IRS Revenue Ruling
2001-4

 Code Sec. 162

<<FULL TEXT>>

Status: Modified by Notice 2001-23


26 CFR 1.162-1: Business expenses.
(Also sections 263; 263A; sections 1.162-4, 1.263(a)-1, 1.263A-1)

Aircraft maintenance costs. Costs incurred by a taxpayer to perform
work on its aircraft airframe as part of a heavy maintenance visit
generally are deductible as ordinary and necessary business expenses under
section 162 of the Code. However, costs incurred in conjuction with a
heavy maintenance visit must be capitalized to the extent they materially
add to the value of, substantially prolong the useful life of, or adapt
the airframe to a new or different use. In addition, costs incurred as
part of a plan of rehabilitation, modernization, or improvement must be
capitalized.


REV. RUL. 2001-4

ISSUE

Are costs incurred by a taxpayer to perform work on its aircraft
airframe, including the costs of a "heavy maintenance visit," deductible
as ordinary and necessary business expenses under section 162 of the
Internal Revenue Code, or must they be capitalized under sections 263 and
263A?


FACTS

X is a commercial airline engaged in the business of transporting
passengers and freight throughout the United States and abroad. To conduct
its business, X owns or leases various types of aircraft. As a condition
of maintaining its operating license and airworthiness certification for
these aircraft, X is required by the Federal Aviation Administration "FAA"
to establish and adhere to a continuous maintenance program for each
aircraft within its fleet. These programs, which are designed by X and the
aircraft's manufacturer and approved by the FAA, are incorporated into
each aircraft's maintenance manual. The maintenance manuals require a
variety of periodic maintenance visits at various intervals during the
operating lives of each aircraft. The most extensive of these for X is
termed a "heavy maintenance visit" (also known in the industry as a "D
check," "heavy C check," or "overhaul"), which is required to be performed
by X approximately every eight years of aircraft operation. The purpose of
a heavy maintenance visit, according to X's maintenance manual, is to
prevent deterioration of the inherent safety and reliability levels of the
aircraft equipment and, if such deterioration occurs, to restore the
equipment to their inherent levels.

In each of the following three situations, X reasonably anticipated at
the time the aircraft was placed in service that the aircraft would be
useful in its trade or business for up to 25 years, taking into account
the repairs and maintenance necessary to keep the aircraft in an
ordinarily efficient operating condition. In addition, each of the
aircraft in the following three situations is fully depreciated for
federal income tax purposes at the time of the heavy maintenance visit.


SITUATION 1

In 2000, X incurred $2 million for the labor and materials necessary to
perform a heavy maintenance visit on the airframe of Aircraft 1, which X
acquired in 1984 for $15 million (excluding the cost of engines). To
perform the heavy maintenance visit, X extensively disassembled the
airframe, removing items such as its engines, landing gear, cabin and
passenger compartment seats, side and ceiling panels, baggage stowage
bins, galleys, lavatories, floor boards, cargo loading systems, and flight
control surfaces. As specified by X's maintenance manual for Aircraft 1, X
then performed certain tasks on the disassembled airframe for the purpose
of preventing deterioration of the inherent safety and reliability levels
of the airframe. These tasks included lubrication and service; operational
and visual checks; inspection and functional checks; restoration of minor
parts and components; and removal, discard, and replacement of certain
life-limited single cell parts, such as cartridges, canisters, cylinders,
and disks.

Whenever the execution of a task revealed cracks, corrosion, excessive
wear, or dysfunctional operation, X was required by the maintenance manual
to restore the airframe to an acceptable condition. This restoration
involved burnishing corrosion; repairing cracks, dents, gouges, punctures,
or scratches by burnishing, blending, stop-drilling, or applying skin
patches or doublers over the affected area; tightening or replacing loose
or missing fasteners, rivets, screws, bolts, nuts, or clamps; repairing or
replacing torn or damaged seats, gaskets, or valves; repairing or
replacing damaged or missing placards, decals, labels, or stenicils;
additional cleaning, lubricating, or painting; further inspecting or
testing, including the use of sophisticated non-destructive inspection
methods; repairing fiberglass or laminated parts; replacing bushings,
bearings, hinges, handles, switches, gauges, or indicators; repairing
chaffed or damaged wiring; repairing or adjusting various landing gear or
flight surface control cables; replacing light bulbs, window panes,
leases, or shields; replacing anti-skid materials and stops on floors,
pedals, and stairways; replacing floor boards; and performing minor
repairs on ribs, spars, frames, longerons, stringers, beams, and supports.

In addition to the tasks described above, X also performed additional
work as part of the heavy maintenance visit for Aircraft 1. This work
included applying corrosion prevention and control compounds; stripping
and repainting the aircraft exterior; and cleaning, repairing, and
painting airframe interior items such as seats, carpets, baggage stowage
bins, ceiling and sidewall panels, lavatories, galleys, and passenger
service units. Other additional work included implementing certain
outstanding service bulletins ("SBs") issued by the aircraft manufacturer
and airworthiness directives ("ADs") issued by the FAA. Implementing these
SBs and ADs involved inspecting specific skin locations and applying
doublers over the areas where cracks were found; inspecting bolts or
fasteners at specific locations, and replacing those found to be broken,
worn, or missing; and installing structural reinforcements between body
frames in a small area in the lower aft fuselage to reduce skin wrinkling
and replacing a small number of the wrinkled skin panels in this area with
stronger skin panels.

None of the work performed by X as part of the heavy maintenance visit
(including the execution of SBs and ADs) for Aircraft 1 resulted in a
material upgrade or addition to its airframe or involved the replacement
of any (or a significant portion of any) major component or substantial
structural part of the airframe. This work maintained the relative value
of the aircraft. The value of the aircraft declines as it ages even if the
heavy maintenance work is performed.

After 45 days, the heavy maintenance visit was completed, and Aircraft
1 was reassembled, tested, and returned to X's fleet. X then continued to
use Aircraft 1 for the same purposes and in the same manner that it did
prior to the performance of the heavy maintenance visit. The performance
of the heavy maintenance visit did not extend the useful life of the
airframe beyond the 25-year useful life that X anticipated when it
acquired the airframe.


SITUATION 2

Also in 2000, X incurred costs to perform work in conjunction with a
heavy maintenance visit on the airframe of Aircraft 2. The heavy
maintenance visit on Aircraft 2 involved all of the same work described in
Situation 1. In addition, X found significant wear and corrosion of
fuselage skins of Aircraft 2 that necessitated more extensive work than
was performed on Aircraft 1. Namely, X decided to remove all of the skin
panels on the belly of Aircraft 2's fuselage and replace them with new
skin panels. The replaced skin panels represented a significant portion of
all of the skin panels of Aircraft 2, and the work performed materially
added to the value of the airframe.

Because Aircraft 2 was already out of service and its airframe
disassembled for the heavy maintenance visit, X also performed certain
modifications to the airframe. These modifications involved installing a
cabin smoke and fire detection and suppression system, a ground proximity
warning system, and an air phone system to enable passengers to send and
receive voice calls, faxes, and other electronic data while in flight.


SITUATION 3

Also in 2000, X decided to make substantial improvements to Aircraft 3,
which was 22 years old and nearing the end of its anticipated useful life,
for the purpose of increasing its reliability and extending its useful
life. X's improvement of Aircraft 3 involved many modifications to the
structure, exterior, and interior of the airframe. The modifications
included removing all the belly skin panels on the aircraft's fuselage and
replacing them with new skin panels; replacing the metal supports under
the lavatories and galleys; removing the wiring in the leading edges of
both wings and replacing it with new wiring; removing the fuel tank
bladders, harnesses, wiring systems, and connectors and replacing them
with new components; opening every lap joint on the airframe and replacing
the epoxy and rivets used to seal the lap joints with a non-corrosive
sealant and larger rivets; reconfiguring and upgrading the avionics and
the equipment in the cockpit; replacing all the seats, overhead bins,
sidewall panels, partitions, carpeting, windows, galleys, lavatories, and
ceiling panels with new items; installing a cabin smoke and fire detection
system, and a ground proximity warning system; and painting the exterior
of the aircraft. The work performed on Aircraft 3 also included
modifications necessary to terminate every aging aircraft AD applicable to
Aircraft 3.

In order to upgrade the airframe to the desired level, X performed much
of the same work that would be performed during a heavy maintenance visit
(as described in Situation 1). The result of the work performed on
Aircraft 3 was to materially increase the value of the airframe and
substantially prolong its useful life.


LAW

Section 162 and section 1.162-1(a) of the Income Tax Regulations allow
a deduction for all the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or business, including
"incidental repairs."

Section 1.162-4 allows a deduction for the cost of incidental repairs
that neither materially add to the value of the property nor appreciably
prolong its useful life, but keep it in an ordinarily efficient operating
condition. However, section 1.162-4 also provides that the cost of repairs
in the nature of replacements that arrest deterioration and appreciably
prolong the life of the property must be capitalized and depreciated in
accordance with section 167.

Section 263(a) provides that no deduction is allowed for (1) any amount
paid out for new buildings or permanent improvements or betterments made
to increase the value of any property or estate or (2) any amount expended
in restoring property or in making good the exhaustion thereof for which
an allowance has been made. See also section 1.263(a)-1(a).

Section 1.263(a)-1(b) provides that capital expenditures include
amounts paid or incurred to (1) add to the value, or substantially prolong
the useful life, of property owned by the taxpayer, or (2) adapt property
to a new or different use. However, that regulation also provides that
amounts paid or incurred for incidental repairs and maintenance of
property within the meaning of section 162 and section 1.162-4 are not
capital expenditures under section 1.263(a)-1.

Section 263A provides that the direct and indirect costs properly
allocable to real or tangible personal property produced by the taxpayer
must be capitalized. Section 263A(g)(1) provides that, for purposes of
section 263A, the term "produce" includes construct, build, install,
manufacture, develop, or improve.

The United States Supreme Court has specifically recognized that the
"decisive distinctions [between capital and ordinary expenditures] are
those of degree and not of kind," and a careful examination of the
particular facts of each case is required. Deputy v. duPont, 308 U.S. 488,
496 (1940), quoting Welch v. Helvering, 290 U.S. 111, 114 (1933). To
determine whether certain costs should be classified as capital
expenditures or as repair and maintenance expenses, "it is appropriate to
consider the purpose, the physical nature, and the effect of the work for
which the expenditures were made." American Bemberg Corp. v. Commissioner,
10 T.C. 361, 376 (1948), aff'd, 177 F.2d 200 (6th Cir. 1949).

Any properly performed repair, no matter how routine, could be
considered to prolong the useful life and increase the value of the
property if it is compared with the situation existing immediately prior
to that repair. Consequently, courts have articulated a number of ways to
distinguish between deductible repairs and non-deductible capital
improvements. For example, in Illinois Merchants Trust Co. v.
Commissioner, 4 B.T.A. 103, 106 (1926), acq., V-2 C.B. 2, the court
explained that repair and maintenance expenses are incurred for the
purpose of keeping the property in an ordinarily efficient operating
condition over its probable useful life for the uses for which the
property was acquired. Capital expenditures, in contrast, are for
replacements, alterations, improvements, or additions that appreciably
prolong the life of the property, materially increase its value, or make
it adaptable to a different use. In Estate of Walling v. Commissioner, 373
F.2d 190, 192-193 (3rd Cir. 1966), the court explained that the relevant
distinction between capital improvements and repairs is whether the
expenditures were made to "put" or "keep" property in ordinary efficient
operating condition. In Plainfield-Union Water Co. v. Commissioner, 39
T.C. 333, 338 (1962), nonacq. on other grounds, 1964-2 C.B. 8., the court
stated that if the expenditure merely restores the property to the state
it was in before the 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.
The Supreme Court's decision in INDOPCO Inc. v. Commissioner, 503 U.S. 79
(1992) does not affect these general principles. See Rev. Rul. 94-12,
1994-1 C.B. 36; Ingram Industries, Inc. v. Commissioner, T.C.M. 2000-323.

<<END RULING>>


Even if the expenditures include the replacement of numerous parts of
an asset, if the replacements are a relatively minor portion of the
physical structure of the asset, or of any of its major parts, such that
the asset as whole has not gained materially in value or useful life, then
the costs incurred may be deducted as incidental repairs or maintenance
expenses. See Buckland v. United States, 66 F. Supp. 681, 683 (D. Conn.
1946) (costs to replace all window sills in factory building were
deductible repairs). See also, e.g., Libby & Blouin Ltd. v. Commissioner,
4 B.T.A. 910 (1926) (costs to replace all the tubing in sugar evaporator,
which were small parts in a large machine, were deductible repairs). The
same conclusion is true even if such minor portion of the asset is
replaced with new and improved materials. See, e.g., Badger Pipeline v.
Commissioner, T.C.M. 1997-457 (costs to replace 1,000 feet of pipeline in
a 25-mile section of pipeline were deductible repairs, regardless of
whether the new pipe was of better quality or has a longer life).

If, however, a major component or a substantial structural part of the
asset is replaced and, as a result, the asset as a whole has increased in
value, life expectancy, or use then the costs of the replacement must be
capitalized. See, e.g., Denver & Rio Grande Western R.R. Co. v.
Commissioner, 279 F.2d 368 (10th Cir. 1960) (costs to replace major
portion of a viaduct -- all of the floor planks and 85-90% of the
stringers -- were capital expenditures); P. Dougherty Co. v. Commissioner,
159 F.2d 269, 272 (4th Cir. 1946) (costs to replace entire stem section of
barge with new materials were capital expenditures); Vanalco Inc. v.
Commissioner, T.C.M. 1999-265 (cost to replace the cell lining, an
essential and substantial component of the cell, was required to be
capitalized); Stark v. Commissioner, T.C.M. 1999-1 (cost to replace
building roof were capital expenditures); Rev. Rul. 88-57, 1988-2 C.B. 36,
modified by Rev. Rul. 94-38, 1994-1 C.B. 35 (costs to perform major
cyclical rehabilitations on railroad freight train cars as part of a plan
of rehabilitation in which all of the structural components were either
reconditioned or replaced were capital expenditures).

In addition, although the high cost of the work performed may be
considered in determining whether an expenditure is capital in nature,
cost alone is not dispositive. Compare R. R. Hensler, Inc. v.
Commissioner, 73 T.C. 168, 177 (1979), acq. in result, 1980-2 C.B. 1 (the
fact that taxpayer's expense was large does not change its character as
ordinary); Buckland at 683 (replacements of relatively minor proportions
of the entire physical asset constitute repairs even where high in cost);
and American Bemberg, 10 T.C. 361 (1948) (deduction allowed for drilling
and grouting to prevent cave-ins even though the total cost of the
expenditures exceeded $1.1 million), with Wolfsen Land & Cattle Co. v.
Commissioner, 72 T.C. 1, 17 (1979) (costs to dragline an irrigation ditch
were capital expenditures, in part, because they could be as high as the
cost to construct a new ditch); and Stoeltzing v. Commissioner, 266 F.2d
374, 376 (3d Cir. 1959) (expenditures could not be incidental repairs
because they exceeded by almost 200% the cost of the building).

Similarly, the fact that a taxpayer is required by a regulatory
authority to make certain repairs or to perform certain maintenance on an
asset in order to continue operating the asset in its business does not
mean that the work performed materially increases the value of such asset,
substantially prolongs its useful life, or adapts it to a new use. See,
e.g., Midland Empire Packing Co. v. Commissioner, 14 T.C. 635 (1950),
acq., 1950-2 C.B. 3 (costs of applying concrete liner to basement walls
and floors in order to satisfy federal meat inspectors were deductible
repairs); L&L Marine Service Inc. v. Commissioner, T.C.M. 1987-428 (work
performed on barges that was necessary to enable the barges to continue to
qualify for sea duty was a deductible repair).

The characterization of any cost as a deductible repair or capital
improvement depends on the context in which the cost is incurred.
Specifically, where an expenditure is made as part of a general plan of
rehabilitation, modernization, and improvement of the property, the
expenditure must be capitalized, even though, standing alone, the item may
be classified as one of repair or maintenance. United States v. Wehrli,
400 F.2d 686, 689 (10th Cir. 1968). Whether a general plan of
rehabilitation exists, and whether a particular repair or maintenance item
is part of it, are questions of fact to be determined based upon all the
surrounding facts and circumstances, including, but not limited to, the
purpose, nature, extent, and value of the work done. Id. at 690. The
existence of a written plan, by itself, is not sufficient to trigger the
plan of rehabilitation doctrine. See Moss v. Commissioner, 831 F.2d 833,
842 (9th Cir. 1987); Vanalco v. Commissioner, T.C.M. 1999-265.

In general, the courts have applied the plan of rehabilitation doctrine
to require a taxpayer to capitalize otherwise deductible repair and
maintenance costs where the taxpayer has a plan to make substantial
capital improvements to property and the repairs are incidental to that
plan. See, e.g., California Casket Co. v. Commissioner, 19 T.C. 32 (1952),
acq., 1953-1 C.B. 3 (costs of repairing the foundation although not in the
original plan became, when undertaken, incidental to and involved in the
plan of completely renovating and remodeling an old warehouse building);
Stoeltzing at 377 (costs to renovate old building by shoring up floors;
constructing steps, landing and new driveway; replacing wiring and
plumbing; installing new roof; plastering; insulating; performing
carpentry work; patching the gutters; and removing rubbish must be
capitalized as part of plan of rehabilitation); Bank of Houston v.
Commissioner, T.C.M. 1960-110 (costs incurred for various repairs incident
to the reconstruction and renovation of a bank building must be
capitalized as part of a general plan of rehabilitation).

On the other hand, the courts and the Service have not applied the plan
of rehabilitation doctrine to situations where the plan did not include
substantial capital improvements and repairs to the same asset, the plan
primarily involved repair and maintenance items, or the work was performed
merely to keep the property in an ordinarily efficient operating
condition. See, e.g., Moss at 840 (repairs incurred in conjunction with a
hotel remodeling project not required to be capitalized as part of a plan
of rehabilitation because the project's capital expenditures were not of
the nature or scope necessary to trigger the plan of rehabilitation
doctrine); Schroeder v. Commissioner, T.C.M. 1996-336 (costs of renovating
barns were not required to be capitalized as part of a plan of
rehabilitation where most of the renovation costs were repairs and
maintenance to keep the barns in an efficient operating condition); Rev.
Rul. 70-392, 1970-2 C.B. 33 (costs incurred to relocate existing capital
assets in order to install new assets intended to increase a utility's
distribution voltage were not required to be capitalized as part of a
general plan of rehabilitation because the relocation merely kept the
existing assets in an ordinarily efficient operating condition).


ANALYSIS

In Situation 1, the heavy maintenance visit on Aircraft 1 primarily
involved inspecting, testing, servicing, repairing, reconditioning,
cleaning, stripping, and repainting numerous airframe parts and
components. The heavy maintenance visit did not involve replacements,
alterations, improvements, or additions to the airframe that appreciably
prolonged its useful life, materially increased its value, or adapted it
to a new or different use. Rather, the heavy maintenance visit merely kept
the airframe in an ordinarily efficient operating condition over its
anticipated useful life for the uses for which the property was acquired.
See Illinois Merchant Trust Co. at 106; Estate of Walling at 192-193;
Ingram Industries, Inc. at 538-539. The fact that the taxpayer was
required to perform the heavy maintenance visit to maintain its
airworthiness certificate does not affect this determination. See Midland
Empire Packing at 642.

Although the heavy maintenance visit did involve the replacement of
numerous airframe parts with new parts, none of these replacements
required the substitution of any (or a significant portion of any) major
components or substantial structural parts of the airframe so that the
airframe as a whole increased in value, life expectancy, or use. Compare
Buckland at 683 with P. Dougherty at 272. Thus, the facts in Situation 1
are distinguishable from those in Rev. Rul. 88-57 in which all of the
structural components of a railroad freight car were either reconditioned
or replaced so that the car was restored to a "like new" condition with a
new, additional service life of 12 to 14 years. Moreover, the heavy
maintenance visit also did not restore the airframe, or make good
exhaustion for which an allowance had been made, within the meaning of
section 263(a)(2). In order to have a restoration under section 263(a)(2),
much more extensive work would have to be done so as to substantially
prolong the useful life of the airframe. See Denver & Rio Grande at 373.
Thus, the costs of the heavy maintenance visit constitute expenses for
incidental repairs and maintenance under section 1.162-4.

Finally, the costs of the heavy maintenance visit are not required to
be capitalized under sections 263 or 263A as part of a plan of
rehabilitation, modernization, or improvement to the airframe. Because the
heavy maintenance visit involved only repairs for the purpose of keeping
the airframe in an ordinarily efficient operating condition, it did not
include the type of substantial capital improvements necessary to trigger
the plan of rehabilitation doctrine. See Schroeder v. Commissioner, T.C.M.
1996-336; Moss at 842. Accordingly, the costs incurred by X for the heavy
maintenance visit in Situation 1 may be deducted as ordinary and necessary
business expenses under section 162.

In Situation 2, in addition to performing all of the work described in
Situation 1 on Aircraft 2, X replaced all of the skin panels on the belly
of the fuselage and installed a cabin smoke and fire detection and
suppression system, a ground proximity warning system and an air phone
system. Because the replacement of the skin panels involved replacing a
significant portion of the airframe's skin panels (which in the aggregate
represented a substantial structural part of the airframe) thereby
materially adding to the value of and improving the airframe, the cost of
replacing the skin panels must be capitalized. See Vanalco, T.C.M.
1999-265; P. Dougherty at 272. In addition, the additions and upgrades to
Aircraft 2 in the form of the fire protection, air phone, and ground
proximity warning systems must be capitalized because they materially
improved the airframe. See Phillips and Easton Supply Co. v. Commissioner,
20 T.C 455, 460 (1953). Accordingly, the costs incurred by X for labor and
materials allocable to these capital improvements must be treated as
capital expenditures under section 263. Moreover, because the improvement
of property constitutes production within the meaning of section
263A(g)(1), X is required to capitalize under section 263A the direct
costs and a proper share of the allocable indirect costs associated with
these improvements.

Further, the mere fact that these capital improvements were made at the
same time that the work described in Situation 1 was performed on Aircraft
2 does not require capitalization of the cost of the heavy maintenance
visit under the plan of rehabilitation doctrine. Whether a general plan of
rehabilitation exists is a question of fact to be determined based on all
the facts and circumstances. See Wehrli at 690. X's plan in Situation 2
was not to rehabilitate Aircraft 2, but merely to perform discrete capital
improvements to the airframe. See Moss at 839; Schroeder v. Commissioner,
T.C.M. 1996-336; Rev. Rul. 70-392. For this reason, the facts of Situation
2 are distinguishable from Rev. Rul. 88-57, which involved a major
rehabilitation that constituted a plan of rehabilitation undertaken near
the end of the freight car's life for the purpose of restoring it to a
"like new" condition. Accordingly, the costs of the work described in
Situation 1 are not part of a general plan of rehabilitation,
modernization, or improvement to the airframe. The costs incurred by X for
the work performed on Aircraft 2 must be allocated between capital
improvements, which must be capitalized under sections 263 and 263A, and
repairs and maintenance, which may be deducted under section 162.

In Situation 3, X is required to capitalize under section 263 the costs
of all the work performed on Aircraft 3. The work in Situation 3 involved
replacements of major components and significant portions of substantial
structural parts that materially increased the value and substantially
prolonged the useful life of the airframe. See P. Dougherty at 272 and
Rev. Rul. 88-57. In addition, the value of Aircraft 3 was materially
increased as a result of material additions, alterations and upgrades that
enabled X to operate Aircraft 3 in an improved way. See Dominion
Resources, 48 F. Supp. 2d 527, 553. In contrast to Situation 1, the
extensiveness of the work performed on Aircraft 3 constitutes a
restoration within the meaning of section 263(a)(2). See, e.g. Denver &
Rio Grande at 373.

X performed much of the same work on Aircraft 3 that would be performed
during a heavy maintenance visit (as described in Situation 1) ("Situation
1-type work"). Although these costs, standing alone, generally are
deductible expenses under section 162, in this context, they are incurred
as part of a general plan of rehabilitation, modernization, and
improvement to the airframe of Aircraft 3 and X is required to capitalize
under sections 263 and 263A the costs of that work. See Wehrli at 689-90.
In this situation, X planned to perform substantial capital improvements
to upgrade the airframe of Aircraft 3 for the purpose of increasing its
reliability and extending its useful life. See Rev. Rul. 88-57. The
Situation 1-type work was incidental to X's plan to upgrade Aircraft 3.
See California Casket at 38. The effect of all the work performed on
Aircraft 3, including the inspection, repair, and maintenance items, is to
materially increase the value of the airframe and substantially prolong
its useful life. Thus, all the work performed by X on Aircraft 3 is part
of a general plan of rehabilitation, modernization, and improvement to the
airframe and the costs associated with this work must be capitalized under
section 263. Further, because the improvement of the airframe constitutes
production of property within the meaning of section 263A(g)(1), X is
required to capitalize under section 263A the direct costs and a proper
share of the allocable indirect costs associated with this improvement
plan.

The conclusions in this ruling would be the same whether X transported
only freight or only passengers.


HOLDINGS

Costs incurred by a taxpayer to perform work on its aircraft airframe
as part of a heavy maintenance visit generally are deductible as ordinary
and necessary business expenses under section 162. However, costs incurred
in conjunction with a heavy maintenance visit must be capitalized to the
extent they materially add to the value of, substantially prolong the
useful life of, or adapt the airframe to a new or different use. In
addition, costs incurred as part of a plan of rehabilitation,
modernization, or improvement must be capitalized.


APPLICATION

Any change in a taxpayer's method of accounting to conform with this
revenue ruling is a change in method of accounting to which the provisions
of sections 446 and 481 and the regulations thereunder apply. A taxpayer
wanting to change its method of accounting to conform with the holding in
this revenue ruling must follow the automatic change in accounting method
provisions of Rev. Proc. 99-49, 1999-2 C.B. 725, provided the change is
made for the first taxable year ending after January 16, 2001. However,
the scope limitations in section 4.02 of Rev. Proc. 99-49 do not apply
unless the taxpayer's method of accounting for costs incurred to perform
work on its aircraft airframes is an issue pending, within the meaning of
section 6.01(6) of Rev. Proc. 2000-38, 2000-40 I.R.B. 3 10, at the time
the Form 3115 is filed with the national office. If the taxpayer is under
examination, before an appeals office, or before a federal court with
respect to any income tax issue, the taxpayer must provide a copy of the
Form 3115, Application for Change in Accounting Method, to the examining
agent, appeals officer, or counsel for the government, as appropriate, at
the same time that it files the copy of the Form 3115 with the national
office. The Form 3115 must contain the name(s) and telephone number(s) of
the examining agent(s), appeals officer, or counsel for the government, as
appropriate.


EFFECT ON OTHER DOCUMENTS

Rev. Proc. 99-49 is modified and amplified to include the prospective
change in accounting method in the APPENDIX. Rev. Rul. 88-57 is
distinguished.


DRAFTING INFORMATION

The principal author of this revenue ruling is Merrill D. Feldstein of
the Office of Associate Chief Counsel (Income Tax and Accounting). For
further information regarding this revenue ruling, contact Ms. Feldstein
or Beverly Katz at (202) 622-4950 (not a toll-free call).

<<END RULING>>

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