Capitalization vs expense

CPA Journal, The, Jun 1999 by Weld, Leonard G, Price, Charles E

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. 9662 (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 , 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. US. (74-2 USTC 9809) and NCNB Corporation v. US. (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 Master(:Charge 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. Ll Jse 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 tJ. 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.