Line Items

A commercial airline, in order to conform to strict government safety standards, adopted a maintenance policy that required each of its airplanes to undergo a complete overhaul every eight years. Typically, each plane was out of commission for approximately 45 days while a $2 million face-lift was completed.

In the past the IRS relied on TC Memo 2000-32, which held that Ingrain Industries’ heavy-duty maintenance of its towboat engines had to be capitalized. Also, a 1996 private letter ruling (no. 9618004) held that FAA rules mandating periodic overhauls were clear evidence that capitalization was required.

However, in revenue ruling 2001-4, the IRS softened its stand in this area and took a less restrictive approach to deducting periodic, heavy-duty maintenance and overhaul expenses. According to the IRS, incidental repairs that do not materially add to the value of an airplane or appreciably prolong its useful life but merely keep it in safe operating condition can now be expensed immediately. Examples of such repairs include inspecting, testing, servicing, cleaning and repainting the aircraft.

Repairs that stop the deterioration and appreciably prolong the useful life of the plane, however, must be capitalized. This includes removing, replacing or upgrading major components of the plane, such as all of the “belly-skin” panels, wiring in the wings, avionics and cockpit equipment, fire detection and ground-proximity warning systems, as well as the fuel tanks, windows, seats, carpeting and galley.

Sale of Property Occurred When Contracts Executed

A taxpayer formed a proprietorship in order to generate tax savings. The business sold residential real estate through contracts for property deeds to poor families with little or no credit history. Once a contract was signed, the buyers obtained possession; were completely responsible for the property’s maintenance, taxes and insurance; and were obliged to make monthly payments of principal and interest toward the purchase price. Upon the last payment, 20 or 25 years later, the buyers received a warranty deed. If the buyers defaulted, the taxpayer would retain all payments as liquidated damages. The buyers were also free to alter the property in any way.

The taxpayer reported the transactions on schedule C. She recorded the annual interest payments as income, and she depreciated the real estate. The principal payments were treated as mere deposits against the purchase price of the homes and were recorded as a liability. It wasn’t until a contract was fully paid that the taxpayer recognized the actual sale of the homes.

The IRS said that the taxpayer’s method of accounting was improper and did not clearly reflect income. Instead, the sale of the homes should have been recognized at the time the contracts were executed, not when they were paid off.

The taxpayer, however, argued that the contracts were merely voidable, executory agreements until final payment was received and that a completed sale did not occur until the title was transferred upon receipt of the final payment.

Following state law, the Tax Court found that the transfer of legal title is not a prerequisite for a completed sale. According to the court, the contracts for deed were sufficient to confer the benefits and burdens of ownership on the buyers. In essence, the buyers were given equitable ownership and the seller was left with a security interest in the property. As a result, the court ruled the taxpayer must report the gain on the sale of the homes in the year that the contracts were executed (J ames W. and Laura L. Keith v. Commissioner, 115 TC no. 42 (12-29-00)).

Reducing IRA Payment Not a Modification

A taxpayer under age 59 12 can escape the 10% penalty on early withdrawals from an IRA (or other qualified plans) by taking a series of substantially equal periodic payments based on his or her life expectancy. However, the penalty for early withdrawal will apply if such payments are substantially modified (other than by death or disability) before the taxpayer reaches age 59 12 , or before the end of 5 years beginning with the date of the first payment and ending after reaching age 59 12 .

In letter ruling 200050046, a taxpayer, under age 59 12 , took $300,000 a year from his IRA for three years. In the fourth year, he divorced his wife. As part of the property settlement, she received $100,000 a year of his IRA tax-free under IRC section 408(d)(6). The husband reduced the payments he received to $200,000 a year. According to the IRS, this was not a modification. The husband could proportionately reduce his equal periodic payment without triggering the 10% early distribution penalty under IRC section 72(t)(1).

The IRS also stated that in any year after the husband reached age 59 12 , he would be free to change the amount of his distribution without having to pay the 10% penalty if he previously had received five payments (even if some were at post-divorce reduced amounts).

Last year, in another case (letter ruling 200027060), the IRS said an ex-wife was not required to conform to her former husband’s distribution plan. She was free to establish her own IRA and receive distributions as allowed under IRC section 72(t)(2)(A) without penalty.

—Michael Lynch, Esq., professor of tax accounting at
Bryant College, Smithfield, Rhode Island.