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

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

Tags: Federal Express

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On these facts, the Tax Court held that the recurring maintenance costs are deductible. As a threshold matter, the court first addressed which "asset" is being repaired or improved--the engine separately or the entire boat. In the repair context, the IRS generally attempts to fragment larger assets in order to amplify the effect of any change in the value, life, or use of the "asset." For the same reason, taxpayers benefit when the asset is defined more broadly. In Ingram, the court agreed with the taxpayer. Judge Gerber found that, as a matter of industry practice, boats and engines are not purchased or treated separately. Instead, boats and engines are purchased as units; the engine (if properly maintained) will have a life co-extensive with that of the boat; and the engines specifically are designed to be maintained without removing them from the boats. There was no indication that towboat owners regularly and periodically replaced the engines over the life of the boats. Accordingly, the Tax Court rejected the IRS argument that as a matter of law or fact the engines should be treated as the relevant asset.

Turning to whether the expenditures appreciably prolonged the life of the asset, the IRS argued that, without maintenance, the engines would completely wear out after four or five years. As a consequence, the IRS argued, the engines have a useful life of only four or five years, and the taxpayer essentially restores and acquires a new asset every time maintenance is conducted and a new four-year operating cycle begins. In contrast, the taxpayer argued that the engines had expected useful lives of 40 years (the same as the boat), and that the periodic maintenance simply was a means of allowing it to achieve that expected useful life. The IRS also pointed to the fact that the taxpayer had to take the boat out of service for 10 to 12 days and to have approximately 10 individuals work on the boat to perform the required maintenance as evidence of the scope of the operation. The taxpayer countered by showing that the total costs incurred represented only 1.6 percent of the costs of a new boat, or 5 percent of the costs of a used boat, and that as a percentage of purchase price, this is equal to a $480 repair bill on a $30,000 automobile.

Again the Tax Court agreed with the taxpayer. First, it agreed that in comparison with either the cost of a replacement boat or the cost and disruption of either overhauling or replacing the engine, the $100,000 cost appears to be an incidental repair. Judge Gerber explained that it would be unreasonable to expect someone to pay $6.5 million for an asset, and then to choose to replace or rebuild the asset every five years at several times the cost of simply maintaining the original asset.

Second, the Tax Court found it significant that the taxpayer performed the maintenance procedures at a time when the engines are completely serviceable, with the purpose of performing the procedures being to keep the towboat engines in a sound operating condition. The court distinguished the cases in which the taxpayer expended funds to restore the asset to an ordinarily efficient operating condition as opposed to keeping it in that condition. By conducting periodic preventive maintenance, the court noted, the taxpayer was able to achieve the 40-year operating life expected at the time that it purchases the engines. Importantly, however, the court also observed that this cyclical maintenance program primarily involved inspecting the vast majority of the engine's parts on a regular basis and replacing only the relatively few that are worn beyond a certain tolerance.