Growing a new business costs more in taxes.
By Leonard G. Weld and Charles E. Price
Capitalize but Don't Amortize
After INDOPCO, the IRS took a piecemeal approach to providing guidance about capitalization. Recently, however, the Tax Court and the IRS have taken a hard line on capitalization.
In one Tax Court case, a mutual fund company expanded its menu of funds available to customers and attempted to expense the costs associated with the new funds. The Tax Court ruled that such costs had to be capitalized and were not amortizable as a start-up expense under IRC section 195 under the future benefit doctrine established in INDOPCO.
A recent technical advice memorandum addressed the issue of whether costs involved in an acquisition qualified as investigation expenses that could be amortized under IRC section 195 or were acquisition costs that must be capitalized. The commissioner held that the decision to acquire was made prior to most of the costs being incurred and, therefore, the costs must be capitalized.
After INDOPCO (92-1 USTC 50,113), the IRS took a piecemeal approach to providing guidance about capitalization. Early guidance benefited the taxpayer, such as Rev. Rul. 96-62 (1996-2 CB 9) on training costs and Rev. Rul. 92-80 (1992-2 CB 57) on advertising expenses. Recently, the IRS has yielded to the temptation to extend the scope of INDOPCO. In July 1998 [RJR Nabisco, Inc., v. Comm'r, CCH Dec. 52,786(M)], the IRS unsuccessfully tried to ignore its own revenue ruling and segment advertising costs into two components, only one of which could be expensed. Two other recent attacks on a taxpayer's ability to currently deduct expenses or to amortize those costs using IRC section 195 are worth noting.
The INDOPCO Decision
INDOPCO clarified the capitalization rule established in Lincoln Savings & Loan Assn. (71-1 USTC 9476). In Lincoln, the U.S. Supreme Court stated that if an expenditure creates or enhances "a separate and distinct asset" that expenditure must be capitalized. In INDOPCO, the Supreme Court held that creation of a separate asset is a sufficient, but not necessary, condition to require capitalization of an expenditure.
The costs in dispute in INDOPCO were for legal and other professional fees incurred by a target corporation in the course of a friendly takeover. Since a separate and distinct asset was not created, the taxpayer wanted to expense the costs. The court ruled that any costs that result in significant future benefits accruing to the taxpayer are capital in nature and not immediately deductible. This "future benefit" doctrine immediately caused taxpayers to question whether all costs that obviously result in future benefits (e.g., training, advertising, and downsizing costs) must be capitalized. At first, the IRS was fairly lenient about using the new future benefit doctrine; however, recent disputes show that the IRS is becoming more aggressive.
FMR Corporation and Subsidiaries v. Comm'r
In the 1998 FMR Corporation and Subsidiaries v. Comm'r (CCH Dec. 52,745) case, the U.S. Tax Court applied the future benefit doctrine to what seemed to be a simple business expansion. FMR Corporation is the parent holding company of an affiliated group of corporations and provides investment management services through its operating subsidiary Fidelity Management & Research Co. FMR currently provides these services to 232 regulated investment companies (RICs), more commonly known as mutual funds. During the years in question, FMR incurred costs for developing and launching 82 new mutual funds. These funds joined the 79 already managed through FMR at that time.
The issue for the court was whether the expenditures to create the new mutual funds were immediately deductible under IRC section 162 as ordinary and necessary expenses paid in carrying on a trade or business or should be capitalized. The costs in question included expenditures to develop the initial marketing plan for the fund, draft the management contract, register the RICs with the SEC and various states where the RICs would be marketed, and other initial costs. Both parties agreed that if the new RICs created separate and distinct assets, all the costs must be capitalized.
The Taxpayer's Argument. The taxpayer cited several court cases that support the principle that costs of expanding a business are currently deductible. Two of those cases were Colorado Springs National Bank v. U.S. (74-2 USTC 9809) and NCNB Corporation v. U.S. (82-2 USTC 9469).
In Colorado Springs, the Court of Appeals for the Tenth Circuit had to decide if the costs associated with implementing a MasterCard system were currently deductible or had to be capitalized as the start-up costs of a new business. The bank's costs included computer costs incurred to keypunch and insert its customer account data into the MasterCard computer, computer service and assessment fees paid to MasterCard, advertising and promotional costs, credit bureau reports, and travel, education, and entertainment expenses of employees reimbursed by the taxpayer for attendance at MasterCard meetings held to motivate the employees and familiarize them with the MasterCharge system.
The court held that "the costs of establishing a credit card operation were deductible because a credit card operation was merely a new method of operating an old business." The court considered the business of a bank to include loaning money to customers. Use of the credit card was simply a new way of doing so.
In NCNB, the Court of Appeals for the Fourth Circuit held that costs of developing bank branches (such as expansion plans, feasibility studies, and regulatory applications) were currently deductible. In that opinion, the court also cited Briarcliff Candy Corporation v. Comm'r (73-1 USTC 9288). "It is a long recognized principle of tax law that expenditures for the protection of an existing investment, the continuation of an existing business, or the preservation of existing income from loss or diminution are ordinary and necessary business expenses within the meaning of IRC section 162." The court closed its opinion by stating the following:
In conclusion, we emphasize that NCNB's business is operating a statewide network of branch banks. In order to maintain this network, NCNB must continually evaluate its market position through various means that utilize both internal and external resources. It has every right to keep abreast of demographic trends and the like in its necessary allocation of resources as well as in ascertaining where the public demand for its services exists. The bank must regularly take actions such as the opening and closing of branches so as to maintain profitability and a sound financial position. Where these actions result in the creation or retirement of separate and identifiable assets such as buildings and equipment, then the taxpayer must make adjustments to its capital accounts. But where these expenditures do not create or enhance separate and identifiable assets, they are properly considered ordinary and necessary.
Given the decisions in those cases, FMR argued that costs to create additional mutual funds represent similar type expansion costs and that these costs should be deductible under IRC section 162.
FMR also argued that the legislative history of IRC section 195, Start-up Expenditures, demonstrates that this type of cost does not result in a future benefit that Congress intended to be capitalized. FMR cited the committee report from the Miscellaneous Revenue Act of 1980 that stated the following:
In the case of an existing business, eligible start-up 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, 1980-2 CB 709).
FMR felt this passage clearly demonstrated congressional intent to allow the current deduction for expansion costs of an existing business.
In addition, FMR provided several reasons to dispute viewing mutual funds as separate and distinct assets. First, the management contract with an RIC is nontransferable and produces no exclusive rights when the fund is launched. Second, at the time of inception, "the RIC is an empty shell with no shareholders and no assets and the petitioner [FMR] will earn revenue from the RIC only if investors make the choice to invest in the RIC after the management contract is entered into." A new mutual fund has no market value until investors participate.
The Commissioner's Position. The IRS cited Lincoln and the proposition that when expenditures create a separate and distinct asset those expenditures must be capitalized. The IRS argued that the 82 "separate and distinct mutual funds" and the right of FMR to own and control those funds through management contracts must result in capitalization of the expenditures in question. In addition, the IRS argued that the expenditures "resulted in a significant future benefit for petitioner [FMR]."
The Tax Court Decision. Unfortunately, the court chose to ignore the question of whether or not FMR had created separate and distinct assets. The opinion states that "where the facts clearly show that expenditures produced a separate and distinct asset, we shall not hesitate to hold that such expenditures must be capitalized on that basis." However, in this case the court chose to focus on the "duration and extent of any benefits the petitioner [FMR] received from its expenditures rather than the existence of a separate and distinct asset."
The court acknowledged the cases cited by FMR, but pointed out that these cases were decided before INDOPCO. In fact, INDOPCO was heard by the U.S. Supreme Court to resolve a conflict among courts of appeals. Next, the Tax Court discounted FMR's argument that expansion costs of an existing business are deductible.
The Tax Court also had a different interpretation of congressional intent for IRC section 195. According to the court--
Congress was simply recognizing that if an expenditure was currently deductible, section 195 did not change the characterization of the expenditure if it was paid or incurred in connection with the expansion of an existing business.
Congress was distinguishing between the costs of creating a new business, when IRC section 195 does apply, and the costs of business expansion, when IRC section 195 does not apply. The opinion continues that IRC section 195 allows amortization of start-up costs but does "not create a new class of deductible expenditures for existing businesses." The opinion then cites IRC section 195(c)(1)(B), which states that for an expenditure to qualify for amortization under IRC section 195, the expenditure must be one that would have been deductible by an existing business under IRC section 162.
The question remains, are the costs deductible as ordinary and necessary business expenses? To resolve the question, the court returned to the future benefit doctrine. The opinion states that FMR intended to receive, and will in fact receive, significant long-term future benefits from the creation of the 82 mutual funds. Therefore, the expenditures must be capitalized and are not amortizable under IRC section 195.
TAM 9825005 (March 9, 1998)
This technical advice memorandum (TAM) addresses the taxpayer's (a bank holding company) use of IRC section 195 to amortize costs incurred while investigating the acquisition of a bank. During the investigation period, the bank incurred salary, travel, meal, legal, merger and acquisition, accounting, and due diligence expenses. The taxpayer reported that all of these expenses were incurred before the final decision to acquire the target bank. The taxpayer made a timely election under IRC section 195 to amortize the investigatory expenses.
IRC Section 195 Start-up Expenditures. The Miscellaneous Revenue Act of 1980 added IRC section 195. The committee report states that--
the provision for the amortization of business start-up and investigatory expenses will encourage formation of new businesses and decrease controversy and litigation arising under present law with respect to the proper income tax classification of start-up expenditures (H. Rept. 96-1278, 1980-2 CB 709).
IRC section 195(a) states that no deduction for start-up costs is allowed except under this code section. IRC section 195(b) allows start-up expenditures to be treated as deferred expenses and amortized over a period of not less than 60 months commencing when the trade or business begins operations. Subsection (c) defines start-up expenditures. As in many tax disputes, the definition of what expenditures are eligible is critical. In subsection (c), start-up expenditures are defined as--
any amount paid or incurred in connection with (i) investigating the creation or acquisition of an active trade or business, or (ii) creating an active trade or business ... which if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business) ... would be allowable as a deduction for the taxable year in which paid or incurred.
The Commissioner's Position. The commissioner applied a narrow interpretation to the "allowable as a deduction" test in section 195(c) cited above. According to the TAM, the IRC section 195 amortization is limited to expenditures that are not deductible only because the taxpayer does not meet the "carrying on" a trade or business requirement found in IRC section 162. Any expenditure that is not deductible under IRC section 162 because it is capital in nature cannot be deducted under IRC section 195 simply because it is incurred prior to the operation of the business. In the present context (an acquisition), the nature of the expenditures is deemed to be capital and, therefore, the commissioner argues that they would not be currently deductible by an active trade or business. The TAM quotes a portion of House Report 96-1278 that directs that "the amortization election for start-up expenditures does not apply to amounts paid or incurred as part of the acquisition cost of a trade or business."
The TAM proceeds with a discussion of the capitalization requirements of IRC section 263 for acquired assets having a useful life beyond one year. Following the examples of acquiring buildings and machinery is a discussion of how those capitalization rules apply to attorney's and accountant's fees and appraisals of property acquired by a taxpayer.
Next, Rev. Rul. 77-254 (1977-2 CB 63) is cited. This ruling explains, "Once the taxpayer has focused on the acquisition of a specific business or investment, expenses that are related to an attempt to acquire such business or investment are capital in nature."
The commissioner's final authority is a Tax Court case. In Ellis Banking Corporation v. Comm'r [CCH Dec. 37,759(M) 1974], the court ruled that expenses for examination of a target bank pursuant to an acquisition agreement were nondeductible capital expenditures incurred in the acquisition of a capital asset. The court stated that, even though the acquisition decision was not final at the time the expenses were incurred, the expenses are not deductible.
From these authorities, the TAM holds that "once the taxpayer has made a decision to acquire a specific business, all costs incurred in an attempt to acquire the business must be capitalized." The holding continues by stating that the "expenditures indicate that the taxpayer had gone beyond a general search or preliminary investigation of Bank 1 [the target bank] and had decided to acquire Bank 1."
Further Analysis. Costs incurred in the investigation process are eligible for IRC section 195 deduction. However, costs related to an acquisition must be capitalized. The statute clearly states in section 195(c) that start-up expenditures include "any amount paid or incurred in connection with (i) investigating the creation or acquisition of an active trade or business" (emphasis added). In addition, House Report 96-1278 explains that eligible expenditures include expenditures "paid or incurred in connection with creating, or investigating the creation or acquisition of, a trade or business entered into by the taxpayer" (emphasis added). These two passages clearly state that investigating the acquisition of a trade or business is an expenditure eligible for amortization under IRC section 195.
A subsequent passage in the house report does explain (as the TAM records) that "amounts paid or incurred as part of the acquisition cost of a trade or business" are not eligible for IRC section 195 deduction. This section, however, refers to "part of the acquisition cost," not to expenditures for the investigation of a business. When identifying eligible expenditures, the House report asserts that "eligible expenses consist of investigatory costs incurred in reviewing a prospective business prior to reaching a final decision to acquire or to enter that business."
The court in Ellis Banking did not have to make such a distinction because the expenditures in question were prior to the enactment of IRC section 195; therefore, it was irrelevant. In 1974, the only choice was to either deduct or capitalize the costs. As stated in the opinion--
the sole issue for decision is whether certain expenditures incurred by petitioner Ellis Banking Corporation were ordinary and necessary business expenses properly deductible under IRC section 162, or whether they were costs incurred in connection with the acquisition of a capital asset and thus required to be capitalized under IRC section 263.
Perhaps the most significant outcome of this TAM is its position when the acquisition was made. The TAM presents the following statement in the facts section: "Taxpayer represents that these investigatory expenditures were incurred prior to its final decision to acquire Bank 1" (the target). However, the holding states that the decision was made prior to most of the costs being incurred. The commissioner has now deemed when the taxpayer made the decision to acquire the target bank--a dangerous precedent.
Both the FMR decision and TAM 9825005 reveal the continuing trend to take a hard line on capitalization issues. FMR effectively ends the deduction of business expansion costs based on the future benefit doctrine and negates a handful of court decisions. It appears the only way any multioutlet company can deduct expansion costs is to deny any future benefit from opening a new store.
TAM 9825005 discloses the commissioner's goal of omniscience. In future acquisitions, taxpayers should use corporate minutes to record decisions about acquisitions. Minutes should clearly state that an investigation will take place to determine the suitability of an acquisition and then note the date the acquisition is voted on and approved. Minutes should also record when a plan has been abandoned. In A.E. Staley Manufacturing [97-2 USTC 50,521 (CA-7)], the Court of Appeals for the Seventh Circuit reaffirmed that costs of an abandoned transaction are deductible under IRC section 165 as a loss not compensated for by insurance. *
Leonard G. Weld, PhD, is chair of the Department of Accounting and Finance and the E.H. Sherman Professor of Accountancy at the Sorrell College of Business at Troy State University in Troy, Ala. Charles E. Price, PhD, CPA, is the Charles M. Taylor Professor of Taxation at Auburn University.
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