David J. Lychuk and Mary K. Lychuk v. Commissioner

116 T.C. No. 27

• Court: United States Tax Court
• Decided: May 31, 2001
• Docket: 11794-99, 11855-99, 11863-99
• Status: Unknown

Opinion

116 T.C. No. 27

UNITED STATES TAX COURT

DAVID J. LYCHUK AND MARY K. LYCHUK, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 11794-99, 11855-99, Filed May 31, 2001. 11863-99.

A acquires and services multiyear installment contracts as its sole business operations. A acquires each contract at 65 percent of its face value and is entitled to all principal and interest payments. A’s employees perform various credit review services in order to decide whether to acquire each contract offered to A and, as to the contracts which A chooses to acquire, perform additional services in paying the sellers. R determined that all of A’s salaries, benefits, and overhead (printing, telephone, computer, rent, and utilities) relating to its acquisition (and not to its service) operation were capital expenditures. R also determined that A had to capitalize professional fees and commissions

1 Cases of the following petitioners are consolidated herewith: Edward C. and Virginia M. Blasius, docket No. 11855- 99; James E. and Mary Jo Blasius, docket No. 11863-99. - 2 -

(collectively, offering expenditures) relating to its offering of notes in 1993 and a second offering that was planned in 1993 and abandoned in 1994. Held: The salaries and benefits are capital expenditures; A’s payment of these items was directly related to its anticipated acquisitions of assets with expected useful lives exceeding 1 year. Held, further, The overhead expenses may be deducted currently under sec. 162(a), I.R.C.; A’s payment of these items was not directly related to the anticipated acquisitions, and any future benefit that A received from these expenses was incidental to its payment of them. Held, further, sec. 165(a), I.R.C., allows A to deduct the portion of the capitalized salaries and benefits that was attributable to installment contracts which it never acquired; A may deduct those amounts for the respective years in which it ascertained that it would not acquire the related contracts. Held, further, A must capitalize all of the offering expenditures; A’s payment of these expenditures was anticipated to provide A with significant future benefits. Held, further, sec. 165(a), I.R.C., allows A to deduct in 1994 the portion of the capitalized offering expenditures that was attributable to the abandoned offering.

Oksana O. Xenos, for petitioners.*

Eric R. Skinner, for respondent.

LARO, Judge: Petitioners petitioned the Court to

redetermine deficiencies attributable primarily to adjustments

which respondent made to their income from a subchapter S

* Briefs of amici curiae were filed by Robert A. Rudnick, B. John Williams, Jr., James F. Warren, and Richard J. Gagnon, Jr., as counsel for Federal Home Loan Mortgage Corporation (FHLMC), and by Felix B. Laughlin and Anna-Liza Harris as counsel for Federal National Mortgage Association (FNMA). - 3 -

corporation, Automotive Credit Corporation (ACC). Respondent

determined a $1,202 deficiency in the 1993 Federal income tax of

David J. and Mary K. Lychuk. Respondent determined $2,149 and

$11,461 deficiencies in the 1993 and 1994 Federal income taxes,

respectively, of Edward C. and Virginia M. Blasius. Respondent

determined $23,683 and $89,609 deficiencies in the 1993 and 1994

Federal income taxes, respectively, of James E. and Mary Jo

Blasius.2 Both Blasius couples alleged in their respective

petitions that they had an overpayment for 1994 on account of

costs which ACC failed to deduct for that year.

Following concessions, we must decide whether ACC must

capitalize certain expenditures made during 1993 and 1994. The

expenditures were generally ACC’s payment of (1) salaries,

benefits, and overhead (printing, telephone, computer, rent, and

utilities) relating to its acquisition of retail installment

contracts (installment contracts) in the ordinary course of its

business (installment contracts expenditures) and (2)

professional fees and commissions relating to a private placement

offering of notes that ACC accomplished in 1993 and a second

offering that ACC planned in 1993 and abandoned in 1994

(collectively, PPM expenditures). We hold that ACC must

capitalize both groups of expenditures to the extent described

herein. We must also decide whether ACC may deduct the portion

2 James Blasius is Edward Blasius’ son. - 4 -

of the capitalized installment contracts expenditures relating to

installment contracts which it never acquired. We hold it may

deduct that portion under section 165(a).3 We must also decide

whether ACC may deduct the portion of the PPM expenditures

relating to the abandoned offering. We hold it may deduct that

portion for 1994 under section 165(a).

FINDINGS OF FACT

The parties have stipulated many of the facts. We

incorporate herein the parties’ stipulation of facts and the

exhibits submitted therewith. We find the stipulated facts

accordingly. Each petitioning couple is a husband and wife who

resided in Michigan when their petition was filed. Each

petitioning couple filed a joint Federal income tax return for

the relevant years.

ACC is a cash method taxpayer that was incorporated in 1992

and elected shortly thereafter to be taxed as an S corporation

for Federal income tax purposes. It was formed to provide

alternate financing for purchasers of used automobiles or light

trucks (collectively, automobiles) who have marginal credit. Its

sole business operation is (1) the acquisition of installment

contracts from automobile dealers (dealers) who have sold

automobiles to high credit risk individuals and (2) the servicing

3 Unless otherwise indicated, section references are to the Internal Revenue Code applicable to the relevant years. Rule references are to the Tax Court Rules of Practice and Procedure. - 5 -

of those contracts. Its primary business activities are credit

investigation, credit evaluation, documentation, and the

monitoring of collections on installment contracts. Its business

is conducted out of space that it rents in Bingham Farms,

Michigan, pursuant to a 5-year lease that began on October 22,

1992. Under the lease, ACC pays monthly rent of $3,137.50 during

the first 24 months and $3,250 afterwards.

ACC’s shareholders and their respective ownership interests

are as follows:

1993 1994

James and Mary Jo Blasius 77% 86% Edward and Virginia Blasius 13 14 Donald Terns 5 0 David Lychuk 5 0

None of the shareholders, except James Blasius, works in ACC’s

daily business. The other male shareholders serve as the

directors of ACC’s board.

ACC’s key management personnel includes its president, James

Blasius, its vice president and chief financial officer, Steven

Balan, its credit manager, Cass Budzynowski, and its credit

investigator, Hope McGee. During the relevant years, each of

these individuals performed services in connection with ACC’s

acquisition of installment contracts. James Blasius managed

ACC’s overall operation and handled personally all contracts with

dealers. Steven Balan supervised and oversaw ACC’s day-to-day

management and its financial and general office management. Cass - 6 -

Budzynowski analyzed credit applications and supervised credit

investigations. Hope McGee analyzed credit reports and verified

all information provided by credit applicants, e.g., by directly

contacting employers, banks, and creditors.

ACC pays each of its key management personnel a base salary.

Each of these individuals is also entitled to receive an annual

bonus at the sole discretion of ACC’s board of directors. The

bonuses are paid from a “bonus pool” established by ACC and in

which ACC places funds in an amount up to 16.25 percent of its

pretax net profits. Except in the case of James Blasius, no

restrictions exist as to the amount of compensation that ACC may

pay to its officers or key employees. James Blasius’ bonus is

limited to 55 percent of the pool.

Under the terms of each installment contract, an individual

buys an automobile from a dealer at a set price to be paid (with

interest) in monthly installments. The average rate of interest

charged to the buyers is approximately 22 percent. The length of

repayment ranges from 12 to 36 months.

ACC and the dealers have an independent agreement under

which the dealers sell some of the installment contracts (and the

right to the corresponding payments of principal and interest) to

ACC at a price equal to 65 percent of each contract’s principal

amount (i.e., at a 35-percent discount). As of April 30, 1993,

ACC acquired the installment contracts from 13 dealers, 3 of - 7 -

which sold to ACC 69.4 percent of the installment contracts which

ACC acquired. ACC is not obligated to acquire all of the

installment contracts offered to it by the dealers but generally

must decide on whether it will acquire a particular installment

contract before the related automobile sale is finalized. ACC

rests its decision as to the acquisition of an installment

contract on its analysis of the buyer’s credit worthiness. That

analysis generally includes ACC’s review of the buyer’s credit

application, ACC’s obtaining of one or more credit reports on the

buyer, ACC’s verifying of the buyer’s job status, salary, and

residence, and ACC’s evaluation of various aspects of the buyer’s

credit history such as payment history and financial stability.

If ACC acquires an installment contract, the dealer generally

assigns its rights under that contract to ACC as part of the

automobile sale, and ACC pays the dealer the 65-percent amount

upon ACC’s receipt of all of the documents relating to the

installment contract. The automobile buyer pays ACC all amounts

due under the installment contract, and the automobile buyer

collateralizes his or her obligation to make those payments with

the purchased automobile.4 ACC may repossess and sell the

automobile if the buyer defaults on the installment contract.

ACC’s acquisition of installment contracts generally

followed an established procedure. First, ACC would contact

4 ACC services all of the installment contracts it acquires. - 8 -

dealers and advise them that it was in the business of acquiring

installment contracts on an ongoing basis. Second, ACC would

enter into the independent agreement with each dealer that

decided to sell its installment contracts to ACC, and the dealer

would provide ACC with its sellers license. Third, the dealer,

when faced with a prospective automobile buyer who did not

qualify for traditional financing, would alert the buyer to ACC’s

financing business. Fourth, a buyer who wanted to finance the

purchase with ACC would complete a detailed credit application

that the dealer would transmit to ACC by facsimile. Fifth, ACC

would record the application in its daily log and perform its

credit review process. Sixth, to the extent that ACC decided

favorably on a credit application, and the buyer accepted ACC’s

financing arrangement,5 ACC would issue the dealer a check for

the 65-percent amount on the next Friday, or, if ACC had not yet

received the requisite documentation from the dealer, on the

first Friday after it received that documentation. One piece of

documentation required by ACC was the fully executed installment

contract that was printed on a form that bore ACC’s name, logo,

address, and telephone number. Upon receipt of this contract,

ACC assigned the applicant an account number and entered all

applicable information into its computerized collection system.

5 ACC’s approval of an application did not always result in its acquisition of the related installment contract. An applicant sometimes decided for one reason or another not to accept ACC’s financing arrangement. - 9 -

ACC’s credit review process generally included six steps,

all of which ACC could perform within 3 to 4 hours. First, ACC

would access electronically credit bureau reports on the

applicant and assign points to certain items shown on the

reports. Second, ACC would measure the total points either

against preestablished levels for approval or denial or against

an arbitrary level of approval or denial that was ascertained

intuitively. Third, ACC would analyze through debt-to-income and

loan-to-value ratios an applicant’s ability to pay the debt,

taking into account his or her disposable income and income per

dependent. ACC would sometimes perform in connection with this

step a budgetary analysis to suggest changes to the loan terms

(e.g., by decreasing the monthly payment over a longer time

frame) so as to meet preestablished target ratios. Fourth, ACC

would conditionally approve or deny an applicant on the basis of

all of the information that it had as of yet accumulated. Fifth,

as to applications that received a conditional approval, ACC

would perform an additional review as to the applicant by

verifying (mainly by telephone) his or her employment, residency,

and personal references, and by interviewing the applicant by

telephone. Sixth, as to the applicants who passed this

additional level of review, ACC would communicate to the dealer

ACC’s approval of the applicant. In some instances, ACC would

inform the dealer that it was unwilling to finance the purchase

under the terms offered to it but would finance a lesser amount - 10 -

of principal and/or would finance the purchase over a shorter

repayment term.

In 1993 and 1994, ACC paid installment contracts

expenditures totaling $267,832 and $339,211, respectively. These

expenditures, which were attributable to ACC’s obtaining of

credit reports and screening of credit histories, related

primarily to the portion of ACC’s payroll and overhead expenses

that was attributable to its credit analysis activities.6 None

of these expenditures included any postacquisition or servicing

expenses. ACC ascertained the amount of these expenditures at

the request of its independent auditors. The parties agree that

these expenditures are “related” to ACC’s credit analysis

activities and that the breakdown of specific expenditures is as

set forth below. The parties dispute whether any or all of the

expenditures is “directly related” to ACC’s credit analysis

activities, as contended by respondent, or is “indirectly

related” to those activities, as contended by petitioners.

6 We use the term “credit analysis activities” to refer to ACC’s credit review services and its funding services (i.e., ACC’s issuance of the checks to dealers in consideration for the installment contracts). - 11 -

Breakdown of Specific Expenditures1 1993

Salary Percentage of Total Expenses Amount And Benefits Related to ACC’s Credit In Employee Wages FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue Steve Balan $69,359 $4,504 $313 $4,062 $78,238 50 $39,119 James Blasius 89,769 4,713 313 4,062 98,857 75 74,143 Cass Budzynowski 43,500 3,213 313 1,790 48,816 100 48,816 Hope McGee 16,248 1,216 313 3,692 21,469 100 21,469 Kelly 16,100 1,193 313 1,790 19,396 100 19,396 Stacey 10,280 767 313 2,086 13,446 75 10,085 245,256 15,606 1,878 17,482 280,222 213,028

Overhead Items Printing 9,412 75 7,059 Telephone 12,454 75 9,341 Computer 19,598 95 18,618 Rent 34,413 50 17,207 Utilities 5,162 50 2,581 81,039 54,806 2 361,261 267,832

Salary, Wages, and Percentage of Total Expenses Amount Estimated Benefits Related to ACC’s Credit In Employee Bonus FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue Steve Balan $95,820 $4,886 $218 $4,932 $105,856 40 $42,342 James Blasius 139,216 5,776 218 4,932 150,142 50 75,071 Cass Budzynowski 52,846 3,813 218 2,177 59,054 100 59,054 Hope McGee 11,508 842 218 4,932 17,500 100 17,500 Kelly 22,200 1,584 218 2,177 26,179 100 26,179 Sue 24,500 1,760 218 4,932 31,410 100 31,410 Kathy 16,921 1,256 218 4,932 23,327 75 17,495 Stacey 1,218 93 32 411 1,754 75 1,316 Kirsten 2,438 167 57 181 2,843 100 2,843 366,667 20,177 1,615 29,606 418,065 273,210

Overhead Items Printing 8,663 75 6,497 Telephone 15,133 60 9,080 Computer 25,919 95 24,623 Rent 37,875 60 22,725 Utilities 5,126 60 3,076 92,716 66,001 510,781 339,211

1 The record does not indicate the surname of each of the listed employees. Nor does the record indicate the job titles of the employees listed without a surname or describe their daily duties. 2 The parties agree than this column equals $267,832. Actually, it equals $267,834. Because the $2 unexplained difference is immaterial to our analysis, we use the parties’ figure of $267,832.

ACC deducted the installment contracts expenditures of

$267,832 on its 1993 Federal income tax return, and it deducted - 12 -

$288,911 of the $339,211 in installment contracts expenditures on

its 1994 Federal income tax return. ACC now claims that it was

entitled to deduct for 1994 the remaining $50,300 of installment

contracts expenditures ($339,211 - $288,911). As to the

respective years, ACC deducted officers’ compensation of $158,099

and $217,036 and salaries/wages of $126,464 and $194,306. The

portion of the officers’ compensation, salaries/wages, and

overhead which was deducted but not in issue is attributable to

ACC’s servicing of the installment contracts.

For financial accounting purposes, ACC separately listed the

installment contracts as assets on its 1993 and 1994 balance

sheets. In addition, ACC initially deducted the installment

contracts expenditures of $267,832 for 1993 but amended that

year’s financial statements to amortize the expenditures over the

expected life of the related installment contracts. ACC’s

independent auditors required the amendment and related

amortization in order to comply with Statement of Financial

Accounting Standards No. 91 (SFAS 91), Accounting for

Nonrefundable Fees and Costs Associated with Originating or

Acquiring Loans and Initial Direct Costs of Leases.7 ACC

7 The record does not indicate why ACC’s auditors believed that the amendment was required under SFAS 91. Whereas SFAS 91 provides explicitly for the deferral of “direct loan origination costs”, it does not provide similarly as to the direct costs of acquiring loans. SFAS 91 provides as to the acquisition of loans that “15. The initial investment in a purchased loan or group of loans shall include the amount paid to the seller plus any fees (continued...) - 13 -

amortized the installment contracts expenditures of $339,211 over

the expected lives of the related installment contracts for 1994.

ACC performed its credit review services as to approximately

1,824 credit applications in 1993 and approximately 2,158 credit

applications in 1994. As to those applications, ACC acquired 693

installment contracts in 1993 and 820 installment contracts in

1994; in other words, ACC acquired in each year approximately 38

percent of the installment contracts which were offered to it.

The original terms of the 1993 installment contracts averaged

23.89 months, and their actual duration averaged 17.5 months.

The original terms of the 1994 installment contracts averaged 29

months, and their actual duration averaged 19.5 months. Of the

693 installment contracts acquired in 1993, 182 had an actual

duration of 12 months or less. Of the 820 installment contracts

acquired in 1994, 217 had an actual duration of 12 months or

less.

ACC issued a private placement memorandum (PPM) on April 30,

1993, offering up to $2.4 million of its subordinated asset

7 (...continued) paid or less any fees received. * * * All other costs incurred in connection with acquiring purchased loans or committing to purchase loans shall be charged to expense as incurred.” We note in passing, however, that rules such as SFAS 91 which are compulsory for financial accounting purposes do not control the proper characterization of an item for Federal income tax purposes. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542-543 (1979); see also Old Colony R.R. Co. v. Commissioner, 284 U.S. 552, 562 (1932). - 14 -

backed notes (Notes). ACC intended through the offering to raise

funds for its current operation, including the acquisition of

installment contracts which would be (and were) pledged to secure

ACC’s obligations under the Notes. The Notes matured in 36

months but could be redeemed by the noteholders at 12 or 24

months. The Notes bore interest at 12 percent during the first

year, 13 percent during the second year, and 14 percent during

the final year. The Notes were purchased by approximately 50

investors, and approximately five of these investors redeemed

their Notes before maturity.

East-West Capital Corporation (East-West) sold the Notes on

ACC’s behalf and was paid a commission equal to 4 percent of the

principal amount of the Notes sold, plus 1 percent of the

principal outstanding at 12 months, plus 1 percent of the

principal outstanding at 24 months. Included in East-West’s

commission was a 1 percent due diligence fee.

ACC deducted $29,647, $38,239, and $33,783 of offering

expenses, commissions, and professional fees, respectively, for

1993. ACC deducted $36,251, $74,361, and $110,432 of offering

expenses, commissions, and professional fees, respectively, for

1994. The deductions for 1993 and 1994 included costs

attributable to a second private placement offering that was

planned in 1993 and abandoned in 1994. - 15 -

Respondent audited ACC’s 1993 and 1994 taxable years. As to

1993, respondent disallowed $198,626 of installment contracts

expenditures deducted by ACC, determining that these expenses

were capital expenditures relating to assets having a life

exceeding one year.8 Respondent also disallowed $55,027 and

$66,652 of PPM expenditures deducted by ACC for 1993 and 1994,

respectively, determining that these expenditures were capital

expenditures which had to be amortized over the terms of the

Notes. The $55,027 included legal fees of $7,274 and a

registration fee of $1,250 paid in 1993 for the private placement

offering that ACC abandoned in 1994. The $66,652 included legal

fees of $21,792 paid in 1994 for the private placement offering

that ACC abandoned in 1994. The remaining adjustments as to the

PPM expenditures consisted of legal fees and commissions paid in

connection with the PPM.

OPINION

We must decide whether ACC may expense any of the disputed

costs or must capitalize them as expenditures to be deducted in

later years. Income tax deductions are a matter of legislative

grace, and petitioners bear the burden of proving ACC’s

entitlement to the claimed deductions. See Rule 142(a); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Interstate Transit

8 Respondent made no adjustment to ACC’s deduction of installment contracts expenditures for 1994. - 16 -

Lines v. Commissioner, 319 U.S. 590, 593 (1943). For Federal

income tax purposes, the principal difference between classifying

a payment as a deductible expense or a capital expenditure

concerns the timing of the taxpayer’s recovery of the cost. As

the Supreme Court has observed:

The primary effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer’s cost recovery: While business expenses are currently deductible, a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. * * * Through provisions such as these, the Code endeavors to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting in a more accurate calculation of net income for tax purposes. * * * [INDOPCO, Inc. v. Commissioner, supra at 83-84.]

Our inquiry begins with the installment contracts

expenditures. Respondent determined and maintains that ACC must

capitalize these expenditures to the extent stated herein.

Respondent argues primarily that these expenditures are capital

expenditures because they were related to ACC’s acquisition of

separate and distinct assets; i.e., the installment contracts.

Respondent argues secondly that ACC’s payment of the installment

contracts expenditures provided it with significant future

benefits in that it was able to acquire the installment contracts

which produced income for it in later years. Petitioners

maintain that the installment contracts expenditures are

currently deductible. Petitioners agree that the expenditures - 17 -

are related to the acquisition of the installment contracts but

argue primarily that the expenditures are deductible as routine,

recurring business expenses arising primarily from an employment

relationship rather than from a capital transaction. Petitioners

argue secondly that the installment contracts expenditures are

deductible because they are not described in either section

263(a) or the related regulations.

We agree with respondent in part and with petitioners in

part. We agree with respondent that ACC must capitalize the

installment contracts expenditures to the extent of the salaries

and benefits.9 We conclude that ACC’s payment of the salaries

and benefits was directly related to its acquisition of the

installment contracts. We agree with petitioners that ACC may

9 We allow ACC to deduct under sec. 165(a) the portion of those expenditures that was attributable to the installment contracts which it never acquired. ACC may deduct those amounts for the respective years in which it ascertained that it would not acquire the related contracts. See Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1382 (11th Cir. 1982), affg. in part and remanding in part T.C. Memo. 1981-123. See generally PNC Bancorp, Inc. v. Commissioner, 110 T.C. 349, 359, 362 (1998) (Commissioner allowed banks to deduct loan origination costs expended in connection with loans which were not successfully approved), revd. on other grounds 212 F.3d 822 (3d Cir. 2000). Respondent argues that petitioners have failed to prove the portion of the expenditures attributable to the installment contracts which it never acquired. We disagree. We have found as a fact that ACC did not acquire approximately 62 percent of the installment contracts which were offered to it in each of the subject years. We hold that ACC may deduct for 1993 and 1994 62 percent of the installment contracts expenditures attributable to installment contracts which in those years it decided not to acquire. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). - 18 -

currently deduct the installment contracts expenditures to the

extent of the overhead expenses. We conclude that ACC’s payment

of the overhead expenses was not directly related to the

anticipated acquisition of any of the installment contracts. We

also conclude that any future benefit that ACC received from the

overhead expenses was incidental to its payment of them. As

discussed in detail below, we believe that the Supreme Court’s

mandate as to capitalization requires that an expenditure be

capitalized when it: (1) Creates or enhances a separate and

distinct asset, see Commissioner v. Lincoln Sav. & Loan

Association, 403 U.S. 345, 354 (1971), (2) produces a significant

future benefit, see INDOPCO, Inc. v. Commissioner, supra at 87-

89, or (3) is incurred “in connection with” the acquisition of a

capital asset,10 Commissioner v. Idaho Power Co., 418 U.S. 1, 13

(1974); see Woodward v. Commissioner, 397 U.S. 572, 575-576

(1970). Given the Supreme Court’s pronouncement in Woodward v.

Commissioner, supra at 577, that an acquisition-related

10 We, like the Court of Appeals for the Eleventh Circuit in Ellis Banking Corp. v. Commissioner, supra at 1379, understand the term “capital asset” to be used for this purpose in its accounting sense to encompass any asset with a useful life exceeding 1 year. See also United States v. Akin, 248 F.2d 742, 744 (10th Cir. 1957) (“it may be said in general terms that an expenditure should be treated as one in the nature of a capital outlay if it brings about the acquisition of an asset having a period of useful life in excess of one year”. Such an understanding is directly consistent with the Secretary’s interpretation set forth in sec. 1.263(a)-2(a), Income Tax Regs., of examples of property for which the costs of acquisition are capital expenditures. - 19 -

expenditure is a capital expenditure when its origin “is in the

process of acquisition itself”, we understand the phrase “in

connection with” in the third situation to mean that the

expenditure must be directly related to the acquisition.

Our analysis begins with the relevant statutory text. We

apply that text in accordance with the related Treasury income

tax regulations, the validity of which has not been challenged by

either party, and the interpretation of that text and those

regulations primarily by the United States Supreme Court.

Section 162(a) provides that “There shall be allowed as a

deduction all the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or

business”. The Treasury regulations specify that ordinary and

necessary business expenses include “the ordinary and necessary

expenditures directly connected with or pertaining to the

taxpayer’s trade or business”, sec. 1.162-1(a), Income Tax Regs.,

such as “a reasonable allowance for salaries or other

compensation for personal services actually rendered”, sec.

1.162-7(a), Income Tax Regs. The Supreme Court has explained

that a cash method taxpayer such as ACC may deduct an expenditure

under section 162(a) if the expenditure is: (1) An expense,

(2) an ordinary expense, (3) a necessary expense, (4) paid during

the taxable year, and (5) made to carry on a trade or business.

See Commissioner v. Lincoln Sav. & Loan Association, supra at - 20 -

352-353. The Supreme Court has stated that a necessary expense

is an expense that is appropriate or helpful to the development

of the taxpayer’s business, see Commissioner v. Tellier, 383 U.S.

687, 689 (1966); Welch v. Helvering, 290 U.S. 111, 113-115

(1933), and that an ordinary expense is an expense that is

“normal, usual, or customary” in the type of business involved,

Deputy v. du Pont, 308 U.S. 488, 495-496 (1940); see also Welch

v. Helvering, supra at 113-115. The Supreme Court has observed

that the need for an expenditure to be ordinary serves, in part,

to “clarify the distinction, often difficult, between those

expenses that are currently deductible and those that are in the

nature of capital expenditures, which, if deductible at all, must

be amortized over the useful life of the asset.” Commissioner v.

Tellier, supra at 689-690.

The fact that a payment falls within a literal reading of

section 162(a) does not necessarily mean that the payment is

deductible. Sections 161 and 261, for example, except certain

payments from the current deductibility provision of section

162(a). See INDOPCO, Inc. v. Commissioner, 503 U.S. at 84.

Section 161 provides that “there shall be allowed as deductions

the items specified in * * * [section 162(a)], subject to the

exceptions provided in * * * sec. 261 and following, relating to

items not deductible”. Section 261 provides that “no deduction - 21 -

shall in any case be allowed in respect of the items specified in

this part”; i.e., part IX (Items Not Deductible).

Section 263 is included in part IX. Section 263(a)

provides, in language that dates back to the Revenue Act of 1864,

sec. 117, 13 Stat. 282, see United States v. Hill, 506 U.S. 546,

556 n.6 (1993) (“section 263(a)(1) has one of the longest

lineages of any provision in the Internal Revenue Code.”), that

“No deduction shall be allowed for--(1) Any amount paid out for

new buildings or for permanent improvements or betterments made

to increase the value of any property or estate.” The Treasury

regulations interpret this text by listing the following item as

an example of a capital expenditure: “The cost of acquisition,

construction, or erection of buildings, machinery and equipment,

furniture and fixtures, and similar property having a useful life

substantially beyond the taxable year.” Sec. 1.263(a)-2(a),

Income Tax Regs.

The determination of whether an expenditure is deductible

under section 162(a) or must be capitalized under section 263(a)

is not always a straightforward or mechanical process. “[E]ach

case ‘turns on its special facts’”, and “the cases sometimes

appear difficult to harmonize.” INDOPCO, Inc. v. Commissioner,

supra at 86 (quoting Deputy v. du Pont, supra at 496).

In accordance with the current law on capitalization, an

expenditure may be deductible in one setting but capitalizable in - 22 -

a different setting. For example, in Commissioner v. Idaho Power

Co., 418 U.S. at 13, the Supreme Court observed the following as

to wages paid by a taxpayer in its trade or business:

Of course, reasonable wages paid in the carrying on of a trade or business qualify as a deduction from gross income. * * * But when wages are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and are then entitled to be amortized over the life of the capital asset so acquired. * * *

Similarly, in Ellis Banking Corp. v. Commissioner, 688 F.2d 1376,

1379 (11th Cir. 1982), affg. in part and remanding in part T.C.

Memo. 1981-123, the Court of Appeals for the Eleventh Circuit

observed as to business expenses in general:

an expenditure that would ordinarily be a deductible expense must nonetheless be capitalized if it is incurred in connection with the acquisition of a capital asset.6 6 We do not use the term “capital asset” in the restricted sense of section 1221. Instead, we use the term in the accounting sense, to refer to any asset with a useful life extending beyond one year.

Accord American Stores Co. & Subs. v. Commissioner, 114 T.C. 458

(2000) (taxpayer required to capitalize legal fees incurred to

defend against State antitrust suit arising out of, and connected

to, prior stock acquisition); cf. Stevens v. Commissioner, 46

T.C. 492, 497 (1966) (otherwise deductible business expenses are

capital expenditures when paid to acquire a capital asset), affd.

388 F.2d 298 (6th Cir. 1968); X-Pando Corp. v. Commissioner, 7

T.C. 48, 51-53 (1946) (salary, rent, advertising, and traveling - 23 -

expenses which would ordinarily be deductible may be a capital

expenditure if made to cultivate or develop business, the

benefits of which will be realized in future years).

The just-quoted observations of the Supreme Court and the

Court of Appeals for the Eleventh Circuit in the Idaho Power Co.

and Ellis Banking Corp. cases, respectively, reflect a

longstanding, firmly established body of law under which

expenditures incurred “in connection with” the acquisition of a

capital asset are considered capital expenditures includable in

the acquired asset’s tax basis.11 Commissioner v. Idaho Power

Co., supra at 13; see Woodward v. Commissioner, 397 U.S. at 575

(“It has long been recognized, as a general matter, that costs

incurred in the acquisition or disposition of a capital asset are

to be treated as capital expenditures”); see also Johnsen v.

Commissioner, 794 F.2d 1157, 1162 (6th Cir. 1986) (“costs

incurred in connection with the acquisition or construction of a

capital asset are capital expenditures”), revg. on other grounds

83 T.C. 103 (1984); Ellis Banking Corp. v. Commissioner, supra at

11 The Commissioner has had a similar longstanding view. See, e.g., Rev. Rul. 73-580, 1973-2 C.B. 86 (portion of compensation paid by corporation to its employees that is attributable to services performed in connection with corporate acquisitions is a capital expenditure); Rev. Rul. 69-331, 1969-1 C.B. 87 (bonuses and commissions paid by gas distributor to secure long-term leases for hot water heaters are capital expenditures); Rev. Rul. 57-400, 1957-2 C.B. 520 (commissions paid by bank to brokers and other third parties for introduction of acceptable applicants for mortgage loans are capital expenditures). - 24 -

1379 (“an expenditure that would ordinarily be a deductible

expense must nonetheless be capitalized if it is incurred in

connection with the acquisition of a capital asset”); cf. A.E.

Staley Manufacturing Co. & Subs. v. Commissioner, 119 F.3d 482,

489 (7th Cir. 1997) (costs are capital expenditures if they are

“associated with” facilitating a capital transaction), revg. on

other grounds and remanding 105 T.C. 166 (1995); Central Tex.

Sav. & Loan Association v. United States, 731 F.2d 1181, 1184

(5th Cir. 1984) (“expenditures incurred in the acquisition of a

capital asset must generally be capitalized”); Commissioner v.

Wiesler, 161 F.2d 997, 999 (6th Cir. 1947) (“well settled rule

that expenditures incurred as an incident to the acquisition or

sale of property are not ordinary and necessary business

expenses, but are capital expenditures which must be added to the

cost of the property”), affg. 6 T.C. 1148 (1946).

Capitalizable expenditures are not limited to the actual

price that the buyer pays to the seller for the asset but

include, for example, the payment of legal, brokerage,

accounting, appraisal and other “ancillary” expenses related to

the asset’s acquisition. Woodward v. Commissioner, supra at

576-577; see United States v. Hilton Hotels Corp., 397 U.S. 580

(1970); see also Ellis Banking Corp. v. Commissioner, supra at

1379. Capitalizable expenditures also include compensation paid

for services performed in connection with an asset’s acquisition, - 25 -

including “a reasonable proportion of the wages and salaries of

employees who spend some of their working hours laboring on the

acquisition”. Briarcliff Candy Corp. v. Commissioner, 475 F.2d

775, 781 (2d Cir. 1973), revg. on other grounds and remanding

T.C. Memo. 1972-43; see Commissioner v. Idaho Power Co., supra at

13; see also Cagle v. Commissioner, 539 F.2d 409, 416 (5th Cir.

1976), affg. 63 T.C. 86 (1974); Perlmutter v. Commissioner, 44

T.C. 382, 404 (1965), affd. 373 F.2d 45 (10th Cir. 1967); cf.

Strouth v. Commissioner, T.C. Memo. 1987-552 (costs of securing

potential leases, including checking the lessee’s credit,

reviewing the lease application, and drafting the lease documents

are capital expenditures).

When the Supreme Court was faced with the question as to the

capitalization of litigation costs incurred appraising the stock

of minority shareholders in connection with the majority

shareholder’s acquisition of that stock, the Court held that the

central inquiry was whether the expenditure originated in “the

process of acquisition”. Woodward v. Commissioner, supra at 577.

In other words, the Court set its focus on the directness of the

costs’ relationship to the acquisition and adopted a test under

which costs originating in the process of acquiring a capital

asset are considered capital expenditures. - 26 -

We believe that the application of the “process of

acquisition” test is appropriate here.12 Both this Court and the

Court of Appeals for the Ninth Circuit applied the process of

acquisition test in Honodel v. Commissioner, 76 T.C. 351 (1981),

affd. 722 F.2d 1462 (9th Cir. 1984), to decide whether the

taxpayer/investors could deduct two types of fees which they paid

to an investment advisory and financial management company. The

first fee was a nonrefundable monthly retainer that the taxpayers

paid for investment counsel and advice. The amount of this fee

depended on the investor’s income level and the investor’s

financial planning, tax advice, and investment needs. The second

fee was a one-shot charge for services rendered in connection

with each investment acquired. The amount of this fee equaled a

specific percentage of the investment’s cost. We allowed the

taxpayers to deduct the monthly fees but required them to

capitalize the one-shot fees. We focused on whether the services

performed by the investment adviser were performed in the process

of acquisition or for investment advice. We concluded that the

services relating to the monthly fee did not arise out of that

process but that the services relating to the one-shot fee did.

See id. at 363-368. The Court of Appeals for the Ninth Circuit

agreed. See Honodel v. Commissioner, 722 F.2d 1462 (9th Cir.

12 This approach is consistent with a test suggested by the amicus for FHLMC. - 27 -

1984). Thus, while the monthly fees were connected to an

acquisition in the sense that they were required to be paid in

order to consummate any acquisition, both this Court and the

Court of Appeals for the Ninth Circuit acknowledged that the fees

were insufficiently connected with an acquisition to require

their capitalization. The process of acquisition test,

therefore, does not simply rest on whether an expenditure is

somehow connected to an asset acquisition but focuses more

appropriately on whether the expenditure was directly related to

that acquisition.

We apply the process of acquisition test to the facts at

hand. The salaries and benefits are a capital expenditure if the

underlying services were performed in the acquisition process,

or, in other words, were directly related to ACC’s anticipated

acquisition of installment contracts. See Woodward v.

Commissioner, 397 U.S. 572 (1970); Honodel v. Commissioner,

supra. We conclude that the underlying services were performed

in that process; i.e., the services were directly related to

ACC’s anticipated acquisition of installment contracts. Each of

the employees spent a significant portion of his or her time

working on credit analysis activities, which was the first (and,

in ACC’s business, an indispensable) step in ACC’s acquisition

process, and, but for ACC’s anticipated acquisition of

installment contracts, ACC would not have incurred the salaries - 28 -

and benefits attributable to those activities.13 The credit

review activities were so inexorably tied to and such an integral

part of the acquisition process that the portion of the salaries

and benefits attributable thereto must be considered as part of

the cost of the installment contracts. To be sure, the Supreme

Court in Commissioner v. Idaho Power Co., 418 U.S. at 13, even

considered the tools and materials used by the construction

workers, in addition to the wages of the workers themselves, as

part of the capital asset’s cost, as did the court in Ellis

Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982),

with respect to office supplies, filing fees, travel expenses,

and accounting fees. We hold that the salaries and benefits are

capital expenditures to the extent that the parties have agreed

that those costs are attributable to the credit analysis

activities.14

13 As a matter of fact, ACC admitted as much in its PPM when it stated:

In the event only a minimal amount of Notes are sold pursuant to this Offering, the Company [ACC] would have to downsize its operations and could, in fact, operate with its current portfolio of retail installment contracts with as few as three (3) individuals, including the President of the Company, James Blasius. 14 To the extent that the specific work performed by each individual as to the acquisition process is not contained in the record, petitioners bear the consequences of any deficiency in the record as they bear the burden of disproving respondent’s determination that the costs of the services and benefits at issue are capital expenditures. - 29 -

As to the overhead expenses, we conclude and hold

differently. Those expenses are capital expenditures to the

extent that they originated in ACC’s acquisition process, or, in

other words, were directly related to ACC’s anticipated

acquisition of installment contracts. We are unable to find that

such was the case. None of these routine and recurring expenses

originated in the process of ACC’s acquisition of installment

contracts, nor, in fact, in any anticipated acquisition at all.

ACC would have continued to incur most of these expenses in the

ordinary course of its business had its business only been to

service the installment contracts. The items of rent and

utilities, for example, were generally fixed charges which had no

meaningful relation to the number of credit applications analyzed

(or the number of installment contracts acquired) by ACC. Nor

did the printing expense have any such meaningful relation. In

fact, ACC’s printing costs were less in 1994 than in 1993, even

though ACC analyzed 18.3 percent more credit applications (and

acquired 18.3 percent more installment contracts) in 1994 than in

1993. Although ACC’s telephone and computer costs did increase

in 1994 from the prior year, we are unable to discern from the

record any direct relationship between that increase and the

increase from the prior year in credit applications analyzed

and/or installment contracts acquired so as to require

capitalization of those costs. - 30 -

We recognize that the Court in Perlmutter v. Commissioner,

44 T.C. at 403-405, required the taxpayer there to capitalize a

portion of his utilities as sufficiently connected to a capital

transaction. In that regard, the Perlmutter case is

distinguishable from the case at hand in that the Perlmutter case

preceded Woodward v. Commissioner, supra, and the related process

of acquisition test. We also distinguish the printing costs at

hand from the printing costs in A.E. Staley Manufacturing Co. &

Subs. v. Commissioner, 119 F.3d at 492-493, the latter of which

we and the Court of Appeals for the Seventh Circuit considered as

associated with a capital transaction. The printing costs there,

unlike those here, were required to be incurred by the taxpayer

so as to facilitate communication with shareholders and others in

connection with the transaction. See A.E. Staley Manufacturing

Co. & Subs. v. Commissioner, 105 T.C. at 180, 197.

Respondent argues that ACC’s payment of the overhead

expenses produced for it a significant future benefit requiring

capitalization under INDOPCO, Inc. v. Commissioner, 503 U.S. 79

(1992). We disagree. On the basis of our discussion above, we

conclude that any future benefit that ACC realized from these

expenses was incidental to its payment of them so as not to

require capitalization on that theory. See id. at 87-88.

Petitioners argue that the salaries and benefits are ipso

facto deductible because they are the routine, recurring expenses - 31 -

of ACC’s business.15 Petitioners make three assertions in

support of this argument. Petitioners first assert that the

salaries and benefits are fixed costs which flow from an

employment agreement and are not dependent upon the occurrence of

a capital transaction. In this regard, petitioners contend, the

amounts of the salaries and benefits paid by ACC are unaffected

by the quantity, principal amount, or duration of the installment

contracts, and those items would have been incurred even without

the acquisition of an installment contract. Petitioners assert

secondly that the salaries and benefits are deductible under a

literal reading of section 1.162-1(a), Income Tax Regs. The

relevant text of that section allows a taxpayer to deduct

reasonable compensation that is “directly connected with or

pertaining to the taxpayer’s trade or business”. Petitioners

assert thirdly that the salaries and benefits are deductible

under the established jurisprudence of First Sec. Bank of Idaho,

N.A. v. Commissioner, 592 F.2d 1050 (9th Cir. 1979), affg. 63

T.C. 644 (1975); First Natl. Bank of South Carolina v. United

States, 558 F.2d 721 (4th Cir. 1977); Colorado Springs Natl. Bank

v. United States, 505 F.2d 1185 (10th Cir. 1974); and Iowa-Des

Moines Natl. Bank v. Commissioner, 68 T.C. 872 (1977), affd. 592

15 The amicus for FNMA also advances this argument. - 32 -

F.2d 433 (8th Cir. 1979) (collectively, credit card cases).16

Petitioners assert that the credit card cases hold that recurring

expenses are deductible under section 162(a) whenever the

expenses are incurred in the ordinary course of business.

Petitioners also point to INDOPCO, Inc. v. Commissioner, supra,

and contend that the Supreme Court acknowledged there that an

expense’s recurring nature is critical to qualifying it as

deductible under section 162(a).

We disagree with petitioners’ argument that section 162(a)

allows ACC to deduct the expenses that recur in the ordinary

course of its business merely by virtue of the fact that the

expenses are everyday and/or routine in nature. In order for a

payment to be deductible under section 162(a), the underlying

expense must not only be “normal, usual, or customary” in the

type of business involved, Deputy v. du Pont, 308 U.S. at 495, it

must be realized and exhausted in the year of payment, see

Stevens v. Commissioner, 388 F.2d at 300. Although an employer’s

payment of salaries and benefits similar to the ones at issue

will usually generate for the employer benefits that will be

realized and exhausted in the year of payment, the same is not

true when those items are directly related to the employer’s

acquisition of a capital asset such as an installment contract.

16 Petitioners also rely on Bankers Dairy Credit Corp. v. Commissioner, 26 B.T.A. 886 (1932). - 33 -

The benefits which ACC will reap from the installment contracts;

namely, interest and excess principal income,17 will not be

realized and exhausted within the year of payment. ACC will

realize those benefits in each of the later years in which the

interest and excess principal are received. Given the Supreme

Court’s observation in INDOPCO, Inc. v. Commissioner, supra at

83-84, that our tax law endeavors to measure taxable income by

allowing expenses to be deducted in the taxable year in which the

related income is recognized, see also Newark Morning Ledger Co.

v. United States, 507 U.S. 546, 565 (1993); Hertz Corp. v. United

States, 364 U.S. 122, 126 (1960), it is only appropriate to defer

ACC’s deduction of its payment of any expenses directly related

to that interest or excess principal income to the years in which

ACC recognizes the income.18 Only then will ACC’s taxable income

be calculated more accurately for tax purposes than if ACC had

deducted those expenses currently.

We find instructive to our decision the case of Helvering v.

Winmill, 305 U.S. 79 (1938), revg. 93 F.2d 494 (2d Cir. 1937),

17 We use the term “excess principal” to refer to the principal on the installment contracts that exceeded 65 percent of their face value. 18 The salaries and benefits were instrumental to the production of that income in that ACC would not have acquired any of the installment contracts without performing its credit analysis activities. In this regard, we disagree with the amicus representing FNMA that all of ACC’s salaries and benefits are indirect expenses to which sec. 263(a) does not apply in the first place. - 34 -

revg. and remanding 35 B.T.A. 804 (1937). There, the taxpayer

claimed that he could deduct as compensation brokerage

commissions paid to acquire securities in the ordinary course of

his business. The Commissioner had disallowed the deduction,

determining that the payments were capital expenditures. The

taxpayer argued that it could deduct the payments because, he

asserted, they were an ordinary and necessary business expense.

The taxpayer asserted that he was in the business of buying and

selling securities. A divided Board of Tax Appeals sustained the

Commissioner’s disallowance. See Winmill v. Commissioner, 35

B.T.A. 804 (1937). The Court of Appeals for the Second Circuit

disagreed with the Board, holding that the payments were

deductible if the taxpayer was in fact engaged in the business of

buying and selling securities. See Winmill v. Commissioner, 93

F.2d 494 (2d Cir. 1937). The Supreme Court held that the

payments were capital expenditures. The Supreme Court noted that

the Treasury regulations (Regs. 77, art. 282 (1932)19) set forth

a longstanding position that commissions paid in acquiring

securities are considered part of the securities’ cost and

stated: “The fact-–if it be a fact-–that * * * [the taxpayer]

was engaged in the business of buying and selling securities does

19 The substance of these regulations regarding commissions paid to acquire securities has been carried forward into sec. 1.263(a)-2(e), Income Tax Regs. - 35 -

not entitle him to take a deduction contrary to this provision.”

Helvering v. Winmill, 305 U.S. at 84.

Petitioners argue that Helvering v. Winmill, supra, is

irrelevant. Petitioners recognize that the taxpayer in the

Winmill case, similar to petitioners here, relied on a provision

in the regulations that provided specifically that compensation

paid in the ordinary course of business qualified as a deductible

expense. Petitioners distinguish the Winmill case by noting that

another provision in those regulations provided specifically that

“commissions paid in purchasing securities are a part of the cost

price of such securities.” Regs. 77, art. 282 (1932).

Petitioners conclude that the Supreme Court’s holding in the

Winmill case rested solely on the presence of the second

provision and assert that no similar provision exists here to

preclude explicitly its deduction of the salaries and benefits.

Petitioners also note that the instant facts are different than

Winmill in that ACC is not a securities dealer, the installment

contracts are not securities, and none of the installment

contracts expenditures are commissions.

We disagree with petitioners’ assertion that Helvering v.

Winmill, supra, is irrelevant. We, like the Supreme Court in the

Winmill case, focus on a specific, longstanding position set

forth in the Treasury regulations to conclude that the salaries

and benefits must be capitalized even though, in a different - 36 -

setting, those costs may have qualified for deduction under a

more general regulatory provision. Specifically, whereas section

1.162-1(a), Treasury Income Tax Regs., provides generally that

“the ordinary and necessary expenditures directly connected with

or pertaining to the taxpayer’s trade or business” are deductible

expenses, section 1.263(a)-2(a), Income Tax Regs., provides

specifically that capitalized expenditures include “The cost of

acquisition, construction, or erection of buildings, machinery

and equipment, furniture and fixtures, and similar property

having a useful life substantially beyond the taxable year.” We

disagree with petitioners when they assert that this latter

provision does not preclude explicitly ACC’s deduction of the

salaries and benefits. The installment contracts, similar to the

buildings, machinery and equipment, and furniture and fixtures

listed specifically in section 1.263(a)-2(a), Income Tax Regs.,

have anticipated useful lives extending substantially beyond the

taxable year of the related expenditures.20 We also disagree

20 Petitioners argue that the installment contracts are not "similar" to the examples in the regulations and, hence, expenditures connected thereto need not be capitalized. We disagree. We understand the word “similar” to encompass any property that, like the examples, has a useful life extending substantially beyond the taxable year of the related expenditure. Petitioners’ narrow interpretation of the regulations fails to recognize that the Supreme Court has consistently taken a wider view as to capital expenditures. See, e.g., Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. 345 (1971) (contributions to depository reserve fund were capital expenditures); Helvering v. Winmill, 305 U.S. 79 (1938) (taxpayer (continued...) - 37 -

with petitioners when they draw factual distinctions between the

two cases sufficient to warrant contrary results. The facts that

ACC is not a securities dealer, that the installment contracts

are not securities, and that none of the installment contracts

expenditures are commissions are, in our minds, merely

distinctions without a difference. Compare Woodward v.

Commissioner, 397 U.S. at 575, 577-578, wherein the Court stated:

The Court recognized [in Helvering v. Winmill, supra,] that brokers’ commissions are ‘part of the (acquisition) cost of the securities,’ Helvering v. Winmill, supra, 305 U.S. at 84, 59 S.Ct. at 47, and relied on the Treasury regulation, which had been approved by statutory re-enactment, to deny deductions for such commissions even to a taxpayer for whom they were a regular and recurring expense in his business of buying and selling securities.

* * * * * * *

in this case there can be no doubt that legal, accounting, and appraisal costs incurred by taxpayers in negotiating a purchase of the minority stock would have been capital expenditures. See Atzingen-Whitehouse Dairy, Inc. v. Commissioner, 36 T.C. 173 (1961). Under whatever test might be applied, such expenses would have clearly been ‘part of the acquisition cost’ of the stock. Helvering v. Winmill, supra. * * *

Accord Commissioner v. Wiesler, 161 F.2d at 999 (“the Winmill

case * * * follow[s] the well settled rule that expenditures

incurred as an incident to the acquisition * * * of property are

not ordinary and necessary business expenses, but are capital

20 (...continued) required to capitalize the regular and recurring costs incurred in acquiring securities). - 38 -

expenditures”); Ellis Banking Corp. v. Commissioner, T.C. Memo.

1981-123 (“Nor would the fact that petitioner was engaged in the

business of acquiring bank stock entitle it to deduct such

expenditures if the bank stock was a capital asset and the

expenditures were incurred in the acquisition thereof. Helvering

v. Winmill, supra.”).

We also apply the case of Commissioner v. Idaho Power Co.,

418 U.S. 1 (1974), revg. 477 F.2d 688 (9th Cir. 1973), revg. T.C.

Memo. 1970-83. There, the taxpayer was a public utility engaged

in the production, transmission, and sale of electricity.

Throughout its long existence, the taxpayer regularly and

routinely constructed additional transmission and distribution

facilities using its own equipment and hundreds of its own

employees. Respondent determined that the taxpayer had to

capitalize the depreciation on its equipment to the extent used

in the construction project. The Supreme Court agreed. The

Court noted that a goal of Federal income tax accounting is to

match income with the related expenses and observed that “‘It has

long been recognized, as a general matter, that costs incurred in

the acquisition * * * of a capital asset are to be treated as

capital expenditures.’” Id. at 12 (quoting Woodward v.

Commissioner, supra at 575; ellipsis in original). Further, the

Court noted: “there can be little question that other

construction-related expense items, such as tools, materials, and - 39 -

wages paid construction workers, are to be treated as part of the

cost of acquisition of a capital asset.” Id. at 13. The Court

concluded that requiring the taxpayer to capitalize its

depreciation would maintain tax parity between it and another

taxpayer who retained an independent contractor to construct the

improvements and additions for it. In the latter case, the Court

stated, the depreciation on the equipment used by the independent

contractor would be part of the cost that the contractor charged

on the project. The Court believed it unfair to allow a taxpayer

to deduct the cost of constructing its facility if it has

sufficient resources to do its own construction work, while

requiring another taxpayer without such resources to capitalize

its cost including the depreciation charged by the contractor.21

See id. at 14. The Court expressed no opinion as to the fact

that the taxpayer in the Idaho Power Co. case had been regularly

and routinely improving its facilities throughout most of its

long existence, nor that these improvements had for the most part

been made by its employees. See id.; see also the opinions of

the lower courts at Idaho Power Co. v. Commissioner, 477 F.2d

688, 690 (9th Cir. 1973); Idaho Power Co. v. Commissioner, T.C.

Memo. 1970-83.

21 The amicus for FHLMC would limit the Supreme Court’s tax parity rationale to cases of self-created assets. We read nothing that would so limit that rationale. - 40 -

The Court of Appeals for the Eleventh Circuit also applied

the case of Commissioner v. Idaho Power Co., supra, in Ellis

Banking Corp. v. Commissioner, 688 F.2d 1376 (11th Cir. 1982), to

require capitalization of certain acquisition-related

expenditures. There, the taxpayer was a bank holding company

that, under State law, had to acquire the stock of other banks or

organize new banks in order to expand its business into new

geographic markets. The taxpayer agreed with another bank

(Parkway) and certain of Parkway’s shareholders to acquire all of

Parkway’s stock in exchange for taxpayer stock. The agreement

was contingent on the satisfaction of certain events. Prior to

consummation of the acquisition, but in connection therewith, the

taxpayer incurred various expenses conducting a due diligence

examination of Parkway’s books. These expenses were for office

supplies, filing fees, travel expenses, and accounting fees. The

taxpayer deducted these expenses, and respondent disallowed the

deduction. Respondent determined that the expenses had to be

capitalized.

We sustained respondent’s disallowance. We held that the

expenses were capital expenditures because they were incurred in

connection with the acquisition of a capital asset. The Court of

Appeals for the Eleventh Circuit agreed. The taxpayer had argued

that the expenses were "ordinary and necessary" because they were

incurred in connection with its decision to acquire the stock and - 41 -

in evaluating the market in which Parkway was located. See id.

at 1381. The taxpayer noted that the expenses were incurred

before it was bound to buy Parkway’s stock. The Court of

Appeals, in rejecting the taxpayer’s claim to current

deductibility, stated:

Ellis also devotes a portion of its brief to arguing that it is in the business of promoting banks, so that the expenditures made in that business are deductible. It is not enough to establish that expenditures are incurred in carrying on a trade or business to qualify for a deduction under section 162--all of the requirements set out above [namely, the five requirements for deductibility set forth in Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. at 352-353,] must be fulfilled. Indeed, if being in the business sufficed, Ellis would be able to deduct the purchase price of the Parkway stock. * * * [Id. at 1381 n.10.]

The Court of Appeals went on to say that

the expenses of investigating a capital investment are properly allocable to that investment and must therefore be capitalized. That the decision to make the investment is not final at the time of the expenditure does not change the character of the investment; when a taxpayer abandons a project or fails to make an attempted investment, the preliminary expenditures that have been capitalized are then deductible as a loss under section 165. * * * As the First Circuit stated, ‘* * * expenditures made with the contemplation that they will result in the creation of a capital asset cannot be deducted as ordinary and necessary business expenses even though that expectation is subsequently frustrated or defeated.’ Union Mutual, 570 F.2d at 392 (emphasis in original). Nor can the expenditures be deducted because the expectations might have been, but were not, frustrated. [Id. at 1382.]

Our opinion as to the salaries and benefits is further

supported by the cases of Godfrey v. Commissioner, 335 F.2d 82 - 42 -

(6th Cir. 1964), affg. T.C. Memo. 1963-1, and Stevens v.

Commissioner, 388 F.2d 298 (6th Cir. 1968). Godfrey v.

Commissioner, supra, concerned deductions that the taxpayer

claimed as to a joint venture in two parcels of real estate known

as the Goose Pond and Adams Packing properties. Before taking

title to the Goose Pond property, the taxpayer and his associates

caused a use survey to be conducted on the property in order to

ascertain its best commercial use. They concluded from the

survey that the upper part of the tract was best suited for an

automobile dealership and that the lower portion could best be

used for a shopping center. They acquired the property and then

discovered that it lacked the zoning classification necessary to

use it in the manner indicated by the survey. They retained

attorneys to try to change the property’s classification. Their

attempt was unsuccessful. The taxpayer deducted his

proportionate share of the cost of the survey and the attorney’s

fee. The taxpayer also deducted travel and living expenses that

he had paid in connection with acquiring both the Goose Pond and

Adams Packing properties.

We denied the deductions, holding that all of the

expenditures were capital expenditures. We observed that the use

survey “represented their first step in the contemplated

development of the property; and its benefits were obviously

expected to extend beyond the year in which the survey was made.” - 43 -

Godfrey v. Commissioner, T.C. Memo. 1963-1. We observed that the

attorney’s fee was part of the cost of the development of a

capital asset, in that it represented an unsuccessful attempt to

have the Goose Pond property rezoned for certain commercial use.

We observed that the travel and living expenses generally related

to the acquisition and development of the property.

The Court of Appeals for the Sixth Circuit agreed with us

that all of the expenditures were capital expenditures. The

court stated:

The Tax Court found that the cost of the “use survey” was a capital expenditure. The court said: “It represented their first step in the contemplated development of the property; and its benefits were obviously expected to extend beyond the year in which the survey was made.” The test of an ordinary business expense is whether it is of a recurring nature and its benefit is generally exhausted within a year. An expenditure is of a capital nature “where it results in the taxpayer’s acquisition or retention of a capital asset, or in the improvement or development of a capital asset in such a way that the benefit of the expenditure is enjoyed over a comparatively lengthy period of business operation.” Louisiana Land & Exploration Co. v. Commissioner, 7 T.C. 507, aff’d, 161 F.2d 842, C.A. 5 * * *. The purpose of the use survey was to benefit the land in a permanent way so that the owners could derive income from it on the basis of its best use. We agree with the Tax Court that this was properly a capital expenditure.

We are of the opinion that the same reasoning is applicable to the expenditure for attorney’s fee. Counsel for the * * * [taxpayer] concedes that if the effort had been successful the expenditure would not have been a deductible item. We think there can be no distinction. The purpose of the expenditure was to create a permanent benefit. The fact that it created neither a permanent nor exhaustible benefit does not - 44 -

change its character. * * * [Godfrey v. Commissioner, 335 F.2d at 85.22]

In Stevens v. Commissioner, 46 T.C. 492 (1966), the taxpayer

and another individual (Woody) entered into various joint

ventures each of which involved acquiring a race horse and

sharing that horse’s winnings or any proceeds from its sale.

Woody paid the purchase price of each horse, and the taxpayer

paid each horse’s maintenance and training expenses. We held

that one-half of the otherwise deductible maintenance expenses

were capital expenditures because they represented the taxpayer’s

cost of acquiring a one-half interest in the horses. We stated:

We agree with respondent to the extent that at least some portion of these expenses, which would otherwise be deductible as ordinary and necessary business expenses, must be capitalized as petitioner’s acquisition costs in the particular factual circumstances here present. It is obvious that petitioner had some acquisition cost for his interests; these interests were not acquired for nothing. Although Woody paid the entire purchase price for each horse, he did not give petitioner a one-half interest in each without consideration. * * *

In effect, Woody assumed petitioner’s half of the purchase price and as consideration for this, petitioner assumed Woody’s half of the expense burden. * * * [Id. at 497.]

22 The court held that our findings as to the remaining expenses were not clearly erroneous. See Godfrey v. Commissioner, 335 F.2d 82, 86 (6th Cir. 1964), affg. T.C. Memo. 1963-1. - 45 -

In affirming our decision, the Court of Appeals for the Sixth

Circuit held that the mere fact that the expenses were recurring

and otherwise deductible business expenses was not enough to make

the expenses deductible under section 162. The court noted that

“Section 162 was primarily intended to cover recurring

expenditures where the benefit derived from the payment is

realized and exhausted within the taxable year” and that the

benefit from the expenses would not be exhausted within the year.

Stevens v. Commissioner, 388 F.2d at 300; accord Perlmutter v.

Commissioner, 44 T.C. at 403-405 (taxpayer required to capitalize

portion of salaries, utilities, insurance, depreciation, legal

and audit expenses, office expenses, and vehicle and truck

expenses allocable to the construction of shopping center

buildings).

We also are mindful of Wells Fargo & Co. & Subs. v.

Commissioner, 224 F.3d 874 (8th Cir. 2000), affg. in part and

revg. in part Norwest Corp. v. Commissioner, 112 T.C. 89 (1999).

There, a bank (Davenport) entered into a transaction with another

bank (Norwest) that resulted in Norwest’s owning all the stock of

an entity of which Davenport was a part. Following the

taxpayer’s concession that section 263(a) required that Davenport

capitalize the costs which were directly related to the

transaction, we were left to decide whether section 162(a)

allowed Davenport to deduct investigatory costs of $87,570, due - 46 -

diligence costs of $23,700, and officers’ salaries of $150,000

which respondent had determined were attributable to the

transaction. Most ($83,450) of the investigatory costs related

to services rendered by a law firm, before Davenport agreed to

participate in the transaction. The remaining ($4,120)

investigatory costs related to services performed by the law firm

in investigating whether, after the transaction, Norwest’s

director and officer liability coverage would protect Davenport’s

directors and officers for acts and omissions occurring before

the transaction. The due diligence costs related to services

performed by the law firm in connection with Norwest’s due

diligence review. The disallowed officers’ salaries were

attributable to services performed in the transaction.

We held that section 162(a) did not let Davenport deduct any

of the disputed costs. Our holding followed our conclusion that

all of the costs bore a sufficient nexus to a transaction

producing a significant long-term benefit to fall within the

rules of capitalization as set forth primarily in INDOPCO, Inc.

v. Commissioner, 503 U.S. 79 (1992). Upon appeal, the

Commissioner conceded that section 162(a) allowed Davenport to

deduct the investigatory costs of $83,450 because they were

attributable to the investigatory stage of the transaction. That

concession followed the Commissioner’s release of Rev. Rul. 99-

23, 1999-1 C.B. 998, 1000, which holds that - 47 -

Expenditures incurred in the course of a general search for, or investigation of, an active trade or business in order to determine whether to enter a new business and which new business to enter (other than costs incurred to acquire capital assets that are used in the search or investigation) qualify as investigatory costs that are eligible for amortization as start-up expenditures under § 195. However, expenditures incurred in the attempt to acquire a specific business do not qualify as start-up expenditures because they are acquisition costs under § 263. The nature of the cost must be analyzed based on all the facts and circumstances of the transaction to determine whether it is an investigatory cost incurred to facilitate the whether and which decisions, or an acquisition cost incurred to facilitate consummation of an acquisition.[23]

As to the remaining fees of $27,820 ($4,120 + $23,700), all

of which were incurred after Davenport had made its final

decision as to the acquisition, the Court of Appeals for the

Eighth Circuit agreed with us that those amounts were capital

expenditures. The Court of Appeals disagreed with us, however,

as to the officers’ salaries and held that those costs were

currently deductible. The court reasoned:

23 The Commissioner’s position as to the deductibility of investigatory expenditures incurred to acquire specific assets is set forth in Rev. Rul. 74-104, 1974-1 C.B. 70. There, the costs were “evaluation” expenditures which the taxpayer incurred in its business of acquiring residential property to renovate and sell to the public. Before acquiring the property, the taxpayer evaluated certain localities to ascertain the feasibility of selling the property in that locality. The taxpayer incurred a cost to secure an initial report from an independent agent and other costs to evaluate the report and the locality involved. The ruling holds that the costs are capital expenditures because they were incurred in connection with acquiring the residential property and provide benefits beyond the current taxable year through the sale of the renovated property. - 48 -

the distinction between the case at hand, and the INDOPCO case lies in the relationship between the expense at issue and the long term benefit. In INDOPCO, the expenses in question were directly related to the transaction which produced the long term benefit. Accordingly, the expenses had to be capitalized. See INDOPCO, 503 U.S. 79, 112 S.Ct. 1039, 117 L.Ed.2d 226. We conclude that if the expense is directly related to the capital transaction (and therefor, the long term benefit), then it should be capitalized. * * * See e.g. INDOPCO, 503 U.S. 79, 112 S.Ct. 1039, 117 L.Ed.2d 226 (1992). In this case, there is only an indirect relation between the salaries (which originate from the employment relationship) and the acquisition (which provides the long term benefit * * *).

Similarly, the instant case is distinguishable from Acer Realty Co. v. Commissioner22, wherein this Court held that the salaries paid to two officers for "unusual, nonrecurrent services" had to be capitalized. 132 F.2d 512, 513 (8th Cir. 1942). The taxpayer was a corporation whose only business was leasing real estate to a related corporation. Its officers were paid no salaries prior to their undertaking a large building program, at which point the two officers began acting as general contractors and "performed all the services necessary to the management of the construction of the buildings." Acer Realty, 132 F.2d at 514. Because the salaries were clearly and directly related to the capital project, this Court determined that most of the salaries paid were extraordinary or incremental expenses which had to be capitalized. Acer Realty Co. v. Commissioner, 132 F.2d 512 (8th Cir. 1942). 22 Acer Realty is the only case in our Circuit, that we are aware of, which denies the taxpayer a deduction for salary expenses.

The instant case is easily distinguishable from Acer Realty because Davenport’s officers had always received salaries, even before the acquisition was a possibility. There was no increase in their salaries attributable to the acquisition, and they would have been paid the salaries whether or not the acquisition took place. Therefore, we determine that the salary expenses in this case originated from the employment relationship between the taxpayer and its officers. - 49 -

Indirectly, the payment of these salaries provided Davenport with a long term benefit. [Wells Fargo & Co. & Subs. v. Commissioner, 224 F.3d at 887-888.]

Judge Bright wrote a concurring opinion in Wells Fargo & Co.

& Subs. to highlight the fact that the record did not allow for a

determination as to the portion of the salaries which were

directly related to the transaction. Judge Bright wrote:

I write separately to emphasize that the record in this case is inadequate to show that the portion of the salaries in question, $150,000, was directly or substantially related to the acquisition. Moreover, the tax court’s findings of fact on this issue does not address the direct or indirect relationship of the work of the officers to the acquisition. That finding recited:

During 1991, DBTC [Davenport] had 9 executives and 73 other officers (collectively, the officers). John Figge, James Figge, Thomas Figge, and Richard Horst worked on various aspects of the transaction, as did other officers. None of the offices were hired specifically to render services on the transaction; all were hired to conduct DBTC’s day-to-day banking business. DBTC’s participation in the transaction had no effect on the salaries paid to its officers. Of the salaries paid to the officers in 1991, $150,000 was attributable to services performed in the transaction. DBTC deducted the salaries, including the $150,000, on its 1991 Federal income tax return. Respondent disallowed the $150,000 deduction; i.e., the portion attributable to the transaction. * * *

This finding does not address whether some officers at any particular period of time devoted substantial work to the acquisition or whether the officers during the period of time in question only incidentally worked on the acquisition while doing regular banking duties. - 50 -

In order to determine whether an allocation of officers’ salaries to an acquisition-transaction such as made here qualifies as a deduction from income or should be capitalized, the taxing authorities should require the taxpayer to show officers’ time devoted to the acquisition as compared to time spent on regular work during a particular and relevant time period. The finding made by the tax court here does not justify capitalization of the officers’ salaries. [Id. at 889- 890 (Bright, J., concurring).]

We do not believe that our view as to the salaries and wages

at hand is inconsistent with the Court of Appeals for the Eighth

Circuit’s view as to the salaries at issue in Wells Fargo & Co. &

Subs., supra. The cases are factually distinguishable. There,

some of Davenport’s 82 officers spent a portion of their time

performing services on a capital transaction; apparently, it was

a relatively small portion, since the total salary attributable

to work performed on the transaction by all of the officers was

$150,000. The services which they performed as to the capital

transaction were extraordinary in the daily course of their

employment, and the capital transaction was extraordinary to

their employer’s business. They would have been paid the same

salaries regardless of whether the transaction was consummated.

Here, by contrast, each of the disputed employees spent a

significant portion of his or her time (in fact, in 8 of the 15

cases, all of his or her time) working on capital asset

acquisitions which occurred in the ordinary course of ACC’s - 51 -

business.24 The employees were paid specifically to perform work

as to the acquisitions, and the amount of the compensation that

ACC paid to the employees hinged directly on the number of

installment contracts that it acquired, e.g., at least some of

the employees were entitled to receive a bonus in profitable

years.25 Thus, whereas the officers in Wells Fargo & Co. &

Subs., supra, performed the typical services of bank employees,

services which could include work on a capital transaction as

part of the bank’s business in general, ACC’s employees were

hired and paid to perform services that necessarily would include

work on capital asset acquisitions.

The record here indicates specifically the portion of ACC’s

total compensation that was directly related to ACC’s acquisition

of the installment contracts, and, in accordance with Supreme

Court precedent (as well as jurisprudence from the Second

Circuit, Fifth Circuit, and this Court), we consider as capital

expenditures that “proportion of the wages and salaries of

employees who spend some of their working hours laboring on the

acquisition”. Briarcliff Candy Corp. v. Commissioner, 475 F.2d

at 781; see Commissioner v. Idaho Power Co., 418 U.S. at 13; see

24 Of the total compensation paid to the disputed employees in 1993 and 1994, 76 percent ($213,028/$280,222) and 65.4 percent ($273,212/$418,065), respectively, was attributable to the acquisition of installment contracts. 25 We also bear in mind the statement in ACC’s PPM discussed supra note 13. - 52 -

also Cagle v. Commissioner, 539 F.2d at 416; Perlmutter v.

Commissioner, 44 T.C. at 404.

Petitioners are mistaken when they assert that established

jurisprudence provides that section 162(a) always allows a

taxpayer to deduct the everyday, recurring costs of its business.

The primary cases upon which petitioners rely, i.e., the credit

card cases, did not merely rest on facts that the costs at issue

there were everyday and recurring in nature. All of those cases

involved costs which were incurred in the businesses’ startup

phase and which did not produce any separate or distinct asset.

In Colorado Springs Natl. Bank v. United States, 505 F.2d at

1192, for example, the Court of Appeals for the Tenth Circuit

noted that "The start-up expenditures here challenged did not

create a property interest. They produced nothing corporeal or

salable." Similarly, in First Natl. Bank of South Carolina v.

United States, 558 F.2d at 723, the Court of Appeals for the

Fourth Circuit noted that “Membership in ASBA is not a separate

and distinct additional asset created or enhanced by the payments

in question.” Likewise, in Iowa-Des Moines Natl. Bank v.

Commissioner, 68 T.C. at 879, we noted that the costs "did not

create or enhance a separate and distinct asset or property

interest."26 Cf. Central Tex. Sav. & Loan Association v. United

26 In First Security Bank of Idaho, N.A. v. Commissioner, 592 F.2d 1050 (9th Cir. 1979), affg. 63 T.C. 644 (1975), the (continued...) - 53 -

States, 731 F.2d at 1184-1185 (court distinguished the credit

card cases by virtue of the fact that the expense of the taxpayer

before it created a separate and distinct asset). Contrary to

petitioners’ assertion (and, as discussed infra, the view of the

Court of Appeals for the Third Circuit), we do not read any of

the credit card cases to hold that everyday, recurring expenses

are ipso facto deductible under section 162(a). In fact, as this

Court observed in Iowa-Des Moines Natl. Bank v. Commissioner, 68

T.C. at 879, costs are entitled to deduction when they are

“related to the active conduct of an existing business and * * *

[do] not create or enhance a separate and distinct asset or

property interest.” Nor do we understand the Supreme Court in

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), to have

espoused the sweeping pronouncement proffered by petitioners as

to this issue.27

Petitioners also rely on PNC Bancorp, Inc., v. Commissioner,

212 F.3d 822 (3d Cir. 2000), revg. 110 T.C. 349 (1998). When

this case was tried, the Court of Appeals for the Third Circuit

had not yet released its opinion in that case, and petitioners

26 (...continued) Court of Appeals for the Ninth Circuit adopted as the law of that circuit the decision of the Tenth Circuit in Colorado Springs Natl. Bank v. United States, 505 F.2d 1185 (10th Cir. 1974). 27 Nor do we read Bankers Dairy Credit Corp. v. Commissioner, 26 B.T.A. 886 (1932), to hold that salaries and benefits are ipso facto deductible when they are recurring costs. - 54 -

took the view that our opinion there was inapplicable to this

case because, they claimed, the cases were factually

distinguishable. We held in PNC Bancorp, Inc., v. Commissioner,

supra, that loan origination costs were capital expenditures.

The Court of Appeals for the Third Circuit disagreed, holding

that the costs were deductible expenses. Petitioners now assert

that PNC Bancorp, Inc. is relevant to our inquiry.

We do not believe that PNC Bancorp, Inc. v. Commissioner,

supra, is so factually distinguishable from the instant case to

support contrary results. Although the cases are obviously

distinguishable by virtue of the fact that PNC (as defined below)

was a loan originator and ACC is a loan acquirer, we do not

believe that this bare distinction is meaningful enough to

support contrary results in the cases, especially given the

Supreme Court’s statements in Commissioner v. Idaho Power Co.,

supra at 12-13, to the effect that the creation of an asset is

subject to the same set of capitalization rules as the

acquisition of an asset. Given the additional fact that the

Court of Appeals for the Third Circuit disagreed with our view as

to the rules of capitalization applicable to the loan origination

costs in PNC Bancorp, Inc., we believe it appropriate to

reconsider our opinion there in light of the contrary view set

forth by the Court of Appeals for the Third Circuit in reversing

our decision. We have carefully done so, giving due regard to - 55 -

the contrary view. For the reasons set forth below, we continue

to adhere to our view on the rules of capitalization as expressed

in PNC Bancorp, Inc., respectfully disagreeing with the contrary

view expressed by the Court of Appeals for the Third Circuit.

PNC was the successor in interest to two banks

(collectively, PNC) which had deducted expenditures paid to

market, research, and originate loans to PNC’s customers. These

expenditures included: (1) Amounts paid to record security

interests, (2) amounts paid to third parties for property

reports, credit reports, and appraisals, and (3) an allocable

portion of salaries and benefits paid to employees for evaluating

a borrower’s financial condition, evaluating guaranties,

collateral, and other security arrangements, negotiating loan

terms, preparing and processing loan documents, and closing loan

transactions. PNC capitalized and amortized these costs for

financial accounting purposes but deducted them for Federal

income tax purposes. PNC argued that the costs were deductible

for tax purposes because they (1) were recurring expenses in the

banking business, (2) were integral to PNC’s daily operation, and

(3) provided PNC with only short-term benefits.

We found that PNC incurred the costs to create separate and

distinct assets, i.e., the loans, and that the costs produced for

PNC long-term benefits in the form of the interest to be received

in later years. The Court of Appeals for the Third Circuit - 56 -

disagreed with both of these findings. The Court of Appeals

focused primarily on the everyday meaning of the word “ordinary”

and, without any reference to Helvering v. Winmill, 305 U.S. 79

(1938), and with only a passing reference to Commissioner v.

Idaho Power Co., 418 U.S. 1 (1974), which the Court of Appeals

cited for the proposition that capitalization prevents the

distortion of income in the case of depreciable property,

concluded that the loan origination costs were ordinary business

expenses for purposes of section 162(a) because the costs were

normal and routine to the business of a bank. See PNC Bancorp,

Inc., v. Commissioner, 212 F.3d at 828-829, 834-835. The court

saw no meaningful distinction between PNC’s loan origination

costs and the costs incurred as "ordinary expenses" by banks in

general. The court stated that PNC’s deduction of the loan

origination costs would not distort its income because it

incurred those costs regularly. See id. at 834-835.

The Court of Appeals for the Third Circuit also stated that

PNC’s costs did not create any separate and distinct asset within

the meaning of Commissioner v. Lincoln Sav. & Loan Association,

403 U.S. 345 (1971). Unlike the assets in Lincoln Sav. & Loan

Association, which were not used by the taxpayer in its everyday

business, PNC used its loans as part of its everyday business.

The Court of Appeals distinguished the respective assets in the

cases by this fact. The Court of Appeals also distinguished - 57 -

PNC’s costs from the payments in Lincoln Sav. & Loan Association

by noting that the payments in Lincoln Sav. & Loan Association

had formed the corpus of the asset, whereas PNC’s costs were not

included in the principal of the loans. The Court of Appeals

analogized PNC’s costs to the expenditures at issue in the credit

card cases, concluding that the costs were deductible under that

line of cases. PNC Bancorp, Inc., v. Commissioner, 212 F.3d at

830-831.

We do not believe that the “normal and routine” nature of

the expenses in question dictates their deductibility. As

discussed above, payments made with a sufficiently direct

connection to the acquisition, creation, or enhancement of a

capital asset must be capitalized even when those payments are

made in the course of the payee’s regular business operations.

See, e.g., Woodward v. Commissioner, 397 U.S. at 575, 577-578;

Helvering v. Winmill, supra. Nor do we believe that any of the

long line of cases addressing this acquisition-related

capitalization requirement supports a conclusion that a payment

is a capital expenditure only if it creates, enhances, or becomes

part of an asset that is unrelated to the taxpayer’s daily

business. An expense that recurs in a taxpayer’s business is a

capital expenditure when it is incurred in direct connection with

the acquisition, creation, or enhancement of a separate and

distinct asset, or provides the taxpayer with a significant - 58 -

future benefit. See, e.g., INDOPCO, Inc. v. Commissioner, 503

U.S. 79 (1992); Commissioner v. Idaho Power Co., supra at 13;

Woodward v. Commissioner, supra; Helvering v. Winmill, supra; see

also Ellis Banking Corp. v. Commissioner, T.C. Memo. 1981-123

(citing Woodward v. Commissioner, supra) (fact that a taxpayer

"incurs expenditures * * * on a recurring basis does not ensure

their characterization as ‘ordinary’ if they are incurred in the

acquisition of a capital asset"). The mere fact that an expense

may have been deductible in the credit card cases (or any other

case for that matter) does not necessarily mean that the same

type of expense is ipso facto deductible in another setting such

as the one found in PNC Bancorp, Inc., v. Commissioner, 212 F.3d

822 (3d Cir. 2000). See, e.g., Commissioner v. Idaho Power Co.,

supra at 13.

We also do not believe that the fact that PNC’s loan

origination costs were recurring in nature means that PNC’s

current deduction of them would allow for an appropriate matching

of income and expense. See PNC Bancorp, Inc., v. Commissioner,

supra at 834-835. The Supreme Court stated explicitly in

INDOPCO, Inc. v. Commissioner, supra at 84, that our Federal

income tax system endeavors to match expenses with the related

revenue in the taxable period for which the income is recognized.

The Court stated in Commissioner v. Idaho Power Co., supra at 16,

that “The purpose of section 263 is to reflect the basic - 59 -

principle that a capital expenditure may not be deducted from

current income. It serves to prevent a taxpayer from utilizing

currently a deduction properly attributable, through

amortization, to later tax years when the capital asset becomes

income producing.” The thrust of these statements, in our minds,

is that an expenditure must be deducted in accordance with its

own individual identity, regardless of the possible recurrence in

the taxpayer’s business of that type of expense. A taxpayer’s

income will be distorted if the taxpayer currently deducts a

recurring expense that should be capitalized and the amount of

that expense fluctuates meaningfully between taxable years. For

example, when the amount of such an expenditure increases

significantly from one year to the next, the deduction of the

expenditure may result in the taxpayer’s income being understated

in the first year and overstated in the second, and the profits

of the business may appear to be sinking, when in fact it is

enjoying great success, or rising, when in fact it may be

seriously diminished. See Electric & Neon, Inc. v. Commissioner,

56 T.C. 1324, 1332-1333 (1971), affd. without published opinion

496 F.2d 876 (5th Cir. 1974). Such an inaccurate reporting of

this fluctuation thwarts, rather than fosters, “a major objective

of efficient tax policy.” Cabintaxi Corp. v. Commissioner, 63

F.3d 614, 619 (7th Cir. 1995), affg. in part, revg. in part, and

remanding on another issue T.C. Memo. 1994-316. - 60 -

Nor do we read anything in section 263 or the related

regulations that hinges section 263(a)’s applicability to an

expenditure on a finding that an asset acquired or created by the

expenditure was used outside of the taxpayer’s daily business.

In fact, if such was the case, the costs incurred to acquire

manufacturing equipment would arguably be deductible because that

equipment is indispensable to the daily operation of the

manufacturer’s business. Moreover, in the case of an appraisal,

the costs of which are clearly capital expenditures when incurred

in connection with the purchase of property, the appraisal

neither adds value to the appraised property nor has a long-term

life. We also note our disagreement with the concept that a cost

is a capital expenditure only if it becomes part of an asset. To

be sure, the depreciation of the equipment used to construct the

facilities in Commissioner v. Idaho Power Co., 418 U.S. 1 (1974),

did not become an actual part of those facilities.

Nor do we find persuasive PNC’s argument to the Court of

Appeals for the Third Circuit that our application of the

“separate and distinct asset test” of Commissioner v. Lincoln

Sav. & Loan Association, 403 U.S. at 354, was too expansive in

that it would require capitalization of costs incurred “in

connection with” or “with respect to” the acquisition of an

asset. PNC Bancorp, Inc. v. Commissioner, 212 F.3d at 830. Such

an argument conflicts directly not only with the Supreme Court’s - 61 -

reasoning in Commissioner v. Idaho Power Co., supra at 12-14, and

Woodward v. Commissioner, 397 U.S. at 575-576, but with the

reasoning of various Courts of Appeals that have required

capitalization of amounts incurred “in connection with” the

acquisition of an asset. See, e.g., Johnsen v. Commissioner, 794

F.2d at 1162; Central Tex. Sav. & Loan Association v. United

States, 731 F.2d at 1184; Ellis Banking Corp. v. Commissioner,

688 F.2d at 1379.

Nor do we believe that the fact an expenditure is somehow

connected to the “needs of current income production” is enough

to qualify that expenditure as a current deduction. PNC Bancorp,

Inc. v. Commissioner, 212 F.3d at 829, 833-834 (citing National

Starch & Chem. Corp. v. Commissioner, 918 F.2d 426 (3d Cir.

1990), affd. sub nom. INDOPCO, Inc. v. Commissioner, 503 U.S. 79

(1992). In our minds, an expenditure that produces both a

current and long-term benefit is neither 100 percent deductible

nor 100 percent capitalizable. Instead, regardless of whether

the expenditure’s primary or predominant purpose is to benefit

significantly the business’ current operation, on the one hand,

or its long-term operation, on the other hand, the expenditure is

a capital expenditure to the extent that it produces a

significant long-term benefit and deductible to the remaining

extent. See Woodward v. Commissioner, 397 U.S. at 577-579;

Commissioner v. Idaho Power Co., supra; Great N. Ry. v. - 62 -

Commissioner, 40 F.2d 372 (8th Cir. 1930), affg. on other grounds

8 B.T.A. 225 (1927); Southern Natural Gas Co. v. United States,

188 Ct. Cl. 302, 412 F.2d 1222, 1264-69 (1969).28

Having rejected petitioners’ first argument as to the

salaries and benefits, we now turn to petitioners’ second

argument that the salaries and benefits are outside the reach of

section 263 because, they contend, those items are not described

in that section. Petitioners make three assertions in support of

this argument. First, they assert that section 263(a) applies

only when an expenditure creates or adds value to a separate and

distinct capital asset29 and that ACC’s payment of the salaries

and benefits neither created nor added value to a capital asset.

According to petitioners, an expenditure is subject to section

263(a) only if it (1) is incurred to increase the value of

28 In Commissioner v. Idaho Power Co., 418 U.S. 1 (1974), the Supreme Court held that the taxpayer must capitalize the portion of depreciation on transportation equipment allocable to part-time use in constructing improvements and other capital facilities for the taxpayer. In Great N. Ry. v. Commissioner, 40 F.2d 372 (8th Cir. 1930), affg. on other grounds 8 B.T.A. 225 (1927), the Court of Appeals for the Eighth Circuit held that a railway had to capitalize the cost of operating its regular trains to the extent it was attributable to the transportation of the railway’s workmen and materials to construction sites. In Southern Natural Gas Co. v. United States, 188 Ct. Cl. 302, 412 F.2d 1222, 1264-69 (1969), the Court of Claims held that depreciation on automotive equipment used primarily for operating and maintaining a pipeline system, but occasionally used in construction operations, had to be capitalized to the extent it was attributable to the construction. 29 The amici for FNMA also advance this argument. - 63 -

property and (2) concerns the permanent improvement or betterment

of that property. Petitioners also contend that the installment

contracts are ordinary (and not capital) assets in the hands of

ACC. Second, they assert that the salaries and benefits are

expansion costs as to an existing business which, they contend,

are deductible under a line of cases including PNC Bancorp, Inc.,

v. Commissioner, 212 F.3d 822 (3d Cir. 2000); Briarcliff Candy

Corp. v. Commissioner, 475 F.2d at 781; Bankers Dairy Credit

Corp. v. Commissioner, 26 B.T.A. 886 (1932); and the credit card

cases. Petitioners also point to the following excerpt from the

legislative history under section 195:

In the case of an existing business, eligible startup 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, at 11 (1980), 1980-2 C.B. 709, 712.]

Third, they assert that the salaries and benefits did not

generate a future benefit to ACC. They contend that the salaries

and benefits are not directly related to the acquisition of any

specific installment contract. They contend that the salaries

and benefits were predecisional expenses which generated

predominately short-term benefit. They contend that the salaries

and benefits did not themselves generate future income but only

allowed ACC to decide whether it would acquire an installment

contract. - 64 -

We reject petitioners’ second argument. As to their first

assertion, we disagree with them that acquisition costs are

capitalizable under section 263(a) only if they create or add

value to a capital asset.30 In Dustin v. Commissioner, 467 F.2d

47, 49-50 (9th Cir. 1972), affg. 53 T.C. 491 (1969), the taxpayer

was a shareholder of an S corporation (Capitol) that agreed to

acquire the stock of a company that owned and operated radio

station KGMS. In 1961, Capitol incurred $12,460 of legal,

engineering, and accounting fees in connection with the transfer

to Capitol of control of station KGMS’ radio-broadcasting

license. The taxpayer deducted his proportionate share of these

expenses, and the Commissioner disallowed the deduction asserting

that the expenses were capital expenditures. The taxpayer argued

in this Court that he could deduct $10,960 of the expenses

because they were attributable to a hearing held by the Federal

Communications Commission on this matter and which did not add

any value to the acquired stock. We disagreed with the taxpayer

that any of these amounts were currently deductible. On appeal,

so did the Court of Appeals for the Ninth Circuit. According to

30 As mentioned above, we understand the term “capital asset” to be used in its accounting sense and not in accordance with its meaning under sec. 1221. We add to our prior discussion that the term as applied to capitalization issues does not arise from the Code but is a byproduct of judicial interpretation. On the basis of our understanding of the meaning of the term, we reject petitioners’ contention that costs related to an “ordinary” asset under sec. 1221 can never be a capital expenditure. - 65 -

that court: “The expenditures connected with the acquisition of

the broadcast license were no less capital in character because

they did not themselves contribute additional and specific

financial value to the license being sought. The important fact

is that the expenditures were made for the purpose of acquiring a

capital asset.” Dustin v. Commissioner, 467 F.2d at 50; accord

King Amusement Co. v. Commissioner, 44 F.2d 709 (6th Cir. 1930)

(fees paid to guarantors of rent under lease were capital

expenditures notwithstanding the fact that the fees added no

value to the lease or to the property leased thereunder), affg.

15 B.T.A. 566 (1929).

In making this assertion, petitioners focus solely on the

latter part of the text in section 263(a)(1); to wit, the phrase

“made to increase the value of any property”. We do not do

likewise. A proper reading of that section in full reveals that

the phrase relates to “permanent improvements or betterments” and

not to “new buildings”.31 Cf. Dustin v. Commissioner, 53 T.C. at

505. Here, we are dealing with salaries and benefits paid to

acquire capital assets (i.e., the installment contracts) and not

with expenditures made to improve or better property already

owned. We also bear in mind that the test for capitalization

31 Under the Treasury Department’s longstanding interpretation of sec. 263(a) as set forth in sec. 1.263(a)-2(a), Income Tax Regs., the cost of acquiring a long-term asset is an example of a capital expenditure. - 66 -

does not hinge on the amount of value added to property but looks

at the nature of the expense itself. See Dominion Resources Inc.

v. United States, 219 F.3d 359, 371 (4th Cir. 2000). When the

nature of an expenditure bears a direct relation to the

acquisition of a capital asset, such as is the case here, the

expenditure must be capitalized.

The amicus for FNMA expands on petitioners’ first assertion

by reference to section 1.263(a)-1(b), Income Tax Regs. That

section provides: “In general, the amounts referred to in

paragraph (a) of this section include amounts paid or incurred

(1) to add to the value, or substantially prolong the useful

life, of property owned by the taxpayer * * * or (2) to adapt

property to a new or different use.” The amicus also references

the following passage from this Court’s Memorandum Opinion in

Mayer v. Commissioner, T.C. Memo. 1994-209: “It appears from the

record that these transaction fees consisted in large part of

general overhead rather than costs specifically allocable to

individual purchases and sales. These expenses are not

capitalizable under section 263.”32 The amicus for FNMA

concludes that the salaries and benefits are indirect costs

outside the realm of section 263(a).

32 This passage is likewise referenced by the amicus for FHLMC. - 67 -

We disagree with the additional arguments set forth by the

amicus for FNMA as to petitioners’ first assertion. The rule of

section 1.263(a)-1(b), Income Tax Regs., upon which the amicus

relies is merely a general rule that is not intended to contain

the sole parameters of capitalization under section 263(a). Nor

do the amici rely correctly on our Memorandum Opinion in Mayer v.

Commissioner, supra. There, the taxpayer was an individual who

argued that he could capitalize his investment-related expenses.

We held he could not because he failed to meet his burden of

proof.

Nor are we persuaded by petitioners’ second assertion that a

body of law treats the salaries and benefits as deductible

expansion costs. As to the body of cases relied upon by

petitioners, we have discussed at length our disagreement with

their reading of these cases and adhere to our belief that none

of the cases supports the result that they desire. Nor does the

record at hand persuade us that any of the salaries and benefits

were incurred in expansion of ACC’s business.33 Even if they

could be construed to be expansion costs, which as just mentioned

we do not find that they are, petitioners would still not

prevail. Simply because a cost may qualify as an expansion cost

33 In fact, petitioners’ assertion that the costs were related to an expansion of ACC’s business is inconsistent with their primary argument that the expenditures were incurred routinely in ACC’s everyday business. - 68 -

does not make it a deductible expense. See, e.g., FMR Corp. &

Subs. v. Commissioner, 110 T.C. 402, 429 (1998) (section 195 does

not require “that every expenditure incurred in any business

expansion is to be currently deductible”.34 Such is especially

true here where the salaries and benefits were incurred in

connection with the acquisition of a capital asset.

We also are unpersuaded by petitioners’ third assertion that

the salaries and benefits did not generate a significant future

benefit to ACC. These costs contributed directly to ACC’s

receipt in later years of interest and excess principal income.

This income significantly benefitted ACC in that it was the bread

and butter of its operation. Because ACC’s payment to its

employees of the disputed salaries and benefits provided ACC with

such a significant long-term benefit, they are capital

expenditures. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79

(1992); see also Commissioner v. Idaho Power Co., 418 U.S. 1

(1974); Woodward v. Commissioner, 397 U.S. 572 (1970); United

States v. Hilton Hotels Corp., 397 U.S. 580 (1970); cf. Colonial

Am. Life Ins. Co. v. Commissioner, 491 U.S. 244, 251 n.5 (1989)

(“the important point is * * * whether the taxpayer is investing

in an asset or economic interest with an income-producing life

that extends substantially beyond the taxable year”).

34 Nor is a cost deductible merely because it preceded the final decision as to the acquisition of a specific asset. - 69 -

The amicus for FNMA concludes as to the salaries and

benefits that capitalizing these costs will administratively

burden ACC. We disagree. It was ACC that identified these costs

for its auditors in order to capitalize the costs for financial

accounting purposes. Contrary to the amicus’ assertion, under

the facts of this case, it is not “impossible” to identify the

portion of the salaries and benefits which are attributable to

each installment contract.35

We now turn to the PPM-related expenditures. Respondent

determined and argues that ACC must capitalize these

expenditures. Respondent points to the fact that the repayment

of the Notes extended beyond the year of their issuance.

Petitioners maintain that the PPM expenditures are currently

deductible. Petitioners repeat many of the same arguments which

we have rejected as to the salaries and benefits, stressing their

assertion that ACC issued the Notes in order to obtain funds to

acquire installment contracts in the ordinary course of its

business. Petitioners also add, with citations to Bonded

Mortgage Co. v. Commissioner, 70 F.2d 341 (4th Cir. 1934), revg.

and remanding 27 B.T.A. 965 (1933), and Franklin Title & Trust

Co. v. Commissioner, 32 B.T.A. 266 (1935), that financing

35 The amicus also raises an issue as to whether ACC’s income was reflected clearly, within the meaning of sec. 446(b), by its deduction of the salaries and benefits. This issue was not raised by the parties and is not before the Court. We decline the amicus’ invitation to address it. - 70 -

companies such as ACC may currently expense commissions connected

to the issuance of long-term debt.

We agree with respondent that the PPM expenditures are

capital expenditures.36 As to each of petitioners’ arguments

which we rejected above, we also reject them here as applied to

the PPM expenditures for the reasons stated above. As to

petitioners’ additional argument, we reject that argument as

well. The fact that ACC incurred the PPM expenditures in

borrowing funds means that the expenditures are capital

expenditures and must be amortized over the life of the debt.

See, e.g., Austin Co. v. Commissioner, 71 T.C. 955, 964-965

(1979); Enoch v. Commissioner, 57 T.C. 781, 794 (1972); Longview

Hilton Hotel Co. v. Commissioner, 9 T.C. 180, 182-183 (1947);

Lovejoy v. Commissioner, 18 B.T.A. 1179, 1181-1183 (1930); see

also S. & L. Bldg. Corp. v. Commissioner, 19 B.T.A. 788, 795-796

(1930), revd. on other grounds 60 F.2d 719 (2d Cir. 1932), revd.

sub nom. Burnet v. S. & L. Bldg. Corp., 288 U.S. 406 (1933);

compare Anover Realty Corp. v. Commissioner, 33 T.C. 671, 675

(1960), wherein we stated:

It is not the purpose for which the loan is made that is important. It is the purpose of the expenditure for loan discounts and expenses. That

36 In contrast with respondent, however, we allow ACC to deduct for 1994, under sec. 165(a), the portion of those expenditures that was attributable to the offering that was abandoned in that year. See Ellis Banking Corp. v. Commissioner, 688 F.2d at 1382. - 71 -

purpose is to obtain financing or the use of money over a fixed period extending beyond the year of borrowing. When we analyze the reason behind the rule of amortizing such debt expenses, the distinction between this case and S. & L. Building Corporation and Longview Hilton Hotel Co. vanishes. Here, as in the cited cases, the mortgage discounts and expenses represent the cost of money borrowed for a period extending beyond the year of borrowing. It matters not that the proceeds of the loans be used to build an income-- producing warehouse as in Julia Stow Lovejoy, or "to purchase additional properties" as in S. & L. Building Corporation or to buy the mortgaged premises, as in the instant case. In all such cases the expenditure represents an expenditure for the cost of the use of money and not a capital expenditure for the cost of any asset obtained by the use of the proceeds of the money borrowed.

As to the two cases upon which petitioners rely to support their

additional argument, those cases are factually distinguishable

from the case at hand and require no further discussion.

We have considered each of the arguments made by the parties

and by the amici. We have rejected all arguments not discussed

herein as meritless.

Decisions will be entered

under Rule 155.

Reviewed by the Court.

WELLS, CHABOT, COHEN, GERBER, COLVIN, VASQUEZ, and THORNTON, JJ., agree with this majority opinion.

CHIECHI, J., did not participate in the consideration of this opinion. - 72 -

SWIFT, J., concurring: Although I would go further than the

majority and allow all of the salaries and overhead included in

the so-called installment contract expenditures to be currently

deductible, I do not dissent because I largely agree with the

result reached by the majority and with the movement reflected

therein away from the approach that would capitalize otherwise

routine business expenses.

In PNC Bancorp, Inc. v. Commissioner, 110 T.C. 349, 370

(1998), revd. 212 F.3d 822 (3d Cir. 2000), a case involving the

treatment of salary expenses very similar to those involved

herein (namely, salary expenses of credit institutions whose

officers and employees, among other things, investigate the

creditworthiness of potential borrowers), we concluded that a

portion of the salary expenses should be “assimilated” into the

capital costs of the loans that were approved.

The Court of Appeals for the Third Circuit disagreed and

held that the salaries and other expenses reflected “recurring,

routine day-to-day business” activities that did not produce

significant future benefits and therefore that the expenses were

currently deductible. PNC Bancorp, Inc. v. Commissioner, 212

F.3d at 834. The Court of Appeals resolved not to expand the

type of expenses that must be capitalized “so as to drastically

limit what might be considered as 'ordinary and necessary'

expenses.” Id. at 830. - 73 -

I believe the facts noted below reflect the noncapital,

ordinary and necessary nature of all of the salary and overhead

expenses that are in issue herein and should control resolution

of this fact issue.

(1) The salaries ACC paid were routine, reasonable and

recurring, and the amounts thereof, including increases and

bonuses thereto, were tied to overall net company profits, not to

the acquisition of specific installment loans. As the Supreme

Court explained:

Of course, reasonable wages [salaries] paid in the carrying on of a trade or business qualify as a deduction from gross income. * * * [Commissioner v. Idaho Power Co., 418 U.S. 1, 13 (1974); emphasis added.]

(2) Generally, and for the most part, the specific benefits

initially received by ACC from the services of its employees

investigating proposed installment loans (namely, the receipt of

information needed to review the creditworthiness of potential

debtors on the installment loans) were exhausted or lost by ACC

almost simultaneously with the receipt of the benefits (i.e., for

various reasons the large majority of the proposed installment

loans that were investigated and considered by ACC were abandoned

within a day (majority op. p. 9)). In my opinion, this fact - 74 -

reflects strongly on the ordinary, noncapital nature of all of

ACC’s related salary and overhead expenses and rebuts the

appropriateness of some complicated and rather arbitrary

adjustment under which a portion of the expenses would be

As stated by the Court of Appeals for the Sixth Circuit in

Godfrey v. Commissioner, 335 F.2d 82, 85 (6th Cir. 1964), the

appellate venue for these cases:

The test of an ordinary business expense is whether it is of a recurring nature and its benefit is generally exhausted within a year. * * * [Emphasis added.]

Generally, the benefits ACC received were exhausted within a few

hours after a majority of the prospective installment loans were

investigated and considered.

Under section 1.263(a)-2(a), Income Tax Regs., expenses are

to be capitalized where they produce benefits to a taxpayer with

a life substantially beyond a year. Computing the average life

of all of the installment loans investigated and considered by

ACC’s employees (including the loan applications rejected or

withdrawn as well as those approved) produces an average life for - 75 -

all of the installment loans investigated and considered of 6.6

months for 1993 and 7.4 months for 1994.1 Because a majority of

the installment loans investigated and considered by ACC were

never purchased and because the average life of all of the

installment loans (factoring in all installment loans

investigated and considered) was not beyond one year, I believe

it would be erroneous to conclude generally that the allegedly

related salaries and overhead provided benefits to ACC with a

life “substantially beyond” one year.

(3) The salaries and overhead were not paid by ACC in

connection with any specific installment loans. Note the Supreme

Court’s words, also from Commissioner v. Idaho Power Co., 418

U.S. at 13, linking expenditures to be capitalized to specific

capital assets:

But when wages [salaries] are paid in connection with the construction or acquisition of a capital asset, they must be capitalized and are then entitled to be

1 My computation of the average life of ACC’s installment loans investigated and considered (including in the “Total” loans those installment loans rejected or withdrawn) is shown below: Number of Installment Loans Rejected or Average Duration Average Duration Year Withdrawn Accepted Total of Accepted Loans of All Loans* 1993 1,131 693 1,824 17.5 months 6.6 months 1994 1,338 820 2,158 19.5 months 7.4 months

* For 1993 [(1,131 V 0) + (693 V 17.5)] ÷ 1,824 = 6.6. For 1994 [(1,338 V 0) + (820 V 19.5)] ÷ 2,158 = 7.4. - 76 -

amortized over the life of the capital asset so acquired. * * * [Emphasis added.]

The point is not whether there is only one capital asset or many

capital assets to which expenses may be attached and capitalized.

Rather, the point is that to require capitalization of what are

otherwise routine and recurring ordinary and necessary expenses,

the expenses must be directly linked and associated with very

specific and identifiable capital assets.

(4) Services relating to ACC’s credit investigations that

were performed by ACC employees simply constituted investigatory

activities and as such the related salaries and overhead expenses

should be currently deductible. See Wells Fargo & Co. & Subs. v.

Commissioner, 224 F.3d 874, 887-888 (8th Cir. 2000), affg. in

part and revg. in part Norwest Corp. & Subs. v. Commissioner, 112

T.C. 89 (1999).

(5) Quite contrary to a possible reading of the majority

opinion (see Ruwe, J., concurring op. p.79), ACC’s primary and

underlying business activity is not the “purchase” of installment

loans. Rather, it is the “holding” of those loans and the

associated provision of funds to debtors and the credit

intermediation relating thereto (and all that is encompassed

within credit intermediation) that ACC provides that constitute

ACC’s primary, dominant, and underlying business activity.

Presumably, the amount of ACC’s income and profit in any one

year relates primarily to its annual cost of funds and to the - 77 -

losses associated with delinquent loan repayments, on the one

hand, as compared to the interest income ACC receives each year

on the installment loans, on the other hand. For Federal income

tax matching purposes, those expenses and income would appear to

be matched fully and completely on ACC’s annual Federal income

tax returns, as filed. To now require capitalization, as

respondent would, of a portion of ACC’s regular and routine

salary and overhead expenses, on the ground that they somehow

relate directly to the acquisition of specific installment loans

would, in my opinion, reflect a misunderstanding of the true

nature (1) of ACC’s underlying business activity, (2) of ACC’s

costs and expenses, and (3) of ACC’s income and profit.

As the majority opinion states (majority op. p. 4), ACC was

formed “to provide alternate financing”. ACC’s credit

investigations and its credit risk decisions relating thereto

represent just one of the steps (and certainly not the dominant

step) in ACC’s business of credit intermediation (i.e., of

providing “financing”).2

2 I acknowledge that the majority opinion (majority op. p. 4) is less than clear in its statement of the business purpose of ACC. Nevertheless, the majority does acknowledge the important role of ACC in providing “financing”, which in my opinion and experience involves much more than just investigating loan applicants and approving or rejecting the applications. - 78 -

Although the majority would allow most of ACC’s salary

expenses in issue to be currently deductible, I would go further

and hold all of such salaries to be currently deductible.

I also am puzzled by the majority's different treatment of

salaries and overhead expenses. I believe that on the particular

facts of this case both salaries and overhead expenses should

receive consistent treatment and, as indicated, be fully

deductible.

The concluding comments made by the Court of Appeals for the

Third Circuit in PNC Bancorp, Inc. v. Commissioner, 212 F.3d at

835, reflect much of my thinking on the issue before us. I quote

a portion thereof:

we find the case before us today to be much farther from the heartland of the traditional capital expenditure (a “permanent improvement or betterment”) than are the scenarios at issue in INDOPCO and Lincoln Savings. We will not mechanistically apply phrases from those precedents in ignorance of the realities of the facts before us. We see no principled distinction between the costs at issue here and other costs incurred as “ordinary expenses” by banks. [Id.] - 79 -

RUWE, J., concurring in part and dissenting in part: I

agree with the majority’s legal analysis and its application of

that analysis to ACC’s expenditures for salaries and benefits

(hereinafter “salaries”) that were incurred in connection with

the acquisition of installment contracts. The majority correctly

holds that the percentage of salaries related to credit analysis

activities must be capitalized. However, the majority then holds

that “overhead” expenditures need not be capitalized. I disagree

with the majority’s conclusion that the “overhead” expenses were

not directly related to the acquisition of installment contracts

because, in my opinion, that conclusion is inconsistent with the

majority’s specific findings of fact.

The following breakdown of specific expenditures appears on

page 11 of the majority’s findings of fact:

Breakdown of Specific Expenditures 1993

Salary Percentage of Total Expenses Amount And Benefits Related to ACC’s Credit In Employee Wages FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue Steve Balan $69,359 $4,504 $313 $4,062 $78,238 50 $39,119 James Blasius 89,769 4,713 313 4,062 98,857 75 74,143 Cass Budzynowski 43,500 3,213 313 1,790 48,816 100 48,816 Hope McGee 16,248 1,216 313 3,692 21,469 100 21,469 Kelly 16,100 1,193 313 1,790 19,396 100 19,396 Stacey 10,280 767 313 2,086 13,446 75 10,085 245,256 15,606 1,878 17,482 280,222 213,028

Overhead Items Printing 9,412 75 7,059 Telephone 12,454 75 9,341 Computer 19,598 95 18,618 Rent 34,413 50 17,207 Utilities 5,162 50 2,581 81,039 54,806 361,261 267,832 - 80 - 1994

Salary, Wages, and Percentage of Total Expenses Amount Estimated Benefits Related to ACC’s Credit In Employee Bonus FICA MESC/FUTA BC/BS Total Expense Analysis Activities Issue Steve Balan $95,820 $4,886 $218 $4,932 $105,856 40 $42,342 James Blasius 139,216 5,776 218 4,932 150,142 50 75,071 Cass Budzynowski 52,846 3,813 218 2,177 59,054 100 59,054 Hope McGee 11,508 842 218 4,932 17,500 100 17,500 Kelly 22,200 1,584 218 2,177 26,179 100 26,179 Sue 24,500 1,760 218 4,932 31,410 100 31,410 Kathy 16,921 1,256 218 4,932 23,327 75 17,495 Stacey 1,218 93 32 411 1,754 75 1,316 Kirsten 2,438 167 57 181 2,843 100 2,843 366,667 20,177 1,615 29,606 418,065 273,210

Overhead Items Printing 8,663 75 6,497 Telephone 15,133 60 9,080 Computer 25,919 95 24,623 Rent 37,875 60 22,725 Utilities 5,126 60 3,076 92,716 66,001 510,782 339,211

These expenditures were all incurred in ACC’s business. The

majority finds that ACC’s only business operation was the

acquisition of installment contracts and the servicing of those

contracts.1 With respect to the salaries and “overhead” expenses

found to be related to ACC’s credit analysis activities ($267,832

for 1993 and $339,211 for 1994),2 the majority makes the

following finding of fact:

In 1993 and 1994, ACC paid installment contracts expenditures totaling $267,832 and $339,211, respectively, * * * which were attributable to ACC’s obtaining of credit reports and screening of credit histories, related primarily to the portion of ACC’s payroll and overhead expenses that was attributable to its credit analysis activities.6 None of these

1 The majority finds: “Its sole business operation is (1) the acquisition of installment contracts from automobile dealers * * * and (2) the servicing of those contracts.” Majority op. pp. 4- 5. 2 The parties agree with the allocations in the above table. - 81 -

expenditures included any postacquisition or servicing expenses. * * * 6 We use the term “credit analysis activities” to refer to ACC’s credit review services and its funding services (i.e., ACC’s issuance of the checks to dealers in consideration for the installment contracts). [Majority op. p. 10; emphasis added.]

From the majority’s findings of fact I conclude: (1) ACC’s

business operation consisted of the acquisition of installment

contracts and the postacquisition servicing of those contracts;

and (2) of the total expenses for salaries and overhead for 1993

and 1994, $267,832 for 1993 and $339,211 for 1994 were related to

credit analysis activities and were not related to any other

business operations of ACC.3 To me, the logical conclusion is

that both salaries and overhead expenses, totaling $267,832 for

1993 and $339,211 for 1994, were exclusively for ACC’s

acquisition of installment contracts and thus were “directly”

related to the acquisition of installment contracts.

The percentage of ACC’s salaries and “overhead” expenses

that related exclusively to ACC’s credit analysis activities

indicates that most of ACC’s business activity concerned the

acquisition of installment contracts. For example, 76 percent of

salaries and 68 percent of “overhead” expenses for 1993 were

related to ACC’s credit analysis activities. For 1994, the

3 The majority finds that “None of these expenditures included any postacquisition or servicing expenses.” Majority op. p. 10. ACC’s only business operation was the acquiring of installment contracts and the postacquisition servicing of those installment contracts. - 82 -

percentages were 65 percent and 71 percent, respectively. The

majority finds that “Each of the employees spent a significant

portion of his or her time working on credit analysis activities

* * * and, but for ACC’s anticipated acquisition of installment

contracts, ACC would not have incurred the salaries and benefits

attributable to those activities.” Majority op. pp. 27-28.

Absent evidence to the contrary, it would seem to follow

logically that if ACC’s business operation had not included

credit analysis activities, ACC would never have incurred the

overhead expenses attributable to those activities.

The majority correctly states that the “overhead” expenses

would be capital in nature if they “originated” in ACC’s process

of acquiring installment contracts. Majority op. p. 29.

However, the majority reasons that the “overhead” expenses were

not directly related to the acquisition of installment contracts

because:

None of these routine and recurring expenses originated in the process of ACC’s acquisition of installment contracts, nor, in fact, in any anticipated acquisition at all. ACC would have continued to incur most of these expenses in the ordinary course of its business had its business only been to service the installment contracts. * * * [Id.]

There is nothing in the majority’s specific findings of fact to

support the conclusion that overhead expenses related to credit

analysis activities did not “originate” in the process of ACC’s - 83 -

acquisition of installment contracts.4 Indeed, it would be

logical to conclude that the type and amount of these “overhead”

expenses did “originate” in ACC’s acquisition of installment

contracts. After all, this activity was ACC’s dominant activity.

If ACC had never engaged in acquiring installment contracts, most

of its expenditures for both salaries and overhead expenses would

have been unnecessary in the first place.

The majority reasons that rent and utilities were “generally

fixed charges which had no meaningful relation to the number of

credit applications analyzed (or the number of installment

contracts acquired) by ACC.” Majority op. p. 29. Again, with

the possible exception of rent,5 there are no specific findings

of fact to support this rationale. Logic would indicate that if

ACC no longer engaged in credit analysis activities, then its

need for office space would decrease, and it would take steps to

reduce its rental and utility costs. The same logic would apply

even more so to printing, telephone, and computer costs. There

is nothing in the majority’s findings to indicate that these were

4 It should be noted in this regard that petitioners bear “the burden of clearly showing the right to the claimed deduction”. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). 5 The majority finds that ACC had a 5-year lease that began in October 1992. There is no discussion of the specific terms of the lease other than the amount of monthly rent. - 84 -

fixed costs.6 Approximately 75 percent7 of the printing and

telephone costs were attributable exclusively to ACC’s credit

analysis activities. Ninety-five percent of the expenses for

computers were related exclusively to ACC’s credit analysis

activities during the years in issue. One can only wonder how

the majority would have treated computer expenses if 100 percent

of such expenses were allocable to ACC’s credit analysis

activities.

The majority provides no legal basis for distinguishing

between expenditures for salaries and expenditures for “overhead”

expenses. Indeed, the majority correctly states that overhead

expenses “are capital in nature to the extent that they

originated in ACC’s acquisition process, or, in other words, were

directly related to ACC’s anticipated acquisition of installment

contracts.” Majority op. p. 29. Therefore, my disagreement with

the majority is based on what I view as the logical disconnect

between the majority’s specific findings of fact and the

majority’s rationale for concluding that the “overhead” expenses

6 The majority notes a variation in printing, telephone, and computer costs from one year to another but does not identify the cause. See majority op. pp. 29-30. 7 For 1993, 75 percent of printing and telephone costs were attributable to ACC’s credit analysis activities. For 1994, 75 percent of printing costs and 60 percent of telephone costs were attributable to ACC’s credit analysis activities. - 85 -

were not directly related to ACC’s credit analysis activities.

It is for that reason alone that I dissent.

WHALEN, HALPERN, BEGHE, FOLEY, GALE, and MARVEL, JJ., agree with this concurring in part and dissenting in part opinion. - 86 -

HALPERN, J., concurring in part and dissenting in part:

I concur in most of the majority’s report, but, like Judge Ruwe,

whom I join, I dissent from the majority’s treatment of the

overhead items-–printing, telephone, computer, rent, and

utilities (overhead).

I. Introduction

Petitioners’ S corporation, Automotive Credit Corporation

(ACC), cannot deduct its expenditures for the installment

contracts here in question because such expenditures are capital

in nature. They are capital in nature because each such

expenditure purchases for ACC the right to receive monthly

payments for a term ranging from 12 to 36 months. With respect

to the overhead, the question is whether ACC may deduct its

overhead costs related (but, in the majority’s view, only

indirectly related) to such capital expenditures. Principally

for the reasons set forth by Judge Ruwe, I do not believe that

they may. I write separately, however, to make the following

points: (1) The majority distinguishes between directly related

and indirectly related costs without telling us how to draw that

distinction. In short, the majority uses the quality of

relatedness not in support of any analysis but only to express a

conclusion (i.e., the overhead was not directly related to ACC’s

capital expenditures). (2) The majority’s analysis also risks

confusion with existing law (and accounting principles) that

distinguish “direct” costs from “indirect” costs. Moreover, - 87 -

under that law (and those principles), indirect costs (including

overhead) are often required to be capitalized. (3) To the

extent the majority distinguishes directly related from

indirectly related costs, it seems to be saying that fixed costs

are period costs because they are only indirectly related to any

capital expenditure. That is also not an accurate statement of

current law (and accounting principles) that often require

absorption or full costing methods of accounting for fixed costs.

(4) The majority has ignored the proper mode of analysis, which

is to determine whether ACC’s accounting for overhead clearly

reflects its income.

II. Agreement of the Parties

The parties agree that the amounts identified by the

majority as ACC’s installment contract expenditures were

“related” to ACC’s credit analysis activities. Apparently, they

agree that overhead was related to ACC’s credit analysis

activities because items such as the telephone and computers

facilitated ACC’s obtaining of credit reports and screening of

credit histories. In turn, the credit reports and case histories

assisted ACC’s employees in determining that any particular

installment contract presented a sufficiently low expectation of

nonperformance to justify its purchase. ACC treated the

installment contract expenditures (including overhead)

disparately for financial accounting and Federal income tax - 88 -

purpose, matching such expenditures to the expected life of the

related installment contracts for financial accounting purposes

but deducting them for Federal income tax purposes, at least for

1993.

III. Majority’s Approach

According to the majority: Overhead expenses must be

capitalized only if they are directly related to the acquisition

of a capital asset, and such expenses are directly related to the

acquisition of a capital asset only to the extent that they

increase on account of such acquisition. For the reasons

discussed below, I do not believe that the majority’s limitation

of overhead costs subject to capitalization to (what I will refer

to as) incremental overhead costs is an accurate application of

the law, nor do I believe that it provides an improvement to the

law relating to the treatment of overhead costs.

IV. Overhead

Overhead is, by definition, an indirect cost. See, e.g.,

Kohler’s Dictionary for Accountants 366 (Cooper & Ijiri, eds.,

6th ed. 1983):

overhead 1. Any cost of doing business other than a direct cost of an output of product or service. 2. A generic name for manufacturing costs of materials and services not readily identifiable with the products or services that constitute the main outputs of an operation. * * *

A cost is an indirect cost, and, thus, overhead, if, at the time

the cost is incurred, it is not identifiable with an individual - 89 -

department, product, activity, or other object to be costed

(without distinction, costing unit). Because overhead costs are

not identifiable with a costing unit, some process is necessary

to allocate overhead among costing units:

Distinctions between overhead costs and direct costs rest upon the methods of measuring unit costs. Direct costs can be identified with units to be costed (i.e., with departments, activities, orders, products) at the time the cost is incurred. This is accomplished by measuring quantities of materials and hours of labor used for each costing unit. * * *

Overhead costs cannot, as a practical matter, be traced directly to individual costing units, either because the process of making direct measurements is judged wasteful or because there is no acceptable method of direct measurement available. As an example of a too costly measurement, electric power used by each department in a factory can be measured, but this is not always done because management does not wish to incur the expense of meters and records. Examples of the lack of a method of distribution may be observed in any endeavor to determine how much of the cost incurred for plant protection, accounting, or the president’s office applies to each unit of production.

Id. at 367. As other authorities on accounting state: “Indirect

expenses, by their very nature, can be assigned to departments

only by a process of allocation.” Meigs et al., Accounting, The

Basis for Business Decisions 820 (4th ed. 1977).

Although such process of allocation undoubtedly involves

many judgments and uncertainties, there are certain standards:

Accounting literature is generally consistent in stating that indirect costs should be charged against operations as incurred if they have no arguable cause- and-effect relationship with future revenues (such as the salary of a mailroom clerk). However, many allocations of indirect costs affect future periods; an - 90 -

example is the allocation of factory overhead to units of inventory produced during a period and remaining on hand at period-end.

Minter et al., Handbook of Accounting and Auditing C2.06[4] (2001

ed.). One area of uncertainty concerns the treatment of fixed

overhead costs. In Belkaoui, the Handbook of Cost Accounting

Theory and Techniques 289 (1991), the author states: “The issue

of whether inventories should be costed at variable or full cost

remains a subject of debate in both academic and business worlds.

The controversy centers mainly on two inventory valuation

methods: the direct or variable costing method and the

absorption or full costing method.” That debate is relevant to

our analysis since, as Professor Belkaoui states: “The main

difference between product costing methods lies in the accounting

treatment of fixed manufacturing overhead. Under the direct

costing method, the fixed manufacturing overhead is regarded as a

period cost (that is, an expired cost to be immediately charged

against period sales). ” Id. at 291. Under the absorption

costing method, on the other hand, “all the manufacturing costs,

whether variable or fixed, are treated as product costs and hence

inventoried with the products.” Id.1 Fixed overhead, thus, is

only released to offset receipts as it flows into cost of goods

1 Professor Belkaoui adds: “Consequently, under absorption costing, the period costs are limited to both selling and administrative overhead.” Belkaoui, Handbook of Cost Accounting Theory and Techniques, 291 (1991). - 91 -

sold (which may or may not be in the period such overhead is

incurred). See id. at 293.

Professor Belkaoui states that the central issue affecting

income determination is whether fixed manufacturing costs are

product or period costs. Id. at 299. He concludes: “From the

theoretical point of view, both methods [direct costing and

absorption] appear to be internally consistent. * * * From the

practical point of view as well, both methods have merit. Thus,

there is no absolute answer to whether a cost is a product or a

period cost.” Id. at 305.

For financial accounting purposes, the treatment of overhead

starts with the recognition that overhead costs are indirect and,

thus, in need of allocation, and it proceeds from there to

allocate such expenses pursuant to various standards, practices,

and judgments, in order to serve management’s (and other’s) needs

for information (including income determination). See Kohler’s

Dictionary for Accountants 366–370 (Cooper & Ijiri eds., 6th ed.

1983).

Overhead presents no different challenge for Federal income

tax purposes. It is, thus, paradoxical that the majority’s

approach should be that all inquiry ends once it is determined

that an overhead cost is only indirectly related to the purchase

of a capital asset. - 92 -

V. Clear Reflection of Income

A. Introduction

By characterizing the printing, telephone, computer, rent,

and utilities costs here in question as overhead, petitioner and

the majority do no more than identify that allocation is

required. In concluding that such costs need not be capitalized,

the majority accepts without question ACC’s allocation, which

allocates the costs to ACC’s postacquisition and servicing

activities (for which an immediate deduction is available). The

majority fails to apply any criteria to its acceptance of ACC’s

allocation. Notwithstanding that such allocation may be

acceptable (even required) for financial accounting purposes, see

majority op. p. 12 note 9, it still involves a method of

accounting. For Federal income tax purposes, the term “method of

accounting” “includes not only the over-all method of accounting

of the taxpayer but also the accounting treatment of any item.”

Sec. 1.446-1(a)(1), Income Tax Regs.; see also sec 1.446-

1(e)(2)(ii)(a), Income Tax Regs. (a change in method of

accounting includes any change in the treatment of any “material

item”: “A material item is any item which involves the proper

time for the inclusion of the item in income or the taking of a

deduction.” (Emphasis added.)). A taxpayer’s method of

accounting must clearly reflect income or the Secretary may

require the computation of taxable income under a method of - 93 -

accounting that does clearly reflect income. See sec. 446(b).

Notwithstanding the majority’s disclaimer that it is not passing

on whether ACC’s method of accounting clearly reflected its

income, see majority op. p. 69 note 37, that is precisely what it

is doing.

B. Clear Reflection and Section 263

We have previously addressed the interplay between the

clear-reflection standard and the requirements of section 263.

In Fort Howard Paper Co. v. Commissioner, 49 T.C. 275 (1967), the

core issue was how to treat overhead in determining the cost of

self-constructed assets. We rejected the Commissioner’s

principal argument that section 263 draws a clear line between

deductible expenses and capital expenditures. We stated that

consideration necessarily had to be given to whether the

taxpayer’s treatment of the overhead in question clearly

reflected income:

We reject as without merit respondent’s contention that section 263 of the Code is in and of itself dispositive of the issue before us. By requiring the capitalization of amounts ‘paid out for new buildings or for permanent improvements or betterments made to increase the value of any property,’ such section begs the very question we are asked to answer. We are satisfied that, under the circumstances involved herein, sections 263 and 446 are inextricably intertwined. A contrary view would encase the general provisions of section 263 with an inflexibility and sterility neither mandated to carry out the intent of Congress nor required for the effective discharge of respondent’s revenue-collecting responsibilities. Accordingly, we turn to a determination as to whether petitioner’s method of accounting ‘clearly reflects - 94 -

income’ pursuant to the provisions of section 446. * * *

Id. at 283–284.

In Fort Howard Paper Co., we found the taxpayer’s method of

accounting clearly to reflect income notwithstanding that the

taxpayer allocated no overhead to self-constructed property under

the “incremental cost” method of accounting adopted by him. The

Commissioner argued for the “full absorption cost” method, which

would have required an allocation of overhead to self-constructed

assets. We stated:

Under all the circumstances herein, we hold that petitioner has satisfied its heavy burden and has convinced us that it employed a generally accepted method of accounting which ‘clearly reflects its income.’ In so doing, we neither hold nor imply that, under all circumstances, a taxpayer has a right to choose between alternative generally accepted methods of accounting or that respondent may not, under some circumstances, require a taxpayer to accept his determination as to a preferred selection among such alternatives. We hold merely that where a taxpayer, in a complicated area such as is involved herein, has over a long period of time consistently applied a generally accepted accounting method (which is considered ‘clearly to reflect’ income by competent professional authority and is not specifically in derogation of any provision of the Internal Revenue Code) and where this method has been frequently applied by respondent in making adjustments to the taxable income of the same taxpayer (as distinguished from respondent’s mere failure to object to its use by such taxpayer), the taxpayer’s choice of method will not be disturbed. * * *

Id. at 286–287 (citations omitted). In Coors v. Commissioner,

60 T.C. 368, 397 (1973), affd. 519 F.2d 1280 (10th Cir. 1975), we

distinguished Fort Howard Paper Co. and found the taxpayer’s - 95 -

method of accounting for the costs of self-constructed assets did

not clearly reflect income, in part because it expensed

incremental overhead costs.

In Dana Corp. v. United States, 174 F.3d 1344 (Fed. Cir.

1999), the taxpayer corporation paid a law firm an annual

retainer fee, which was paid to prevent the law firm from

representing parties adverse to the taxpayer in a takeover

attempt and for standing by to represent the taxpayer both if

subject to a hostile takeover and in other matters. Id. at 1346.

The law firm received the retainer whether it rendered legal

services during the retainer year or not. Id. at 1350. For some

years it rendered no legal services and, during others, it

rendered services in connection with deductible (non-capital)

matters. Id. During the year in question, the law firm rendered

services in connection with the taxpayer’s acquisition of a

capital asset and credited the year’s retainer amount against the

amount billed for those services. Id. For that year, the

taxpayer deducted the retainer amount and capitalized the

remaining fee. Id. The Court of Appeals disallowed the

taxpayer’s deduction of the retainer amount, stating: “Even

though the retainer fees were allowed as deductible expenses for

most of the years * * * [the taxpayer] paid them, the use of the

fee in a particular year determines the deductibility of the

expense in that year, and not the pattern of other years of - 96 -

paying it.” Id. at 1350-1351. Although that issue was not

decided on the basis of clear reflection of income, the taxpayer

was required to allocate a fixed cost incurred for multiple

purposes to a single, capital expenditure purpose.

C. Criticism of Majority

My criticism of the majority is not, per se, with its

finding that there were no incremental overhead costs

attributable to capital expenditures (although I doubt that that

is true). My criticism is with the majority’s uncritical

acceptance of the taxpayer’s method of accounting for overhead.

Judge Tannenwald’s nuanced analysis in Fort Howard Paper Co. v.

Commissioner, supra, exemplifies the considerations traditionally

given to clear reflection of income cases. Consider also Judge

Dawson’s’ analysis in Coors v. Commissioner, supra. The Supreme

Court cases that figure so prominently in the majority’s

analysis, see majority op. p. 18, are inapposite. Simply, they

do not address the accounting question here before us: Namely,

does it clearly reflect ACC’s income for Federal income tax

purposes for ACC to use a method of accounting that allocates

zero overhead to a costing unit (ACC’s credit analysis

activities) to which such overhead concededly relates? If ACC’s

accounting method is rejected, and some or all of the overhead is

allocated to ACC’s credit analysis activities, then, I suppose,

such overhead would, in the majority’s terminology, be directly - 97 -

related to those activities, and the Supreme Court cases would be

no bar to capitalization. The question here is not whether the

overhead directly or indirectly relates to ACC’s credit analysis

activities; the question is whether ACC has proven that its

method of accounting clearly reflects its income. It has not.

D. Majority’s Reasoning

Once the majority’s approach is stripped of the erroneous

notion that overhead can, without allocation, be identified to an

individual costing unit (e.g, a capital expenditure), what

remains is an approach that says that, for Federal income tax

purposes, overhead need not be allocated to a costing unit when,

if that costing unit were eliminated, the overhead would still be

incurred. Immediately, that approach raises analytic

difficulties. What if the overhead is incurred on account of two

costing units (one a capital expenditure and one not), and the

overhead would be incurred in the same amount if either (but not

both) were eliminated? Why is the default rule that the overhead

is allocated in total to the noncapital expenditure? Looked at

from a different perspective, what if there is not a linear

relationship between the taxpayer’s business activities and

overhead? The relationship may be step-wise, so that the

taxpayer’s business activities would have to increase by some

quantum before rent, for instance, would increase. Assume, for

example, that office space may only be rented in blocks of - 98 -

several thousand square feet. There is, thus, no incremental

cost in adding a capital activity to space not fully occupied by

a noncapital activity. Likewise, there is no decrement in cost

(once having added the capital activity) of completely

subtracting the noncapital activity. Must we conclude that the

rent still is not allocable to the capital activity? The fact

that a taxpayer would incur the same overhead costs should it

discontinue a capital activity may only be evidence that it is

amenable to an economically inefficient use of space or

equipment. Short of adopting the accounting concept of direct or

variable costing as normative for Federal income tax purposes,

that does not seem to me a sufficient reason to foreclose any

capitalization of fixed overhead. If the direct or variable

costing method is to be made normative for Federal income tax

purposes, that is a job for the Secretary or the Congress, not

for us.

Besides which, as Judge Ruwe points out, the majority has

made no specific findings of fact to support its conclusion that

ACC’s acquisition activities did not give rise to any incremental

overhead. Indeed, petitioner has proposed the following finding

of fact: “ACC’s payroll and overhead costs attributable to

credit review and other tasks relating to contract acquisition

were not materially affected by whether any given installment

contract was ultimately acquired by ACC from a dealership.” - 99 -

That, of course, is not to say that overhead would not be

materially affected if none of the contract acquisition activity

were continued.

VI. Conclusion

I am not here arguing for a rigid rule, requiring allocation

of overhead in all cases where overhead is related to a capital

activity. See, e.g, Dunlap v. Commissioner, 74 T.C. 1377, 1426

(1980) (no capitalization required for overhead where capital

activity (acquisition of banks) was incidental to taxpayer’s

principal business of holding and managing banks, revd. and

remanded on another issue 670 F.2d 785 (8th Cir. 1982)).2 I am,

2 The majority states: “[W]e conclude that any future benefit that ACC realized from these expenses was incidental to its payment of them so as not to require capitalization”. Majority op. p. 30. The majority has failed, however, to explain or quantify that finding. Without the overhead, the acquisition activity would, at the least, have been substantially reduced.

Judge Swift, in his concurring opinion, suggests that any benefit derived by ACC from both salaries and overhead associated with the credit analysis activities was incidental to ACC’s primary business activity: the holding of installment loans. He would, therefore, permit a current deduction for both. Judge Swift’s position is based upon his finding that any benefits associated with the credit analysis activities “were exhausted or lost by ACC almost simultaneously with the receipt of the benefits”; i.e., most of the installment loans were immediately rejected. Swift, J., concurring op., p. 73. He also views such activities as “investigatory activities” the costs of which are currently deductible.

I believe that all of the credit analysis activities related to the purchased loans. Therefore, the costs of that activity should be capitalized. The acquisition of installment loans was an essential part of ACC’s business, and an unavoidable cost of (continued...) - 100 -

however, arguing against what appears to be the rigid approach of

the majority that, if the taxpayer’s method of accounting for

overhead is to deduct all overhead that does not increase on

account of capital activities, such method of accounting clearly

reflects income and, thus, must be accepted by respondent.

I can do no better than to close with the majority’s own

words:

In our minds, an expenditure that produces both a current and long-term benefit is neither 100 percent deductible nor 100 percent capitalizable. Instead, regardless of whether the expenditure’s primary or predominant purpose is to benefit significantly the business’ current operation, on the one hand, or its long-term operation, on the other hand, the expenditure is capital in nature to the extent that it produces a significant long-term benefit and deductible to the remaining extent. * * *

Majority op. p. 61.

WHALEN and BEGHE, JJ. agree with this concurring in part and dissenting in part opinion.

2 (...continued) such acquisitions was that associated with the need to distinguish between acceptable and unacceptable risks; i.e., the credit analysis activities. Put simply, the hunt was essential to the capture. - 101 -

BEGHE, J., concurring in part and dissenting in part:

Having joined the side opinions of Judges Ruwe and Halpern, I

write on to empathize with the concerns that may underlie the

majority’s view on the treatment of the overhead costs, as

amplified by Judge Swift’s concurrence.

It bears observing that the oft-quoted passage in the

opinion of the Court of Appeals for the Seventh Circuit in

Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212, 217

(7th Cir. 1982), revg. T.C. Memo. 1981-255, which includes the

statement that “The administrative costs of conceptual rigor are

too great,” was uttered in the course of sustaining the

Commissioner’s determination that the costs in issue in that case

had to be capitalized. However, the Court of Appeals then

suggested that the distinction between recurring and nonrecurring

costs might provide the line of demarcation in some cases, but

went on to observe that the distinction wouldn’t make sense when

the taxpayer’s sole business was the creation or acquisition of

capital assets. Although ACC’s business includes the servicing

as well as the acquisition of capital assets, the relatively

short average time the acquired loans remain outstanding raises

questions about administrability, the costs of conceptual rigor,

and whether the exercise has been worth the candle.

These musings lead me to suggest the time has come to

request respectfully that the Congress step in and enact some - 102 -

bright-line rules that will provide guidance to the business

community and the Internal Revenue Service and reduce the burdens

of compliance and controversy on the public, the Service, and the

courts. Sections 195 and 197 come to mind as possible starting

points or models.

GALE, J., agrees with this concurring in part and dissenting in part opinion.