Super Food Services, Inc. v. United States

• Decision Date: 10 September 1969
• Docket Number: No. 17254.,17254.
• Parties: SUPER FOOD SERVICES, INC., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

416 F.2d 1236 (1969)

SUPER FOOD SERVICES, INC., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 17254.

United States Court of Appeals Seventh Circuit.

July 28, 1969.

September 10, 1969.

Charles W. Davis, John L. Snyder, William L. Heubaum, Chicago, Ill., Samuel H. Horne, Washington, D. C., for plaintiff-appellant; Hopkins, Sutter, Owen, Mulroy, Wentz & Davis, Washington, D. C., of counsel.

Thomas A. Foran, U. S. Atty., Chicago, Ill., Johnnie M. Walters, Asst. Atty. Gen., Bennet N. Hollander, Lee A. Jackson, Jonathan S. Cohen, Attys., Dept. of Justice, Washington, D. C., for defendant-appellee.

Before MAJOR, Senior Circuit Judge, KILEY and CUMMINGS, Circuit Judges.

On Plaintiff's Bill of Costs September 10, 1969.

CUMMINGS, Circuit Judge.

This is an appeal from a summary judgment denying certain depreciation and loss deductions in connection with retail grocery store franchise contracts acquired by taxpayer.

Taxpayer, Super Food Services, Inc., is a Delaware corporation, with its principal place of business in Chicago. It kept its books and records and filed its income tax returns on the basis of a fiscal year ending on August 31. The taxable year in controversy ended August 31, 1960.

During that taxable year, plaintiff operated four divisions covering various territories in the United States. In those territories, it holds exclusive Independent Grocers Alliance Distributing Company ("IGA") wholesale franchise contracts. Under those contracts, it licenses independently-owned retail grocery stores to sell IGA merchandise, use the IGA name and operate under IGA merchandising, advertising and promotional programs. Taxpayer pays IGA a monthly fee for its services and receives a fee from each associated retail store based on gross sales. Taxpayer sells groceries at wholesale to the IGA stores that it franchises. Its earnings are derived from those wholesale grocery operations and from the fees paid by its licensees.

The present controversy concerns the taxpayer's F. N. Johnson Division which operates in 39 counties in Ohio. Taxpayer acquired this division in 1959 by purchasing the capital stock of the F. N. Johnson Company for $3,025,000. On August 31, 1959, the Johnson company was liquidated pursuant to Section 332 of the Internal Revenue Code (26 U.S.C. § 332), and all its assets distributed to taxpayer. $1,905,641 of the purchase price was allocated to the tangible assets, $17,978 was allocated to goodwill, and $1,101,381 was allocated to 184 of the retail franchise contracts Johnson had with IGA retailers. A value was assigned to each contract in accordance with a formula discussed below. No value was allocated to 23 of Johnson's retail franchise contracts which had been in existence for less than twelve months, nor was any value allocated to the exclusive IGA wholesale franchise contract that Johnson had acquired in 1927. All the retail franchise contracts were terminable by either party upon 30 days' notice.

For the taxable year ending August 31, 1960, plaintiff claimed a deduction of $121,832 for depreciation of 184 of the 207 retail contracts acquired from Johnson, together with a loss of $29,199 for retail contracts that terminated during that year. The Internal Revenue Service disallowed both deductions and plaintiff paid the deficiency asserted. After taxpayer's subsequent refund claim was disallowed, it filed a complaint in the district court seeking a refund of $93,939.50 on income taxes paid for that taxable year, together with interest. This amount was based on taxpayer's claim that it was entitled to a deduction of $149,263.88 for depreciation of the 184 retail franchise contracts and $31,389 for loss on contracts terminated during the taxable year. The district court granted the Government's motion for summary judgment, holding that taxpayer was not entitled to either the depreciation or loss deduction. The taxpayer has asked us to direct the district court to enter summary judgment for it or to proceed to trial of this case. We have concluded that summary judgment was improperly granted and that the case should be remanded for trial.

Depreciation of Retail Franchise Contracts

As to 184 of the retail franchise contracts acquired in 1959, taxpayer asserts that it is entitled to a depreciation deduction under Section 167(a) of the Internal Revenue Code (26 U.S.C. § 167 (a)), which provides:

"There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) — (1) of property used in the trade or business."

The applicable regulation provides:

"If an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance. Examples are patents and copyrights. An intangible asset, the useful life of which is not limited, is not subject to the allowance for depreciation. No allowance will be permitted merely because, in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life. No deduction for depreciation is allowable with respect to good will. * * *." (Treasury Regulation § 1.167(a)-3.)

The prerequisites to a depreciation deduction for an intangible asset are (1) that the asset be shown to have a limited useful life and (2) that its length be able to be estimated "with reasonable accuracy." A "reasonable certainty" or "reasonable approximation" of the fact and rate of depreciation or exhaustion is sufficient. Burnet v. Niagara Falls Brewing Co., 282 U.S. 648, 654-655, 51 S.Ct. 262, 75 L.Ed. 594. It is also settled that contracts with limited useful lives, like other business intangibles, may be the proper subject of a depreciation deduction.¹ Nor is the useful life necessarily limited to the stated duration or termination period "when taxpayer can demonstrate, as he did here, that the contract will be extended over a longer period of time." Commissioner of Internal Revenue v. Seaboard Finance Co., 367 F.2d 646, 653 (9th Cir. 1966). Franchise contracts are no exception (4 Mertens Law of Federal Income Taxation § 23.10, at p. 33 (rev. ed. 1966)) even though there may be uncertainty in determining their expected duration. Cf. Northern Natural Gas Co. v. O'Malley, 277 F.2d 128, 135 (8th Cir. 1960). In order to sustain the district court's award of summary judgment to the Government, it must appear that as a matter of law based on undisputed facts one of the prerequisites to a depreciation deduction is absent in the present case.

The Government does not dispute, nor could it in defense of its summary judgment, that some of the 184 franchise contracts were terminated during the taxable year and are of no further value to the taxpayer. Moreover, in its brief the Government recognizes that the cancellation of any retail franchise contract reduces the value of taxpayer's business. It is argued, however, that the retail franchise contracts were purchased by taxpayer as part of an "indivisible asset" with lost contracts constantly being replaced by new ones, so that the asset viewed as a whole has an unlimited life akin to goodwill or customer structure. This mass asset doctrine has recently been subjected to strong criticism in Note, "Amortization of Intangibles: An Examination of the Tax Treatment of Purchased Goodwill," 81 Harv.L.Rev. 859, 864-868 (1968), for the reason that the customer structure which may inhere in a group of purchased contracts only guarantees patronage for a limited period of time. In the present case it is clear that each retail franchise contract represents a distinct relationship between the taxpayer and a franchisee operating in a certain geographic area. The purchase of the franchise contract merely provides taxpayer an opportunity to attempt to maintain the relationship established by its predecessor. When, for example, through the pressure of local competition, ill health, or dissatisfaction with the services provided under the contract, a franchisee terminates his relationship with taxpayer and IGA, the value of the purchased business is diminished. Only through taxpayer's own efforts in recruiting a new franchisee will that value be restored. While there may be some residual advantage in seeking new outlets by reason of the reputation of taxpayer's predecessor, this is a matter of goodwill and cannot be relied on to establish that new contracts should be considered merely part of an indivisible asset purchased from the former owner.

Even if we were to find the indivisible asset doctrine sound in theory, we would have no occasion to apply it to facts such as those presently before us where the taxpayer has made a reasonable showing that the contracts were valued individually at the time of the purchase decision. Seaboard Finance Co., 23 T.C.M. 1512, 1537 (1964), affirmed, 367 F.2d 646, 652-653 (9th Cir. 1966). The record reveals that at the time of the Johnson acquisition in 1959, counsel and personnel of taxpayer undertook an analysis of Johnson's experience with contract terminations in order to evaluate the existing contracts to determine a purchase price. Using all available figures, covering the period from 1947 to the date of purchase, some 486 contracts were studied, and it was determined that a contract which has been in force for more than 12 months had an average contract life of 86 months. An affidavit of Davis F. Roenisch, an actuary, confirmed that the contracts "display a definite and consistent pattern of termination" which would have been discernible as of the date of purchase. He further concluded that taxpayer's...