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Rev. Rul. 96-62: a lump of coal or a nicely wrapped present?

Two days before Christmas, the Internal Revenue Service issued a ruling on the treatment of training expenses. Rev. Rul. 96-62 holds that the Supreme Court's 1992 decision in INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), "does not affect the treatment of training costs as business expenses, which [remain] generally deductible under [section] 162." The ruling prompted a letter of commendation from Tax Executives Institute, which said that Rev. Rul. 96-62 "promises to bring much needed certainty to this area."

Other commentators, however, were far less sanguine. Most notably, the Wall Street Journal published an article about the ruling on January 14 headlined "Tax Rule May Crimp Firms' Expansion." The article apocalyptically warned that Rev. Rul. 96-62 "could have a chilling effect on U.S. companies' expansion plans [by making] training costs harder to deduct." The Journal article quoted one corporate executive as saying the ruling is "devastating" and may "put the brakes on our efforts to expand." It then elaborated that "tax experts" believe "the auto industry could have trouble trying to deduct the cost of training workers who design and build new vehicle models."

Who is correct? Is Rev. Rul. 96-62 a lump of coal the IRS placed in taxpayers' stockings on December 23rd or is it a nicely wrapped present? In my view, the IRS was playing more Santa than Scrooge in issuing the ruling, and a pessimistic view of the IRS's training ruling is unwarranted. And since I am the only person quoted in the Journal story as being pleased with the ruling, I want to explain why.

Satisfying a Compelling Need

for Guidance

The Journal article notwithstanding, the issuance of Rev. Rul. 96-62 is a good thing. First, it provides guidance on a subject where guidance was needed, and second, the guidance that it provides is generally pro-taxpayer.

Taxpayers have been seeking guidance from the IRS about the continued deductibility of training and other expenses in the aftermath of INDOPCO, almost from the time the Supreme Court handed down its decision. Rev. Rul. 96-62 is responsive to those requests. Stated differently, almost any guidance is better than no guidance. Given the broad language of the Supreme Court's decision in INDOPCO (that "capitalization is the norm"), TEI and others have long contended that the National Office needed to rein in aggressive agents. Otherwise, they would strain to capitalize all sorts of expenses that historically have been currently deducted. One of the reasons that TEI filed an amicus brief in INDOPCO back in 1991 was to express concern over the possible breadth of the Third Circuit's decision in the case: "If the Third Circuit's definition of a capital expenditure as any expenditure yielding income substantially beyond the taxable year gains currency," the Institute wrote, "then the manifest deductibility of untold ordinary and necessary expenses will be jeopardized.

"Indeed, the language used by the court in this case is at once so broad and nebulous that it undermines the ordinary and necessary' character of expenses long held to be currently deductible. These expenses include expenses for ... employee training...

For example, Treas. Reg. 1.162-5(a)(1) provides that expenditures made for education and employee training are deductible as ordinary and necessary business expenses if the education maintains or improves skills required by the individual in his employment. Employee training clearly yields a multi-year benefit to the employer, but it does not generate any separate and distinct asset. The regulations, which were adopted in 1967, recognize this and distinguish between those educational expenses that are ordinary and necessary' expenses of an employer's trade or business and those that are personal to the employee and capital expenditures.... The Third Circuit's opinion threatens to blur that distinction."

When the dust settled, of course, the Supreme Court's decision in INDOPCO was even worse than the Third Circuit's, and the result was a flurry of audit activity by agents, which resulted in numerous IRS challenges to the deductibility of training and other traditionally deductible expenses. Slowly, the IRS National Office came around to the view that clarifying guidance was necessary. In Rev. Rul. 94-12 (which deals with the treatment of incidental repairs), the IRS confirmed that INDOPCO did not "change the fundamental legal principles for determining whether a particular expenditure can be deducted." Similar guidance was provided in respect of advertising expenditures (in Rev. Rul. 92-80) and soil remediation and groundwater treatment expenditures (in Rev. Rul. 94-38). And in all three cases, the IRS propounded general rules that the expenses at issue were deductible.

Rev. Rul. 96-62 continues the tradition. The "Holding" segment of the ruling provides that training costs are generally deductible under section 162. The "Law and Analysis" segment of the ruling elaborates:

Training costs must be capitalized only in the unusual circumstances where the training is intended primarily to obtain future benefits significantly beyond those traditionally associated with the training provided in the ordinary course of a taxpayer's trade or business.

The ruling then cites the Court of Claims's decision in Cleveland Electric Illuminating Co. v. United States, 7 Ct. Cl. 220 (1985), parenthetically noting that the case required "capitalization of costs for training employees of an electric utility to operate a new nuclear power plant, which were akin to start-up costs of a new business."

The Journal story makes no reference to the rule of general deductibility that is affirmed in Rev. Rul. 96-62. Rather, the article latches on to the ruling's reference to "a new business" in its parenthetical reference to Cleveland Electric and makes it the focal point of its story. Apparently, the Cleveland Electric "unusual circumstances" exception is seen as swallowing up the favorable "generally deductible" rule. I disagree.

The Danaher TAM

The Journal story exaggerates the significance of what it calls a "precedent-setting" 1995 technical advice memorandum (PLR 9544001), in which the IRS held that certain just-in-time manufacturing expenses (including training costs) must be capitalized.(1) Although private letter rulings are routinely cited, section 6110(j)(3) technically operates to prevent their use as "precedent." Second, even if the TAM had authoritative value when it was released, the subsequent issuance of Rev. Rul. 96-62 muted, or perhaps even obliterated, it.(2) The published ruling not only underwent more levels of review than the previously issued TAM (during which the IRS'S thinking could be assumed to have evolved), but it benefitted from the plethora of comments that the IRS received in response to Notice 96-7, which requested taxpayers' views the need for further capitalization guidance. TEI was one of the commentators that recommended the issuance of a ruling on the treatment of training expenses.

That one should not make too much of the Danaher TAM is underscored by the ultimate disposition of the case. Following the issuance of the TAM a settlement was negotiated in the case that was almost wholly satisfactory to the taxpayer: not only were the just-in-time manufacturing training expenditures involved in the case determined to be currently deductible (or amortizable over a relatively short time frame), but it was agreed that the taxpayer's ongoing expenditures for training could be currently deducted as ordinary and necessary business expenses.(3)

A New Rule, Same as

the Old Rule

Even without regard to undue reliance on the Danaher TAM, I fail to appreciate a "sky is falling" interpretation of Rev. Rul. 96-62. The key to the Journal article's message is the intimation that IRS agents will distend Rev. Rul. 96-62's reference to a "new business" to disallow all manner of training expenses. In other words, examining agents will adopt a broad definition of the "new business," claim that a taxpayer's training expenses relate to such "new businesses," and thereby rule that the expenses must be capitalized. The argument proves too much.

To be sure, the determination whether something is a "new business" is intensely factual and must be made on a case-by-case basis. To be sure, too, there is always the potential for revenue agents to abuse the discretion provided under a case-by-case test by contriving a "new business" to which they could attempt to relate certain training costs. And to be sure, taxpayers themselves could draft a more favorable ruling -- say, one providing that any expenses they characterize as being for training are currently deductible. But that is not to say that taxpayers should lose sleep over the matter. The "ordinary and necessary" determination under section 162 is always case by case. Whether a meal is lavish or extravagant within the meaning of section 162(a) is a question whose answer will never be absolute (since the Code says "under the circumstances"), but that does not mean that taxpayers need worry whether they will be denied a deduction for an Arch Deluxe (as compared with a Quarter Pounder with Cheese).

In other words, although the potential exists for agents to use Rev. Rul. 96-62's reference to Cleveland Electric as a sword to cut away the protection of the ruling's general deductibility rule, only a Cassandra would read the ruling so negatively. After all, Rev. Rul. 92-80 -- which confirms the general deductibility of advertising expenses -- contains a caveat virtually identical to the one contained in Rev. Rul. 96-62,(4) and revenue agents have not interpreted the advertising ruling as giving them a green light to capitalize advertising expenditures. Rather, with phrases such as "only in the unusual circumstances" where the benefits extend "significantly beyond those traditionally associated" with the expenditure, the IRS has sought to clarify its general rule of the current deductibility of advertising expenditures. Rev. Rul. 96-62 offers the same clarification in respect of training expenses. True, the ruling does not set forth an absolute, pro-taxpayer position, but I do not think that means taxpayers should fear it.


In summary, Rev. Rul. 96-62 should be viewed, not as the end of the world a$ we know it, but as a positive development in the ongoing expense-versus-capitalization debate. Although it is not inconceivable that some revenue agents might seize upon the "new business" language in the ruling to disallow a current deduction for training expenses (especially following the Journal's assigning such prominence to the argument(5)), most taxpayers should seek to avoid that self-fulfilling prophecy. Accordingly, they should embrace Rev. Rul. 96-62 in the spirit in which it was offered: not as a lump of coal but as a nicely wrapped Christmas present.

(1) The article incorrectly states that the TAM, which was in connection with an examination of Danaher Corporation, was issued in 1992.

(2) Indeed, an argument can be made that whatever effect the Danaher TAM had on the general deductibility of training costs was vitiated by Rev. Rul. 95-32, which held that expenses incurred by a public utility in connection with its demand-side management programs were ordinary and necessary business expenses even though they created future benefits in the form of reduced future operating and capital costs.

(3) That the Danaher TAM remains outstanding even though its practical effect has been nullified (with the agreement of the IRS) is troubling. Ideally, the TAM should be withdrawn in order to prevent its being misconstrued, even for the limited purposes permitted by section 6110(j)(3).

(4) The advertising ruling reads in part: "Only in the unusual circumstances where advertising is directed towards obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising or with institutional or goodwill advertising, must the costs of that advertising be capitalized. See, e.g., Cleveland Electric Illuminating Co. v. United States, 7 Ct. Cl. 220 (1985) (capitalization of advertising costs incurred to allay public opposition to the granting of a license to construct a nuclear power plant)."

(5) Although conspiracy theorists sometimes assign ominous, politically inspired significance to agents that show up at taxpayers' doors following press reports of their activities, there can be no doubt that the audit teams often (and legitimately) get leads from reading the newspaper -- perhaps most especially The Wall Street Journal.
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Author:McCormally, Timothy J.
Publication:Tax Executive
Date:Mar 1, 1997
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Next Article:Toward an IRS for the twenty-first century.

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