ABC Rentals of San Antonio, Inc. v. C.I.R.

• Decision Date: 27 September 1996
• Docket Number: Nos. 95-9008,s. 95-9008
• Citation: 97 F.3d 392
• Parties: -6634, 96-2 USTC P 50,508 ABC RENTALS OF SAN ANTONIO, INC.; David R. Peters; Diana L. Peters; John P. Parsons; Melba R. Parsons, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Grauel Enterprises, Inc., Amicus Curiae. to 95-9010.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 392

97 F.3d 392

78 A.F.T.R.2d 96-6634, 96-2 USTC P 50,508

ABC RENTALS OF SAN ANTONIO, INC.; David R. Peters; Diana

L. Peters; John P. Parsons; Melba R. Parsons, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Grauel Enterprises, Inc., Amicus Curiae.

Nos. 95-9008 to 95-9010.

United States Court of Appeals, Tenth Circuit.

Sept. 27, 1996.

Timothy P. O'Sullivan (Lyndon W. Vix and John R. Gerdes, with him on the brief), of Fleeson, Gooing, Coulson & Kitch, Wichita, Kansas, for petitioners-appellants.

Linda E. Mosakowski (Jonathan S. Cohen, with her on the brief), Tax Division, Department of Justice, Washington, D.C., for respondent-appellee.

Michael J. Henke and Jeffrey W. Ferguson, of Vinson & Elkins, L.L.P., Washington, D.C., for Grauel Enterprises, Inc., amicus curiae.

Before PORFILIO, KELLY and BRISCOE, Circuit Judges.

BRISCOE, Circuit Judge.

In these consolidated appeals, we decide whether the rent-to-own industry may properly depreciate its inventory for tax purposes using the income forecast method rather than the Modified Accelerated Cost Recovery System (MACRS) under I.R.C. § 168(f)(1). The Tax Court held that appellants' rent-to-own inventory was not properly depreciable under the income forecast method, and thus upheld the Commissioner's notice of deficiency. We reverse and remand for further proceedings.

Based on our analysis of the statutory language and legislative history, we conclude that § 168(f)(1) does not preclude use of the income forecast method for property like taxpayers' rent-to-own inventory, provided other conditions are met. If the taxpayers can establish that the income forecast method is a reasonable and consistent method under § 167(b)(4) and that it complies with the limitations of § 167(b)(4) and (c), as modified by § 168(f)(1), this method of depreciation is available to them. To satisfy the requirements of § 167(b)(4) and (c), an alternative method must (1) be a reasonable and consistent method of determining a reasonable allowance for depreciation; (2) be no faster than the declining balance method of § 167(b)(2) over the first two-thirds of the useful life of the property; and (3) apply to property with a useful life of at least three years. Section 168(f)(1) relaxes the second requirement by requiring only that the property be properly depreciated under a method not expressed in a term of years for the first taxable year for which the taxpayer can take a depreciation deduction for the property. Accordingly, for property to be properly depreciated by a method not expressed in a term of years under § 168(f)(1), the method must (1) be reasonable and consistent; (2) produce no greater depreciation in the first taxable year than the declining balance method; and (3) be applied to property with a useful life of at least three years.

The income forecast method as limited by § 167(b)(4) and (c) is a reasonable and consistent method for depreciating the taxpayers' inventory. However, to be properly depreciated by a method not expressed in a term of years under § 168(f)(1), the method must also produce greater depreciation in the first taxable year than the declining balance method of § 167(b)(2), and the useful life of the property must be at least three years. We remand to the tax court for determination of those issues.

Background

At issue are depreciation deductions claimed by two rent-to-own companies on their inventory of rental units for the tax years ending December 31, 1987, and December 31, 1988. ABC Rentals of San Antonio, Inc. (ABC) was a subchapter C corporation for its fiscal year ended May 31, 1987, and was a subchapter S corporation thereafter. John P. Parsons was ABC's sole shareholder. Guaranteed Rental, Inc. (Guaranteed) was a subchapter S corporation and Parsons and Diana L. Peters were shareholders in Guaranteed. Parsons and Peters each filed joint tax returns for the years at issue with their respective spouses, Melba R. Parsons and David R. Peters.

During the years at issue, ABC and Guaranteed operated rent-to-own businesses that leased appliances, furniture, televisions, stereos, and videocassette recorders to customers in Texas. Under the rental agreements, customers leased the rental property for a specified time period, which varied based on the type of property and the number of times the property had been leased. Generally, the initial lease term on a rental unit was between twelve and twenty-one months. If a customer paid the weekly or monthly rental amount for the full term of the rental contract, the customer would obtain full title to the rental property at no additional cost. The customer also had the right under the rental contract to return the property before expiration of the full term with no further obligation. Each particular rental unit would be leased to subsequent customers until a customer retained the unit for the entire lease term and obtained title to the property. On average, ABC and Guaranteed dispose of rental units within two years of purchase, and they dispose of about 90% of all rental units within three and one-half years of purchase.

Prior to 1981, rent-to-own companies generally used an eighteen, twenty-one, or twenty-four month straight line method to depreciate their inventory of rental units. With enactment of the Accelerated Cost Recovery System (ACRS) by Congress in 1981 and MACRS in 1986, industry practice has been to calculate the depreciation deduction on rental units using the income forecast method. Under the income forecast method, the yearly depreciation deduction for a particular rental unit is equal to the cost of the rental unit multiplied by a percentage obtained by dividing the income produced by that rental during the year (numerator) by 300% of the cost of the unit (denominator), which represents the total anticipated gross rental revenue for the life of the unit. Under this method, a rental unit is depreciated in full during its income-producing life. When a rental unit leaves the company's inventory and stops producing income, the company ceases claiming a depreciation deduction on that particular unit. Both ABC and Guaranteed used the income forecast method to determine their depreciation deductions for the years in question.

The Commissioner served a notice of deficiency on appellants and disallowed a portion of the depreciation deductions claimed by ABC and Guaranteed, contending the taxpayers were prohibited from using the income forecast method; rather, they were required to calculate their depreciation deductions under MACRS. The Commissioner determined that, under MACRS, the rental inventory had a class life of nine years and the applicable recovery period was therefore five years. Obviously, this longer recovery period under MACRS results in smaller yearly depreciation deductions. Appellants petitioned the Tax Court to challenge the notices of deficiency. The Tax Court adopted the Commissioner's reasoning and upheld the notices of deficiency, holding the rental units were not properly depreciated under the income forecast method.

Discussion

I.

We review tax court decisions "in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury." I.R.C. § 7482(a)(1). Therefore, we review the tax court's findings of fact under a clearly erroneous standard while questions of law are reviewed de novo. Worden v. C.I.R., 2 F.3d 359, 361 (10th Cir.1993).

The parties disagree as to whether this appeal presents a factual or a legal question. The Commissioner argues a determination of whether the rent-to-own inventory at issue fits into the exception to MACRS created by I.R.C. § 168(f)(1) is a factual issue regarding the nature of rent-to-own property. Appellants correctly point out, however, that given the stipulated facts, the question of whether the inventory fits into the exception to MACRS presents a legal issue regarding application and interpretation of § 168(f)(1). Even if the facts were not stipulated, this case still would present a mixed question of law and fact in which the legal issues predominate. Because this is a legal question, the Commissioner incorrectly contends appellants had a burden of proof at trial to establish the nature of the inventory.

II.

Section 167(a) of the Code establishes the right to claim "as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)" of property used in trade or business or property held for the production of income. The amount of the depreciation deduction for tangible property is governed by MACRS, which is set out in I.R.C. § 168. Nevertheless, MACRS does not apply to all tangible property; § 168(f)(1) creates an exception whereby other methods of depreciation than that prescribed by MACRS are permitted. Section 168(f)(1) states in part:

(f) Property to which section does not apply.--This section shall not apply to--

(1) Certain methods of depreciation.--Any property if--

(A) the taxpayer elects to exclude such property from the application of this section, and

(B) for the 1st taxable year for which a depreciation deduction would be allowable with respect to such property in the hands of the taxpayer, the property is properly depreciated under the unit of production method or any method of depreciation not expressed in a term of years.

(Emphasis added.)

The Tax Court correctly concluded, and the parties do not dispute, that the income forecast is a "method of depreciation not expressed in a term of years," as required by § 168(f)(1)(B). The remaining inquiry is whether the rent-to-own inventory is "properly depreciated" under the income forecast method. The government contended, and the Tax Court agreed, that only property whose economic usefulness cannot adequately be measured by its physical condition or the passage of time and that may produce an uneven stream of...