Deductions for cellular phone commissions fall victim to INDOPCO.

The IRS ruled in Letter Ruling (TAM) 9813001 that, when a telecommunications company pays one-time commissions to third-party distributors for acquiring new cellular service customers, the commissions must be capitalized under Sec. 263. Citing INDOPCO, Inc., 503 US 79 (1992), the Service concluded

Since the Supreme Court's decision in INDOPCO, some IRS examiners have challenged telecommunications companies on this issue. The new TAM clarifies and publicizes the Service's position. Because most telecommunications service providers have arrangements with third parties that include customer enrollment commissions, the TAM's implications for the industry are significant, and the IRS can expect litigation. For taxpayers in other industries, the TAM serves as another illustration of the Service's use of INDOPCO.

In the TAM, a cellular telephone service provider paid commissions to third-party distributors for securing new monthly service customers for its cellular service, and residual commissions based on customers who remained with the company for more than 180 days. The company's contract with newly enrolled customers generally provided an initial one-month service term, with automatic renewal on a month-to-month basis until the customer terminated the contract by giving the taxpayer seven days' advance notice. Once a third-party distributor enrolled a customer, the distributor did not provide any additional services to the taxpayer as to that customer.

The taxpayer deducted the commissions as ordinary and necessary business expenses under Sec. 162. In general, Sec. 162 allows a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. Sec. 263 generally provides that no deduction is allowed for the cost of permanent improvements or betterments made to increase the value of property. Regs. Sec. 1.263(a)-2(a) requires the capitalization of costs incurred to acquire property with a useful life substantially beyond the close of the tax year. The Supreme Court held in INDOPCO that the costs of acquiring an asset with a useful life extending substantially beyond the end of the tax year or conferring a long-term benefit on the taxpayer must be capitalized.

IRS Attack in New TAM

In the TAM, the IRS concluded that the commission payments resulted in the company's acquiring an asset with a life extending substantially beyond the close of the tax year in which the contracts were entered into that could be expected to provide economic benefits extending substantially beyond the close of the tax year. The Service argued that the taxpayer paid the commissions to distributors to obtain new customers that contract for the taxpayer's cellular telephone services, with the expectation that these customers will remain with the taxpayer for an extended period of time.

The IRS compared the taxpayer's acquisition of cellular telephone customers to customer account buying in Sirovatka, TC Menlo 1983-634, in which the Tax Court held that the tax payer (an accounting firm) had to capitalize the costs incurred in obtaining new clients. The stated difference between the purchased clients in that case and the cellular customers in the TAM was that the Tax Court decision cited Lincoln Savings & Loan Ass'n, 403 US 345 (1971), while the TAM also cited INDOPCO. The more recent INDOPCO decision focuses on the long-term benefit, without requiring the Service to identify any specific asset acquisition to which the capitalized costs relate. In both instances, the customer contract is the specific asset acquired and capitalized.

The taxpayer argued that the ability of either party to terminate the contract on seven days' notice showed that the contracts necessarily are short-lived, and that the commissions did not produce benefits extending substantially beyond the close of the tax year. Also, the customer did not face a penalty or sanction for canceling the contract at any time. Further, the taxpayer argued, the commissions did nothing more than introduce the customer to the taxpayer's services for one month, while future renewals depended on the quality of service provided during this initial one-month period and thereafter. In other words, the taxpayer believed the long-term customer relationship resulted from providing good service, rather than paying the commissions.

The taxpayer was unsuccessful in convincing the IRS that the commissions would not give rise to an asset with a life extending beyond the close of any given tax year. The Service stated that it takes renewal periods into account when analyzing the life of a contract, unless the taxpayer proves that contract renewal is not reasonably certain. The IRS focused on the following facts to determine reasonable renewal certainty: (1) company history suggested that 67% of the company's contracts were renewed beyond the close of the tax year and only 3% of the contracts were not renewed in a given month; (2) the company paid relatively high initial commissions, suggesting renewal expectations; (3) the customer had no ability to change cellular carriers without switching telephone numbers; and (4) the company paid commissions only if the contracts remained in force for at least 30 to 180 days. Citing Nachman, 191 F2d 934 (5th Cir. 1951), the Service indicated that a significant initial investment in an asset with a relatively short contractual term (absent renewals) strongly suggested an expectation of renewal.

The TAM also drew a distinction between commissions paid in connection with inventory or property sales and commissions paid for services. The taxpayer cited Fidelity Associates, TC Memo 1992-142, in which a taxpayer was in the business of selling schoolbooks and maintained a schoolbook inventory; the taxpayer paid sales representatives a commission for obtaining two-year sponsorship agreements. The Tax Court allowed a current deduction for the commissions. The IRS distinguished Fidelity on the grounds that the taxpayer in the TAM is not a dealer, does not maintain an inventory and is not paying sales commissions.

The TAM does not discuss the time period over which the capitalized commissions are to be recovered. If the Service were to be successful in asserting that such costs fall within the definition of customer-based intangibles under Sec. 197 (d) (2), 15-year amortization would be required; thus, the taxpayer would have to track each contract and related commission separately and amortize it over 15 years.

A 15-year amortization period seems unusually harsh for a telecommunications service provider that can establish customer retention periods of fewer than five years (as in the TAM). The adverse impact is compounded by the fact that, pursuant to Sec. 197(f), the acquired intangibles' 15-year amortization period may not be accelerated by disposition of those assets. Thus, for example, a telecommunications service provider might have to amortize over 15 years commissions paid to a distributor for the enrollment of a customer who terminates a contract two months after enrolling.