Taxes and Training

The Training Time Bomb

See also:
Employee or Independent Contractor? -- Part One
Employee or Independent Contractor? -- Part Two
Employee or Independent Contractor? -- Part Three

          Internal Revenue Bulletin 1996-53, dated December 30, 1996, promulgates a significant reinterpretation of the IRS’s treatment of certain business expenses -- viz., training expenses. This new ruling will have an inimical impact upon many owner/ managers of smaller businesses and entrepreneurs.

          The nub of this ruling is the determination of whether expenses are incurred (a) for the "training of employees that relate to the regular conduct of the employer’s business," or (b) for the training of employees to undertake a new line of business, i.e., "where 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." In the latter circumstance, training costs must be capitalized and amortized over their anticipated beneficial life for the new line of business.

          The two relevant sections of the Internal Revenue Code are:

Section 162 and 1.162-1(a) in the Income Tax Regulations allow a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, whereas
Section 263(a) and 1-263(a)-1(a) provide that no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property.

          To understand the likely reasoning of the IRS in determining whether incurred costs are to be treated as current expenses [Section 163] or as payments to be capitalized and amortized over future periods [Section 263(a)], it is helpful to examine INDOPCO Inc. v. Commissioner,¹ the Decision of the US Supreme Court upon which this new ruling is based. In INDOPCO, the Court concluded that certain legal and professional fees that had been incurred by a target corporation to facilitate a friendly merger created significant long-term benefits for the taxpayer and, therefore, were capital expenditures. In reaching this decision, the Court specifically rejected the argument that its long-standing decision in Commissioner v Lincoln Savings and Loan Association² should be read as holding "that only expenditures that create or enhance separate and distinct assets are to be capitalized under 263."³

          The INDOPCO decision clarifies that the creation or enhancement of a separate and distinct asset is not a prerequisite for capitalization. However, the actual interpretation of this distinction is not sharp. Anthony Burke, a spokesman for the IRS has noted, "There really isn’t a strict definition out there." The Supreme Court has specifically recognized the "decisive distinctions [between capital and ordinary expenditures] are those of degree and not of kind ..."⁴ "Therefore, with respect to expenditures that produce benefits both in the current year and in future years, the determination of whether such expenditures must be capitalized or may be deducted requires a careful examination of all the facts. Although the mere presence of some future benefit may not warrant capitalization, a taxpayer’s realization of future benefits is undeniably important in determining whether an expenditure is immediately deductible or must be capitalized.⁵ ... Training costs must be capitalized ... where 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." The IRS offers the example of "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."⁶

          The impact of this ruling can be far-reaching for both Fortune 500^® corporations as well as smaller companies and entrepreneurs. The major auto makers face the capitalization of the costs of training employees who design and build new vehicle models with an anticipated production life of three to seven years. Similarly, both large and small businesses face the capitalization of training employees to implement popular new work improvement programs -- e.g., "just-in-time manufacturing" (JIT) and ""total-quality management" (TQM). The IRS has interpreted this ruling that the installation of these work improvement programs can constitute a new line of business. However, with the deduction of costs associated with advertising, environmental cleanup, incidental repairs and severance payments connected with corporate downsizing being routinely allowed as current expenses, the interpretations are not yet clear; there are no "bright lines."

          For owner/managers of smaller businesses and entrepreneurs, what we do see is a red flag! The costs of employee training -- a $60.0 billion per year industry in the United States -- may not be routinely deductible expenses; the unique facts in each situation must be evaluated on a case-by-case basis. With this new ruling giving IRS officials considerable leeway to determine what constitutes a "new line of business," predictability is shaken.

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¹ INDOPCO, Inc. v Commissioner, 503 US 79 (1992).
² Commissioner v Lincoln Savings and Loan Association, 403 US 345 (1971).
³ INDOPCO , Inc. v Commissioner, supra, 503 US at 86-87.
⁴ Welch v Helvering, 290 US 111,114 (1933); and Deputy v du Pont, 308 US 488,496 (1940).
⁵ See, INDOPCO, Inc. v Commissioner, supra, 503 US at 87-88.
⁶ Cleveland Electric Illuminating Co. v United States, 7 Cl Ct 220,227-229 (1985).

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Thomas A. Faulhaber, Editor
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Revised: March 17, 1997 TAF