New IRS Guidance on Tax Treatment of Materials and Supplies (including Rotable Parts)

The IRS announced in December Temporary Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property.  At the same time, they announced a proposal to make that temporary guidance permanent.

These new rules are meant to help companies distinguish between expenses and capital expenditures related to property.  It also provides guidance on depreciating materials and supplies (guidance that may change the tax treatment of some inventory held by your customers).  Aircraft Parts distributors may find themselves affected by several elements of this rule, including guidance distinguishing “materials and supplies” from inventory, as well as new guidance for the tax treatment of rotable parts.

One purpose of the new (proposed) regulations is to clarify that if an expenditure merely restores the property to the state it was in before the work (like a repair), then situation prompting the expenditure arose and does not make the property more valuable, more useful, or longer lived, then such an expenditure is usually considered a deductible repair. In contrast, a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property.

For example, if you decide to repair weather-related damage to your warehouse, this should be treated as a repair that does not need to be capitalized.  On the other hand, if you decide to construct a new bay door on your warehouse to accommodate larger trucks, then this adds to the utility of the property and it should be treated as a capital expenditure.

The new rules also address the tax treatment of materials and supplies. They clarify that the costs of acquiring or producing units of tangible property are required to be capitalized.  This means that if a company purchases and /or produces goods for resale, the amount paid to acquire or produce those goods must be capitalized.  So if you are supplying a manufacturer, the manufacturer may not deduct the cost of the inventory that goes into the final product until the product is actually sold.  This provides a firm tax basis for just-in-time manufacturing and discourages manufacturers from carrying a substantial raw materials or parts inventory.

The new rule also clarifies that an exception exists for materials and supplies that are not considered inventory.  Amounts paid for such materials and supplies are deductible in the year in which the goods are used in your company’s operations.  However, incidental materials and supplies for which no records of consumption, or for which beginning and end of year inventories are not taken, may be deducted in the year in which they are purchased (yes, this will provide a tax inventive to avoid keeping metrics on items, but the value of tracking such materials usually exceeds the tax inventive to not track them).  In all cases, the materials and supplies do not need to be capitalized into the value of the larger items on which the materials and supplies are used.

The formal definition of materials and supplies is:

Definitions—(1) Materials and supplies. For purposes of this section, materials and supplies means tangible property that is used or consumed in the taxpayer’s operations that is not inventory and that—

(i) Is a component acquired to maintain, repair, or improve a unit of tangible property (as determined under § 1.263(a)–3T(e)) owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;

(ii) Consists of fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less, beginning when used in taxpayer’s operations;

(iii) Is a unit of property as determined under § 1.263(a)–3T(e) that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations;

(iv) Is a unit of property as determined under § 1.263(a)-3T(e) that has an acquisition cost or production cost (as determined under section 263A) of $100 or less (or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter)); or

(v) Is identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter) as materials and supplies for which treatment is permitted under this section.

Finally, the guidance specifies 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.  This new guidance may drive some interesting recordkeeping among air carriers that carry rotable inventory.  Under this new rule, there is a distinct tax advantage to being able to show that you are using rotables in the year purchased (so they can be treated as ordinary and necessary business expenses in the year that they are purchased).  This may encourage air carriers to keep fewer rotables in their inventories, relying more heavily on distributors to provide rotables on a just-in-time basis.

Rotables in a distributor’s inventory will usually be treated as inventory, rather than under the new rotable rule, because the new rule defines rotables as

“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”

Obviously, distributors typically do not use rotables in this way; however repair stations may find some of their parts inventory being treated as rotables under the new rule.

The temporary regulations can be found online here:

http://www.gpo.gov/fdsys/pkg/FR-2011-12-27/pdf/2011-32024.pdf

The purpose of the temporary regulations is to implement the rule immediately before going through notice and comment.

The permanent version of the regulation is subject to notice and comment.  The proposed permanent rule can be found online here:

http://www.gpo.gov/fdsys/pkg/FR-2011-12-27/pdf/2011-32246.pdf

Comments on whether these temporary rules should be made permanent are due by March 26, 2012.

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About Jason Dickstein
Mr. Dickstein is the President of the Washington Aviation Group, a Washington, DC-based aviation law firm. He represents several aviation trade associations, including the Aviation Suppliers Association, the Aircraft Electronics Association, the Aircraft Fleet Recycling Association and the Modification and Replacement Parts Association.

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