FedEx v. Commissioner: the continuing debate over cyclical maintenance costs.

• Author: Atkinson, James L.

The treatment of repair costs is one of the tax system's most fertile plains of controversy. The reams of paper devoted over the decades to court opinions, briefs, administrative pronouncements and deficiency notices, academic musings, and well-meaning yet ill-fated proposals on the characterization of expenditures as either deductible repairs or capital improvements surely have depleted entire forests. (1) A recent district court opinion in FedEx Corp. v. United States, (2) however, has the potential to resolve this controversy for at least one embattled industry--the nation's air carriers. This article explores the recent history of the cyclical maintenance costs issue and the air transportation industry's seemingly endless battle with the IRS over these costs. The article concludes with an overview of new administrative tools that may allow taxpayers in other industries to resolve similar repair and maintenance issues more quickly and less expensively.

Introduction: General Principles of Capitalization

The Internal Revenue Code provisions applicable in determining whether an expenditure is currently deductible under section 162 as a trade or business expense or instead must be capitalized under section 263(a) as a capital improvement are well known. Section 263(a) provides simply that no deduction shall be allowed for (1) any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate or (2) any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

The applicable Treasury regulations provide little more clarity. Treas. Reg. [section] 1.162-4 permits a current deduction for the cost of incidental repairs that neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition (so long as the repair costs are not added to the property's basis). This regulation also provides that repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, must be capitalized and depreciated in accordance with section 167.

Treas. Reg. [section] 1.263(a)-1(b) provides the counterpart to Treas. Reg. [section] 1.162-4 (collectively referred to as the Repair Regulations). This section provides in general that amounts required to be capitalized include amounts paid or incurred (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. Amounts paid or incurred for incidental repairs and for the maintenance of property are not capital expenditures.

Nearly every word and phrase of the Repair Regulations have been scrutinized, parsed, and debated by courts, taxpayers, and the IRS for decades. Students of capitalization can recite the litany of "repair cases" like a mantra. (3) The decades-long judicial scrutiny of the Repair Regulations has produced several general principles relevant to cyclical maintenance costs.

First, costs incurred to "keep" an asset in an ordinarily efficient operating condition generally are deductible, while those incurred to "put" an asset into such a condition generally must be capitalized. (4) This rule dates to the Board of Tax Appeals' 1926 decision in Illinois Merchants Trust. (5) The taxpayer owned a brick building located along a river. The building was partially built on wooden pilings that were in the river. Unexpectedly, the river level dropped significantly, exposing the top portion of the wooden pilings to the air, causing them to rot. This in turn caused the building to begin to collapse. To save the building, the taxpayer sawed off the wooden pilings above the water line and replaced them with concrete pillars. The taxpayer also had to shore up part of a wall that had begun to collapse. The court found that the work did not prolong the original estimated life of the building or increase its value.

The issue was whether the taxpayer was entitled to deduct the cost of the structural work that was done to the building. The taxpayer argued that the work only kept the building in an ordinarily efficient operating condition. The IRS argued that the work was in the nature of a replacement, since it arrested deterioration and appreciably prolonged the life of the building. The issue thus was framed as whether the costs simply repaired the existing building, or whether they instead replaced a significant structural component.

In holding that the costs were deductible as repairs, the Board of Tax Appeals set forth a test that remains the touchstone of any repair analysis:

In determining whether an expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciable prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use. The one is a maintenance charge, while the others are additions to capital investment which should not be applied against current earnings. (6) This standard is routinely applied by courts trying to determine whether an expenditure is a repair--keeping an asset in an ordinarily efficient operating condition--or instead is a capital improvement--putting the asset in such a condition. (7)

Second, replacing major structural elements of an asset is not a repair, but replacing numerous, less significant components may be. Capitalization is not required if the replacements are a relatively minor portion of the physical structure of the asset, or of its major parts, such that the asset as a whole has not gained materially in value or useful life. (8) The costs of replacing a major component or a substantial structural part of the asset must be capitalized, however, where the value, life-expectancy, or uses of the asset have materially increased. (9)

Third, the tax code is not concerned with why the taxpayer undertakes the repair, only with the effect of that repair. In Swig Investment Co. v. United States, (10) for example, a landmark San Francisco hotel was required by a city ordinance to replace its historic masonry cornices and parapets with lighter weight replicas that posed less of a public hazard in the event of an earthquake. The hotel argued that the cost of installing the new cornices should be deductible because the old cornices were not damaged or deteriorated, and the hotel only replaced the old cornices because the city ordered it to. Rejecting this argument, the Federal Circuit agreed with its sister courts that what matters is what you do, not why you do it. (11)

Fourth, otherwise deductible repair costs must be capitalized if they are part of a "plan of rehabilitation." A plan of rehabilitation starts with the presumption that the asset in question is in need of "rehabilitation," in other words that there is a need to "put" the asset in an ordinarily efficient operating condition. One typically does not need to rehabilitate an asset that is in a generally sound working condition. Other than this general assumption, whether a general plan of rehabilitation exists, and whether a particular repair or maintenance item is part of it, are questions of fact. Relevant factors include the purpose, nature, extent, and value of the work done. (12) The existence of a written plan, by itself, is not sufficient to trigger the plan-of-rehabilitation doctrine. (13)

Upon finding a plan of rehabilitation, all costs that are incidental to that overall plan must be capitalized, including those that would otherwise be deductible as repairs. Capitalization, however, is only required if these erstwhile repair costs are "incidental" to the plan of rehabilitation--in other words, if they are part of and contribute to the purpose and goals of the plan of rehabilitation. It is not sufficient that the repairs simply occurred concurrently with the plan of rehabilitation. (14)

There has been some debate whether a plan of rehabilitation may consist only of otherwise deductible repairs or whether a "plan" must include at least one activity that would independently meet the definition of a capital expenditure. The general view is that at least one capital expenditure must be present in order to sweep incidental and otherwise deductible repair expenditures into a plan of rehabilitation. (15) Thus, while this is a factual inquiry, the general rule is that a plan of rehabilitation exists if there is at least one capital improvement plus related repair-type costs that are all incidental to an overall plan of putting the asset into an ordinarily efficient operating condition.

Finally, while the high cost of an activity may be probative concerning whether it is an incidental repair or a capital improvement, cost alone is not determinative. (16) Instead, the cost must be compared with, for example, the original cost of the asset and the cost of a replacement asset. (17) A $1 million expenditure may be large in absolute terms, but it may be modest in comparison to the multimillion dollar cost of replacing an aircraft that is not properly maintained and likely will have only an incidental effect on the aircraft's overall value or useful life. (18) As with everything in the capitalization area, the totality of the facts and circumstances...