UNITED STATES of America, Appellant, v. S & A COMPANY, Appellee.
No. 17555.
United States Court of Appeals Eighth Circuit.
Nov. 27, 1964.
338 F.2d 629
Before VAN OOSTERHOUT, BLACKMUN and MEHAFFY, Circuit Judges.
John S. Hibbs, Minneapolis, Minn., made argument and filed brief for appellee; John W. Windhorst and Dorsey, Owen Marquart, Windhorst & West, Minneapolis, Minn., were with him, on the brief.
BLACKMUN, Circuit Judge.
This tax controversy centers on the unanticipated and non-customary good-faith sale, during the taxpayer‘s fiscal year 1956, of all operating assets used in its business of manufacturing and marketing outboard motors. The sale price was greater than the assets’ adjusted basis at the beginning of the tax year and, indeed, was even greater than original cost. The question is whether, on these facts, the taxpayer is entitled to any deduction for depreciation on the sale assets in the sale year. Chief Judge Devitt found that the deduction claimed was a “reasonable allowance“, within the meaning of
218 F.Supp. 677 (D.Minn.1963). Judg
From a practical point of view, the issue is whether, on the one hand, depreciation in a favorable sale year may serve to offset ordinary income, with, as a result, greater capital gain on the sale, or, on the other hand, may not be so offset, with resulting greater ordinary income and less capital gain.2
Here, once again, see General Bancshares Corp. v. Commissioner, 326 F.2d 712, 713 (8 Cir. 1964), cert. denied, 85 S.Ct. 62, it may offhand seem surprising that this question arises only now, after the modern federal income tax and depreciation as a specified deduction have been with us continuously for over fifty years. Revenue Act of 1913, § II B and G(b). Nevertheless, the point is one strenuously in contest at the present time. The cases recently decided do not appear to be uniform. The Second Circuit, in opinions simultaneously filed by two separate panels on July 15, 1964, with a different judge vigorously dissenting in each case, has upheld the disallowance of the deduction. Fribourg Nav. Co. v. Commissioner, 335 F.2d 15 (2 Cir. 1964); United States v. Motorlease Corp., 334 F.2d 617 (2 Cir. 1964). To the same effect is Killebrew v. United States, 234 F.Supp. 481 (E.D.Tenn.1964). On the other hand, three district courts, in addition to Judge Devitt here, have approved deductibility and rendered decisions in favor of the taxpayer. Wyoming Builders, Inc. v. United States, 227 F.Supp. 534 (D.Wyo.1964), on appeal to the Tenth Circuit; Kimball Gas Products Co. v. United States, 63-2 USTC, par. 9507 (W.D.Tex.1962), on appeal to the Fifth Circuit; and Motorlease Corp. v. United States, 215 F.Supp. 356 (D.Conn.1963), which the Second Circuit reversed by its split decision, 334 F.2d 617.
In addition, the Tax Court, on September 29, 1964, in a decision reviewed by the entire court (with one judge concurring separately and five judges dissenting), although reciting agreement with the results on the facts of Fribourg and Motorlease, has disagreed “with the rationale” of those decisions and has upheld depreciation in the year of sale. Macabe Co., 42 T.C. No. 87. And in still another case, decided October 20, 1964, and reviewed by the entire court (with three judges concurring separately and one judge dissenting), the Tax Court disallowed acquisition-year depreciation where the sale was negotiated during the acquisition year and closed at the very beginning of the succeeding year. Smith Leasing Co., 43 T.C. No. 5.
We are confronted, therefore, with varying approaches to the problem.
The facts here. These are established by the pleadings and stipulations. The taxpayer, S & A Company, uses the fiscal year ended August 31 and the accrual method of accounting. On April 1, 1956, the taxpayer sold all its outboard motor operating assets to McCulloch Corporation for cash, notes, and the assumption of liabilities. McCulloch acquired the assets it so purchased “for the purpose of continuing to carry on the business of manufacturing and selling outboard motors in the same manner as said business was carried on by” S & A and “has continued and expects to continue to carry on said business at the same location with substantially the same employees“.
Taxpayer timely filed its return for its fiscal year 1956. It allocated the sale price among the several assets sold and elected to report its gain on the installment basis. In the return it claimed a
The government by its brief concedes, and the district court found: At all times from its acquisition of the depreciable assets and until their sale, the taxpayer intended to use those assets in its business for their entire economic life. The taxpayer also estimated their period of business usefulness to be the entire economic life. This expectation “at all times prior to the effectuation of the sale” was reasonable and consistent with prior experience. At no time before the sale did the taxpayer have any plan to sell or otherwise dispose of the depreciable assets before the end of their life. This life had not terminated at the time of the sale.
Questions which are not before us. It is well to note what is not in contest here: (1) No question is raised as to the taxpayer‘s allocation of the sale proceeds among the several assets sold; the propriety of this is accepted. (2) No question is raised as to the taxpayer‘s right to report its gain on the sale by the installment method; this is assured by
The issue, therefore, we emphasize again, is simply whether the fact that this favorable sale took place during the tax year necessitates, in the light of all the other facts here, the disallowance of otherwise allowable depreciation.
The statute and the regulations. The 1954 Code, of course, controls.
The pertinent portions of the regulations under the 1954 Code are set forth in the margin.4 It is readily apparent
We particularly note that the Second Circuit majority in Motorlease, supra, p. 618 of 334 F.2d stated that “neither the Code nor the regulations are dispositive of the issue“, and that the Fribourg and Motorlease dissenters took issue with that statement.
Legislative history. Until 1942 any gain on the sale of a depreciable business asset was taxed at ordinary rates. Consequently, the allowance or disallowance of depreciation in the sale year, with corresponding presence or absence of adjustment in basis, made no difference in ultimate tax. The 1942 Act extended capital gain treatment to gains realized upon the sale of certain depreciable non-inventory business assets.5 Thereafter, on a number of occasions, Congress was advised of situations deemed to present undeserving capital gain advantages and of the possible need to treat certain gains in this business asset area as ordinary income. See Hearings Before the House Committee on Ways and Means, 80th Cong., 1st Sess., on Revenue Revisions 1947-48, Part 5, p. 3756; remarks of Senator Milliken in connection with H.R. 8920, 81st Cong., 2d Sess., 96 Cong. Rec. 14057 (1950); H.Rep. No.3124, 81st Cong., 2d Sess. 29 (1950); H.Rep.No. 586, 82d Cong., 1st Sess. 26 (1951); Hearings Before the Senate Committee on Finance, 83d Cong., 2d Sess., on H.R. 8300, Part 3, p. 1324; H.Rep.No.1337, 83d Cong., 2d Sess. A275 (1954); remarks of Representative Curtis at 100 Cong.Rec. 3678 (1954); remarks of the President in his budget message to Con
As to all this, the government says that the suggestions to Congress were directed at sale gains attributable to depreciation allowable in prior years and not to sale year depreciation.
Supreme Court cases. United States v. Ludey, 274 U.S. 295, 300-301, 47 S.Ct. 608, 610, 71 L.Ed. 1054 (1927), contains Mr. Justice Brandeis’ characterization of depreciation6 as the “reduction” of the
Massey Motors, Inc. v. United States, 364 U.S. 92, 93, 107, 80 S.Ct. 1411, 1413, 1419, 4 L.Ed.2d 1592 (1960), refines the Ludey approach with the rule that the reasonable allowance for depreciation of business property “is to be calculated over the estimated useful life of the asset while actually employed by the taxpayer, applying a depreciation base of the cost of the property to the taxpayer less its resale value at the estimated time of disposal“, and 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“. Hertz Corp. v. United States, 364 U.S. 122, 80 S.Ct. 1420, 4 L.Ed.2d 1603 (1960), accompanies Massey and upholds the provision of the regulations that “in no event shall an asset * * * be depreciated below a reasonable salvage value“. One must mention, also, Detroit Edison Co. v. Commissioner, 319 U.S. 98, 101, 63 S.Ct. 902, 904, 87 L.Ed. 1286 (1943), with its concise statement of the purpose of the depreciation deduction,8 repeated with approval in Massey, p. 104 of 364 U.S., p. 1418 of 80 S.Ct., and Virginian Hotel Corp. v. Helvering, 319 U.S. 523, 525-526, 63 S.Ct. 1260, 87 L.Ed. 1561 (1943), with its emphasis on the continuity of wear and tear and on the year as the unit of taxation.
We emphasize at this point that the automobiles with which Massey was concerned were not retained by those taxpayers for their economic life and had not been acquired with the intent so to retain them for that period. Thus their “salvage value was not junk value but the resale value at the time of disposal”9 and “the experience of the taxpayers clearly indicates a utilization of the asset for a substantially shorter period than its full economic life“. Pp. 95-97 of 364 U.S., pp. 1413-1414 of 80 S.Ct. It was in the context of these factual observations that the Court made its references, pp. 97 and 101, pp. 1414, 1416 and 1417 of 80 S.Ct. to salvage value, at the end of full economic life, as being “ordinarily nominal“; to the conversion of amounts “from income taxable at ordinary rates to that taxable at the substantially lower capital gains rates“; to the effect that “Congress intended by the depreciation allowance not to make taxpayers a profit thereby, but merely to protect them from a loss“; and that “Accuracy in accounting requires that correct tabulations, not artificial ones, be used“.
Other pertinent cases. Cohn v. United States, 259 F.2d 371 (6 Cir. 1958), concerned depreciable assets owned by three flying schools, the programs of which had December 31, 1944, as the “target date” of reasonable maximum duration. Depreciation was computed accordingly but with no provision for salvage value. The assets of each school were sold at or about the end of useful life at prices in excess of adjusted cost at the beginning of the tax year. Depreciation for the year of sale was claimed but disallowed. The district court upheld the disallowance for the sale year and, as to one school,
“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. We are not concerned with mere fluctuations or with any fluctuations from year to year. On the contrary, we have a single and final adjustment in the closing of the books on the asset involved.”
Wier Long Leaf Lumber Co., 9 T.C. 990 (1947), reversed in part on another issue, 173 F.2d 549 (5 Cir. 1949), concerned depreciation on a sawmill and on three business automobiles. Here the useful life of the mill was dependent upon available standing timber. The mill was favorably sold, due to war conditions, at the time the timber was substantially exhausted. The automobiles were sold in the same year but before the end of their estimated useful life. The Tax Court, in a decision reviewed by the court, with five dissents, disallowed depreciation on the mill in the year of sale, but, with two dissents, allowed it on the automobiles. The court‘s theory of decision as to the mill is revealed when it refers to “the currently ascertained correct salvage value” and an “adjustment to correct for mistaken salvage value“, p. 998 of 9 T.C. On the automobile issue the court observed, p. 999, that “mere appreciation in value due to extraneous causes has no influence on the depreciation allowance, one way or the other. * * * The sole fact * * * that a given price is received for articles not fully depreciated throws no light on the effect upon the depreciation allowance“. The court thus drew a distinction between what it regarded, on the facts of that case, as a justifiable adjustment in salvage value on a sale at or near the end of economic life and the impropriety of such an adjustment merely because of the fact of sale in midlife. It may be of some interest and significance, so far as the Commissioner‘s attitude is concerned, that he acquiesced in Wier, 1948-1 C.B. 3, for fourteen years and then, after the present suit was instituted, withdrew that acquiescence, 1962-1 C.B. 5.
This same distinction, as to the timing of the sale, appears to have been made in Kimball Gas Products Co. v. United States, supra, 63-2 USTC, par. 9507 (W.D.Tex.1962), at p. 89127, now on appeal to the Fifth Circuit. Mr. Justice Harlan in his separate dissenting-concurring opinion in Massey observed, p. 113 of 364 U.S., p. 1427 of 80 S.Ct., 5 L.Ed.2d 78, that there “even the Commissioner does not contend that a taxpayer who happens to dispose of some asset before its physical exhaustion must depreciate it on a useful life equal to the time it was actually held“. Although this statement appears in dissent, it is factual in nature and we see no reason why it is not to be accepted as true.
Wyoming Builders, Inc. v. United States, supra, 227 F.Supp. 534 (D.Wyo.1964), now on appeal to the Tenth Circuit, and Motorlease Corp. v. United States, supra, 215 F.Supp. 356 (D.Conn.1963), reversed, as above noted, by the Second Circuit, 334 F.2d 617, are other cases where, with opposition by the government, trial courts have allowed depreciation in the year where the asset was sold at a price greater than adjusted basis at the beginning of the year.
Then came the Second Circuit‘s decisions in Fribourg and Motorlease, supra. Fribourg concerned a ship sold, after two years of its three year “concededly reasonable” estimated life, at a price made extraordinarily favorable because, as the Court described it, the estimate of economic life and salvage value, originally specifically approved by the Commissioner, “was thrown out of kilter by a scarcity of ships resulting from the Suez Crisis of 1956-57, which sharply inflated the values of ships normally considered obsolete“.
Randolph D. Rouse, 39 T.C. 70, 76-77 (1962), did not draw the distinction which, as we have noted, was made in Cohn and Wier. The taxpayer there, because of changes in real estate conditions, sold certain houses he had held for rental. His sales prices were in excess of adjusted basis as of the year‘s beginning. The Tax Court judge, in an opinion not reviewed by the entire court, concluded, citing Cohn, “Accordingly, no depreciation deduction is allowable on account of a home thus sold for the taxable year during which it was sold“. In rather dramatic contrast, however, he also concluded that the Commissioner erred in disallowing claimed depreciation on similar houses not sold. Two later single judge cases followed Rouse, Fribourg Nav. Co., 21 T.C.M. 1533 (1962), affirmed by the Second Circuit, supra, 335 F.2d 15, and Contra Costa Trucking Co., 22 T.C.M. 1018 (1963). See also, Edward V. Lane, 37 T.C. 188 (1961), which, however, concerned a taxpayer who employed the completed contract method and thus was not required to make the original estimates for annual depreciation deductions.
Rouse was followed by the September 29, 1964, decision of the Tax Court in Macabe Company, Inc., supra. This case concerned a downtown Portland, Oregon, office building reconstructed after acquisition by the taxpayer. It was “unexpectedly disposed of” in midlife, partly because of the cash requirements of the estate of a deceased shareholder of the taxpayer. It was stipulated that after reconstruction of the building the value of downtown rental properties in Portland “increased substantially“. The Tax Court majority concluded that the Commissioner‘s position failed to take into account the distinction between true depreciation, that is, the gradual exhaustion of property, on the one hand, and, on the other, a rise or fall in value because of market conditions, and, further, that the Commissioner failed to comply with the underlying intent of the statute and the provisions of his own regulations. It noted the Second Circuit‘s opinions in Fribourg and Motorlease; chose not to disagree with the results in those two cases on the theory that at least a portion of the gains there seemed to have resulted from “inaccurate estimates” and that there was lack of proof as to the gain‘s being due to market appreciation; concluded, apparently, that the opposite was true in Macabe; and stated that, to the extent that Rouse, supra, was inconsistent, “we decline to follow it“. Judge Withey concurred on the ground that Congress, in allowing a deduction for depreciation, did so with the intent that it was to be offset against ordinary income and not against a capital gain resulting from a sale or exchange of the asset. Smith Leasing Co., which we have noted above, came down three weeks later.
In addition, we note, for what it may be worth, that there is an imposing number of other older cases which reveal situations where depreciation has been computed and allowed during the year of a favorable sale. Among these are the Supreme Court cases of United States v. Ludey, supra, 274 U.S. 295, 47 S.Ct. 608, 71 L.Ed. 1054, reversing 61 Ct.Cl. 126, and Eldorado Coal & Mining Co. v. Mager, 255 U.S. 522, 526, 41 S.Ct. 390, 65 L.Ed. 757 (1921); our own case of Forrester Box Co. v. Commissioner, 123 F.2d 225 (8 Cir. 1941); apparently the Second and Third Circuit cases of Kittredge v. Commissioner, 88 F.2d 632 (2 Cir. 1937); Beckridge Corp. v. Commissioner, 129 F.2d 318 (2 Cir. 1942); and Rieck v. Heiner, 25 F.2d 453, 454 (3 Cir. 1928), cert. denied, 277 U.S. 608, 48 S.Ct. 603, 72 L.Ed. 1013; the Court of Claims
Rulings. There is also a series of administrative pronouncements in which depreciation to the date of sale seems consistently to have been recognized. I.T. 1158, I-1 C.B. 173 (1922); I.T. 1494, I-2 C.B. 210 (1922); A.R.R. 6930, III-1 C.B. 45 (1924); G.C.M. 1597, VI-1 C.B. 71 (1927); the publication of Rieck v. Heiner, supra, at VII-1 C.B. 200 (1928); the Commissioner‘s acquiescence, supra, 1948-1 C.B. 3, in Wier Long Leaf Lumber Co., on the automobile issue as well as on the mill issue; and the examples in Reg. § 1.1238-1 which remain in substantially the same form since the issuance of T.D. 5851, 1951-2 C.B. 63.
We recognize, of course, that the Commissioner may change his interpretation of a statute to correct a mistake of law. Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 183-184, 77 S.Ct. 707, 1 L.Ed.2d 746 (1957); Stevens Bros. Foundation, Inc. v. Commissioner, 324 F.2d 633, 641 (8 Cir. 1963), cert. denied 376 U.S. 969, 84 S.Ct. 1135, 12 L.Ed.2d 84. And the Commissioner would detract from the significance, if any, of these cases and rulings by urging (a) that most of them appeared in the 1920‘s; (b) that none occurred later than 1942 when capital gain rates were made applicable to favorable dispositions of certain business assets; (c) that in every reported case since 1942 the Commissioner has opposed the deduction; (d) that in some of these the taking of depreciation to the date of sale was no more than a “mere recitation“; and (e) that the regulations’ examples, while “unfortunate” and an “inadvertency“, are not in the section on depreciation and are not intended as an illustration of proper depreciation allowances.
Summary. We thus have a situation where (a) the statutes and the regulations do not, in so many specific words, resolve the situation before us; (b) the successive revenue statutes have shown a disposition on the part of Congress not to tamper comprehensively with final year depreciation; (c) the Supreme Court‘s guidelines do not afford a definitive answer to our present question; (d) the Commissioner and the courts for some time, at least, accepted depreciation in the favorable-sale year; (e) the Tax Court in Wier in 1947 and the Sixth Circuit in Cohn in 1958 upheld a redetermination of salvage value when a favorable sale took place at or near the end of the originally intended and estimated useful life; (f) nevertheless, the Tax Court in Wier also approved final year depreciation on automobiles sold in midlife; (g) three district courts have approved and one has disapproved year-of-sale depreciation; (h) the Second Circuit, dividedly, has upheld disallowance of such depreciation; and (i) the Tax Court, by an 11 to 5 vote, has disagreed with the Second Circuit‘s reasoning, has overturned one of its recent single judge opinions, and has reaffirmed the Cohn-Wier distinction.
All this, we suspect, leaves us free to do our own groping in the dark.
There is, as the Tax Court said in Macabe, supra, “a beguiling appeal” in the government‘s contention. Judge Devitt seems to agree when he said, p. 679 of 218 F.Supp., “At first blush, it would appear that the taxpayer is attempting to ride with the hares and hold with the hounds, and thus to unjustly enrich itself * * *.” And Mr. Justice Harlan, at p. 107 of 364 U.S., 80 S.Ct. 1424, prefaced his opinion of dissent and concurrence in Massey with a reference to “what may be thought to be an appealing practical position on the part of the Government“.
It would seem, offhand, that the issue presented by the simple and undisputed facts of this case should be of no greater consequence than a straightforward routine income tax accounting matter obviously to be resolved by consistent treatment in each of the calendar years in which the assets are held, including the first and the last, and that this would justify the deduction of depreciation in the year of midlife sale. Yet this apparent simplicity of solution has not been forthcoming. Instead, we are confronted with the complicated and detailed mixture of statutes, legislative history, regulations, cases, and rulings which we have attempted to outline. This background and the length and vigor of the opposing arguments disclose that the question is taken to be close and difficult. We venture to say that much of the trouble, if the question is a difficult one, is attributable not to the governing statute, which is most general in its terms, but to the consistent failure of the regulations to be definite and specific upon this ever-recurring final year question.
After earnest consideration of all the arguments which have been advanced upon us by the contending parties, we reach the conclusion that, on the facts here presented — unanticipated and non-customary sale in midlife of a depreciable asset; acceptance of the correctness and reasonableness of the taxpayer‘s acquisition estimates of useful life and salvage value; actual approval of depreciation based on these estimates in prior years, some of which still remained open; and the inescapable inference that the claimed depreciation would have been allowed for the sale year had the sale not taken place — the taxpayer has sustained its burden of proof and is entitled to the deduction. We reach this conclusion because we feel that the following in the aggregate are persuasive:
1. The facts here possess impressive strength. The taxpayer‘s sale of its outboard motor assets was a sale of a going business. It acquired those assets and continued to hold them with, at all times, the intent to keep and utilize them in its business until the end of their economic life. It did not intend to dispose of them in the midst of that life and it had established no practice of early disposal, as was the situation in both Massey and Hertz. No challenge is made as to the correctness of the acquisition estimates of useful life and salvage value at the end of that life. The Commissioner accepted these estimates for all prior tax years and would have accepted them for fiscal 1956 had the sale not taken place in that year.
2. Cost or other basis, that is, the taxpayer‘s investment, not sale price, is depreciation‘s anchor. Both the statute, § 167(f) [§ 167(g), since the Revenue Act of 1962] and Reg. §§ 1.167 (a)-1(a), 1.167(f)-1, and 1.167(b)-(O) (a) emphasize cost or other basis. Replacement of that investment by appropriate current charges against business income is the purpose of the depreciation deduction. Detroit Edison, supra, p. 101 of 319 U.S., 63 S.Ct. 902; Ludey, supra, p. 301 of 274 U.S., 47 S.Ct. 608; Massey, supra, p. 104 of 364 U.S., 80 S.Ct. 1411.
3. The emphasis is on the taxable year as a unit and depreciation is to be taken in each year of the depreciating asset‘s useful life. Reg. § 1.167(a)-10(a). “Congress has elected to make the year the unit of taxation. * * * Thus the amount ‘allowable’ must be taken each year. * * * Congress has provided
4. This emphasis on the tax year as a unit extends to the year in which the depreciable asset is retired. A proportionate part of a year‘s depreciation is then allowable for that last year. Reg. § 1.167(a)-10(b). The asset continues to depreciate in the hands of the taxpayer right up to the date of sale. At that date it is older, more worn, and possessed of shorter economic life.
5. Straight line depreciation depends upon three factors, cost or other basis, useful life, and salvage value. Cost or basis is known. Useful life and salvage value are estimates and are seemingly independent of each other. Massey, so heavily relied upon by the government here, ends with the comment, p. 107 of 364 U.S., p. 1419 of 80 S.Ct.:
“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]
This emphasizes cost, estimated useful life and estimated salvage. The Tax Court in Macabe recognized this when it said, p. 1111 of 42 T.C., “The essential concept underlying the depreciation allowance as set forth in section 167 is prediction or estimation.” See, also, Burnet v. Niagara Falls Brewing Co., 282 U.S. 648, 655, 51 S.Ct. 262, 75 L.Ed. 594 (1931).
6. With no dispute here as to either cost or useful life, the case hinges on salvage value. But this is to be determined, not at the time of the asset‘s retirement, but at the time of acquisition. Reg. § 1.167 (a)-1. Salvage value under certain circumstances may be redetermined as, for example, when useful life is properly redetermined. But it is not to be redetermined “merely because of changes in price levels“. Reg. § 1.167 (a)-1(c). The possibility of gain on retirement of a depreciable asset is contemplated.
7. There is no absolute identity of salvage value with sales price. The one is not necessarily equivalent to the other. Neither the statute nor the regulations equate them or make an exception out of the sale year. The emphasis, as has been noted, is, instead, on the estimate of salvage value, on such estimate at acquisition, on redetermination as the exception, on the distinct possibility of gain or loss on disposition, and on divorcement of salvage value from price level fluctuations.
8. Massey and Hertz are not authority to the contrary. They hold merely that useful life in the hands of a taxpayer who
“[E]ven the Commissioner does not contend that a taxpayer who happens to dispose of some asset before its physical exhaustion must depreciate it on a useful life equal to the time it was actually held. It is only when the asset ‘may reasonably be expected’ to be disposed of prior to the end of its physical life that the taxpayer must base depreciation on the shorter period.”
9. Depreciation and capital gain or loss are separate concepts in the income tax law although, of course, the one necessarily affects the other. The former in theory rests on a base independent of market fluctuations. The latter is aimed at those fluctuations. This dichotomy is inherent in the statute. It is defeated and ignored if depreciation is inevitably to be tied to sale price. The two concepts are easily confused for we tend to use the word “depreciation” not only in the sense of consumption but, as well, in the sense of a downward market fluctuation.
10. On the facts before us those provisions of Reg. § 1.167 (b)-(O) (a) which deny depreciation beyond cost less salvage value and which determine the reasonableness of a claim for depreciation upon “conditions known to exist at the end of the period” do not defeat this taxpayer‘s claim for depreciation. Of course, a favorable sale price might, in some instances, be a factor indicative of acquisition-estimate error. But this is not necessarily so and, it seems to us, is distinctly not so where, as in this case, there has been and still is no challenge as to cost and as to the useful life and salvage value acquisition estimates. The propriety of all three factors is accepted. The lack of challenge to the taxpayer‘s claimed and parallel depreciation deductions in prior tax years which were still open for audit adjustment is a concession to their propriety.
The government pins its case, instead, on the happy fact that the sale price exceeded beginning-of-year basis and it says that depreciation for the final year must therefore be “unreasonable“. The favorable sale, however, does not serve to deny the correctness of the taxpayer‘s cost or the propriety of its useful life estimate or the propriety of its salvage value estimate. It does show that the market at the time of sale turned out to be different than that estimated. The difference may be due entirely to a fluctuating market or to other causes such as general inflation, a buyer‘s market, or the availability of the asset for more productive alternate uses.
The government gives some emphasis to the fact that the sale price exceeded not only adjusted basis at the beginning of the year, but, as well, the original acquisition cost. Presumably it does so in the thought that this demonstrates extreme unreasonableness of the claimed final year depreciation. But, with no challenge to the acquisition estimates, the fact‘s significance may well be the other way. That sale price exceeds acquisition cost may tend to show that there was no element at all of unreality in the original estimates, which were necessarily based on cost, and that the excess is obviously due, instead, to market change.
11. This is not a situation where the assets are sold at or near the very end of useful life in the taxpayer‘s hands. When such time identity is present and is accompanied by excess of sale price over estimated salvage value, there may be justification in a given case for the disallowance of final year depreciation. This disallowance would then have to be based on a proper redetermination as of that time of the originally estimated salvage value. This is something more than the
12. We have here, instead, an unanticipated sale in midlife. This record contains nothing which discloses any change in the economic life of the assets. The sale itself did not change this.
13. There is a logical inconsistency in the government‘s attack on year-of-sale depreciation and its allowance of the depreciation in preceding years still open for adjustment when the sale facts became known to the government. In justifying this, the government is forced into the position of paying its respects to our formalized and structured annual income tax reporting system. This illogic was recognized by the Second Circuit in Fribourg and by the dissenters in both Fribourg and Motorlease and is illustrated by the apparently overruled Rouse, where the Tax Court disallowed depreciation on houses sold but allowed it in the same year on similar houses unsold. As has been said in 3 Rabkin and Johnson, Federal Income, Gift and Estate Taxation, § 43.14, p. 4397m, “The Service has unjustifiably extended the rationale of the Massey and Cohn cases into a blanket rule that depreciation is to be disallowed for the year of sale whenever the selling price exceeds the depreciated basis at the beginning of the year“.
The same illogic would be illustrated, too, if a sale, largely negotiated during one tax year, is closed within the first week of the succeeding tax year. The taxpayer, when his return for the prior year is later prepared and filed, certainly knows the sale facts. Yet the Commissioner, seemingly, would allow depreciation for the year of negotiation but disallow it for the sale year. Compare Smith Leasing Co., supra, 43 T.C. No. 5 (1964). If “reasonableness” of depreciation is to be determined in the light of the sale price, the claimed deduction would seem just as unreasonable for the taxpayer in the negotiation year as in the sale year. To say, under these assumed facts, that the conditions were not known to exist at the end of the negotiation year lends support to the claim that the Commissioner‘s disallowance for the sale year is distinctly and solely related to the fact of the fortuitous sale.
14. The government‘s present position exceeds that taken by it in one case (Evans) covered by the Massey opinion, for there the Commissioner did not precisely identify sales price with salvage value. There the Commissioner was not trying to eliminate all interplay between
15. The government‘s position seems to emphasize hindsight and to abandon the concept that depreciation rests on prospective estimates which, to be sure, must be reasonable. It would, to use Judge Blumenfeld‘s words in Motorlease, p. 363 of 215 F.Supp., “set up an automatic hindsight re-evaluation which becomes a self-executing redetermination of salvage value triggered by the sale of depreciable assets“.
16. There is no suggestion of tax evasion or, even, of tax avoidance here and no element of double deduction. Depreciation in the year of sale, while beneficial to this taxpayer in reducing ordinary income, is detrimental to it in increasing gain.11 Nothing escapes taxation. That there is a difference in the tax rate upon ordinary income and the tax
17. There is at least some significance in the recognition, over a long period of time, in many cases, including one of our own, in rulings, and in the regulations’ examples still outstanding today, of depreciation as a deduction in the year of favorable sale. It is true that the regulations’ examples are not in the sections dealing with depreciation, and that until 1942 it made no difference in tax whether the amount of claimed depreciation did or did not serve to reduce ordinary income with consequent increase or no change in sale gain. Nevertheless, we suspect that this long-continued practice and recognition, administrative and decisional, is indicative of the Commissioner‘s attitude and demonstrates that he felt this was correct and proper income tax accounting and in line with accepted business principles. It was only when the difference in tax impact entered the law that his change in attitude came about. This would seem to be attributable, not to a reevaluation of what is proper tax accounting, but to the fact that the new point of view, if it could be upheld, would result in greater tax.
18. There is some significance, also, in Congress’ persistent failure directly to attack final year depreciation by way of statutory amendment. It was content, instead, to recharacterize gain with which it was dealing as ordinary income. And the 1962 and 1964 additions of
19. We have deep respect for the conclusions reached by the Second Circuit majorities in Fribourg and Motorlease. But we cannot escape the feeling that the results in those cases underestimate both the law‘s dichotomy of approach to depreciation and to capital gain and, as well, the fact distinction, so apparent in Wier and so inherent in Cohn, between an intended sale of depreciable assets at or near the end of useful life and an unanticipated sale in midlife. To us, and obviously to the substantial Tax Court majority in Macabe, these appear to be important and significant.
We mention, by way of caveat, that we do not, by our conclusion here, hold that salvage value may never be redetermined in the year of sale or, conversely, that in every case depreciation must be allowed in the sale year; that we do not decide the question whether redetermination of salvage value may be effected only when there is a redetermination of useful life, as the taxpayer insists is the case under Reg. § 1.167 (a)-1(c), and as the district court held; and that we do not say that the facts in Fribourg and Motorlease, on the one hand, and those in Macabe, on the other, are so distinguishable that the results in all three cases are entirely consistent.
We conclude that this good-faith taxpayer‘s claimed deduction for depreciation on the sale assets in its fiscal 1956 return was a proper deduction under
VAN OOSTERHOUT, Circuit Judge (dissenting).
Judge Blackmun has fairly stated the facts and has admirably assembled all the background material pertinent to the decision of this case. He has adequately set out the respective contentions of the litigants and the statutes, regulations and decisions bearing upon the issue confronting us.
I agree that the taxpayer‘s estimates of cost, useful life and salvage value were reasonable when made. I do not question the finding that the depreciation claim here asserted is based upon well-established and recognized accounting practices. The depreciation claimed and allowed prior to the sale year is entirely proper and is not here attacked.
I disagree with the court‘s conclusion that the depreciation claimed for the sale year is reasonable under all the circumstances here existing. “Reasonable” is a flexible word. The reasonableness of the depreciation allowance here claimed is to be determined upon the basis of conditions known to exist at the end of the taxable year for which the return is made. It is not reasonable to say that depreciation is allowable in the sale year when it conclusively appears during such year that the taxpayer has already recovered more than its adjusted basis at the beginning of the year. I do not believe that Congress in providing for reasonable depreciation contemplated that any further depreciation should be allowable in the situation here presented. The overall pattern of the income tax laws is entitled to consideration. The tax consequences of allowing the additional depreciation claimed cannot be ignored in applying a test of reasonableness.
I am in accord with the interpretation made of the depreciation statute and regulations by the separate panels of the Second Circuit in Fribourg Nav. Co. v. Commissioner, 2 Cir., 335 F.2d 15, and United States v. Motorlease Corp., 2 Cir., 334 F.2d 617.
I would reverse upon the basis of the majority opinions in such cases.