IRS Delays Applicability of the Special “Rotable Accounting Rule” until 2014

Last December, the IRS announced new regulations concerning the distinctions between expenses and capital expenditures related to improvements to articles, like overhauls of rotable aircraft parts.  The title of the rulemaking was “Temporary Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property;” although at the same time, they had announced a proposal to make that temporary guidance permanent.  Recently, the IRS announced that taxpayers may rely parts of the guidance for tax year 2012, but will not be allowed to use the optional method for accounting for rotable parts until 2014 (when the guidance become required for all).

The rules in question are the IRS accounting rules for “Materials and Supplies.”   These regulations provide that a taxpayer may capitalize and depreciate any expenditure for materials and supplies (with certain exceptions), but they impose some limits on when those expenditures can be treated as expense (which can be immediately deducted in the present tax year and are not required to be depreciated).

The new regulations were generally meant to help companies distinguish between expenses related to property, and capital expenditures related to property.  Other guidance in the new rule did the following:

• Provided advice on depreciating materials and supplies (guidance that could affect the tax treatment of some inventory held by your customers).
• Clarified that if an expenditure merely restores the property to the state it was in before the work (like a repair), and the restoration does not make the property more valuable, more useful, or longer lived than it was when new, then such an expenditure is usually considered a deductible repair. In contrast, an activity that more permanently affects the longevity, utility, or worth of the property is to be considered capital expenditure (for example, a software upgrade to avionics that provides additional functionality that did not exist before).
• Addressed the tax treatment of materials and supplies.
• Clarified that an exception exists for materials and supplies that are not considered inventory.

Tax Accounting for Rotables

Finally, last year’s rule specified that rotable and temporary spare parts are used or consumed in the taxpayer’s operations in the taxable year in which the taxpayer disposes of the parts.  26 C.F.R. § 1.162–3T(a)(3).  This is important for air carriers because they may use a rotable part for many years before disposing of the part.  This could make tax accounting for such parts rather difficult, because the finance department will have to track the disposal of the part in order to know when to treat it as a deductible expense.  As matter of real-world practical application, this probably means that such parts have to be depreciated.  This guidance could affect recordkeeping practices among air carriers that carry rotable inventory, as well as distributors that carry rotables for use in their own equipment (like forklifts, etc.).

The rules provides an optional alternative for tax accounting of rotables.  Under the optional provision, an air carrier would deduct the amount paid to acquire or produce the part in the taxable year that the part is first installed on an aircraft in the air carrier’s operations.  26 C.F.R. § 1.162–3T(e)(2)(i).  Upon removal, the air carrier would then treat the fair market value of the part as income, and treat the fair market value and also the cost incurred to remove the part as part of the part’s basis.  26 C.F.R. § 1.162–3T(e)(2)(ii).  The repair cost would also be treated as part of the part’s basis.  26 C.F.R. § 1.162–3T(e)(2)(iii).  Then, when (if) the part is reinstalled in an aircraft, the basis, as well as the cost of installation, would be deductible in the tax year in which the part is installed.  26 C.F.R. § 1.162–3T(e)(2)(iv).

Under this optional provision, there is a distinct tax advantage to being able to show that you are using rotables in the same year that they are purchased/repaired (so they can be treated as ordinary and necessary business expenses in the year that they are purchased/repaired, instead of carrying-over that deduction to a later year in which they are installed/re-installed).  Air carriers with sensitivity to tax issues may keep fewer rotables in their inventories, relying more heavily on distributors to provide rotables on a just-in-time basis, in order to better take advantage of these tax accounting provisions.

The optional rotable accounting provision seems to make sense for rotables with longer lives such as those which may be found in many aviation products.  Under the recent announcement by IRS, though, this optional provision may not be used by the industry until tax years beginning on or after January 1, 2014.  This delay means that the air carriers and others must continue to use the primary rotables accounting language, which forbids a taxpayer from expensing a rotable until it is disposed-of (and thus likely fores most taxpayers to depreciate their rotables).

Rotable aircraft parts in a distributor’s inventory will usually be treated as inventory, rather than under the tax-accounting-for-rotables rule, because the rules defines rotables as things that are acquired for installation on the taxpayer’s own property:

“rotable spare parts are materials and supplies under paragraph (c)(1)(i) of this section that are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation”

Distributors typically do not use rotables in this way, so their rotables will be treated as inventory; however repair stations may find some of their parts inventory being treated as rotables under the new rule, particularly if they are purchasing rotables for use on exchange units of loaner units that they own themselves.

Distributors may have rotable parts that they must account-for under these rules if the rotable are used ofr the distributors own property (like rotable parts for a forklift used in the distributor’s warehouse).

The announcement concerning timing of the guidance (that the guidance becomes fully effective in 2014 but may be used at the discretion of the taxpayer until then) can be found at 77 Federal Register 74583 (December 17, 2012). As always, this article is meant to be informative only and it does not constitute tax advice.