Rotable spare parts - the elephant in the room
TAX ALERT |
Many taxpayers use rotable spare parts in their daily business activities, but few understand how to properly account for such items under the final tangible property regulations. This article discusses the definitions, options, and considerations taxpayers face when determining the treatment for rotable and temporary spare parts that will provide the most favorable results while ensuring compliance with the final regulations.1
The final tangible property regulations (the final regulations) have unleashed a flurry of new definitions, rules and accounting methods related to the acquisition, use and disposition of tangible property. One area affected by the final regulations is the treatment of a subset of materials and supplies‒rotable and temporary spare parts. While rotable and temporary spare parts themselves are nothing new, the final regulations give these items a formal definition and provide three separate ways to account for such items for federal income tax purposes. Taxpayers across a wide range of industries, including manufacturing, construction, transportation and mining/drilling, may find themselves affected by this new definition and the associated accounting methods/elections.
Defining rotables and temporary spare parts
Materials and supplies
Materials and supplies include items that fall into one of the following four categories:2
- A component acquired to maintain, repair or improve a unit of property (UOP) owned, leased or serviced by the taxpayer that is not acquired as part of any single UOP
- Fuel, lubricants, water and similar items reasonably expected to be consumed in 12 months or less
- A UOP that has an economic useful life of 12 months or less
- A UOP that has an acquisition or production cost of $200 or less
- An item identified in published guidance as a material and supply under Reg. section 1.162-3
Rotable spare parts
The final regulations provide that rotable spare parts are materials and supplies:
- Acquired for installation on a UOP
- Removable from the UOP
- Generally repaired or improved
- Re-installed or stored for future installation3
Temporary spare parts
Temporary spare parts are very similar to rotable spare parts. However, these are materials and supplies that are used only on a temporary basis until a new or repaired part can be installed. These parts are then removed and stored for installation at a future time.4
A common example of a rotable spare part is a gear on the drive-shaft of nearly any machine. These items may meet the definition of a material and supply under Reg. section 1.162-3 since they are components acquired to maintain, repair or improve a UOP. Additionally, they are subject to heavy wear and tear and are commonly removed, replaced and then refurbished and re-installed on the same or a different machine. Alternatively, if the gear is to be used only temporarily until the permanent gear is repaired or replaced, and will not become a permanent part of the machine, that gear may be considered a temporary spare part.
Accounting for rotable and temporary spare parts
Many taxpayers may find themselves deducting the cost of rotable and temporary spare parts in the tax year such costs are paid or incurred, regardless of when the parts are installed or disposed of. While generally taxpayer-favorable and thus desirable, this method of accounting for rotables is not permissible. Instead, the final regulations provide the following three options for accounting for rotable and temporary spare parts for federal income tax purposes:5
The general method of accounting
Generally, the final regulations provide that a rotable and temporary spare part is deductible in the taxable year such part is disposed of by the taxpayer.5 Since rotable and temporary spare parts may last for a long time in a taxpayer's operations, recovery of these expenditures may not occur for several years, requiring the taxpayer to track these items. This default treatment is a method of accounting that will generally require an existing taxpayer to file a Form 3115 (a request for change in method of accounting) to implement this treatment. However, this change in method of accounting is implemented on a modified cut-off basis. That means that if a taxpayer implements this method for their first year beginning after 2013, the taxpayer will not have a section 481(a) adjustment.7 If the method is implemented after 2014, the taxpayer's 481(a) adjustment would only reflect costs incurred on or after Jan. 1, 2014.
The election to capitalize and depreciate
Instead of capitalizing and recovering the cost of rotable and temporary spare parts in the year of disposal, taxpayers may make an irrevocable election to treat rotable and/or temporary spare parts as depreciable assets by capitalizing and depreciating such parts, beginning with the tax year the parts are placed in service. This election may provide taxpayers with accelerated deductions as compared to the default method of accounting. However, there are limitations on the ability to make this election.
Specifically, the election to capitalize and depreciate does not apply:
- If the rotable or temporary spare part is intended to be used as a component of a UOP with an economic useful life of 12 months or less
- To a UOP with an acquisition or production cost of $200 or less or a UOP that is identified in published guidance as a material and supply under Reg. section 1.162-38
- If the rotable or temporary spare part was acquired and intended for use to maintain, repair or improve a UOP the taxpayer has not elected, or cannot elect, to capitalize and depreciate9
- If the taxpayer uses the optional method for accounting for the rotable or temporary spare part (discussed below) 10
The election to capitalize and depreciate rotable and/or temporary spare parts is made annually for each separate rotable or temporary spare part and does not constitute a method of accounting. No statement is required to elect to treat one or more parts this way; a taxpayer merely ‘elects by doing' on a timely (including extensions) originally filed tax return for the tax year the part is placed in service. Because the election does not constitute a method of accounting, the election cannot be made or revoked through a Form 3115.11
If a taxpayer adopts this treatment, the taxpayer still has to track each item and expense the rotable and/or temporary spare part when the item is disposed of. If the item has not been fully depreciated, failure to deduct the remaining basis in the item in the year of disposition could create a permanent disallowance. Taxpayers that do not want to track dispositions of rotable and/or temporary spare parts can elect to place the items in a General Asset Account.
The optional method of accounting
The third alternative for accounting for rotable and temporary spare parts is the “optional method” under Reg. section 1.162-3(e). This is likely the most complicated and burdensome method available for accounting for rotable and temporary spare parts and requires compliance with respect to the following:12
- Initial installation – the taxpayer must deduct the amount paid to acquire or produce the part in the year the part is initially installed for use in the taxpayer's operations
- Removal from use – in each tax year the part is removed from a UOP, the taxpayer must include in gross income the fair market value of the part and increase the part's basis by the amount of gross income recognized
- Repair, maintenance or improvement – any repair or improvement costs incurred with respect to the part must be included in the basis of the part and may not be currently deducted
- Reinstallation – when the part is reinstalled, the taxpayer must deduct any costs of reinstallation, as well as those costs previously included in the basis of the part under items 2 and 3 above, to the extent those amounts have not been previously deducted
- Disposition – when the taxpayer disposes of the part, it must deduct the amounts included in the basis of the part under items 2 and 3 above to the extent such amounts have not been previously deducted
A taxpayer that wishes to apply the optional method must use this method for all pools of rotable spare parts used in the same trade or business and for which it uses the method for its books and records.13 This method requires a detailed level of recordkeeping, valuation and accounting for rotable and temporary spare parts that may make the method undesirable for many taxpayers. However, for those taxpayers that are able to track the use of rotable and temporary spare parts (and that use the method for financial statement purposes), this method may provide the most accelerated deductions for rotable and temporary spare parts. The optional method is considered a method of accounting that an existing taxpayer generally must adopt through the filing of a Form 3115. Unlike the general rule for rotable and temporary spare parts, a method change to adopt the optional method of accounting does require a section 481(a) adjustment.14
As discussed above, both the general and optional methods are considered methods of accounting that will generally require adoption by an existing taxpayer with rotable or temporary spare parts through the filing of a Form 3115. However, both method changes may be made by following the automatic method change procedures of Rev. Proc. 2011-14 and can thus generally be filed by Sept. 15, 2015, for fully extended, calendar-year taxpayers that wish to file the Form 3115 for their 2014 tax year. Additionally, the scope limitations that generally apply to prohibit certain taxpayers from filing automatic Forms 3115 are waived for any tax years beginning before 2015, facilitating the unencumbered adoption and filing of any necessary changes.15
Because the final tangible property regulations provide multiple ways to account for rotable and temporary spare parts, taxpayers should work with their tax advisors that have rotables and/or temporary spare parts to determine the most advantageous and feasible method of accounting (or election) to use. Common factors that may affect the method chosen include the level of detail that historical records provide and the amount of time and effort that can be devoted to future accounting and recordkeeping. As with the other provisions of the final regulations, new processes and additional accounting measures may need to be designed to properly account for rotable and temporary spare parts going forward.
1 This article is only intended to give a high-level overview of the potential treatment for rotable and temporary spare parts under Reg. section 1.162-2 and is not intended to be relied on when making final decisions regarding any changes in method of accounting or elections under the final tangible property regulations.
2 Reg. section 1.162-3(c)(1).
3 Reg. section 1.162-3(c)(2).
5 Note that this article does not discuss the de minimis safe harbor election under Reg. section 1.263(a)-2(f). If a taxpayer elects the de minimis safe harbor, the safe harbor may capture and require the deduction for amounts paid for rotable or temporary spare parts in the year such amounts are paid or incurred. For a discussion of the de minimis safe harbor election, see The final tangible property regulations – Part I.
6 See Reg. section1.162-3(a)(3).
7 See appendix section 10.11(6)(b)(i) of Rev. Proc. 2011-14, as modified by Rev. Proc. 2014-17. This method change generally requires that section 481(a) adjustments only take into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2014. Alternatively, taxpayers have the option of calculating a section 481(a) adjustment that takes into account amounts paid or incurred in tax years beginning on or after Jan. 1, 2012.
8 Reg. section1.162-3(d)(2)(i).
9 Reg. section1.162-3(d)(2)(ii).
10 Reg. section1.162-3(d)(2)(iii).
11 Reg. section 1.162-3(d)(3).
12 Reg. section 1.162-3(e)(2).
13 Reg. section1.162-3(e)(1).
14 See appendix section 10.11(6)(b)(i) of Rev. Proc. 2011-14, as modified by Rev. Proc. 2014-16.
15 See appendix section 10.11(2)(a) of Rev. Proc. 2011-14, as modified by Rev. Proc. 2014-16.