Lead Opinion
OPINION
The respondent determined a deficiency of $45,935.83 in the income tax of petitioner Macabe Co., Inc. (hereinafter sometimes referred to as the petitioner), for its fiscal year ended July 31, 1958.
It has been stipulated that if the respondent’s disallowance of the depreciation deduction claimed by the petitioner for its fiscal year ended duly 31, 1958, is sustained by this Court, the amount of the deficiency determined by respondent is correct. The parties have further agreed that the petitioners involved in docket Nos. 4782-62 to 4785-62, inclusive, would be liable for any such deficiency as the transferees of the assets of Macabe Co., Inc., pursuant to section 6901.
All of the facts have been stipulated, are so found, and are incorporated herein by this reference. Those necessary to an understanding of our inquiry are recited below.
The petitioner was incorporated under Oregon law on or about February 15, 1947. It timely filed its income tax return for its fiscal year ended July 31,1958, with the district director of internal revenue, district of Oregon.
The petitioner acquired in 1946
Between the years 1949 and 1958 the fair market value of downtown Portland rental properties (into which category the building falls) increased substantially.
One of the principal stockholders of the petitioner died on August 15, 1957. Motivated in part by the cash requirements of the estate of the deceased stockholder, the directors and stockholders of the petitioner resolved to sell the building and land and liquidate the petitioner pursuant to section 337. On July 25,1958, 6 days prior to the expiration of its fiscal year, the petitioner sold the building and land for $3,900,000 under an agreement which provided that it would pay all of the building operating expenses and retain all of the operating income therefrom to and including July 31, 1958, the end of its fiscal year. Thereafter the building was operated by the purchaser.
After the payment of its then ascertained liabilities, the petitioner, pursuant to its plan of liquidation under section 337, distributed its remaining 'assets to the individual petitioners involved in docket Nos. 4782-62 to 4785-62, inclusive, who at that time were petitioner’s sole stockholders.
For each year from 1949 through its fiscal year ended July 31,1957, the petitioner claimed a depreciation deduction with respect to the building in the amount of $85,054.85. In computing the annual depreciation allowance for the building, the petitioner employed the straight-line method, using an estimated useful life of 33% years,
Under the circumstances of this case, the petitioner’s estimate of a zero salvage value for the building was reasonable.
Respondent, relying on Cohn v. United States,
Respondent contends that petitioner is not entitled to a depreciation deduction for the building in its fiscal year ended July 31, 1958, because (1) the sales proceeds received by petitioner show that the building had not depreciated, but had appreciated in value and (2) petitioner had fully recovered before the end of that year (by virtue of the sales proceeds for the building) more than its undepreciated basis in the building as of the beginning of said year. Respondent maintains that this disallowance is necessary to carry out the underlying purpose of section 167, which sanctions the tax-free recovery of the cost of depreciable property used in the taxpayer’s trade or business or held for the production of income. See H. Rept. No. 1337, to accompany TLR. 8300 (Pub. L. 591), 83d Cong., 2d Sess., p. 22. It is the respondent’s position that if a depreciation deduction were allowed in the year of sale when the sales price equals or exceeds a taxpayer’s unde-preciated basis as of the beginning of said year, the taxpayer would, in effect, be recovering, tax free, more than the cost to him of the asset. In making this argument, respondent relies upon Cohn v. United States, supra; Randolph D. Rouse,
We find merit in petitioner’s argument that the granting of a reasonable allowance for depreciation is a matter separate and distinct from the computation of gain upon the sale of property formerly held in the taxpayer’s trade or business or for the production of income. The concepts of depreciation through the process of exhaustion, on the one hand, and of appreciation or depreciation because of market conditions, on the other hand, are mutually exclusive. Eespondent, however, has sought to equate the two. The purpose of the depreciation allowance is to permit a taxpayer to recover, by deductions against his income, his cost or investment in any depreciable asset. United States v. Ludey,
(1) Where an asset is retired by sale at arm’s length, recognition of gain or loss will be subject to the provisions of sections 1002, 1231, and other applicable provisions of law.
Respondent, by contending that petitioner has recovered the remaining portion of its cost or basis in the building upon its receipt of the sales proceeds, is, in a manner of speaking, attempting to recast into ordinary income, by way of disallowance through the depreciation provisions of section 167, a portion of the gain realized by petitioner upon the sale of the building (gain which, by the way, is in its entirety attributable to appreciation in value because of market conditions). This, we believe, is akin to trying to fit a square peg in a round hole.
The Second Circuit Court of Appeals in its very recent affirmance of a Memorandum Opinion of this Court in Fribourg Navigation Co. v. Commissioner,
A closer analysis of section 167 and the applicable regulations thereunder indicates to us that respondent, in disallowing the depreciation deduction claimed by petitioner, ignored the specific provisions of his own regulations, which we believe correctly interpret the statute.
Pertinent portions of the Income Tax Begulations provide (1) that the allowance for depreciation is the amount which should be set aside for the taxable year in accordance with a reasonably consistent plan, so that the aggregate of the amounts set aside, plus the salvage value of the property, will at the end of its estimated useful life to the taxpayer equal the cost or other basis of the property and (2) that an asset shall not be depreciated below a reasonable salvage value regardless of the manner employed in computing depreciation. Sec. 1.167 (a)-l(a), Income Tax Begs. The concept expressed in this regulation has received the approval of the Supreme Court in Massey Motors v. United States, supra at 107, and Hertz Corp. v. United States, supra at 126.
Bespondent’s disallowance of the depreciation deduction claimed by petitioner was based upon respondent’s insertion into the depreciation equation of a kiown figure, the actual sales price for the building, in place of an estimated figure, the salvage value of the building. Whether the depreciation deduction on the building claimed by petitioner in the year of sale is to be allowed depends in this case upon the meaning of the term “salvage value.”
First of all, respondent’s own regulations define salvage value as—
the amount (determined at the time of acquisition) which is estimated, will he realizable upon sale or other disposition of an asset when it is no longer useful in the taxpayer’s trade or business or in the production of his income and is to be retired from service by the taxpayer. Salvage value shall not he changed at any time after the determination made at the time of acquisition merely because of changes in price levels. However, if there is a redetermination of useful Ufe under the rules of paragraph (b) of this section, salvage value may fie redetermined based upon facts 1mown at the time of such redetermination of usefullife. * * * [Emphasis supplied. Sec. 1.167 (a)-l(c), Income Tax Regs.][12 ]
Respondent has made no such redetermination of the useful life of the building as estimated by the petitioner, at least with respect to the year of sale in which year he sought to redetermine the salvage value of the building. Nor does respondent contend that any such redetermination was required. In fact, having in his possession all of the facts relating to the sale of the land and building, respondent (1) determined that, with respect to petitioner’s fiscal year ended July 31, 1957, the year prior to that in which it sold the building, the useful life of the building to petitioner, for depreciation purposes, should have been 40 rather than 3314 years,
The essential concept underlying the depreciation allowance as set forth in section 167 is prediction or estimation. Massey Motors v. United States, supra at 105; and Detroit Edison Co. v. Commissioner,
Obviously a meaningful annual accrual requires an accurate estimation of bow much the depreciation will total. The failure to take into account a known estimate of salvage value prevents this, since it will result in an understatement of income during the years the asset is employed and an overstatement in the year of its disposition. * * *
Of course, there is a risk of error in such projections, but prediction is the very essence of depredation accounting. Besides, the possibility of error is significantly less where probabilities rather than accidents are relied upon to produce what is hoped to be an accurate estimation of the expense involved in utilizing the asset. * * *
We therefore conclude that the Congress intended that the taxpayer should, under the allowance for depreciation, recover only the cost of the asset less the estimated salvage, resale or second-hand value. This requires that the useful life of the asset be related to the period for which it may reasonably be expected to be employed in the taxpayer’s business. Likewise salvage value must include estimated resale or second-hand value.' * * * [Emphasis supplied.]
See also Cohn v. United States, supra at 377, where it is stated: “Useful life is necessarily an estimate made at the time when the property is first put to its business use.” Necessarily, salvage value is also an estimate made at the time when the asset is first subject to a depreciation allowance. Burnet v. Niagara Brewing Co.,
Respondent has not been able to show us, nor has this Court been able to find, any cogent authority permitting respondent to depart from the use of estimates and to equate salvage value with the actual sales price received in a situation where depreciable real property is unexpectedly sold substantially prior to the expiration of its estimated useful life (which in this instance is the full physical life of the property) and where, as here, there has been no determination that useful life or salvage value had been incorrectly determined. Although respondent did not specifically call to our attention section 1.167(b)-0(a) of the Income Tax Regulations, it is obvious from the decisions cited in his brief (Randolph D. Rouse, supra at 77, and Cohn v. United States, supra at 379) that he regards that regulation as providing suofa. authority.
The Supreme Court in Massey Motors v. United States, supra at 105, was careful to note that the real salvage price and the actual duration of use of depreciable property are relevant and may be used in con-ne,etion with the correction of a depreciation base- only where it appears that a miscalculation has been made. The respondent has made no determination that tbe original estimate as to tbe useful life or salvage value was inaccurate.
Possibly there is one situation where tbe actual sales proceeds received for depreciable property may be of some relevance in determining whether salvage value has been correctly estimated. That would be where such property is sold at or near the end of the period during which a taxpayer estimated the property would be used by him, viz, its useful life to the taxpayer. This is exactly what occurred in Cohn v. United States, supra;
In examing the eases, it must be borne in mind that even the Commissioner does not contend that a taxpayer who happens to dispose of some asset before its physical exhaustion must depreciate it on [the basis of] a useful life equal to the time it, was actually held. It is only when the asset “may reasonably he expected” to be disposed of prior to the end of its physical life that the taxpayer must base depreciation on the shorter period. * * *
Similarly, the concept of “salvage value” as employed in connection with the depreciation allowance is totally different from “the amount received upon the sale of an asset,” except where the asset is sold at or near the end of its useful life. Cf. Cohn v. United States, supra, and Edward V. Lane, supra. To the extent that the decision of this Court in Randolph D. Rouse, supra, is inconsistent with this principle, we decline to follow it.
The enactment in 1942 of the predecessor of section 1231 would appear to have been the primary factor prompting respondent to disallow as a matter of general practice depreciation deductions claimed in the year of sale with regard to property sold at a price in excess of (but not less than) a taxpayer’s undepreciated basis therein at the beginning of the year of sale. The predecessor of section 1231 changed existing law to the extent that gain realized upon the sale or exchange of a depreciable asset held in excess of 6 months was treated as capital gain, rather than ordinary income. Although, prior to the enactment of the predecessor of section 1231, respondent had specifically taken the position that a taxpayer must continue to depreciate an asset up to the time of its sale (see Herbert Simons,
We do not believe that the mere enactment of the predecessor of section 1231, which simply provided that gains on the sale or exchange of depreciable property held for more than 6 months would be considered as capital gains, also changed in any way the previously existing statutory scheme providing for (1) the depreciation of an asset up to the time of sale and (2) the taxation of any gain or loss realized upon the sale of such an asset, as a result of market conditions, pursuant to the applicable provisions relating to gain or loss.
Congress and the Treasury Department have, at least since 1947, been well apprised of the revenue losses resulting from the allowance of depreciation deductions at a more rapid rate than the actual exhaustion of the property involved. See Evans v. Commissioner,
Because of this legislation, the potentiality of abuse theretofore inherent in the depreciation provisions has been curbed as of January 1, 1963, in the case of personal property and as of January 1, 1964, in tbe case of real property. The position taken by respondent whereby he disallowed, in the year of sale, any depreciation deduction (in excess of the amount by which the adjusted basis of the asset at the beginning of the year exceeds the amount realized upon the sale) can best be characterized as an administrative shortcut relied upon by respondent to recapture, to some extent in the year of sale,
Under the circumstances now before us, not only does it appear that respondent’s action lacks authorization either in the statute or his own regulations, but it also seems that his action was misdirected. For there was no element of abuse or tax avoidance in the depreciation claimed by petitioner. Respondent had no question regarding the useful life of the building. Nor is there any indication that depreciation was taken on the building at a faster rate than the actual exhaustion of the building was occurring. Moreover, the parties have stipulated that during the period between 1949, when the renovation of the building was completed, and the date of its sale in 1958, the market value of rental property in downtown Portland, where the building was situated, “increased substantially.”
For these reasons, we believe petitioner should prevail.
Reviewed by the Court.
Decisions will he entered under Bule 50.
Notes
Respondent asserted an additional deficiency with regard to the Income tax of petitioner Macabe Co., Inc., for Its fiscal year ended July 31, 1957. This deficiency resulted from respondent’s determination that the useful life to petitioner of an office building owned by it should be increased from 33% to 40 years and that, accordingly, the depreciation deduction allowable for that- year should be decreased. In their stipulation of facts the parties have reached a compromise as to this item.
unless otherwise indicated, all section references are to the Internal Revenue Code of 1954.
The parties have not explained the seeming disparity in their stipulation between the date of the petitioner’s incorporation “on or about February 15, 1947,” and the statement also contained therein that “In 1946 Macabe Company, Inc. acquired [the property herein involved].” However, the actual date upon which the petitioner acquired the property, or the form of its organization at that time, whether a partnership or otherwise, is not relevant to the issue involved herein.
The term “useful life” as used herein means the period during ■which a taxpayer reasonably estimates he will use a depreciable asset. Although in some cases, like the one now before us, the useful life of the asset to a taxpayer may be the full physical or economic life of the property, useful life is not necessarily equivalent to the physical or economic life of the asset. See fn. 14, infra.
This amount, by stipulation, was later reduced slightly.
Petitioner and respondent did not attempt to allocate the sales price between the land and the building, but did stipulate that “The selling price of the building and other depreciable assets comprising the [building] exceeded the adjusted basis of those assets [as of the start of the year in which they were sold].” These “other depreciable assets” consisted of alterations and improvements made to the building and additional equipment installed therein from 1951 to 1955 at a cost of $48,819.19. On the basis of estimated useful lives ranging from 10 to 20 years, petitioner had, as of the end of the fiscal year in which the sale occurred, claimed depreciation thereon totaling $29,011.44. The respondent did not make any adjustment or otherwise attempt to disallow the depreciation claimed on these “other depreciable assets” in the year of sale. There is nothing in the record to indicate that the amount received for these assets upon their sale exceeded the petitioner’s adjusted basis therein. Thus, even if the portion of the sales price attributable to these “other depreciable assets” could be determined, there is no reason to believe that it would affect our finding that the amount received for the building upon its sale exceeded petitioner’s adjusted basis therein as of the beginning of the fiscal year in which it sold the building. Aside from the foregoing, these “other depreciable assets” are of no relevance in these proceedings.
This fact is of significance because, in his failure to do so, respondent violated his own regulations which specifically forbid the redetermination of salvage value merely to reflect changes in the current market value or even for other causes, except where there has been a concomitant redetermination of useful life (sec. 1.167(a)-!(c), Income Tax Regs.).
See. 167 (a) provides that there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear, and tear (including a reasonable allowance for obsolescence) of property used in a business or held for the production of income.
The Second Circuit, in United States v. Motorlease Corporation, 334 F. 2d .617 (C.A. 2, 1364), reversing
This is so because the aggregate depreciation claimed by petitioner on the building prior to the year in which it was sold, $755,099.89, was much less than its original cost in the building, $2,835,161.55. Thus, it follows that petitioner would be entitled to the depreciation deduction claimed unless the respondent may at this time, as he contends, substitute the amount received upon the sale of the building for the amount the petitioner, at the time he started to take depreciation on the building, estimated its salvage value would be a the end of its useful life.
It Is to be noted that the present regulations under sec. 167,1.R.C. 1954, finally adopted June 11, 1956, 21 Fed. Reg. 3985 et seq., differ materially from the proposed regulations published Sept. 28, 1954, 19 Fed. Reg. 6229, and those published Nov. 11, 1955, 20 Fed. Reg. 8454 et seq., In that the italicized language in the above-quoted portion of the regulations did not appear in the proposed regulations.
See fn. 2, supra.
The Supreme Court, in Massey Motors v. United States,
Sec. 1.167 (b)-0(a), Income Tax Regs., provides:
“Any reasonable and consistently applied method of computing depreciation may be used or continued in use under section 167. Regardless of the method used in computing depreciation, deductions for depreciation shall not exceed such amounts as may be necessary to recover the unrecovered cost or other basis less salvage during the remaining useful life of the property. The reasonableness of any claim for depreciation shall be determined upon the basis of conditions known to exist at the end of the period for which the return is made. * * * ”
We believe that a careful examination of sec. 1.167(b)-0(a), Income Tax Regs., indicates that it is merely a general provision which does not confer such authority, especially in light of the more specific portions of the regulations explicitly (1) forbidding redeter-mination of salvage value after the time of acquisition of the asset merely because of changes in price levels and (2) providing for determination of salvage value only if the Commissioner is permitted to redetermine, and does in fact redetermine, “useful life.” See sec. 1.167(a) — 1 (c), Income Tax Regs. When that portion of the regulations setting forth the conditions under which “useful life” may be redetermined is examined, it becomes clear that the Commissioner is authorized to redetermine merely the “estimated remaining useful life” of the asset and not to reject a reasonable estimate in favor of a known factor, i.e., the period during which the asset was actually held. Sec. 1.167 (aj^-lib), Income Tax Regs.-
This Court has, upon occasion, in denying a depreciation deduction for an asset in the year of its sale, indicated that “no consideration was given to the salvage value,” when the taxpayer therein originally estimated the proper depreciation schedule. See Randolph D. Rouse, 39 T.C. TO, 76 (19.62). See also Edward T. Lane,
The Court of Appeals in the Gohn case was extremely explicit in defining the scope of the question before it. It stated (p. 378) :
“In so far as this case is concerned the issue is whether salvage value can be adjusted at or near the end of the useful life of the asset when it is shown by an actual sale of the asset that there is a substantial difference between what was estimated and what it actually is. * * *”
In essence, sec. 1245 has modified sec. 1231 to the extent that, npon the sale or exchange of depreciable personal property, the lower of (1) the aggregate amount of depreciation deductions previously claimed or (2) the gain realized will be treated as ordinary income.
In essence, sec. 1250 has modified sec. 1231 to the extent that upon the sale or exchange of depreciable real property, there shall be taxed as ordinary income the lower of (1) the gain realized or (2) the amount by which accelerated depreciation taken exceeds the amount of straight-line depreciation that would have been allowable.
The correction sought to he effected by respondent was, to some extent, limited because respondent believed that, pursuant to certain decisions, he .was not permitted to disallow depreciation claimed in any year other than the year of sale, even though there may have been prior “open” years. See Cohn v. United States, supra.
Concurrence Opinion
concurring: I concur in the result reached herein. In my view this case is distinguishable on its facts from either United States v. Motorlease Corporation,
Dissenting Opinion
dissenting: I believe that this Court, in deciding the instant case, should have followed the two recent decisions of the Court of Appeals for the Second Circuit in Fribourg Navigation Co. v. Commissioner,
The two panels, after considering the controlling statutes, the pertinent Income Tax Regulations, and various conflicting judicial views (including those upon which the majority of this Court here relies) each approved the position of the Internal Revenue Service, which was first accepted in 1958 by the Sixth Circuit in Cohn v. United States,
For this Court, almost immediately following the affirmance of our decision in the Fribourg case (see also our decisions in Randolph D. Rouse,
The result In the Fribourg case where the property was sold at a large profit which greatly exceeded the adjusted basis at the beginning of the year was that no depreciation for the year of sale was allowed; and that In the Motorleme case, only a limited amount of depreciation for the year of sale was allowed.