By Milt Zall
Whether the cost of an engine overhaul can be written off (expensed) or must be capitalized can make a big difference in the annual taxes that an engine’s owner has to pay. The general rule is that a business can write off the cost of any item that will be used up immediately or within the tax year. For example, engine oil or office supplies can be expensed.
On the other hand, you generally cannot deduct in one year, the entire cost of property you purchased for use in your trade or business, if the property is something that will wear out or become obsolete but has a useful life substantially beyond the tax year. Instead, you must depreciate it. That is, you can spread the cost over a number of years, and deduct a part of the cost each year.
You can depreciate machinery, equipment, buildings, vehicles and furniture as property.
Those are the rules but the rules aren’t always crystal clear. You’re supposed to depreciate machinery but what’s the proper way to handle a machinery repair? Or an engine overhaul? Is an engine overhaul a maintenance expense that can be immediately written off? Are you prepared to properly assist your customers in answering these questions?
That question was raised recently during an IRS audit of FedEx Corp.’s 1993 tax return. As part of its business, FedEx operates a fleet of aircraft that are propelled by jet aircraft engines. Off-aircraft inspection, heavy maintenance, and repair of jet aircraft engines and auxiliary power units (APUs) are conducted by third-party vendors performing an off wing maintenance program called ESVs, through removal of the engines or the APUs from the aircraft.
During 1993 and 1994, the average interval between successive ESVs for an aircraft engine was approximately 24 to 36 months for some of FedEx’s engines and 48 to 60 months for its other engines. ESVs included some or all of the following activities: disassembly, cleaning, inspection, repair, replacement, reassembly, and testing. In the ESVs at issue in this case, the engine or APU was removed from the aircraft by FedEx and shipped to an outside vendor who performed the maintenance. After removing an engine or APU, FedEx assessed the condition of the engine or APU and reviewed the work performed during previous ESVs to determine the level of maintenance an engine or APU was likely to require. This assessment resulted in a preliminary plan of maintenance that FedEx provided to the vendor.
When the engine or APU arrived at the vendor, it was further inspected using a variety of testing procedures.
The engine or APU was then disassembled into major parts or "modules." If inspection or testing disclosed a discrepancy in a part’s conformity to the specifications set forth in FedEx’s Engine Inspection and Maintenance Program, the part was repaired, or if necessary, replaced with a new or used serviceable part conforming to the specifications.
Minor repairs included cleaning and restoring the surface finish of engine blades. An example of a more extensive repair would be restoring the tip of a blade by welding additional metal to the end. After necessary repairs and replacements were completed, the engine or APU was reassembled, tested, and returned to FedEx.
The cost of ESVs varied based on the scope of the maintenance performed and the model of engine or APU at issue. The costs of the ESVs were written off by FedEx, but challenged by the IRS. The IRS thought FedEx should capitalize the costs of the ESVs. FedEx appealed the IRS decision to the U.S. district court for the western district of Tennessee.
The tax code allows taxpayers to deduct ordinary and necessary business expenses paid or incurred during the current taxable year. One of the IRS’ regulations says "The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinary efficient operating condition, may be deducted as an expense." The same regulation says "Items are capital expenditures if they "(1) ... add to the value, or substantially prolong the useful life, of property owned by the taxpayer or (2) ... adapt property to a new or different use." This regulation further provides that "Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures...."
The court ruled that the IRS regulations allow taxpayers to deduct the cost of "incidental repairs" which do not (1) materially add to the value of the property, (2) appreciably prolong the life of the property, or (3) adapt the property to a new or different use. Therefore, FedEx was allowed to deduct the cost of the ESVs as incidental repairs.
This case establishes the precedent that the cost of an engine overhaul can be deducted as an incidental repair that does not materially add to the value of an engine. Make sure your customers are aware of this – it could have a positive impact on your business and your customers’ tax bills.
Milton Zall is president of Zall Enterprises, an editorial consulting firm based in Silver Spring, MD. He writes on taxes, investments, technology, the Internet and HR/business issues. He is a Certified Internal Auditor and a Registered Investment Advisor. He can be reached via email at email@example.com