third Circuit Court of Appeals (which tribunal had overturned the Tax Court’s holding) in the PNC Bancorp case: The Third Circuit had ruled that “loan origination” costs, of the type at issue here, incurred by a bank, were currently deductible.

In Lychuk, the taxpayer–an ‘S’ corporation–was engaged in the business of acquiring (and servicing) installment contracts from automobile dealers who sold to “high credit risk” individuals. At issue was whether the corporation (ACC) could deduct the “payroll” (salaries and benefits) and “overhead” (rent, etc.) expenses properly attributable to its “credit analysis” activities. The I.R.S., predictably, argued that it couldn’t because the expenses were capital expenditures; they were, in the Service’s estimation, “directly related” to the acquisition of “separate and distinct” assets; the installment contracts—the very argument it unsuccessfully advanced in the PNC Bancorp case.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

However, here, the Service was “preaching to the choir:” The Tax Court awarded the Service a major, yet incomplete, victory—The court held that the salaries and benefits must be capitalized yet, at the same time, it ruled that the overhead expenses were currently deductible.

In reaching its conclusion, the Tax Court employed the test that, in its judgment, the Supreme Court devised in the Idaho Power case. There, the Court stated that wages paid in connection with the acquisition of a “capital asset” (an asset whose productive life extends beyond the year in which it is acquired) must be capitalized.

Thus, in Lychuk, the Tax Court concluded that the so-called “process of acquisition” test is appropriately used: Costs originating in the process of acquiring a capital asset must be capitalized. On this basis, the critical question became were the services (in respect of which the disputed salaries and benefits were paid) performed in the acquisition process? The court concluded that they were; the services were directly related to the acquisition of the installment contracts; themselves, for the purposes of this rule, capital assets.

The services were directly related because each of the taxpayer’s employees spent a significant amount of his or her time working on credit analysis activities which the court, correctly no doubt, characterized as the first and indispensable step in the acquisition process; in the court’s view, credit research activities were an “integral part” of the acquisition process. In addition, “but for” the acquisition of the installment contracts, the taxpayer would not have incurred the disputed salaries and benefits; a further indicator that the relevant services were directly related to the acquisition of the installment contracts.

On the other hand, the overhead expenses were found to be currently deductible: None of these expenses were found to have originated in the acquisition process: ACC would have continued to incur these expenses had its business not entailed the acquisition of installment contracts but, instead, consisted exclusively of servicing such contracts.

The most interesting aspect of the decision involved the court’s attempt to reconcile its holding with the conflicting decisions reached by two higher courts; the Eighth Circuit Court of Appeals in the Wells Fargo case and, as indicated, the Third Circuit Court of Appeals in the PNC Bancorp case.

The court distinguished the Wells Fargo case. There, it was held that compensation paid to officers of a bank, that was attributable to services they performed in connection with mergers, was, nonetheless, deductible—The court found that there was only an indirect relation between the salaries and the acquisition.

This case was, in the Tax Court’s judgment, distinguishable: In Lychuk, each employee spent a significant amount of time working on “capital asset acquisitions” and, in fact, each was hired specifically for that purpose. By contrast, in Wells Fargo, each of the employees under scrutiny spent “small portions” of his or her time working on capital transactions, were not hired for that express purpose and, importantly, such capital transactions were “extraordinary” to the employer’s business. Moreover, here, unlike in Wells Fargo, where there was an evidentiary problem, there was no dispute as to the amount of time that was actually spent working on capital asset acquisitions.

On the other hand, as regards the reasoning of the Third Circuit in the PNC Bancorp case, the Tax Court simply chose to reject such reasoning. Thus, the Tax Court disagreed with the notion that the “normal and routine” nature of the expenses somehow dictated their deductibility.

Moreover, the Tax Court refused to read into Sec. 263 (the provision that defines, obliquely, a capital expenditure) anything that “hinges its applicability” to a finding that the asset acquired by the expenditure must (for capitalization to be proper) be used outside of the taxpayer’s “daily business”.

Finally, with respect to the Third Circuit’s approach to the problem, the Tax Court rejected the concept that a cost constitutes a capital expenditure only if it becomes “part of” an asset—an approach that, improperly in the Tax Court’s estimation, would limit capitalization to only the amounts paid to the seller that constitute the “purchase money” for the asset.

Thus, the Tax Court has placed itself in the Service’s camp with respect to the agency’s longstanding position (See Rev. Rul. 73-580; taxpayer required to capitalize the compensation paid to officers and employees that was attributable to services they performed in connection with mergers and acquisitions) that salaries, wages and other recurring and routine expenses can, nevertheless, be capital expenditures in cases where the services—to which the expenses pertain— are performed in the acquisition (of a capital asset) process.

If, as seems entirely likely, the Lychuks’ choose to appeal the Tax Court’s verdict, and the appeals court decides to uphold such verdict, thus creating a conflict with the Third Circuit’s holding in PNC Bancorp, we could easily wind up back in the Supreme Court where, hopefully, the Court will take the salutary step of clarifying the jurisprudence which lies at the root of these controversies; the infamous Indopco case.

Robert Willens is a Managing Director and Tax & Accounting Analyst at Lehman Brothers.