Lychuk v. Comm'r

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, 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 cósting 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 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 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 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 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.

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. 382 note 7, 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-l(a)(l), Income Tax Regs.; see also sec 1.446-l(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 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. 416 note 35, 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 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 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 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. pp. 386-387, 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 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 non-capital 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 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 non-capital 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.” 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, 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 a 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. * * * [Majority op. p. 412.]

Whalen and Beghe, JJ., agree with this concurring in part and dissenting in part opinion.

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).

The majority states: “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”. Majority op. p. 393. 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. 419. 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 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.