Capitalize or expense?
Proposed IRS regulations would make it tougher to write off heavy maintenance costs when you incur them
By Jeff Wieand - August 1, 2008
When a company buys jet fuel for a business flight, the fuel will be consumed immediately. So the cost is tax deductible as an ordinary expense in the current period. Most expenses of owning and operating a business jet are like that–they can be deducted currently and thus offset taxes on current business income.
Depreciation, however, is not currently deductible. Unlike jet fuel, the aircraft will not be used up in a single flight and is intended to serve the company for years. Thus, instead of permitting a firm to write off a jet’s whole cost when it is acquired, the Internal Revenue Code says the amount must be capitalized and employed to offset taxable income over a period of years. Similarly, an improvement to the aircraft, like adding winglets to enhance range, would be capitalized, not currently deducted. The benefit of the winglets will continue far beyond the current tax year, most likely for the life of the aircraft.
Unfortunately, the tax treatment of many aircraft expenses isn’t as obvious. Some costs, especially for maintenance, inhabit a gray area. The area may be gray, but it sheds light on how the interests of the aircraft owner and the IRS are diametrically opposed: the owner wants to deduct everything now to reduce current taxable income, while the IRS wants to spread the deduction over future years to maximize current taxes.
The IRS has traditionally said that maintenance and repairs are current expenses if they don’t add materially to the property’s value, appreciably prolong its life or adapt it to a new use. Though you could argue that any required maintenance prolongs an aircraft’s life because, if you don’t perform it, the airplane is grounded, the general view is that routine maintenance preserves value and useful life but doesn’t increase it. Not surprisingly, the aircraft maintenance bills that have caught the IRS’ attention are also the most expensive and therefore generate the largest deductions: so-called heavy maintenance of engines, such as hot sections and overhauls.
The battle over whether such expenses should be capitalized has been waged for years in court cases and IRS rulings. The most significant case involved FedEx, which was assessed an additional $70 million in taxes and interest when the IRS determined that it must capitalize, rather than deduct currently, expenses for maintenance on aircraft engines and auxiliary power units.
Like most operators, FedEx had engines removed and shipped to a maintenance facility when they needed a hot section or overhaul. Maintenance performed at the facility ran the gamut from cleaning and testing to repair and replacement of parts. Meanwhile, the airframe remained in service with replacement engines that FedEx kept on hand. This made the airframes and engines look like separate assets that should be treated separately for tax purposes. Viewed in isolation, the often expensive repairs to the engines seemed essential to prolong their useful life, especially if, like the IRS, you want to view the useful life of the engines as having expired immediately prior to the heavy maintenance.
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