As a fundamental rule, taxpayers are entitled to take deductions only where specifically authorized by the Internal Revenue Code. Thus, because deductions are a matter of "legislative grace," courts closely scrutinize taxpayers' claims and reject those that do not clearly satisfy the letter of the law. Each taxpayer bears the burden of proving his or her entitlement to a deduction, and ambiguities are often resolved in favor of the government. Accordingly, taxpayers should carefully review their expenditures to maintain or recondition property used in a trade or business to determine whether such amounts are deductible or capitalizable and in addition, retain full and adequate records to substantiate all such costs.

A business expense deduction is allowed generally for all the ordinary and necessary expenses paid or incurred by a taxpayer during the taxable year in carrying on any trade or business. This deduction has essentially three key statutory elements. First, the activities of the taxpayer must constitute a trade or business. Second, the expense to be deducted must be paid or incurred during the taxable year in carrying on the trade or business. Third, the expense itself must be an ordinary and necessary expense in the context of the taxpayer's trade or business. "Incidental repairs" are deductible business expenses for these purposes.

Taxpayers engaged in a trade or business normally use some type of "tangible" property (such as equipment) for business purposes. Such property often requires maintenance or reconditioning to keep it in proper working order or to fix problems caused by breakdowns, accidents, or other causes. Such an expenditure is deductible as an "incidental repair" if it is limited to keeping the property in an ordinarily efficient operating condition or restoring it to that condition. Conversely, if an expenditure materially adds value to the property or appreciably prolongs its life, the expenditure must be capitalized rather than deducted. A capital expenditure is thus a more permanent increment in the value, utility and longevity of the property. Accordingly, repairs incidental to a general plan of rehabilitation, improvement, alteration and modernization must be capitalized. Detailed rules are provided for environmental cleanup costs.

The line between a deductible repair expense and a nondeductible capital expenditure is indistinct and is dependent upon the factual context in which the expenditure is made. Virtually the same expenditure may be treated as a repair in some circumstances but as a capital expenditure in other situations. The shadowy nature of the distinction between the two types of expenditures has caused much confusion and produced considerable litigation. Much of the law in this area is thus dependent on case law and IRS rulings.

One key to distinguishing between a repair and a capital expenditure is the purpose for which the taxpayer made the expenditure. An expenditure that returns the property to the state it was in before it became necessary to incur the expenditure is considered a deductible repair so long as it does not make the property materially more valuable, more useful, or longer-lived. A capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property.

Repair expenditures can be roughly divided into three groups:

•  Maintenance items,

•  Replacement of minor items that regularly wear out, and

•  Repair expenditures necessitated by a casualty.

I will discuss each of these briefly in turn:

Maintenance Items: Incidental maintenance expenditures that neither materially add to the value of the property nor appreciably prolong its life may be deducted as an expense, provided that the basis of the property is not increased as a result of the expenditure. Thus, taxpayers can deduct the cost of various expenditures that alleviate damage or deterioration so long as the property in question is not improved or otherwise adapted to a new use. Taxpayers cannot, however, deduct expenditures that restore their property, enabling it to have a new period of expected life.

Replacement of Minor Items That Regularly Wear Out: A taxpayer ordinarily can deduct as a repair regularly recurring expenditures to replace relatively small components of a larger asset, particularly where the replacement of the worn-out parts is necessary to keep the asset operating in an ordinarily efficient fashion. When such activities are regularly necessary, an abnormally large expenditure resulting from the same reasons is still deductible. On the other hand, taxpayers must capitalize the cost to replace a separate, distinct component that has its own useful life.

Repairs Necessitated by a Casualty: A business that incurs expenses to remedy damage to an asset caused by a casualty can deduct those expenditures as repairs even though they may also be deductible as a casualty loss. In addition, the fact that the taxpayer received compensation for the damage through insurance does not preclude a repair deduction. If property is lost, destroyed, or abandoned as a result of a casualty, the loss can only be deducted as a casualty loss, and the cost of replacing the property must be capitalized.

For example, the cost to recondition a building seriously damaged by fire has been held to be a capital outlay. Similarly, the costs of restoring a fire damaged oil derrick, of rebuilding an ore dock and its underpinning after it collapsed into a river, and of rebuilding the upper canal and tail race of a mill after it is washed away by a flood must be capitalized. Conversely, if the casualty merely damages or displaces the property, and the taxpayer recovers and repairs the property for further use in the business in a manner that does not permanently improve it or prolong its useful life, those expenditures are deductible as repairs. If, however, in the process of making repairs, substantial improvements or betterments are made to the property, or if such costs are incurred to prevent future damage, such expenditures extend the useful life of the property and must hence be capitalized. When repairs are incurred due to a casualty, they are deductible in the year they are incurred rather than the year the damage occurred.

In general, taxpayers cannot deduct the following:

•  Amounts paid for improvements or betterments that increase the value of the property;

•  Amounts paid to extend appreciably the useful life of the property or otherwise arrest its deterioration; and

•  Amounts associated with an overall plan to recondition or improve the property (although certain exceptions are provided in connection with environmental cleanup costs).

Such expenditures must either be capitalized or charged to the taxpayer's depreciation reserve.

There are a host of other factors or considerations that are relevant to the determination of whether a particular expenditure is deductible as a repair:

•  Any properly performed repair adds some value to the property repaired, but that does not mean it cannot be deducted. The test of deductibility is whether the expenditure materially enhances the value, use, life expectancy, strength, or capacity of the repaired property.

•  A common rule of thumb is that the cost of property having a useful life greater than one year must be capitalized. However, even though most repairs use materials that will last longer than one year, and most repairs are also intended to last much longer, they are still deductible. Instead of examining the life of the repair, the correct test is whether the expenditure simply kept the property in, or restored it to, an efficient operating condition.

•  The size of the expenditure does not control whether it is a deductible repair.

Taxpayers have been permitted to deduct expenditures of significant magnitude in comparison to the value of the asset being repaired. The courts have also permitted taxpayers to deduct expenditures that were large in absolute terms if the criteria for a repair expense were satisfied. In addition, expenditures for repairs will not be disallowed merely because they significantly exceed the taxpayer's average annual repair expenditures. On the other hand, a taxpayer cannot deduct his cost to replace an asset on the ground that repairing the asset would be roughly comparable in cost.

•  Extensive repairs to an asset shortly after its acquisition suggest that the taxpayer has materially altered the asset and should not be allowed to deduct those costs. Nevertheless, taxpayers have occasionally been permitted to deduct expenditures in that context. Thus, no definitive rule is possible, and taxpayers should carefully consider the deductibility of repair and restoration expenditures incurred shortly after the acquisition of an asset.

•  Taxpayers frequently argue that they should be permitted to deduct involuntary expenditures caused by regulatory requirements or some other governmental action. These arguments uniformly fail, however, if the expenditure does not fit the usual criteria for a repair deduction. Although taxpayers cannot deduct the cost of required capital expenditures, they can deduct the cost to remove equipment rendered useless by the governmental order.

Taxpayers can deduct the cost of repairing property they own. Lessees are also permitted to deduct the cost of repairs to the leased property. Taxpayers can also deduct the cost to maintain assets they have installed on property owned by others. If the repaired property is owned by more than one taxpayer, the cost of the repairs must be allocated among the different owners.

Taxpayers can also deduct the cost of materials and labor to conduct repairs, but a self-employed taxpayer may not deduct the value of his own labor to perform repairs.

A taxpayer that erroneously capitalizes repairs and materials used in repairs may deduct those costs in the year they are incurred. However, if a taxpayer consistently capitalizes a particular type of expenditure, or treats it as a repair, any change to that treatment is a change in accounting method that requires IRS permission.

Many of the rules in this area are complex and may also be affected by other tax laws. For this reason, the facts of your situation should be carefully reviewed. Should you have any other questions or comments concerning the above, or you wish to discuss your situation further, please contact us.