Docket: Bankers Knock IRS Plan To Capitalize Loan Costs

Industry officials are urging a federal judge to reject an Internal Revenue Service decision requiring lenders to capitalize the cost of making loans.

If upheld by the courts, most banks would pay significantly more in federal income taxes, although exact estimates are unavailable.

At issue is how banks treat the costs involved in extending credit, such as salaries for loan officers, the cost of office equipment, and fees paid to record deeds.

The industry has always deducted these costs just like any other business expense by subtracting them from their taxes during the year in which they were incurred.

The IRS, however, wants banks to capitalize these costs, which means they must spread them out over the life of the loan. That would mean banks could only deduct a small portion of the expenses each year, resulting in higher taxable incomes.

The IRS asserts that banks have always been required to capitalize lending expenses. However, it did not start enforcing this requirement until recently. The agency proposed a rule last year to clarify its position on when lenders must capitalize loan origination expenses. But lawyers said they do not expect the agency to finalize the rule until the courts resolve the issue.

Two of the first institutions snared by the policy shift were First National Pennsylvania Corp. and United Federal Bank Corp., both Pennsylvania-based banking companies that have since been acquired by PNC Bancorp.

PNC challenged the legality of the IRS policy change before the Tax Court, which conducted a fact-gathering trial in May. The American Bankers Association and PNC filed briefs in August, explaining their legal arguments, and the IRS is set to file its response brief by Oct. 6. A decision is not expected until next year.

"This is a big deal," said Robert J. Jones, a partner at the Washington law firm Arnold & Porter who represents PNC. "If the government's broad stance is accepted, it could require the capitalization of a lot of costs that banks have traditionally deducted."

"This affects all banks, large and small," agreed Mark Baran, the ABA's tax counsel. "These expenses are akin to operating expenses and should be deductible."

IRS officials declined to comment. But in a court filing, the agency said PNC has failed to prove that loan origination expenses should be deducted all at once rather than capitalized.

"Costs incurred in originating new loans are capital expenditures and are not currently deductible," the IRS wrote in a brief.

The dispute dates back to the thrift crisis of the late 1980s. The Financial Accounting Standards Board was worried that some thrifts were inflating their income by recording loan origination fees on their books but depreciating the expenses incurred in making mortgages.

To stop this practice, the group adopted Financial Accounting Standard 91. The rule, effective for fiscal years beginning after Dec. 15, 1987, requires lenders to capitalize both the expenses and revenue from loan originations if it would materially affect an institution's income.

Although the IRS requires banks to follow separate accounting rules for tax filing purposes, the agency used the FASB decision to justify its policy change.

"Everyone who makes a loan ought to be applauding ... PNC for refusing to roll over," said Jim O'Connor, tax counsel at America's Community Bankers. "The IRS adopted a position that makes no sense with what is really going on economically."

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