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

Tax Executive, The, Nov-Dec, 2003 by James L. Atkinson

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)