Pacific First Fed. Sav. & Loan Ass'n v. Comm'r of Internal Revenue, Docket No. 6114-80.

• Decision Date: 23 September 1982
• Docket Number: Docket No. 6114-80.
• Parties: PACIFIC FIRST FEDERAL SAVINGS & LOAN ASSOCIATION, PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

79 T.C. 512

PACIFIC FIRST FEDERAL SAVINGS & LOAN ASSOCIATION, PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 6114-80.

United States Tax Court

Filed September 23, 1982.

Petitioner was in the business of making loans for the purchase or construction of commercial and residential real estate. Held, “loan origination fees,” which were variable percentages of the face amount of loans, constituted interest and not compensation for services rendered. Donald W. Hanford, for the petitioner.

Wayne R. Appleman, for the respondent.

DRENNEN, Judge:

Respondent determined a deficiency of $834,778 in petitioner's 1976 Federal income tax. Due to concessions, the only issue is whether a “loan origination fee” charged by petitioner in connection with loans it made constituted interest, a charge for services, or, in part, both.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of facts and exhibits attached thereto are incorporated herein by reference.

Petitioner Pacific First Federal Savings & Loan Association had its principal office in Tacoma, Wash., at the time it filed the petition herein. Petitioner filed its income tax return for the taxable year 1976 with the Western Service Center, Ogden, Utah.¹

Petitioner is engaged in the business of making loans for the purchase or construction of commercial and residential real estate. During the calendar year 1976, petitioner loaned in excess of $235 million for such purposes. All of these loans were conventionally financed except for approximately $700,000 of FHA- and VA-insured loans. The loans were primarily long-term loans, generally for 30 years. Over 90 percent of the loans were held by petitioner until prepayment or maturity.

The typical real estate loan made by petitioner began with an interview of the prospective borrower to collect financial, credit, and personal information so as to determine if its preliminary requirements for the loan sought were met. The borrower then filed a loan application which petitioner verified for accuracy. Petitioner then ran a credit check on the borrower and obtained an appraisal of the real property to be used as collateral for the loan.² The loan application was then submitted to petitioner's loan committee for approval. If the loan was approved, a preliminary title report was prepared, and petitioner drew up the documents necessary to obtain a first lien position in the real property as collateral, including conveyancing documents, the borrower's note, and the deed of trust. In addition, for construction loans, petitioner inspected the property from time to time to determine the percentage of completion of the project, which governed the timing of loan disbursements. All of the above activities are generally referred to in the savings and loan industry as underwriting activities.

For those loans involving the purchase of real property, petitioner generally prepared closing statements, obtained the signatures of the parties, and recorded the conveyancing and security documents. On some loans an attorney, title company, or escrow closed the sale under instructions provided by petitioner.

Most third-party costs incurred by petitioner in making its loans, such as obtaining a title report and credit report, recording fees, and hazard insurance, were separately charged to and paid by the borrower. However, the borrower was not required to pay for appraisal services or for escrow services performed by either petitioner or a third party. Petitioner provided these services free of charge in order to give it a competitive advantage over other savings and loans associations, most of which did charge for such services.

As consideration for a loan from petitioner, a borrower was required to pay an amount designated as interest over the life of the loan, and a loan origination fee (hereinafter the loan fee) at the time the loan proceeds were disbursed. The loan fee was a fixed percentage of the principal amount of the particular loan, and during 1976, varied from 1 to 4 percent of each loan made. Petitioner collected this fee at the time the loan proceeds were disbursed by debiting the amount of such fee from the proceeds and paying the remainder over to the borrower.

Petitioner charged the loan fee instead of a higher interest rate on its loans so that it could receive a portion of the overall interest yield “up front,” rather than collect it over the life of the loan. The common term used in the savings and loan industry in referring to such loan fees is “points.”

The loan fee rate and the interest rate charged on a particular loan were negotiated between petitioner and the borrower as mutually dependent variables. Thereafter, the higher the loan fee rate, the lower the interest rate was, and vice versa. The overall interest yield which petitioner sought on a given loan was determined by a combination of the loan fee rate and interest rate charged thereon. Both were determined by the degree of risk involved in making the particular loan and the current money market, taking into consideration the rate charged by competitor savings and loan associations. The loan fee rate charged by petitioner was competitive with those associations.

No relationship existed between the amount of the loan fee charged on a particular loan and the costs incurred by petitioner in underwriting such loan. Indeed, although the loan fee charged on a large loan most likely would be greater than that charged on a small loan by virtue of its being calculated as a percentage of the principal amount of such loan, petitioner engaged in the same underwriting activities for both. In addition, petitioner charged the same fee on a loan irrespective of whether third-party escrow or appraisal services were used.

Approximately 20 percent of the loan applications submitted to petitioner in 1976 did not close. In such case, no loan fee was charged to the borrower, regardless of how far the particular loan application had proceeded.

Petitioner designated the loan fee as a prepaid finance charge on its Federal “truth in lending” statements, and added it to the interest rate in determining the annual percentage rate indicated thereon. The fee was treated as interest for purposes of determining compliance with State usury laws. The loan fees charged by petitioner on its residential mortgage loans were reported as exempt interest for State of Washington business and occupation tax purposes and that treatment has not been challenged by the Washington State Department of Revenue. See Wash. Rev. Code sec. 82.04.430(11) (1974).

Prior to the taxable year 1976, petitioner reported the loan fee, for tax purposes, in a manner provided by the Federal Home Loan Bank Board regulations. Pursuant to that method, petitioner was required to report as income for the year in which received, the amount of the loan fee received equal to 2 percent of the principal amount of the loan in the case of construction loans and 1 percent of such amount in the case of all other loans, plus $200. The balance of the loan fee was taken into income ratably over a period of 7 to 10 years. For accounting purposes, petitioner used the same method.

On January 26, 1976, petitioner filed an application with the Internal Revenue Service to change its method of accounting with respect to the loan fee income. Petitioner sought to change from the method provided by the Federal Home Loan Bank Board regulations to an acceptable method which would allow it to report the loan fee income ratably over a specified period so as to comport with its overall accrual method of accounting. The method also would permit petitioner to defer the reporting of such income. A formula was proposed which was in accordance with Rev. Rul. 64-278.³ The application indicated that the loan fee included “points, escrow fees, appraisal fees, and inspection fees.”

By letter dated January 25, 1977, petitioner submitted additional information in connection with its request for a change of accounting method. In that letter, petitioner indicated that it was applying to change to the “composite method” of accounting⁴ (rather than the liquidation method referred to in the letter of January 26, 1976)⁵ for reporting the loan fee income, and that such fees represented “points which are in the nature of additional interest.”

On March 25, 1977, petitioner was granted approval by the Internal Revenue Service to change its accounting method of reporting “discounted points” “from the method of reporting such points as income in the year in which the loans are made to the method of reporting discounted points as income in the year in which earned, computed on a composite basis * * * beginning with the year of transaction.”

For accounting purposes, petitioner had loan fee income in 1976 in the amount of $4,062,933, which consisted of $3,816,648 of loan fee income received in 1976 and $247,285 of such income received in earlier years and amortized to 1976. On its 1976 income tax return, petitioner reported only $633,164 of loan fee income.⁶

In his statutory notice of deficiency, respondent determined that a portion of the loan fee represented a charge for services rather than for interest (points). Respondent determined that the loan fee income allocable to services amounted to $3,429,769 and could not be deferred pursuant to the composite method, but must be reported in 1976, the year received.⁷ He adjusted petitioner's tax liability accordingly.

ULTIMATE FINDING OF FACT

The loan fees received by petitioner were additional interest income.

OPINION

The only issue presented is whether the loan fee was a charge solely for interest or was, in part, a charge for services as well.

Petitioner maintains that the loan fee represented additional interest charged by it in connection with its loans. Therefore, petitioner claims that the loan fee income in question was properly deferred to years...