Current deductibility of training costs.

The IRS recently determined in Rev. Rul. 96-62 that the Supreme Court's decision in INDOPCO, Inc., 503 US 79 (1992), does not affect the treatment of training costs as business expenses, which are generally deductible under Sec. 162. In INDOPCO, the Court concluded that certain legal and professional fees incurred by a target corporation to facilitate a friendly merger created significant long-term benefits for the taxpayer and, therefore, were capital expenditures. The INDOPCO decision has been frequently cited by examining agents challenging the treatment of many different categories of expenditures historically regarded as currently deductible.

In Rev. Rul. 96-62, the Service held that amounts paid or incurred for training, including the costs of trainers and routine updates of training materials, are generally deductible as business expenses under Sec. 162, even though they may produce some future benefit. Rather than setting a new standard for deductibility, Rev. Rul. 96-62 clarifies that applying the INDOPCO decision to require capitalization of training costs would be inappropriate. Prior to INDOPCO, the courts and the IRS consistently agreed that the costs of various types of training were currently deductible as business expenses. For instance, the costs of training employees to operate new equipment in an existing business were held to be currently deductible in Cleveland Electric Illuminating Co., 7 Cl. Ct. 220 (1985). Similarly, the costs of training new employees to keep an assembled workforce unchanged were currently deductible, according to Ithaca Industries, Inc., 97 TC 253 (1991), aff'd, 17 F3d 684 (4th Cir. 1994), cert. denied. In Rev. Rul. 58-238, the Service stated that the costs of training employees that relate to the regular conduct of the employer's business are currently deductible.

The types of training costs that may be currently deductible include internal and external costs associated with routine employee training to maintain the skills of the workforce, and special training such as that associated with the implementation of new software programs, quality improvement programs to meet ISO 9000 quality standards, and similar programs designed to improve the production process or the operation of an existing business.

Expansion-Related Training

Costs incurred in starting a new business generally need to be capitalized, but training costs need not be capitalized merely because they are associated with a business expansion project. Absent a new line of business, costs normally incurred to expand an existing business are currently deductible, as indicated by the legislative history of Sec. 195 (requiring capitalization of start-up expenses of a new business). Recently, in Letter Ruling (TAM) 9645002, the IRS ruled that a retailer may deduct costs associated with opening new retail stores, including hiring and training expenses and other normal, recurring operating expenses (such as payroll and related costs for receiving, preparing and stocking inventory). The allowance of a current deduction was supported by the recurring nature of the costs and the short-term nature of the benefits that resulted from the costs.

Rev. Rul. 96-62 states that training costs must be capitalized only in the unusual circumstance in which the training is intended primarily to obtain future benefits significantly beyond those traditionally associated with training provided in the ordinary course of a taxpayer's trade or business. An example of an unusual circumstance is illustrated, according to the Service, in the Claims Court's ruling in Cleveland Electric in which the costs of training employees of an electric utility to operate a new nuclear power plant were held to be capitalizable, because they were akin to start-up costs of a new business (the opening of the new nuclear power plant required a new license). Absent such an unusual circumstance, the training costs incurred by a taxpayer to expand its existing business should be currently deductible.

Just-In-Time Manufacturing--TAM 9544001

Rev. Rul. 96-62 could be interpreted as a retraction of the IRS's position in Letter Ruling (TAM) 9544001, in which the Service determined that the costs incurred by a manufacturer to convert from an assembly line to just-in-time manufacturing JITM) must be capitalized. The taxpayer in TAM 9544001 incurred one-time initial expenses to reconfigure manufacturing facilities to physically accommodate the JITM processes, acquire materials and supplies used in JITM processes, train employees for the new JITM processes and compensate consultants for implementing the JITM processes. Citing INDOPCO, the IRS determined that all of these costs had to be capitalized, since the taxpayer expected the conversion to produce significant benefits of a long-term nature. The TAM has been criticized by many commentators because it did not consider the uncertain and indeterminable nature of the future benefits.

In the TAM, the taxpayer did not create a new line of business or alter its end product. Rather than introducing and training employees to use a new piece of equipment (as in Cleveland Electric), new manufacturing processes were introduced and employees were trained to use them. Applying the conclusions reached in Cleveland Electric and Rev. Rul. 96-62, the training costs associated with the JITM conversion should be currently deductible. Although the Service may continue to distinguish the training in TAM 9544001 and require training costs in that particular situation to be capitalized, the position taken in TAM 9544001 would appear to be difficult to maintain after Rev. Rul. 96-62.

From Carol Conjura, CPA, J.D., and Pauline Mak, CPA, Washington, D.C.