Kem v. CIR

• Decision Date: 10 December 1970
• Docket Number: No. 24151.,24151.
• Parties: Harry H. KEM, Jr., and Diane C. Kem, Charles E. Miller and Mary J. Miller, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

432 F.2d 961 (1970)

Harry H. KEM, Jr., and Diane C. Kem, Charles E. Miller and Mary J. Miller, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 24151.

United States Court of Appeals, Ninth Circuit.

September 11, 1970.

Rehearing Denied December 10, 1970.

Walter H. Pendergrass (argued), Bullivant, Wright, Johnson, Pendergrass & Hoffman, Portland, Or., for petitioners-appellants.

Issie L. Jenkins (argued), Meyer Rothwacks, Wm. A. Friedlander, Attys., Johnnie M. Walters, Asst. Atty. Gen., Tax Division, Dept. of Justice, Richard M. Hahn, Acting Chief Counsel, I. R. S., Washington, D. C., for respondent-appellee.

Before DUNIWAY, WRIGHT and TRASK, Circuit Judges.

EUGENE A. WRIGHT, Circuit Judge:

At issue in this case is whether a depreciation deduction is available to an owner of breeding cattle who leases them to another under conditions so strict as to protect the lessor against any real economic loss. We hold it is not and affirm the ruling of the Tax Court.

Cattle breeding, the business involved here, presents a classical example of how to derive income from capital within the meaning of Eisner v. Macomber, 252 U. S. 189, 40 S.Ct. 189, 64 L.Ed. 521 (1920). The breeder's capital is his herd, and the annual calf crop his income. According to the record, a healthy cow begins to breed at around age two, and produces one calf a year until her breeding life ends at age seven or eight whereupon she is sold to a slaughterhouse. New heifers to replaced aged or diseased animals are either purchased from other ranchers, or diverted from the calves that would normally be sold for cash.

The variant engaged in by the taxpayers consisted of leasing the breeding herd rather than managing it themselves. In January of 1963, their partnership, the Circle Bar Ranch, leased a breeding herd of about 9,600 head to the group of persons from whom Circle Bar had purchased the cattle only a few days earlier at a price of $200 per head.

The lease was for a three-year term, with two one-year renewal options given to the lessor. It provided an annual rental fee of $40 per cow, and included comprehensive provisions requiring the lessees to cull all diseased or otherwise "undesirable" cattle, to replace the culled cows at their own expense with two-year-old bred heifers, and generally to maintain a herd of the same quality as the one leased to them. The cull was in no event to consist of less than ten percent of the herd. The culled cows were to belong to the lessees, but the replacement ones became the property of the lessors. The crucial provisions of the lease are set out in the margin.¹

A number of cattle were sold out of the lease, but about half the herd — subject to culls and replacements — remained together for the three-year term of the lease and the nine month extension which, by a later agreement, followed. They were then sold in October, 1966, as a breeding herd for $200 per head. The fair market price of comparable range cows in central Oregon remained fairly constant at $200 per head throughout this period.

Circle Bar's partnership returns in 1963 and 1964 claimed a depreciation deduction on the cows subject to the lease, using the declining balance method and placing a five-year useful life on the cattle. Salvage value, though not immediately crucial in view of the election to use the declining balance method, was claimed to be $46.20, the going price for older cows in the canners' and cutters' market in Portland, Oregon. The Commission, taking the position that no depreciation was reasonable under the circumstances, disallowed the deduction, and assessed a deficiency against the partners' tax. The Tax Court upheld the Commissioner, 51 T.C. 455 (1968), and the taxpayers brought the case here. 26 U.S.C. § 7482.

The Tax Court found, and we cannot say the finding is clearly erroneous, that the provisions of the lease would if carried out have restored to the taxpayers any possible loss resulting from the physical deterioration or aging of the herd. All diseased or "undesirable" cows (including barren ones, since a barren cow is undesirable in a breeding herd) were required to be culled and replaced with bred two-year old heifers. Given the age composition of the original herd, and the taxpayers' own estimate that the useful life of a breeding cow terminated at seven or eight years, the effect of the cull-and-replace requirement of the lease was to ensure that, at the end of the five-year (maximum) term of the lease, the lessors would receive back a herd of the same or better quality and age composition as the one they had leased.²

It is of course elementary that the purpose of the depreciation deduction is to protect the taxpayer against loss, not to give him a profit. Massey Motors v. United States, 364 U.S. 92, 101, 80 S.Ct. 1411, 4 L.Ed.2d 1592 (1960). It follows, as the Tax Court properly said, that if no loss is suffered, no allowance for depreciation is reasonable. 51 T.C. at 460.

Where leases of property are concerned, we think the proper rule was laid down nearly 40 years ago in Commissioner of Internal Revenue v. Terre Haute Electric Co., 67 F.2d 697 (7th Cir. 1933). In that case the taxpayer had leased all its property to a third party under a lease requiring the lessee to "renew, repair, and replace the same, so as to keep the demised premises in as good order, repair and condition as the same are now and in their present state of efficiency." The property was to be appraised at the beginning and end of the lease period and the lessee was required to make good to the lessor any diminution in value. The court held that under such circumstances no deduction for depreciation was available to the taxpayer-lessor, since it had "failed to show a present loss." 67 F.2d at 698. See also A. Wilhelm Co., 6 B.T.A. 1 (1927).

We are not persuaded by the taxpayers' argument that the Terre Haute doctrine is limited to situations where the lease contains an express covenant by the lessee to restore the full value of the property originally leased. Several cases have relied on Terre Haute to deny depreciation to lessors even in the absence of a full value restoration clause from the lease. Atlantic Coast Line R.R. v. Commissioner of Internal Revenue, 81 F.2d 309 (4th Cir. 1936); Georgia Ry. & Electric Co. v. Commissioner of Internal Revenue, 77 F.2d 897 (5th Cir. 1935); Mississippi River & Bonne Terre Ry., 39 B.T.A. 995 (1939); Cincinnati Gas & Electric Co., 36 B.T.A. 1122 (1937). The rule contended for by the taxpayers, moreover, would exalt form over substance by treating differently those whose leases give them full protection against loss, simply because in one case the protection is stated explicitly, while in the other it follows necessarily from the subsidiary terms of the lease.

The taxpayers also rely on a number of cases which they say have limited or rejected the Terre Haute rule. North Carolina Midland Ry. v. United States, 163 F.Supp. 610, 143 Ct.Cl. 30 (1958); Alaska Realty Co. v. Commissioner of Internal Revenue, 141 F.2d 675 (6th Cir. 1944); St. Paul Union Depot Co. v. Commissioner of Internal Revenue, 123 F.2d 235 (8th Cir. 1941); Helvering v. Terminal R. R. Ass'n, 89 F.2d 739 (8th Cir. 1937); Terminal Realty Co., 32 B.T.A. 623 (1935).³ Examination of the cited cases, however, discloses that they are not in point here.

In each, the lessee was required to keep the leased property in good repair, but not to renew or replace it at the termination of its useful life. The courts held that under the circumstances of the cases the lessor faced a very real possibility of loss from the increasing age...