Sec. 174: "just in time" for deducting costs of developing new or improved manufacturing processes.

Over the past several years, increased competition and customer demands have forced companies to improve their manufacturing efficiency and effectiveness. One response to these pressures has been to convert traditional processes to just-in-time manufacturing (JITM). JITM involves reconfiguring to a cellular system that better integrates and automates manufacturing, resulting in better inventory management, reduced processing time and reduced labor requirements.

Costs incurred to transform a manufacturing process to JITM were at issue in IRS Letter Ruling (TAM) 9544001. These costs included the reconfiguration of manufacturing facilities to accomodate JITM physically; materials and supplies used in JITM; training of employees in JITM; and use of consultants in implementing JITM. The IRS concluded that these costs were not deductible under Sec. 162, and had to be capitalized under Sec. 263, because of the perceived long-term benefits lasting beyond the tax year in which incurred. (Note: See the item on page 399 in this column on the deductibility of business expansion costs in light of this TAM.)

Absent from the TAM was a discussion of whether any of these costs qualified as research and experimental (R&E) expenditures under Sec. 174. That provision was intended to eliminate uncertainties for taxpayers investing in product or process development, and to encourage business investment in product and process development by allowing deductions for such costs (see H. Rep. No. 1337, 83d Cong., 2d Sess. 28 (1954), and S. Rep. No. 1622, 83d Cong., 2d Sess. 33 (1954)). As stated in the Joint Tax Committee's General Explanation of the Tax Reform Act of 1986 (p. 128):

[A] taxpayer may elect to deduct currently the amount of research or experimental expenditures incurred in connection with its trade or business, notwithstanding the general rule that business expenditures to develop or create an asset that has a useful life extending beyond the taxable year must be capitalized.

Thus, expenditures that are capital in nature, but qualify as R&E expenditures under Sec. 174, nevertheless may be deducted currently in the year incurred.

The final regulations under Sec. 174 state that expenditures qualify "if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product." Uncertainty exists if the information available to the taxpayer does not establish either the capability or method for developing or improving the product, or its appropriate design. A product includes any process or technique.

To switch to JITM, a business may have to develop and implement new technologies in production, measurement, quality control, handling and assembly. Further, the business may have to create new software to enhance the JITM process. Thus, at least a portion of the costs incurred for development of a JITM process seems eligible to qualify as Sec. 174 expenditures. In several previous rulings, the Service concluded that costs to develop and design a manufacturing system were deductible as R&E expenditures; see, e.g., Rev. Rul. 73-275, Letter Rulings (TAMs) 8835002 and 9522001. TAM 9544001 does not address these prior rulings or Sec. 174 issues.

The facts in TAM 9544001 stated that JITM was a radical redesign of existing manufacturing processes resulting in a fundamental change in the business processes at the taxpayer's manufacturing facilities. This statement indicates that the conversion to JITM may involve research and development in the experimental or laboratory sense to discover an improved manufacturing process based on JITM that would meet the requirements of Sec. 174. Meeting these requirements would relieve the taxpayer of capitalizing the costs and provide a current benefit. This treatment of costs that are capital in nature is available for qualifying expenditures and could encourage more businesses to incur similar costs to increase their competitiveness. Neglecting this opportunity could cost a company significant tax benefits that may be available on closer examination of the incurred costs.