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

• Decision Date: 14 April 1998
• Docket Number: Nos. 95-9008,s. 95-9008
• Citation: 142 F.3d 1200
• Parties: -1473, 98-1 USTC P 50,340 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 1200

142 F.3d 1200

81 A.F.T.R.2d 98-1473, 98-1 USTC P 50,340

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.

April 14, 1998.

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

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

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 could not be properly depreciated under the income forecast method, and thus upheld the Commissioner's notice of deficiency.

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. Under § 168(f)(1), taxpayers may elect to exclude from the MACRS property that is "properly depreciated" under any method not expressed in a term of years, such as the income forecast method. We conclude I.R.C. § 167 is the measure of whether property is properly excluded under a method not expressed in a term of years. Under the version of § 167 in effect for the 1987 and 1988 tax years at issue, property is properly depreciated under a method not expressed in a term of years if it qualifies as a presumptively reasonable method under § 167(b)(4) and (c), or if the taxpayer can prove the method is a reasonable method of calculating annual depreciation allowances under § 167(a). Here, the Commissioner conceded the method is reasonable but did not concede it was properly applied to produce reasonable depreciation allowances or that the taxpayers made a proper election under § 168(f)(1). Accordingly, because the Tax court did not reach the issues of proper election and proper application of the method, we reverse and remand for further proceedings.

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 Commissioner contended the income forecast method was inapplicable to taxpayers' rental units. The Commissioner also contended the taxpayers had not properly elected out of the MACRS and their computation of depreciation under the income forecast method was incorrect because they did not accurately forecast the income expected over the life of the assets and did not make an adjustment for salvage value. The Tax Court upheld the notices of deficiency, holding the rental units could not be properly depreciated under the income forecast method. The Tax Court did not decide whether taxpayers had made a proper election or whether they had applied the income forecast method properly because it concluded taxpayers were prohibited from using the income forecast method to depreciate their rental units.

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 income based on its popularity is properly depreciated under the income forecast method. This argument is based on the...