Life after INDOPCO: are business expansion costs deductible?

In Letter Ruling (TAM) 9544001, the IRS relied on Sec. 263 in ruling that costs of converting from a batch manufacturing process to a just in-time manufacturing (JITM) process must be capitalized. This TAM reflects a continuing trend at the Service to capitalize costs that result in long-term benefits, based on the Supreme Court's decision in INDOPCO, Inc., 503 US 79 (1992).

In 1980, Sec. 195 was enacted to allow taxpayers to amortize "start-up expenditures," i.e., costs incurred prior to the date on which an active trade or business begins. The legislative history of this provision compared deductible business expansion costs incurred in an ongoing trade or business to costs incurred to enter a new trade or business, which were not deductible under Sec. 162(a) because the trade or business had not yet begun. The purpose of Sec. 195 was to eliminate the discrepancy that existed solely because one taxpayer already was operating an active trade or business and another taxpayer was creating an active trade or business.

In NCNB Corp., 684 F2d 285 (4th Cir. 1982), the court relied on the business expansion principles discussed in the Sec. 195 legislative history (Briarcliff Candy Corp., 475 F2d 775 (2d Cir. 1973), and Colorado Springs National Bank, 505 F2d 1185 (10th Cir. 1974)) to allow a current deduction under Sec. 162(a) for costs incurred by a bank to develop branch banking facilities. The court in NCNB also relied on the "separate and distinct additional asset" test thought to be established by Lincoln Savings and Loan, 403 US 345 (1971). (In INDOPCO, the Supreme Court rejected the "separate and distinct additional asset" test.) In his dissent to NCNB, Judge Murnaghan argued that Sec. 195 applies only to costs that otherwise would be currently deductible in an active trade or business, not to all business, not to all business expansion costs; he further stated that currently deductible costs typically exhibit a "short life span."

In INDOPCO, the Supreme Court ruled that certain advisory fees incurred in connection with a creative corporate restructuring and acquisition were not deductible under Sec. 162(a). Arguably, the only absolute rules established by the INDOPCO decision are that (1) costs do not have to create a separate and distinct additional asset to be capitalizable and (2) based on the facts of the case, the taxpayer did not demonstrate that the advisory fees were "ordinary and necessary" business expenses deductible under Sec. 162(a). The reason the Supreme Court granted certiorari in INDOPCO was to establish clearly the first of these two rules (see footnote 3 of the opinion). All other comments in the decision should be evaluated in light of the case's particular factual circumstances.

In Letter Ruling 9331001, the IRS ruled that costs incurred by a wholesaler to open its first boutique/retail operation qualified under Sec. 195, but costs to open additional boutiques did not. The Service ruled that once the taxpayer opened the first boutique, the taxpayer was in the business of operating boutiques. Also, in this ruling, the IRS invited the case manager to request technical assistance to determine whether costs incurred to open the additional boutiques should be capitalized, nothing that such expenditures might not be currently deductible based on INDOPCO. Since qualification for Sec. 195 amortization is based on the expenses being currently deductible if incurred in an ongoing trade or business, it is not clear how costs could be amortized under Sec. 195 for the first boutique if similar costs for additional boutiques would not be currently deductible.

In the 1995 TAM, the Service relied on Cleveland Electric Illuminating Co., 7 Cl. Ct. 220 (1985), in determining that costs for factory supervision, factory labor, factory training, indirect supervision and indirect labor incurred to establish a trained work force for each JITM cell were capitalizable under Sec. 263. Actually, Cleveland Electric presented two fact patterns. One fact pattern involved costs to train a work force to operate a nuclear power plant; i.e., these training costs were incurred five years before a nuclear operating license was obtained and commercial operations at the plant began. The training costs for the nuclear plant were held not deductible under Sec. 162(a). The second fact pattern involved costs to train workers to operate a technologically improved facility that doubled the capacity of the taxpayer's plant. These training costs were held to be deductible under Sec. 162(a) because "immediate benefit was [not] lacking." Why the IRS ruled that the training costs in the 1995 TAM were more analogous to the first Cleveland Electric fact pattern than the second is not clear. Even more troublesome, however, is that in this TAM, the Service ruled not only that the training costs were not deductible under Sec. 162(a), but also that the training costs were capitalizable under Sec. 263.

The general rule followed by the courts is that a cost must be capitalized unless a deduction is provided for that cost in the Code. Sec. 162(a) provides this "legislative grace" in the form of a broad exception from capitalization for "ordinary and necessary" business expenses. Even costs that qualify as ordinary and necessary under Sec. 162(a), however, are capitalizable if specified in Sec. 263 (see Secs. 161 and 261). In the cases noted, the courts considered the principle of long-term benefits as reflected in Sec. 263 as one of many factors relevant for determining whether the costs were deductible under Sec. 162(a). In these cases, none of the costs for intangibles were held to be capitalizable. In fact, the Second Circuit in Briarcliff noted:

[Sec. 263] is couched in terms which refer to tangible capital assets such as consumable resources or tools, structures, or machinery which wear out and for which depreciation has already been taken. It may also be applied to intangible assets provided they have an ascertainable and measurable value in money's worth, so that they are no longer regarded as an expense but as a distinct and recognized property interest.

Does a trained work force as described in the 1995 TAM really provide the taxpayer with the type of property interest to which Sec. 263 may apply? At the Federal Bar Association (FBA) Tax Law Conference earlier this year, an IRS representative indicated that the taxpayer in the 1995 TAM was granted an amortizable life of five years for the training costs because the Service did not think the taxpayer should be in a worse position than it would have been in under Sec. 195 had it acquired a new business. If the training costs are capitalizable under Sec. 263, however, they would not qualify for amortization under Sec. 195. Furthermore, having been disqualified from Sec. 195, these costs would not be deductible under any other provision for a company not yet engaged in an active trade or business. This result is what Congress intended to avoid by enacting Sec. 195. The real issue should be whether the expenses qualify as an "ordinary and necessary" expense under Sec. 162(a).

In INDOPCO, the Supreme Court discussed several factors to be considered in determining if an expense was "ordinary and necessary." While one factor was the presence of long-term benefits, the Court acknowledged that this factor alone was not controlling. Based on Letter Ruling 9331001, TAM 9544001 and the cited IRS comments at the FBA conference, however, it appears that the Service (as well as Judge Murnaghan in NCNB) viewed long-term benefits as the controlling aspect as to whether or not an expense was "ordinary and necessary."

This isolation of long-term benefits as the controlling factor seems contrary to Lincoln Savings, Colorado Springs, Briarcliff Candy, the Sec. 195 legislative history, NCNB and INDOPCO, and also to established judicial precedents dating back to Welch, 290 US 111 (1933), and Du Pont, 308 US 488 (1940). Yet, this appears to be the direction the IRS is taking by inviting a challenge to business expansion costs and requiring capitalization of costs to train employees to implement a new method to produce the exact same product merely because long-term benefits are present. Taxpayers should be alerted that carefully documenting the characteristics that demonstrate how a business expansion expense is ordinary, necessary and deductible may not be sufficient to avoid capitalization.