LARRY MAPLES COMPARES THE IMPLICATIONS OF A RECENT TAX COURT DECISION HOLDING THAT SALARIES AND BENEFITS MUST BE CAPITALIZED WITH RECENT CIRCUIT COURT REVERSALS OF SIMILAR DECISIONS.
The Tax Court, in a divided opinion,1 has held that salaries and benefits paid by an S corporation in connection with the acquisition of auto financing installment contracts must be capitalized, but that overhead costs are deductible.2 This is a very interesting development because both the Third and Eighth Circuits have recently reversed Tax Court decisions that required the capitalization of salaries and benefits. Of these decisions, the majority believes the Wells Fargo decision3 is factually distinguishable and continues to disagree with the PNC Bancorp decision.4
The issue is whether recurring salary and overhead costs should be capitalized when paid in connection with the creation or acquisition of a capital asset. Generally speaking, capitalization would be required. But, what if the activities for which the salaries are paid are the nuts and bolts of the business? In other words, does it make any difference that the assets generated by these efforts are not isolated transactions, but instead, are the raison ditre of the business? For example, should a bank whose very existence depends on continually making loans capitalize salaries connected with loan making? There are differences within and among the courts on the interpretation of the controlling statutes. Despite the division of the Tax Court, the opinion in D.J. Lychuk has the merit of focusing attention on the crucial issues that will have to be resolved at the appellate level or legislatively.
Lychuk Case
The taxpayers in Lychuk are shareholders in an S corporation (ACC) that provides alternate financing for automobile purchasers who have marginal credit. ACC's only line of business is the acquisition of installment contracts from dealers who have sold automobiles to high-credit-risk individuals and the servicing of these contracts. Its primary business activities are credit investigation, credit evaluation, documentation and the monitoring of collections on installment contracts. The personnel involved in the acquisition of installment contracts are paid a base salary and an annual bonus at the discretion of the board of directors.
The process begins with an individual purchasing an automobile from a dealer at a set price to be paid in installments over a 12-month to 36-month period at an average interest rate of 22 percent. ACC purchases some of the installment contracts at a 35-percent discount. ACC is under no obligation to purchase these high-credit-risk contracts, but must decide whether to purchase a particular contract before the dealer finalizes the sale. If ACC purchases the contract, it pays the dealer 65 percent of the purchase price and is then entitled to all principal and interest payments under the contract. ACC may repossess and sell the automobile if the buyer defaults.
ACC can perform the credit review process on a contract in three to four hours and rejects approximately 62 percent of the contracts offered. Twenty-five to 30 percent of the acquired contracts have an actual duration of 12 months or less. The average duration of acquired contracts is 17 to 20 months. The IRS disallowed salary and overhead expenditures relating to assets having a life exceeding one year. The Tax Court agreed that salary costs should be capitalized, but allowed current deductions for overhead expenses under the theory that these costs were not directly related to the acquisitions and that any future benefit was incidental to the payment of these expenses.
The Majority Opinion
The case turns on whether the salary and overhead expenditures are "ordinary."5 An ordinary expense is an expense that is "normal, usual or customary" in the type of business involved.6 But an expense, which meets this definition, may nevertheless be capitalized under the regulations if it results in "property having a useful life substantially beyond the taxable year."7 More specifically, the Supreme Court has held that wages paid in connection with the acquisition of a capital asset may be capitalized.8 So, the question is under what circumstances should "normal, usual or customary" expenditures be capitalized? The standard adopted by the majority is whether the costs originate in the process of acquiring a capital asset, a test derived from the Supreme Court's EW Woodward decision.9 The majority demonstrates that this test has been interpreted as focusing the inquiry on whether the expenditure is directly related to the acquisition of the capital asset.10 Applying this test to Lychuk, the majority said the salaries at issue should be capitalized if the underlying services were directly related to ACC's acquisition of installment contracts. The majority reasoned that each of the employees spent a significant proportion of his or her time working on credit analysis activities, which was the first and most crucial step in the acquisition process. Further, "but for ACC's anticipated acquisition of installment contracts, ACC would not have incurred the salaries and benefits attributable to those activities."
The majority reached the opposite conclusion concerning the overhead costs, ie., that these costs did not originate in the process of acquiring the installment contracts because ACC would have continued to incur these expenses had it only been in the business of servicing installment contracts. Some of these costs (rent and utilities) were fixed. Others (printing, telephone and computer) did not appear to respond in predictable ways to changes in volume of credit applications.
The majority completes its long opinion by reviewing several cases in which various appellate courts have upheld the capitalization of regular and routine expenditures. The most intriguing of these cases is PC. Winmill.11 The other cases involve the more traditional singular capital projects like the construction of a facility or the acquisition of the stock of a company. But in Winmill, like Lychuk, the payments are for numerous assets acquired constantly throughout the year. The taxpayer in Winmill was in the business of buying and selling securities. The question was whether he could deduct brokerage commissions paid to acquire securities. The Supreme Court required capitalization of the commissions and commented that being in the business of buying and selling securities did not entitle the taxpayer to take a deduction contrary to a longstanding IRS position requiring the capitalization of security commissions.
Wells Fargo Distinguished
The Eighth Circuit recently reversed the Tax Court on the issue of capitalization of salaries. In Wells Fargo, a bank incurred investigatory costs, due diligence costs and officers' salaries in connection with a bank combination. The Tax Court required capitalization of all these costs. On appeal, the IRS conceded some of the investigatory costs after releasing Rev. Rul. 99-23, 12 which allows deduction of investigatory costs incurred before the final acquisition decision. The Eighth Circuit agreed with the Tax Court that investigatory and due diligence expenditures after the final decision should be capitalized but disagreed on the officers' salaries, holding them to be deductible.
The Eighth Circuit reasoned that the salaries should be capitalized if they were directly related to the capital transaction. But the court saw only an indirect relation because the salaries originated from the employment relationship rather than the acquisition. The court contrasted this situation with Acer Realty,13 where officers who were paid no salaries prior to a large building program, received salaries for managing the construction project. The court pointed out that in Wells Fargo, there was no increase in salaries attributable to the acquisition.
The Tax Court majority believes Wells Fargo and Lychuk are factually distinguishable. In Wells Fargo, it appeared that the officers spent a relatively small portion of their time on the capital transaction, and the transaction was "extraordinary in the daily course of their employment." But in Lychuk, "each of the disputed employees spent a significant portion of his or her time (in fact, in eight of the 15 cases, all of his or her time) working on capital asset acquisitions that occurred in the ordinary course of ACC's business." The Tax Court saw as significant the fact that ACC's employees were "hired and paid to perform services that necessarily would include work on capital asset acquisitions."
Tax Court Continues Disagreement with Third Circuit
