Capitalization vs expense

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

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 961278 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.