Discussion:Dry dock issues

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Discussion Forum Index --> Basic Tax Questions --> Dry dock issues


Discussion Forum Index --> Tax Questions --> Dry dock issues

Actionbsns (talk|edits) said:

5 September 2009
My client had a major overhaul on his boat last year - he's a scuba/snorkel operater in town. Costs are over $50,000 and are higher than usual. The overhaul is required by the Coast Guard. I'm sorting through receipts now. My question is whether or not this needs to be capitalized or expensed? or a little bit of both and how do I know which way to go?

MWPXYZ (talk|edits) said:

5 September 2009
I guess you could start reading Ingram Industries v Commr (TC Memo 2000-323) and Revenue Ruling 69-229.

But even if the expenditures are capitalized, would Section 179 be available?

Actionbsns (talk|edits) said:

5 September 2009
I'll take a look at your citations Mike, thanks. I just finished looking through the receipts and I don't see any large expenses for things like new decks, new engine, new sails. Lots and lots of parts, paint, a little wood, one of the biggest single items was a shaft, but not all that costly. Lots of labor. I'm thinking that overall the cost is about $38,000 greater than last year and since it's a major dry dock look through required by the Coast Guard, my client needs to be sure to keep this file together and it really is a gigantic R&M expense. He doesn't have to do a dry dock this extensive every year. 179 won't work because he operates at a loss almost every year and this year has been atrocious for all of our cruise boats.

Derwood (talk|edits) said:

5 September 2009
Act, the pharse you use "major overhail" says it all. Since major overhall is not performed on an annual basis, then there is no doubt that it has to be capitalized and depreciated.

I suggest that you consider taking Sec 179 or 50% bonus depreciation on the $50K.

Captcook (talk|edits) said:

5 September 2009
Action, I used to operate charter boats and had to take my vessel through CG inspections each year. It would appear to me that the bulk of this is actually deferred maintenance. The only reason it is higher this year is because, while it is required to be done every year by the CG, most operators won't perform some of this maintenance until directed to do so. Inquire of your client if this is the case. If so, I wouldn't have any problem taking it as R&M.

Hope that helps.

Actionbsns (talk|edits) said:

5 September 2009
I have asked those questions Captain, his answers are in line with what you have said. He has to take the boat out for annual inspections and maintenance, every two to three years evidently the inspection requirements are more arduous than others. I have another client in the same line of business and last year their dry dock experience was more significant as well. I don't prepare that tax return though. I'm going to go back and re-read the TC memo cited by Mike, but I'm pretty sure I understood it correctly and this is a similar instance to that one.

JR1 (talk|edits) said:

September 5, 2009
Maintenance to me and to the courts the way I read it.

Death&Taxes (talk|edits) said:

5 September 2009
For another decent read, try http://www.thefreelibrary.com/FedEx+v.+Commissioner:+the+continuing+debate+over+cyclical...-a0113304280 which touches on the many levels of Fedex's dispute with the government, and stops with Ingram along the way. The entire piece is an excellent view of this dispute.

Though I agree with JR, I have often thought in cases like this to capitalize and then write off using 179, but in doing so, recognize my clientele are not in states with personal property assessments on assets.

JR1 (talk|edits) said:

September 5, 2009
I agree that that's the safe play in this case with liberal 179 available.

NYea (talk|edits) said:

5 September 2009
FWIW - Field Service Advisory 3/16/94

Subject: Repairs v. Capitalization in the Maritime Industry

REPAIR VS CAPITAL EXPENDITURE IN THE MARINE INDUSTRY LAW AND ANALYSIS I. Internal Revenue Code and Regulations

Section 263(a)(1) of the IRC provides generally that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. 
Section 263(a)(2) denies a deduction for any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. 
Section 1.263(a)-1 of the IRR, in general, repeats the code section above and adds in  section 1.263(a)-1(b) that the amounts referred to in section 1.263(a) include amounts paid or incurred 

(1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures, within the meaning of 1.263(a)(1) or (2). See section 162 and section 1.162-4.

Section 162 of the Code provides there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. 
Section 1.162-4 of the regulations provides that the cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinary efficient operating condition, may be deducted as an expense, provided the cost of acquisition or production or the gain or loss basis of the taxpayer's plant, equipment, or other such property, as the case may be, is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with  section 167 or charged against the depreciation reserve if such account is kept. 

A summary of the general rules is to

Capitalize expenditure if it

(1) materially adds to the value of the property (2) Appreciably extends the life of the property (3) Constitutes a repair in the nature of a replacement (4) Adapts property to a new or different use (5) Is part of an overall pattern of rehabilitation Expense if

(1) Maintains property in ordinary efficient operating condition (2) Constitutes an incidental repair, such as a replacement of a recurring minor item. III. Does the expenditure materially increase the value of the property?

Shore v. Commissioner 18 TCM 721 (1959), (rev'd on different issue) 281 F.2d 742 (5th Cir 1961), the taxpayer installed two secondhand engines in a ship whose hull was rotting out. The court stated the question is one as to the """purpose and effect" of the expenditures, and a replacement can under certain circumstances have the same effect as a repair. (IRS Engineer Analysis: It would be instructive to examine the nautical history surrounding the case to understand the uniqueness of the situation. In 1950 the ship in question was a 24 year old Danish built ex yacht converted to a banana boat. The ship was powered with a Danish manufactured Burmeister & Wein (B&W) diesel engine. B&W only manufactured 10 of that type and 8 no longer existed. By 1950 the crankshaft(s) were in need of replacement. Crankshaft replacement, a difficult operation at best, was made even more difficult because the part in question is not a stock item.) (In 1950 the Danish Merchant Marine was in the middle of a tremendous rebuilding program: over 1/2 the fleet had been lost in 1939-1945 during World War II. Lacking a legal requirement to do so (the taxpayer had acquired the ship in question used, so we assume no warranty), and having to turn out new engines for the many ships under construction in Denmark in the early 1950s (they are probably the biggest engine manufacturer in Denmark), B&W found replacing the pre war crankshafts a "custom job" that would have taken 10-12 months. They probably no longer had even the drawings or specifications!) (On the other hand, in 1950 there was a tremendous surplus of diesel engines manufactured in the United States during WWII. The "278s" and the throwaway """645s", intended as replacements for invasion craft by the Navy, were but one type favored to this day on tugboats and work craft. Small wonder the taxpayer obtained the two Cooper-Bessemer engines as "spares" and proceeded to place these in the old, deteriorating ship!)

In the opinion the judge states: "The installation of the used engines, at a cost no greater than crankshaft replacements, was solely for the purpose of doing what the replaced crankshafts would do, namely, propel the ship as long as its weak and damaged bottom remained afloat."

This case, in short, represents an unusual fact package where replacing the engine probably was a far more timely and cheaper "repair" than trying to get the required part. It sets no precedent for allowing main engine replacement or the replacement of any other major vessel component as a repair expenditure

Zimmern v. Commissioner, 28F.2d 769 (5th Cir. 1928), a barge sank and the taxpayer incurred costs to recondition it by cleaning out the hull, chipping, scraping and painting to eliminate rust. The court concluded that the repairs were necessary to restore the barge to the condition it was in at the time it sank and the expenses were not for additions, improvement, or betterment and therefore deductible.

P.Dougherty & Co V. Commissioner, 159F.2d 269 (4 Cit 1947), cert. denied, 331 U.S. 838 (1947). The rebuilding of the stern of a barge because the woodwork rotted away was in the nature of a "permanent betterment". The court said the replacement of the entire stern of the vessel can hardly be deemed an incidental repair. In addition the court noted that the barge had been fully depreciated and that the repairs were in the nature of a restoration for which an allowance through depreciation has been made and had to be capitalized. The Zimmern case had no bearing here.

Bonwit Teller 17 BTA 1019 (1929) (rev'd on different issue), 53 F.2d 381 (2d Cir.) Cert. denied, 284 US 690 (1931). Here the taxpayer changed from using a coal furnace to an oil burning furnace which resulted in no increase in fair market value of the building to the taxpayer. The court concluded it was not an ordinary and necessary expense. (IRS Analysis: From the 1970s forward, merchant ships have improved fuel efficiencies in many ways, up to and including replacing the entire engine. Bonwit Teller gives us a perspective when looking at any expenditures that enable the taxpayer to change and/or improve fuel burning efficiencies for components and sub components aboard ship. They are a capital improvement.)

IV. Does the expenditure appreciably extend the life of the property?

Where the replacement is of a major segment and has a useful life of more than one year, the courts generally conclude that the improvement constitutes a capital expenditure.

Electric Energy Inc V. US (1981, Cl CT) 13 Cl CT 644, 60 AFTR 2d 87-5933, 87-2 USTC para. 9587. The court ruled that costs incurred by an electric plant were capital expenditures for the total replacement of all the horizontal elements within the economizers of six boilers to reduces leaks and avoid forced outages, which resulted in prolonging the useful life of the economizers. (IRS Analysis; see note on boilers in Section V)

Denver and Rio Grande Western R.R. v. Commissioner, 279 F2d 368 (10 Cir 1960), the taxpayer replaced all of the floor planks and 85-90% of the stringers connecting a viaduct. New stringers were also added to strengthen the support. The court concluded this was a substantial restoration, strengthening and improvement of the viaduct. It was a replacement of a major portion of the viaduct that could no longer be repaired. The viaduct appears to have been fully depreciated.

West Virginia Steel Corp v. Commissioner, 34 T.C. 851 (1960), the taxpayer installed a new engine in delivery vehicles, purchases spare motors and standby equipment for overhead cranes and rewired the business. All had to be capitalized. (IRS Engr Analysis; Ships in their middle age, especially tankers, tend to get extensive work done in cargo areas, tanks, and compartments that have frequently not been accessed for years. Frequently these are termed "crop and renewal" and literally tons of steel can be replaced.. the work frequently costs millions of dollars. Work such as sandblasting, systematic audio gauging of plating and internals, use of expensive coating systems (epoxy, isobutyl rubber,etc.) especially in ballast and other tanks frequently signals a substantial restoration. For guidance see Dolan and d'EBourneuf "Life Extension". American Bureau of Shipping, 28 Sept 1989)

V. Does the expenditure constitute a repair in the nature of a replacement?

Since the regulations and leading authorities speak of incidental repairs the primary criterion has been whether a major portion of the property has been replaced.

See Denver and Rio Grande Western RR above.

Buffalo Union Furnace Co. v. Commissioner 72 F.2d 399 (1934), the taxpayer was an iron founder with three blast furnaces lined with fire brick. The linings were repeatedly used up an on an average last between two and 2-1/2 years. The furnace had to be laid off for a considerable amount of time, and the whole interior cleaned of the old brick and relined at a cost of $50,000 to $100,000. The court held such had to be capitalized. It also noted that the substitution of a valve or a piece of pipe would scarcely be a replacement because it is too small an incident and too regularly repeated in the life of any large factory and that was one reason why the replacement of piping in Libby & Blouin was not treated as a capital expense. (IRS Engr Analysis: As of this writing in 1994 the youngest steam powered ship in the US fleet is 11 years of age. Generally boilers are a fairly reliable item. Any major work on a ships boiler should be scrutinized carefully with regards to repair vs. capitalization, and the Buffalo Union case can provide guidance here, as well as Electric Energy, cited above)

VI. Does the expenditure adapt the property to a new and different use?

The rationale for capitalizing these expenditures seems to be that the adaption of a piece of equipment or an entire property to the taxpayers use is analogous to taxpayer's purchase of a new asset.

Coors Porcelain Co. v. Commissioner, 52 T.C. 682 (1969), aff'd, 429 F.2d 1 (10 Cir. 1970) Expenses incurred in changing the motion of a grinder from oscillating to rotary had to be capitalized as the expenditure was for permanent improvement or betterment made to increase the value of the grinder.

VII. Is the expenditure part of an overall pattern of rehabilitation?

I.M. Cowell v. Commissioner, 18 B.T.A. 997 (1930). The court concluded that to fix a door or patch plaster might very well be treated as an expense when it is an incidental minor item arising in the use of the property in carrying on business, and yet as here, may be properly capitalized when involved in a greater plan or rehabiliation, enlargement, and improvement of the entire property.

U.S. v. Wehrli, 400 F.2d 666 (10th Cir. 1968). It was held that an expenditure made for an item which is part of a "general plan" of rehabilitation, modernization, and improvement of the property must be capitalized, even though standing alone, the item may appropriately be classified as one of repair. Whether the plan exists, and whether an particular item is part of it, are usually questions of fact to be determined by the fact finder and circumstances, including, but not limited to, the purpose, nature, extent, and value of the work done, e.g. whether the work was done to suit the needs of an incoming tenant, or to adapt the property to a different use, or in any event, whether what was done resulted in a appreciable enhancement of the property's value. (IRS Engr; Ships are frequently built in "series", with the same major components. They have for all intents and purposes been made with a "cookie cutter". For example, there are ten ships in the US fleet classified as C6/C8- S-85 contianerships. Four are owned by one steamship company, and 6 by another. Except for length they all have basically the same design, including 28,000 hp

Westinghouse main engines. This is, by the way, all publicly available information.) (Assume a "package', or "bundle" of minor (or even major) work orders was found to exist in a given year or cycle on ships of the same series. For purposes of this discussion, assume all of the economizers on all of the Tx-S-99b series tankers owned by Apple

Oil had the same work done for $4x in 1979. On one ship this might have legitimately represented a repair, but on all ships in the same series it could represent, as in Cowell and Wherli, part of an overall plan of rehabilitating to the fleet that should be capitalized.)

VIII. Does the expenditure merely maintain the property in ordinary efficient operating condition?

While most courts have determined that expenses that keep the property in an ordinary efficient operating condition should be expensed, expenses that put the property into such condition should be capitalized.

Stoetzling v. Commissioner 266 F.2d 374 (3d Cir. 1959) reapirs made to put rather than to keep a building in an ordinary efficient operating condition had to be capitalized. The fact that the taxpayer had spent $200,000, or 200% of the cost of the building in additional repairs and increased the value of the property only 5% did not matter to the court.

L&L Marine Service Inc. TC Memo 1987-428. Incidental repairs and maintenance expenses incurred by taxpayer to keep barges in ordinary efficient operating condition were deductible, despite capitalization of certain expenses for certified financial statement purposes. The work performed on the barges was necessary to enable the barges to qualify for sea duty and the repairs did not appreciably prolong their useful lives or enhance their value. Moreover, there was an adequate showing that taxpayer's financial situation forced it to accede to the accourtant's demands to capitalize the expenses despite being convinced that the expenses were properly deductible. (IRS Engr; A detailed analysis of this case reveals that facts and circumstances will preclude mere reliance on "M1" adjustments for determining capitalization of repairs. Detailed analysis will further reveal that there was much discussion between L&L (who wanted to expense the repairs) and Peat Marwick Mitchell, who actually refused to certify the statements unless the repairs were capitalized.)

Bloomfield S.S. Co. vs. Commissioner 33 T.C. 75 (1959), aff'd per curiam, 285 F 2d 431 (5th Cir, 1961) Cost of repairs of putting into service eight ships had to be capitalized. (IRS Engr; Some nautical nomenclature and an appreciation of nautical history is required here. This case involves the purchase of eight of the thousands of WWII built ships sold under the Merchant Ship Sales Act of 1946.) (As WWII surplused merchant ships, the Bloomfield vessels were outfitted with gun tubs, ammo lockers, berthing and messing facilities for USN gun crews etc which were a detriment to the peacetime operation of the ships. Removal of these items, expensed by the taxpayer, was capitalized under the findings of the court.) (Ships are required to be maintained "in class" in a matter similar to the state mandated annual inspection and issuance of an inspection stamp for a car. Listed in the court case as typical "surveys" (in early 50s parlance and requirements) were:

Annual Classification Survey (every year)

USCG Inspection (every year)

ABS Special Surveys (every 4 years)

Tail Shaft Inspection (varied with ship series)

Annual Mach/Boiler Survey (every year)

Int'l Loadline Ren'l (every 5 years)

Pressure Vessels Inspotn (every 2 years)

ABS Boiler valves/mtgs (annually)

Radiotelegraph Inspotn (annually) (It should be noted that the surveys themselves involve a great deal of preparation and work, even though they might seem the equivalent of a $15-$20 state auto inspection (putting the car on a lift and pulling the tires). In addition to this, repairs might be mandated, and the systems must be tested out before the certificates are issued.) (In opinion Judge Black cited Stoeltzing, noting the taxpayer expended the money to put rather than to "keep" the ships in ordinarily efficient operating condition. The cost of the repairs was capitalized over the life of the ships). (Bloomfield S.S. did not give any answer on the "life" of a survey. In fact, Judge Black corrected just such a "stipulation of fact". The opinion further goes on to state that "the useful life of the work was less than one year because the inspections ... were annually occurring. Yet when on annually occurring, inspections "petitioner failed to show that any of the work had a useful life of less than one year".)

Parkersburg Iron & Steel Co V. Commissioner (CA-4) 1931 CCH Para. 9201, 48 F.2d 163. Factory alterations that improved lighting conditions are capital expenditures although made at the request of engineers of the United States Army where 2/3 of the factory output consisted of articles made under Government contracts. The alterations were not later abandoned. (IRS Engr Analysis: Expenditures made to prepare a ship for charter should be judged as to the "limited use" of the expenditure to that particular charter. Based on facts and circumstances the appropriate depreciable life of the asset and not the duration of the charter party should prevail. This case is particularly on point with regard to expenditures made for U.S. Government (e.g.-

Military Sealift Command) charter parties.)

This document may not be used or cited as precedent. Section 6110(j)(3) of Internal Revenue Code.

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