“Time is our most precious commodity, and there are conveniences that wealth brings to essentially get you more time. —retired Microsoft CEO Steve Ballmer, explaining why he commutes via private jet from his Seattle home to watch games of the Los Angeles Clippers, the basketball team he bought last year for $2 billion. ”
Capitalize or expense?
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.
The federal court, however, refused to treat the engines and airframes as different assets and regarded the aircraft as the appropriate unit of property for determining whether expenses should be capitalized. The court did agree with the IRS about the need to compare the state of the property before and after the repair. But instead of looking to the state of the aircraft immediately prior to the engine overhaul, the court looked at its state following the previous overhaul. In other words, it viewed the new overhaul as restoring the engine to the value it had following the last overhaul. Nor did the court conclude that the overhaul increased the aircraft's useful life. On the contrary, the court viewed the overhaul as essential maintenance to sustain the aircraft's existing useful life.
The IRS may have lost the battle, but not the war. In August 2006, the agency issued proposed regulations with the imposing title "Deduction and Capitalization of Expenditures Related to Tangible Property." Then, in March 2008, after receiving a deluge of comments, the tax agency issued substantially revised proposed regulations. The 29 tiny-print triple-column Federal Register pages are complicated and daunting and generally make it more difficult to write off heavy maintenance expenses when incurred.
On the threshold issue of whether the aircraft as a whole or the engines themselves are the appropriate unit of property, the IRS replaces the factors employed by the FedEx court and the factors the agency itself proposed in 2006 with a "functional interdependence" test. Based on this test, engines will generally be a functionally interdependent part of the aircraft if their being placed in service by the taxpayer is dependent on the taxpayer's placing the airframe in service, and the aircraft would thus appear to be the appropriate unit of property. The airframe needs the engines to fly, and vice versa.
Second, the new proposed regulations replace the traditional capitalization test of whether maintenance "adds materially to the value" with a new concept: betterment. According to the IRS, an amount paid for work on an aircraft (the "unit of property") will result in a "betterment" only if it ameliorates a material condition or defect, results in a material addition or results in a material increase in capacity, productivity and the like. If this fails to shed sufficient light on whether work constitutes a betterment, the agency deploys the infamous "facts and circumstances" test, an invitation to figure it out for yourself based on all relevant information.
To determine whether a betterment has been made, you would ordinarily compare the condition of the aircraft immediately before and after the work. For example, an aircraft will be "bettered" if you add satellite TV. However, contrary to the FedEx decision, if maintenance is designed "to correct the effects of normal wear and tear," the IRS asks the taxpayer to compare the condition of the aircraft following the work with its condition "after the last time the taxpayer corrected the effects of normal wear and tear" or, if this is the first time the taxpayer has corrected it, "the condition of the property when placed in service by the taxpayer" (my emphasis).
At first glance, this may seem bizarre. Suppose you're about to buy an aircraft with engines that have one hour remaining before overhaul. If the current owner (who we will assume performed the last overhaul) overhauls the engines again prior to the sale, there is no betterment. He's simply restoring the aircraft to the condition he put it in after the last overhaul. Conversely, if you buy the aircraft and then overhaul the engines, the cost must be capitalized because (under the proposed regulations) it constitutes a betterment compared with the condition of the aircraft when you bought it.
But take another look. If the prior owner had overhauled the engines at a cost of, say, $1 million right before closing, he would have expected you to pay an additional $1 million for the aircraft. And since that $1 million would be part of the purchase price, you'd capitalize it. Thus, the result to you is the same whether the overhaul occurs before or after closing: in either case, the cost is capitalized. But once you've invested-one way or another-in freshly overhauled engines, the cost to maintain them in operating condition, including the next overhaul, would appear to be currently deductible.
The proposed regulations also contain a safe harbor allowing costs to be expensed for routine maintenance "that the taxpayer reasonably expects to perform" more than once during the aircraft's class life (six years for noncommercial aircraft). Much airframe maintenance will accordingly qualify for the safe harbor, but engine overhauls on most business aircraft will not.
In general, the proposed regulations will cause an accounting nightmare for business jet operators who must figure out whether wear and tear is allocable to an aircraft's prior owner or falls within the safe harbor. And, as a practical matter, the proposed regulations will make it tougher for business jet owners to avoid capitalizing the cost of engine overhauls.