IT&S of Iowa, Inc. v. Comm'r of Internal Revenue, Docket No. 10741-88.

• Citation: 97 T.C. 496,97 T.C. No. 34
• Decision Date: 12 November 1991
• Docket Number: Docket No. 10741-88.
• Parties: IT&S OF IOWA, INC., AND IOWA TRUST AND SAVINGS BANK, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: United States Tax Court

97 T.C. 496

97 T.C. No. 34

IT&S OF IOWA, INC., AND IOWA TRUST AND SAVINGS BANK, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 10741-88.

United States Tax Court

Filed November 12, 1991.

P, a State bank, acquired the assets and liabilities of another State bank, W. P allocated a portion of the purchase price to a core deposit intangible asset, based on its calculation of the cost savings realized by using the core deposits, rather than an alternative funding source, to fund P's assets. After allocation of the purchase price among specific assets, including the core deposit intangible, P allocated the residual amount of the purchase price to goodwill. P claimed amortization deductions on account of the core deposit intangible asset based on the present value of the cost savings arising in each year of the core's life, calculated as of the time of the acquisition.

HELD, the core deposit intangible asset arising from the purchase of W is separate and distinct from goodwill and has a limited useful life, the duration of which can be ascertained with reasonable accuracy. P therefore may depreciate such intangible asset under sec. 167(a), I.R.C. 1954, and sec. 1.167(a)-3, Income Tax Regs. Citizens & Southern Corp. v. Commissioner, 91 T.C. 463 (1988), affd. without published opinion 900 F.2d 266 (11th Cir. 1990), followed.

HELD FURTHER, P erroneously calculated the value of the core deposit intangible asset by including interest sensitive deposits, by failing to reduce the core for reserve requirements and float on deposits, by using an inappropriate alternative funding source, and by using an incorrect discount rate.

HELD FURTHER, P may depreciate the value of its core deposit intangible on an accelerated basis. Philip C. Cook, Terence J. Greene, and Timothy J. Peaden, for the petitioners.

Anne Hintermeister and William H. Stoddard III, for the respondent.

WELLS, JUDGE:

Respondent determined deficiencies in petitioners' Federal income tax as follows:

+--------------------+
                ¦Year  ¦Deficiency   ¦
                +------+-------------¦
                ¦1972  ¦$6,703       ¦
                +------+-------------¦
                ¦1974  ¦75,008       ¦
                +------+-------------¦
                ¦1979  ¦1,241        ¦
                +------+-------------¦
                ¦1984  ¦77,252       ¦
                +--------------------+
                

After stipulations by the parties, the issues remaining in the instant case relate to petitioners' entitlement to depreciate, under section 167, ¹ the value of a core deposit intangible asset acquired in the purchase of another bank. The issues we address are: (1) Whether petitioners have established that the core deposit intangible of the acquired bank has an ascertainable value separate and distinct from goodwill; (2) whether petitioners have proved that the core deposit intangible has a limited useful life; (3) whether the values and amortization schedules utilized by petitioners in calculating their depreciation deductions with respect to the core deposit intangible are reasonable; and (4) whether petitioners may amortize the core deposit intangible on an accelerated basis.

FINDINGS OF FACT

Some of the facts and certain documents have been stipulated for trial pursuant to Rule 91. The stipulated facts are incorporated in this Opinion irrespective of any restatement below. Petitioners are Iowa corporations, and their principal business is commercial banking. At the time the petition in the instant case was filed, petitioners' principal place of business was located in Oskaloosa, Iowa.

In April or May of 1981, petitioner ² learned that the First State Bank of What Cheer (What Cheer bank) was for sale because its controlling stockholder and manager, Mrs. Dorothy Baylor, wished to retire. The What Cheer bank is located in the small town of that name some 20 miles from petitioner's main office in Oskaloosa. At such time, What Cheer, Iowa ³ was a small rural community with a population of approximately 800 residents, who generally worked outside of the town, primarily in agricultural occupations. The What Cheer bank was the only bank in What Cheer. Fourteen other banks and banking offices were located within a 25-mile radius of What Cheer. At such time, petitioner's assets exceeded $40 million, while the assets of the What Cheer bank totaled about $7.5 million.

Petitioner considered the What Cheer bank an attractive acquisition prospect. It had above average earnings, a good reputation in the community, stable and loyal customers who were local residents, good management, and a good location, and was experiencing growth in deposits. Approximately 25 percent of the bank's assets consisted of loans, while the remainder was made up of high quality securities. The bank had no bad loans. Furthermore, under Iowa bank regulatory policy, the only way that petitioner could have established an office in What Cheer was to acquire the What Cheer bank.

The prospect of marketing banking services to the customers of the What Cheer bank was another attractive feature of the acquisition. Petitioner desired to expand the number of banking services available to customers of the What Cheer bank by offering additional trust services, expanded access to loans, individual retirement accounts, and Keogh plans. Petitioner desired to have its customers use as many of its services as possible.

Upon learning of the availability of the What Cheer bank, petitioner's president contacted a banking consultant to assist in arriving at a price for the bank and obtaining regulatory approval for the acquisition. After an initial offer by petitioner was rejected, Mrs. Baylor, in June 1981, informed petitioner of the price she considered acceptable.

To decide whether to pay the asking price, petitioner's president met with the banking consultant and a representative of an outside accounting firm. They considered the earning potential of the What Cheer bank by comparing its cost of funds against projections of historical earnings, as well as its core deposits. Petitioner also considered that none of the target bank's deposits consisted of “hot money,” defined as deposits highly sensitive to interest rate changes, which enhanced the value of the What Cheer bank to petitioner.

The group also discussed the concept of the core deposit intangible asset and whether the value of the What Cheer bank's core deposits could be booked as part of its regulatory capital in order to meet the capital adequacy requirements set by Iowa banking regulators, as well as whether the core deposit intangible could be amortized for tax purposes. A rough estimate of the value of the core deposit intangible was used in assessing whether to purchase the bank at the asking price, but no attempt was made to study the interest rate sensitivity of the core deposits or to perform a study to value the core deposit intangible at such time. The outside accountant advised petitioner that a study valuing the core deposit intangible would be needed to sustain a tax deduction based on amortization of the core deposit intangible. Based on all of such factors, petitioner and its advisers concluded that the transaction would be profitable at the price asked by Mrs. Baylor and decided to accept her offer.

Mrs. Baylor, however, did not want to wait until petitioner completed the lengthy process of obtaining regulatory approval for the acquisition before selling her bank. Consequently, petitioner's president, one of its directors, and the banking consultant were authorized by petitioner's board to purchase the stock of the What Cheer bank. Petitioner agreed to purchase the bank stock from them at the price they had paid for it, plus any interest costs incurred in carrying such stock, contingent upon receipt of approval for the acquisition from the Iowa Department of Banking and the Federal Deposit Insurance Corporation (FDIC). No adjustment of such amount on account of changes in the value of the What Cheer bank's stock while it was held by the three individuals could be made under the agreement. If the requisite approvals had not been obtained, the three individuals would have continued to own the What Cheer bank.

Pursuant to such plan, on July 16, 1981, the three individuals agreed to purchase the stock of the What Cheer bank from Mrs. Baylor and the other stockholders for a sum equal to two times the book value of the capital, surplus, and undivided profits of such bank at the time such sale was settled. The book value of the What Cheer bank stock was $961,500 as of the date of the purchase. The three individuals financed the purchase of the What Cheer bank with a loan from a bank in Des Moines at the prime rate.

On May 12, 1982, petitioner and the three individuals entered into a sale agreement calling for the stock of the What Cheer bank to be sold to petitioner under the terms of their prior arrangement. The agreement provided for allocation of the purchase price among various assets, including goodwill; however, no amount of the price was allocated to a separate core deposit intangible asset. Subsequently, petitioner undertook the task of obtaining regulatory approval for the acquisition of the What Cheer bank, filing the required applications with the Iowa Department of Banking on April 12, 1982, and the FDIC on May 29, 1982.

Petitioner sought approval from the FDIC and the Iowa Department of Banking for recording the core deposit intangible asset to be obtained in the acquisition of the What Cheer bank. At such time, the FDIC had stated, in BL-5-82, issued March 5, 1982, that it would allow, on a case-by-case basis, the recording of an acquired core deposit intangible as an asset. The FDIC permitted such booking because it viewed the core deposit intangible as an asset and considered that its amortization was necessary to avoid distorting a bank's income. The core deposit intangible is also treated as an asset under generally accepted accounting principles (GAAP).

Petitioner's outside accounting firm conducted a preliminary study valuing the core...