Zaninovich v. C. I. R.

• Decision Date: 03 April 1980
• Docket Number: No. 78-1818,78-1818
• Parties: 80-1 USTC P 9342 Martin J. and Margaret M. ZANINOVICH and Vincent M. and Dorothy F. Zaninovich, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 429

616 F.2d 429

80-1 USTC P 9342

Martin J. and Margaret M. ZANINOVICH and Vincent M. and Dorothy F. Zaninovich, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 78-1818.

United States Court of Appeals Ninth Circuit.

April 3, 1980.

John J. McGregor, Thomas, Snell, Jamison, Russell, Williamson & Asperger, Fresno, Cal., on brief; William N. Snell, Fresno, Cal., for appellants.

Gilbert E. Andrews, Chief App. Dept. of Justice, Washington, D. C., on brief; George L. Hasting, Jr., Tax Div. U. S. Dept. of Justice, Washington, D. C., for appellee.

Appeal from the United States Tax Court.

Before WALLACE, KENNEDY and FERGUSON, Circuit Judges.

FERGUSON, Circuit Judge:

This case presents the issue of whether a rental payment by a cash basis taxpayer for a lease year that extended eleven months beyond the year of payment is fully deductible in the year of payment as an ordinary and necessary business expense ¹ or must be deducted on a prorated basis as a capital expenditure. We hold that the payment in this case was fully deductible in the year of payment.

Petitioners Martin J. and Margaret M. Zaninovich, husband and wife, and Vincent M. and Dorothy F. Zaninovich, also husband and wife, filed their federal income tax returns on a cash basis for the taxable year 1973. Martin and Vincent Zaninovich are partners in a farming business in the San Joaquin Valley in California. The partnership used the cash basis method of accounting.

On October 3, 1973, the partnership entered into a lease of farm land for the period December 1, 1973 to November 30, 1993. Yearly rent of $27,000 for the period running from December 1 to November 30 was payable on December 20 of each lease year. ² On December 20, 1973, the partnership paid $27,000 rent for the lease year running from December 1, 1973 to November 30, 1974. The partnership deducted this entire amount on its return for the taxable year 1973.

The Commissioner disallowed $24,934 of the $27,000 payment, reflecting that portion of the rental allocable to the period January 1 through November 30, 1974, and adjusted each partner's share of income accordingly. The Tax Court sustained the Commissioner's determination in Zaninovich v. Commissioner, 69 T.C. 605 (1978). We reverse the holding of the Tax Court.

The Tax Court held, largely on the basis of University Properties, Inc. v. Commissioner, 45 T.C. 416 (1966), aff'd, 378 F.2d 83 (9th Cir. 1967), that the partnership had to prorate the 1973 rental payment and therefore could deduct in 1973 only the portion of the rental attributable to that year, i. e., one-twelfth. ³ The court found the following language from University Properties controlling:

Rentals may be deducted as such only for the year or years to which they are applied. If they are paid for the continued use of the property beyond the years in which paid they are not deductible in full in the year paid but must be deducted ratably over the years during which the property is so used.

Id. at 421.

The taxpayers here argued that the rule in University Properties was inapplicable to their case because the December, 1973 rental payment was allocable to a period of only twelve months. In response to this contention, the Tax Court admitted that many of the cases upon which it relied "involve(d) payments which were properly allocable over a period far in excess of 12 months." Zaninovich v. Commissioner, supra, 69 T.C. at 607. The court nonetheless found the taxpayers' attempt to distinguish those cases unpersuasive.

We are persuaded that the cases requiring rental payments to be capitalized are distinguishable from the case before us, and that different treatment is warranted here. ⁴ The significance of the length of the period to which payments are allocable is apparent in Treas.Reg. 1.461-1(a)(1) and § 263 of the Internal Revenue Code. Treas.Reg. 1.461-1(a)(1) provides, as a general rule, that a cash basis taxpayer shall deduct expenses in the year of payment. It further provides, however, that where an expenditure results in the creation of an asset having a useful life extending "substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made." The "substantially beyond" limitation implements § 263 which disallows a deduction for capital expenditures. Expenditures falling into that category are generally defined in Treas.Reg. 1.263(a)-2(a) as assets having a "useful life substantially beyond the taxable year."

Because the classification of the 1973 rental payment as either a deductible expense in the taxable year 1973 or a capital expenditure depends on whether or not eleven months is "substantially beyond" the taxable year, it is significant that many of the cases requiring capitalization of rent related payments involve payments allocable to periods far in excess of eleven months beyond the year of payment. See, e. g., Main & McKinney Bldg. Co. v. Commissioner, 113 F.2d 81 (5th Cir.), cert. denied, 311 U.S. 688, 61 S.Ct. 66, 85 L.Ed. 444 (1940) (payments over 25 year period allocable to 99 year lease term); University Properties, Inc. v. Commissioner, supra (payments over three year period allocable to 35 year lease term); Cartan v. Commissioner, 30 T.C. 308 (1958) (payment in one year allocable to 20 year term). It is also significant that several of the cases treating payments as capital expenditures have involved not rental payments but rental premiums or payments made as consideration for the lease. See, e. g., Main & McKinney Bldg. Co. v. Commissioner, supra (payments in addition to rent of $10,000 a year for the first 25 years of a 99 year lease); Baton Coal v. Commissioner, 51 F.2d 469 (3d Cir.), cert. denied, 284 U.S. 674, 52 S.Ct. 129, 76 L.Ed. 570 (1931) (payments totalling $101,250 in the first seven months of a mineral lease of indefinite duration); University Properties, Inc., supra (payments of $240,000 in addition to rent in the first three years of a 35 year lease).

The cases involving substantially shorter terms in which taxpayers have been required to amortize have, unlike the case before us, involved advance payments, see, e. g., Williamson v. Commissioner, 37 T.C. 941 (1962) (payment on December 27, 1956 for a lease running for one year from March 1, 1957 where payment was not due until beginning of lease); cf. D.K. McColl v. Commissioner, P 41,050 P-H Memo B.T.A. (Vol. 10, 1941) (deduction disallowed where rent paid on December 31 for following year because transaction was a sham but dicta indicated advance payment was deductible in year to which it applied), or accrual basis taxpayers, see, e. g., Bloedel's Jewelry, Inc. v. Commissioner, 2 B.T.A. 611 (1925) (payment in May, 1920 of rental due for a lease term running from September 1, 1920 to August 31, 1921). ⁵

We recognize that there are cases supporting the result urged here by the Commissioner. See, e. g., Wood v. Commissioner, P 75,189 P-H Memo T.C. (Vol. 44, 1975) (payment on October 1, 1969 for lease term running from October 1, 1969 to December 31, 1970 had to be prorated between 1969 and 1970). Neither Wood, nor the Tax Court here, nor any of the prepaid rent cases cited by the Tax Court, however, discusses the qualification to the general rule for cash basis taxpayers for an expenditure that creates an asset having a useful life which extends "substantially beyond" the close of the taxable year. We feel that these provisions are controlling here, and adopt the "one-year rule" applied by several circuits in distinguishing between currently deductible expenses and capital expenditures having a useful life extending "substantially beyond" the taxable year. See, e. g., Fall River Gas Appliance Co. v. Commissioner, 349 F.2d 515 (1st Cir. 1965); Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2d Cir. 1973); Jack's Cookie Co. v. United States, 597 F.2d 395 (4th Cir.) cert. denied, --- U.S. ----, 100 S.Ct. 207, 62 L.Ed.2d 134 (1979); Bilar Tool & Die Corp. v. Commissioner, 530 F.2d 708 (6th Cir. 1976); United States v. Akin, 248 F.2d 742 (10th Cir. 1957), cert. denied, 355 U.S. 956, 78 S.Ct. 542, 2 L.Ed.2d 532 (1958).

Under the "one-year rule" an expenditure is treated as a capital expenditure if it creates an asset, or secures a like advantage to the taxpayer, having a useful life in excess of one year. ⁶ The rationale behind the rule is as follows:

The one-year rule is useful because it serves to segregate from all business costs those which cannot possibly be considered capital in nature because of their transitory utility to the taxpayer.

Jack's Cookie Co. v. United States, supra, 597 F.2d at 405.

None of the cases applying the "one-year rule" has involved land rentals. See, e. g., Jack's Cookie Co. v. United States, supra (portion of rental payments); Bilar Tool & Die Corp. v. Commissioner, supra (attorney's fees); Colorado Springs Nat'l Bank v. United States, 505 F.2d 1185 (10th Cir. 1974) (costs incurred in participation in credit card system); Briarcliff Candy Corp. v. Commissioner, supra (cost of acquiring business entity); American Dispenser Co. v. Commissioner, 396 F.2d 137 (2d Cir. 1968) (payment to competitor in exchange for covenant not to manufacture); Fall River Gas Appliance Co. v. Commissioner, supra (installation costs for leased gas appliances); United States v. Akin, supra (sums paid by farmers to ditch companies). Cf. Waldheim Realty & Inv. Co. v. Commissioner, 245 F.2d 823 (8th Cir. 1957) (insurance for one year period is deductible expense even though protection extends into subsequent year); Bell v. Commissioner, 13 T.C. 344 (1949) (payment for insurance for period from November, 1946 to August, 1947 is deductible in 1946); Jephson v. Commissioner, 37 B.T.A. 117 (1938) (payments in October and November, 1934 for two separate policies, each running one year from time of payment, are deductible in year of payment); Kauai Terminal,...