IRS clarifies direct labor costs cannot be MSC.

In Technical Advice Memorandum (TAM) 200609018, the IRS relied on traditional cost accounting principals to determine whether the costs of a taxpayer's engineering and procurement departments qualified as mixed service costs (MSC) that can be allocated between capitalizable activities and deductible activities under Regs. Sec. 1.263A-1(e)(4)(ii)(c). It concluded that, to the extent those departments' costs include labor costs that can be identified or associated with particular units or groups of units of specific produced property, such costs are direct labor costs and not MSC.

Issue

The taxpayer filed Form 3115, Application for Change in Accounting Method, to change its method of allocating MSC to self-constructed assets. It previously employed the step-allocation method, using reasonable factors and relationships. Under its proposed method, it sought to use the simplified service cost method (SSCM) under Regs. Sec. 1.263A-1(h) to allocate MSC to self-constructed assets. The taxpayer indicated it would treat such costs of its engineering and procurement departments as MSC for SSCM purposes.

The examining agent questioned the treatment of those costs and requested technical advice from the IRS National Office. Specifically, the agent asked whether engineering department labor costs and procurement department costs are MSC that may be allocated between capitalizable activities and deductible activities for SSCM purposes.

Background

The taxpayer is a regulated public utility. In accordance with Federal regulatory accounting rules, it uses a uniform system of accounts that requires assigning and allocating costs based on types or cost pools. Consistent with this system, it established major cost pools including (among others) (1) engineering labor costs for individuals involved in the planning, design and implementation engineering of specific projects; (2) engineering supervision and clerical support; (3) other engineering department costs; and (4) "provisioning" costs of material and supplies.

In their submissions with the request for technical advice, the agent and the taxpayer disagreed about how the taxpayer allocates cost pools under this system. Thus, each set of facts was considered in the alternative by the IRS.

Agent's view: According to the agent, the taxpayer allocates cost pools to projects, and ultimately expenses or capitalizes such costs using "costs drivers," which determine how costs are "driven" to different projects or codes. Costs drivers are collected either in directly reported project hours or in specific dollars of material used. The agent also stated that, under the taxpayer's cost pool allocation system, certain plant and engineering employees have to report their time to the specific projects and/or codes they are working on (referred to as "time-reporting" employees). Similarly, the costs of material used on specific projects are recorded to the specific projects and/or codes. These labor and material costs are then multiplied by a standard rate and allocated to the project and/or code by accounting entries. Standard rates are developed by collecting incurred costs in appropriate cost pools. Each cost pool has certain costs drivers to determine how costs are allocated to different projects or codes. Using a rolling 12-month total, the total cost of a cost pool is divided by the applicable cost driver to arrive at the standard rate.

The taxpayer's engineering department provides estimates, project planning and project design to plant department personnel engaged in the construction, maintenance, repair, rearrangement and removal of the taxpayer's systems. The engineering department also performs work for other departments, such as assisting the sales and marketing departments with cost studies. Each activity is assigned a project number and an alpha code (e.g., C for construction activities, R for repair and maintenance, M for rearrangement and X for removal activities). For financial and regulatory accounting purposes, construction activity costs are capitalized; costs for repair and maintenance, rearrangement and removal activities are all expensed.

The time-reporting employees have to report the hours they spend working each day. Regulatory accounting rules identify their labor as either "direct plant labor" or "direct engineering labor." As previously noted, engineers who perform the design, planning and implementation-engineering functions associated with a specific project are time-reporting employees, required to report 100% of their time. Certain supervisors and support employees in the engineering department are not time-reporting employees and do not report their time. The labor costs incurred by these employees are collected in cost pools and allocated by costs drivers, as described above. For regulatory accounting purposes, these allocated labor costs are referred to as "indirect engineering labor."

The taxpayer's procurement department employees analyze and evaluate suppliers' products, select suppliers, negotiate supply contracts, place orders, develop standards for material purchases, and administer vendor or user claims. In addition, certain procurement department employees engage in "provisioning" activities, such as overseeing the receiving, stocking and requisitioning of materials and supplies used in construction, repair and maintenance. Costs incurred for these provisioning activities are collected in a cost pool and allocated based on the acquisition costs of the materials used.

Taxpayer's view: According to the taxpayer, time-reporting engineers do not specifically record their time to alpha codes. They record the hours worked on a specific project, but do not specifically record their time to capital or expense activity codes within the project. Such time is allocated to codes within a specific project based on allocation percentages, established by a planning engineer who initiates the specific project, based on the total projected project cost. Thus, engineering labor reported to a specific project is allocated to the codes of projects based on pre-determined allocation percentages established for the project by the planning engineer. Under this method, engineers who spend all of their time working on issues concerning only one code in a project do not specifically report all of their time to the code, but instead allocate time based on the total cost estimates the planning engineer established.

There were no factual disagreements concerning the procurement department. Thus, the analysis below is limited to a discussion of the Service's ruling on the engineering department's costs.

Analysis

Engineering department labor costs: The agent took the position that costs incurred in the taxpayer's engineering department were not MSC because the department was not a mixed service department, and even if the department were in some part a service department, all of its costs were not service costs as defined in Regs. Sec. 1.263A-1(e)(4). The agent argued that a service department only includes general and administrative departments that incurred only general and administrative expenses. The IRS rejected the agent's attempt to apply such a narrow view of a service department, in light of the plain language of Regs. Sec. 1.263A-1(e)(4)(i)(A), which provides "[s]ervice costs are defined as a type of indirect costs (e.g., general and administrative costs) that can be identified specifically with a service department or function or that directly benefit or are incurred by reason of a service department or function" It pointed out the parenthetical provides only an example of indirect costs that may be service costs; the list is not exhaustive. Having clarified that point, the IRS noted that, to determine whether the engineering department's costs were service costs, one must first determine whether the department was a service department within the meaning of Regs. Sec. 1.263A-1(e)(4)(i)(B). Under Regs. Sec. 1.263A-1(e)(4)(i)(B), a service department is an administrative, service or support department that incurs service costs. The facts and circumstances of a taxpayer's activities and business organization control whether a department is a service department.

The IRS also looked to the plain language of the regulations to find whether an engineering department may be viewed as a service department; see Regs. Sec. 1.263A-l(g), which provides several illustrations of MSC allocations using reasonable factors and relationships. In particular, under Regs. Sec. 1.263A-l(g) (4) (iv) (E) "the costs of an engineering or design department are generally directly allocable to the departments or activities benefited based on the ratio of the approximate number of hours of work performed with respect to the particular activity to the total number of hours of engineering or design work performed for all activities." Based on this illustration involving an engineering and design department, the IRS reasoned the regulations clearly contemplated that the costs of an engineering department may be viewed as service costs and allocated between capitalizable and deductible activities using various cost allocation methods. However, the analysis of whether the taxpayer's engineering department costs were service costs was not complete.

As noted, the agent contended the costs incurred by the taxpayer's engineering department were not service costs, but direct labor costs. In support, the agent pointed out one of the department's activities involved the selection or implementation of designs, materials and methods for the production of specific plant assets. The taxpayer had always considered costs associated with this activity as direct costs for financial accounting purposes, and until it filed an accounting method change these costs were considered direct costs for tax purposes. Moreover, the taxpayer's books and records directly identify and associate these costs with particular units or groups of units of specific property produced. Finally, time-reporting engineers directly report their time to project codes and thus their costs should be direct labor costs.

In opposing the agent's position, the taxpayer argued that, under the regulations, engineering costs are categorically treated as indirect costs. It cited Regs. Sec. 1.263A-1 (d) (3) (ii) (P) for support, which lists engineering and design costs as an example of indirect costs. In addition, direct labor costs include only the costs of production workers directly involved in product fabrication. That is, only the costs of personnel who "touch" the production process are considered direct labor costs.

The Service refused to apply such a narrow definition of direct labor costs. On the contrary, it noted the definition of direct labor costs contained in Regs. Sec. 1.263A-1(e)(2)(i)(B), which provides that such costs include the costs of labor that can be identified or associated with particular units or groups of units of specific property produced. Based on this definition, the Service concluded that, if the time-reporting engineers directly report their time to project codes, such costs are being identified or associated with particular units or groups of units of specific property produced, and thus are direct labor costs. Further, it noted that the taxpayer ignored the definition of indirect costs provided in Regs. Sec. 1.263A-1(e)(2)(i)(B), which provides indirect costs are all costs other than direct material costs and direct labor costs. In addition, the Service noted that the SSCM is a method for allocating indirect costs that qualify as MSC and does not apply to costs that are direct costs.

The Service spent considerable time analogizing direct labor costs under Regs. Sec. 1.263A-1(e)(2)(B) and its conclusion regarding time-reporting engineers who directly report their time to project codes, to traditional cost accounting principles, noting that direct labor has traditionally been defined as labor quantities that can be specifically identified with a cost object in an economically feasible manner. Under cost accounting principles, a cost objective is generally defined as a product, contract, project, organizational subdivision or the like. Similarly, whether it is economically feasible to relate costs directly must be determined on an entity-by-entity basis. Thus, continuing with the traditional cost accounting analogy, the Service reasoned that whether a cost is direct must be viewed in the context of a company's cost accounting system and whether a company has determined the economic feasibility of tracing the subject cost directly to a cost objective.

Looking at the taxpayer's cost accounting systems and its method of allocating costs to codes within specific projects based on allocation percentages established by the planning engineer who initiates the project and based on the total projected costs of the project for each code, as well as using cost pools for labor costs of supervisors and support employees that are subsequently allocated to various projects and/or codes, the Service ruled that if the agent determines that time-reporting engineers specifically track time to project codes, such labor costs are direct labor costs. Alternatively, the Service ruled that if the agent determines the time-reporting engineers do not specifically track time to project codes, such labor costs are not direct labor costs.

Implication 

This case is certainly an indication that field agents are looking deeper into a taxpayer's application of simplified methods when it comes to allocating uniform capitalization costs. One practical implication of the TAM is taxpayers may expect agents to be more aggressive in scrutinizing the treatment of costs of so-called multifunctional departments that taxpayers view as mixed service departments, and applying traditional cost accounting principles that were embraced by the Service in this TAM to rule out (or in) costs that are in fact direct costs. To the extent such departments are defined to be overly broad, there may be some exposure.

FROM TERRANCE MCWHORTER, J.D., LL.M., WASHINGTON, DC