REPAIRS

Expenditures for incidental repairs, maintenance, replacement, and improvements that are not capital expenditures may be deducted as ordinary and necessary business expenses. Reg. Section 1.162-1(a). Repair expenditures generally maintain property in an ordinary efficient operating condition, while an improvement that is a capital expenditure materially adds to the value or utility of the property or appreciably prolongs its useful life.

FLOOR REPAIRS:   patching and repairing floors (Libby & Blouin, Ltd. v. Commissioner, 4 B.T.A. 910 (1926)); piecemeal repair to floors (Farmer's Creamery Co. v. Commissioner, 14 T.C. 879 (1950)); reinforcing sagging floors (Regenstein v. Edwards, 121 F. Supp. 952 (M.D. Ga. 1954)); casting floor plates for steel mill (Knoxville Iron Co. v. Commissioner, T.C. Memo. 1959-54).

ROAD AND DRIVEWAY REPAIRS:   patching on asphalt driveway (Knoxville Iron Co. v. Commissioner, T.C. Memo. 1959-54).

OBSERVATION:   Although the conclusion reached in Rev. Rul. 94-12 seems obvious to many practitioners, it is still nice to have the IRS's agreement. In addition, the fact that the IRS felt compelled to issue this ruling indicates the seriousness with which it views INDOPCO.  Thus, it is important that practitioners be aware of INDOPCO's potential impact on the ability to continue claiming a current deduction for expenditures providing a benefit in both the current and future years.

Examples of non-deductible repairs

The following items have been held to be capital expenditures and, therefore, not deductible as repair expenses:

In Rev. Rul. 94-77, 1994-2 C.B. 19, the IRS ruled that the Supreme Court's holding in INDOPCO v. Commissioner, 112 U.S. 1039 (1992), does not affect the treatment of severance payments; that is, such payments generally are deductible as ordinary and necessary employer business expenses, even though they may produce some future benefits. The IRS pointed out that although the realization of future benefits is important in determining whether an expenditure is deductible or must be capitalized, the mere presence of some future benefit does not warrant capitalization. For example, although severance payments made by a taxpayer to its employees in connection with a business downsizing may produce some future benefits, such as reducing operating costs and increasing operating efficiencies, the severance payments principally relate to the previously rendered services of the employees and, therefore, are deductible as business expenses under Code Section 162. However, the IRS also ruled that if the severance payments are made to  dismissed employees under a plan, method, or arrangement deferring the receipt of compensation, such payments are deductible under Code Section 404, subject to the limitations thereof. See Ch. 104 for a discussion of non-qualified deferred compensation plans.

Code Section 198 allows taxpayers to elect to deduct qualified environmental remediation expenses in the year they are incurred, rather than   treating them as capital expenditures. A "qualified environmental remediation expense" generally is an expense that is incurred in connection with the abatement or control of hazardous materials at a qualified contaminated site and that otherwise would be a capital expenditure. Code Section 198(b)(1).

To qualify as a "qualified contaminated site" the property must be the site of the release or disposal of a hazardous substance; the property must be held by the taxpayer for use in its trade or business or for the production of income; and it must be in a "targeted area" (i.e., meet certain population and zoning requirements or be included as a brownfields pilot project of the EPA). Code Section 198(c)(1). In addition, the taxpayer must get a statement from its state environmental agency attesting that the site is within a targeted area and is the site of the release or disposal of a hazardous substance. Code Section 198(c)(1)(B).    "Hazardous substance" is defined by reference to the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. Code Section 198(d).    Taxpayers generally must elect to treat qualified environmental remediation expenditures as deductible on or before the due date of their return for the year in which the expenditures were paid or incurred. Rev. Proc. 98-47, 1998-37 I.R.B. 8, sets forth the procedures for making the election. Taxpayers must make the election for each year that they want to deduct their qualified environmental remediation expenditures.  

The provisions of Code Section 198 apply to expenditures paid or incurred after August 5, 1997. The provision is due to expire December 31, 2001. Code Section 198(h).

The costs of acquiring property,  including commissions, professional fees,  transportation,  and installation <35> are capital expenditures. The cost of defending or perfecting title to property owned by the taxpayer also is a capital expenditure, a part of the cost of the property, rather than a deductible business expenses. Reg. Section 1.263(a)-2(c). Similarly, selling expenses reduce the taxpayer's amount realized and are not ordinary and necessary expenses.

BORROWING EXPENSES

Expenditures incurred to borrow funds and other finance costs generally are capital expenditures that must be amortized over the term of the loan rather than deducted as a current expense. <37> The costs that generally are required to be capitalized include commissions and other fees paid to obtain a loan (Rev. Rul. 70-360, 1970-2 C.B. 103), the cost of issuing bonds, including legal fees and printing costs (Rev. Rul. 73- 134, 1973-1 C.B. 60), and finder's fees and commissions paid by a lender to find borrowers (Rev. Rul. 57-400, 1957-2 C.B. 520). The unamortized balance of a decedent's loan costs is deductible in the year of death. Rev. Rul. 86-67, 1986-1 C.B. 238.

A taxpayer may elect to treat up to $15,000 of qualified architectural and transportation barrier removal expenses as a deduction rather than as a charge to a capital account for any taxable year.   The term "architectural and transportation barrier removal expenses" is defined as an expenditure for the purpose of making any facility or public transportation vehicle, owned or leased by the taxpayer for use in his trade or business, more accessible to and usable by, handicapped and elderly individuals. Code Section 190(b)(1). A "qualified architectural and  transportation barrier removal expense" is an architectural and transportation barrier removal expense with respect to which the taxpayer establishes, to the satisfaction of the IRS, that the resulting removal of any such barrier meets the standards promulgated by the IRS with concurrence of the Architectural and Transportation Barriers Compliance Board and set forth in IRS regulations.

A "handicapped individual" means any individual who has a physical or mental disability (including, but not limited to blindness and deafness) that for such individual constitutes or results in a functional limitation to employment, or who has any physical or mental impairment (including, but not limited to, a sight or hearing impairment) that substantially limits one or more major life activities of such individual. Code Section 190(b)(3).

The cost of starting a business is a capital expenditure. Richmond Television Corp. v. United States, 345 F.2d 901 (4th Cir.), rev'd & remanded on another issue, 382 U.S. 68 (1965). This includes expenses that typically would be considered ordinary and necessary business expenses, such as salaries, planning costs, and consulting and professional fees, incurred before the time "the business has begun to function as a going concern and performed those activities for which it was organized."

The precise point at which business operations begin can be difficult to establish. However, if a license is required for the business, such as in the case of a broadcasting business, business operations cannot begin until the necessary license has been obtained. <41> On the other hand, an established business generally is given a great deal of leeway in deducting the cost of expanding the business or starting new but related operations.

Start-up expenses are capital expenditures even if business operations never begin and the venture is abandoned.   However, if the taxpayer can establish that the expenses were more than investigatory and the taxpayer has actually entered into a transaction for profit, a loss deduction may be available under Code Section 165(c)(2).

Amortization of start-up expenditures

Although Code Section 195(a) provides that start-up expenditures (as defined below) are not deductible, taxpayers can elect to treat start-up expenditures as deferred expenses, amortizable over a period of not less than 60 months, beginning with the month in which the active trade or business begins. Code Section 195(b)(1). Once an amortization period has been selected, it may not be changed. Code Section 195(d)(2). 

The regulations describe how a taxpayer makes the election to amortize start-up expenditures. The election is made by attaching a statement to the taxpayer's return that sets forth a description of the trade or business to which it relates with sufficient detail so that expenses relating to the trade or business can be identified properly for the taxable year in which the statement is filed and for all future taxable years to which it relates. In addition, the statement, to the extent known at the time it is filed, must include a description of each start-up expenditure incurred (whether or not paid), the month when the active trade or business began (or was acquired), and the number of months (not less than 60) over which the expenditures are to be amortized. A revised statement to include any start-up expenditures not included in the taxpayer's original election statement may be filed with a return filed after the return that contained the election, but the revised statement may not include any expenditures for which the taxpayer had previously taken a position on a return inconsistent with their treatment as start-up expenditures.

This statement must be filed no later than the time prescribed by law for filing the return (including any extensions thereof) for the taxable year in which the active trade or business begins.  The statement may be filed with a return for any taxable year before the year in which the taxpayer's active trade or business begins, but no later than the date previously described.

A successor in interest to a corporation with start-up expenditures may elect to amortize the start-up expenditures incurred by the corporation whose interest it acquired. Subsequent to the acquisition, the acquirer may currently expense under Code Section 162 those expenditures incurred after the acquisition date that would have been start-up expenditures of the acquired corporation. PLR 9828018.  Go to sample election to amortize start-up expenditures.

For purposes of Code Section 195, a start-up expenditure is an expenditure paid or incurred in connection with (1) investigating the creation or acquisition of an active trade or business, (2) creating an active trade or business, or (3) any activity engaged in for profit or for the production of income in anticipation of such activity becoming an active trade or business. Code Section 195(c)(1)(A). A start-up xpenditure must be an expense that would be allowable as a deduction if it were paid or incurred in connection with the operation of an existing trade or business in the same field. <48> A start-up expenditure does not include any amount with respect to which a deduction is allowable under Code Section 163(a) (relating to interest on indebtedness), Code Section 164 (relating to various taxes), or Code Section 174 (relating to research and experimental expenditures). Code Section 195(c)(1)   A taxpayer will be considered as having entered into an active trade or business only if the taxpayer has an equity interest in, and actively participates in the management of, the business. S. Rep. No. 1036, 96th Cong., 2d Sess. 12 (1980). Thus, a taxpayer owning preferred stock, bonds, or debt instruments does not hold a qualifying interest with respect to the investment and may not amortize investigation expenditures. A literal interpretation of the legislative history would indicate that a limited partner could never benefit from Code Section 195, but the IRS has ruled that a limited partnership that engages in a trade or business may amortize start-up expenditures. Rev. Rul. 81-150, 1981- 1 C.B. 119.    Costs incurred in the course of a general search for, or an investigation of, an active trade or business (i.e., to determine whether to enter a new business and which new business to enter) are generally start-up expenditures. Rev. Rul. 99-23, 1999-20 I.R.B. 3. They include expenses incurred for the analysis or survey of potential markets, products, labor supply, and transportation facilities. Start-up expenditures also include costs that are incurred after a decision to acquire or establish a particular business and before its actual operation, as long as they would be deductible if paid or incurred in connection with the operation of an existing business.  These costs include expenses related to advertising, employee training, professional services and setting up books and records, and lining up distributors, suppliers, or potential customers.

Costs connected with the sale of stock, securities, or partnership interests are not start-up costs because they would not be deductible if incurred in connection with the expansion of an existing business. In addition, start-up costs do not include the acquisition costs of a trade or business or other amounts that must be capitalized. Rev. Rul. 99-23,  1999-20 I.R.B. 3. Also excluded are amounts paid or incurred for the  purchase of property to be held for sale or property that may be depreciated or amortized based on its useful life, including expenses incident to a lease and leasehold improvements.    For purposes of an existing business, eligible start-up costs do not include deductible Code Section 162 expenses paid or incurred in connection with an expansion of the business.  As stated above, start-up expenditures must be incurred in connection with the investigation or creation of an active trade or business. Thus, expenditures attributable to an investment are not eligible for amortization. S. Rep. 1036, 96th Cong., 2d Sess. 12 (1980). In the case of rental activities, significant services must be furnished to constitute an active business rather than an investment. The operation of an apartment complex, an office building, or a shopping center would generally constitute an active trade or business for purposes of Code Section 195.

PROFESSIONAL FEES RELATED TO BANKRUPTCY REORGANIZATION

In Hillsborough Professional Holdings Corp. v. United States, Nos. 89-9715-8P1-89-9746-8P1, 90-11997-9P1 (Bankr. M.D. Fla. April 7, 1999), a case involving a corporate restructuring, the bankruptcy court held that professional fees incurred during a Chapter 11 proceeding must be capitalized. The bankruptcy court determined that the fees were not ordinary deductible expenses within the meaning of Code Section 162(a) because a corporate restructuring is an extraordinary event outside the   scope of the corporation's usual trade or business activities as well as an event that confers a long-term benefit on the reorganized corporation.

Insurance premiums must be capitalized if they create a separate and distinct capital asset or provide significant long-term benefits. Insurance premiums provide significant long-term benefits if they provide a guaranteed option to renew, prepayment of premiums, and/or the possibility of the refund of premiums. Black Hills Corporation v. Commissioner, 101 T.C. 173 (1993), modified, 102 T.C. 505 (1994), aff'd,  73 F.3d 799 (8th Cir. 1996). They create a separate asset if they create insurance policy coverage for future years, or a reserve account. FSA 199925007.

Examples of insurance premiums that had to be capitalized include:

SECTION 1.263(a)-3. ELECTION TO DEDUCT OR CAPITALIZE CERTAIN EXPENDITURES.

(b) The sections referred to in paragraph (a) of this section include:

(1) Section 173 (circulation expenditures).

(2) Section 174 (research and experimental expenditures).

(3) Section 175 (soil and water conservation expenditures).

(4) Section 177 (trademark and trade name expenditures).

(5) Section 179 (election to expense certain depreciable business assets).

(6) Section 180 (expenditures by farmers for fertilizer, lime, etc.).

(7) Section 182 (expenditures by farmers for clearing land).

(8) Section 248 (organizational expenditures of a corporation).

(9) Section 266 (carrying charges).

(10) Section 615 (exploration expenditures).

(11) Section 616 (development expenditures).

(A) expenditures for the development of mines or deposits deductible under section 616,

(B) research and experimental expenditures deductible under section 174,

(C) soil and water conservation expenditures deductible under section 175,

(D) expenditures by farmers for fertilizer, etc., deductible under section 180,

(E) expenditures for removal of architectural and transportation barriers to the handicapped and elderly which the taxpayer elects to deduct under section 190,

(F) expenditures for tertiary injectants with respect to which a deduction is allowed under section 193;