November 1998 Issue


The Tax Court held that a bank must capitalize, rather than deduct, loan origination costs if the life of the related loan extends beyond the year in which the costs are incurred (PNC Bancorp, Inc. et al. v. Commissioner, 110 T.C. No. 27, 6/8/98).

In this case, interest charged on loans was the primary source of revenue for the taxpayer/bank. Costs incurred by the bank to create new loans (i.e., loan origination costs) included 1) amounts paid to record security interests; 2) expenditures to third parties for property reports, appraisals, and credit reports; and 3) a portion of the salaries and fringe benefits paid to employees for evaluating the borrower's financial condition, evaluating security arrangements, negotiating loan terms, preparing loan documents, and closing the transaction.

For accounting purposes, the bank deferred the loan origination costs (net of related fee income) over the expected life of the loans. However, the bank treated the costs as current deductions for Federal income tax purposes. To qualify as a current tax deduction, an expenditure must be paid or incurred during the taxable year, and must be an ordinary, necessary expense of carrying on a trade or business. According to a Supreme Court ruling (INDOPCO case), an expenditure that creates or enhances a separate and distinct asset should be capitalized, not deducted.

In defending the current deduction, the taxpayer argued that loan origination costs 1) are expenditures incurred every day in the banking business, 2) are integral to day-to-day banking operations, and 3) provide only short-term benefits.

Court Opinion. The Tax Court ruled that loan origination costs must be capitalized because the expenditures create separate and distinct assets that generate revenue over a period beyond the current tax year. Additionally, the Court noted the following:

* An expenditure incurred when creating capital assets must be capitalized even when the expenditure otherwise might be deemed deductible.

* The fact that banks incur loan origination costs on a recurring basis does not ensure their characterization as "ordinary" if the expenditures result in the creation of a separate and distinct asset.

* The expenditures are directly related to the creation of loans (i.e., the IRS did not question current deductions for costs associated with loans that were not closed or costs incurred after the closing of the loan).

* Current deduction of loan origination costs does not clearly reflect the bank's income, and therefore, is not a proper method of accounting. *

Source: Deloitte and Touche Review, July 20, 1998.

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