Many businesses rely on a standby line of credit to cover their expenses, to weather downturns, and to grow. But this credit can be expensive in terms of interest and fees. The fees can be problematic as they may not be deductible for federal income tax purposes at the time they are paid. The IRS recently issued Legal Memo 20182502F that explains how borrowers might structure credit standby fees to ensure that they are currently deductible.
The Facts in the IRS Memo
The taxpayer entered into a five year revolving credit agreement. The interest was to be set at the prevailing rates at the time the credit agreement was used. The taxpayer could pre-pay the balance without penalty, but all amounts used had to be repaid by the five year termination period.
The taxpayer also had to pay a quarterly “commitment fee” in arrears, which was computed based on the average daily amount of the then unused credit available under the agreement during the prior quarter. The failure to pay the commitment fee was a grounds for default under the credit agreement.
The taxpayer deducted the commitment fees. The IRS auditor asked the IRS attorney whether these fees are currently deductible or have to be capitalized and deducted over time.
Tax Rules for Options
The IRS memorandum starts with the basic rules that allow a deduction for ordinary and necessary expenses. The IRS had no problem concluding that these fees are ordinary and necessary for a taxpayer in this industry (the industry was redacted and not provided to the public), subject to the capitalization rules.
As noted in the IRS memorandum, there is an exception for certain capital expenses. These capital expenses include those that are for an asset that has a useful life beyond the current tax year. The cost to acquire an option an intangible asset that may have a useful life beyond the current tax year.
For federal income tax purposes, an option is a part of, and capitalized into, the cost of the property if it is exercised. The option cost is then deductible over the life of the acquired property. If the option is not exercised, it may be deductible when the option period expires.
The question addressed in the IRS memorandum is whether a “commitment fee” part of a revolving credit line is an option that must be capitalized.
Credit Standby Fees Are Typically Capitalized
Revenue Ruling 81-160 is the primary authority credit standby fees. It holds that loan commitment fees in the nature of credit standby fees must be deducted ratably over the term of the loan to which they relate. The rationale is that the fee is for the use of money, which is a property right, rather than for a service. This position has been reiterated in several IRS rulings.
For example, in 1999 IRS CCA LEXIS 357, the IRS considered loan commitment fees where the underlying credit was made available indefinitely and the party never borrowed or intended to borrow on the line of credit. The IRS concluded that the commitment fees in that matter were akin to option premiums and therefore had to be capitalized. This is similar to the decision in 1981 PLR LEXIS 4970, which is cited in the CCA.
Credit Standby Fees Paid in Arrears
The IRS memorandum does not address these prior rulings. Instead, it focuses on the fact that the payments here are for the use of money in the preceding quarter. Although not explained in the IRS memorandum, this differs from credit standby fees that are to keep a line of credit open in the future. But based on this fact, the IRS concludes that the prior use of money is not an option and, therefore, the commitment fees are deductible immediately as ordinary expenses.
The IRS also noted that even if its position was incorrect, the fees were payable for the prior three months and therefore they would be deducted at the expiration of the three month period anyway.
All things being equal, borrowers may prefer this type of payment in arrears arrangement as it may allow their credit standby fees to be immediately deductible.
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