Everything old is new again: reaching the limits of INDOPCO's future benefits with the just-in-time management philosophy.

• Author: Walberg, Glenn

Overzealous descriptions of company programs designed to motivate employees may trigger dire tax consequences. The Danaher Corporation ("Danaher") discovered this disturbing fact when the IRS ("the Service") denied the immediate deduction of employee training costs incurred while implementing a Just-in-Time (JIT) manufacturing system.(1) In requiring Danaher to capitalize the costs, the Service relied on Danaher's own description of "long-term benefits" obtained from "New Technician[s]" trained in the JIT philosophy.(2) In actuality, the JIT system used the same factory, machines, and employees to manufacture the same products; only the method of use changed.(3) The descriptions, however, led the Service to conclude that Danaher's extensive training created a new business that would not qualify for an immediate expense deduction otherwise available to existing businesses.(4) This result further complicates the somewhat amorphous expense/capitalization debate.

The difficulties inherent in determining the proper treatment for various expenditures have fueled an endless conflict between taxpayers and the Service. For large corporations, capitalization issues comprise the primary source of contested tax determinations.(5) Even though the Danaher ruling cannot provide reliable precedent for other taxpayers,(6) it suggests that many other businesses face the risk of unanticipated adjustments related to their training expenditures.(7) This threat appears realistic in light of recent claims of increasingly aggressive IRS behavior in capitalization issues,(8) despite a denial by the Service of any change in its policy.(9) Regardless of any change in position, the ruling adds uncertainty to the treatment of training expenditures at a time when manufacturers implement new processes and procedures almost daily.(10)

This Note examines the Service's position on JIT training expenditures. The first part provides a brief overview of the management philosophy of JIT to assess its implementation and expected results. The second part shifts the focus to the evolving classifications of expenditures requiring capitalization. The third part considers the specific application of these classifications in light of some recent IRS rulings and one case involving an expanding business. This Note then concentrates on the Danaher ruling and concludes that the new business characterization appears inappropriate. Furthermore, the recurring nature of the JIT training expenditures and the lack of a clear association with future benefits requires a current deduction to avoid a distortion of income. The last part of this Note explains that other expenditures with patterns resembling the recurring nature of JIT training, with similarly indeterminable benefits, also require an immediate deduction.

THE JUST-IN-TiME PHILOSOPHY

JIT manufacturing represents an approach to decreasing costs and increasing efficiency during the production process.(11) Unlike some production control methods, JIT encompasses an entire "philosophy of manufacturing."(12) At its heart lie two "common sense" aspects: the "elimination of wasteful practices" and the "habit of improvement."(13) The elimination of waste aspect stresses that nothing should remain "in the production process ... unless it adds value to the product."(14) The habit of improvement complements this elimination of waste by seeking to improve the remaining parts of the process.(15) These aspects appear in the basic JIT components of flow, quality, and employee involvement.(16)

The flow component typically concerns itself with eliminating the waste caused by maintaining large inventories.(17) It focuses on creating reductions in lead time throughout the entire process to avoid delays and the accumulation of inventory at any stage in the manufacturing process.(18) To reduce lead times and inventories within the system, JIT strives to accomplish a continuous materials flow that arrives at the next stage of production at the very moment that it is needed.(19) This streamlined system can reduce capital funds previously held in inventories, while the short lead times can increase the system's flexibility and enable it to respond to specialized customer needs.(20) These potential benefits from a relatively simple concept earned JIT praise as "a return to basics" that offers "a new vision of manufacturing--a purer efficiency than managers ha[ve] ever known."(21)

JIT"s apparent simplicity obscures its latent ability to produce calamitous results. Accumulated inventories provide a safety net that can be drawn upon when an unexpected event disrupts the manufacturing process.(22) In addition to introducing unique problems caused by operating at low inventory levels, JIT reveals problems that previously were masked by the system's ability to continue operating by using the inventory safety net.(23) Without a net, "[s]mall amounts of inventory mean that the wrong part, machine breakdowns, absent workers, nonstandard design components, and sudden schedule changes will rapidly disrupt the manufacturing system."(24) An inability to deal effectively with these common problems may prove disastrous.(25)

JIT's habit of improvement attempts to address these problems by emphasizing quality and the importance of employee involvement. Arguably the most important feature of JIT,(26) quality enhances production flow by "doing it right the first time;"(27) product flow cannot occur when components require continual reworking and inspection.(28) Building quality into products enables the line to keep moving.(29) Implementing this philosophy requires the cooperation and involvement of employees who will endure most of the changes(30) Gaining employees' commitment to improving quality requires employee involvement.(31)

Beyond the general common objectives of eliminating waste and improving the underlying system, JIT develops its particularized character in the individual businesses that adopt it.(32) Although this "fungible concept"(33) lacks a standardized form, the implementation of JIT appears to have taken two distinct courses: the pragmatic and the romantic.(34)

The pragmatic approach simply views JIT as addressing practical problems within the manufacturing system.(35) A pragmatic implementation proceeds slowly, with careful deliberation over minor aspects of the production process, to accomplish small feats that aid in the manufacturing process.(36) Inventory reductions follow this slow pace when the "process-improvement tactics ... do their work before pushing inventories down further."(37)

The pragmatic implementation of JIT uses continuous improvement to develop the system through an "accumulation of many small gains in efficiency over a sustained period of time."(38) Creating sustainable improvements through a series of process refinements provides greater benefits than attempting to address all problems with a one-time change.(39) The proximity of the line-employees to the process makes them ideal sources for most of these improvements; they are positioned to investigate the process, suggest improvements, and monitor the results of any changes instantly.(40) Thus, the improvements within the system occur from "employee experience and creativity" in an environment with a "natural equilibrium [of] constant improvement and change.(41)

In contrast to a pragmatic implementation, a romantic approach seeks a revolution in the workplace.(42) Often motivated by the perceived threat of foreign competition, this approach mandates urgent change toward the goal of simplicity.(43) JIT does not simply improve operations, rather it involves a complete and immediate transformation of the company.(44) Any part of the organization that hinders progress needs to be eliminated.(45) In particular, romantics cut inventory levels in order to drive reform rather than let inventory levels fall as a result of reform.(46) Frequently, this type of reform results from the motivations of senior managers acting without regard for their subordinates' roles on the actual factory floor.(47) Driven by a top-down approach, management seeks the revolution's benefits but fails to consider the real consequences that may be inflicted upon the manufacturing operations; instead of coordinating process improvements and inventory reductions, management unleashes all the problems caused by inventory reductions in the hope that JIT will take hold.(48) These rash acts sometimes produce "gruesome tales of chaotic plants, furious customers, and financial wreckage.(49)

EXPENDITURE CLASSIFICATIONS

Every business expenditure faces two alternate routes that eventually lead to the tax return. The first leads to the inviting immediate deduction as a business expense.(50) Eligibility, however, depends on the "ordinary and necessary" nature of the expense.(51) Ordinary expenses connote a "normal, usual, or customary" character,(52) suggesting a degree of recurrence, in the business operations.(53) The necessity of the expense imposes a minimal hurdle that the expense appear "appropriate and helpful" in the business.(54) Despite the emphasis frequently placed on the terms "ordinary and necessary," other requirements stipulate that the expense be paid or incurred during the taxable year, while carrying on the business.(55) The last requirement prevents the deduction of "start-up" costs.(56)

The alternate route leaves the taxpayer with a nondeductible capital expenditure.(57) These expenditures include the purchase of assets and improvements or restorations that increase the value or life of property.(58) Unlike their expense counterparts, capital expenditures presumably leave the taxpayer with something of value after the end of the tax year. Despite the apparent harshness of denying a deduction, the Internal Revenue Code ("the Code") generally permits the taxpayer to deduct a ratable portion of the asset's cost over its estimated useful life(59) in order to...