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DOJ Contends Trucking Company's License and Insurance Expenses Must Be Capitalized

OCT. 13, 2000

USFreightways Corp., et al. v. Commissioner

DATED OCT. 13, 2000
DOCUMENT ATTRIBUTES
  • Case Name
    USFREIGHTWAYS CORPORATION, FORMERLY TNT FREIGHTWAYSCORPORATION, AND SUBSIDIARIES, Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE Respondent-Appellee
  • Court
    United States Court of Appeals for the Seventh Circuit
  • Docket
    No. 00-2668
  • Institutional Authors
    U.S. Department of Justice
  • Cross-Reference
    USFreightways Corp., et al. v. Commissioner, 113 T.C. No. 23; No.

    459-98 (November 2, 1999) (For a summary of this opinion, see Tax

    Notes, Nov. 8, 1999, p. 754; for the full text, see Doc 1999-35231 (15

    original pages) or 1999 TNT 212-2 Database 'Tax Notes Today 1999', View '(Number'.)
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    accounting methods
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-27268 (65 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 221-18

USFreightways Corp., et al. v. Commissioner

 

=============== SUMMARY ===============

 

In a brief for the Seventh Circuit, the Department of Justice has argued that a trucking company's license and insurance expenses must be capitalized and recovered ratably over the taxable years to which they relate.

USFreightways Corp. transported freight by trucks and, under state and local laws, is required to pay for various licenses, permits, and fees. In 1993 USFreightways spent $4.3 million for licenses, as well as liability and property insurance coverage. For purposes of book accounting and financial reporting, the company allocated the license and insurance expenses ratably over 1993-94. It, however, deducted the entire amounts on its 1993 tax return. The IRS disallowed the deductions, determining that the expenditures had to be capitalized. The Tax Court agreed, holding that the company, as an accrual-method taxpayer, was not entitled to currently deduct the license and insurance expenses because the benefits extended substantially beyond the tax year in which the company incurred the costs. (For a summary of that opinion, see Tax Notes, Nov. 8, 1999, p. 754; for the full text, see Doc 1999-35231 (15 original pages) or 1999 TNT 212-2 Database 'Tax Notes Today 1999', View '(Number'.)

Justice argues that the Tax Court correctly determined that, because USFreightways' expenditures created future benefits extending into the subsequent years, it was required to capitalize its expenses. The DOJ maintains that USFreightways can't establish that the expenses didn't provide benefits extending into future years. The DOJ notes that there is no one-year rule for distinguishing capital expenditures from ordinary business expenses and to the extent a one- year rule exists, it is inapplicable to the costs here or to an accrual basis taxpayer. Finally the DOJ insists that USFreightways' method of accounting does not clearly reflect its income.

 

=============== FULL TEXT ===============

 

IN THE UNITED STATES COURT OF APPEALS

 

FOR THE SEVENTH CIRCUIT

 

 

ON APPEAL FROM THE DECISION

 

OF THE UNITED STATES TAX COURT

 

 

BRIEF FOR THE APPELLEE

 

 

PAULA M. JUNGHANS

 

Acting Assistant Attorney

 

General

 

 

RICHARD FARBER (202) 514-2959

 

ELLEN PAGE DELSOLE (202) 514-8128

 

Attorneys

 

Tax Division

 

Department of Justice

 

Post Office Box 502

 

Washington, D.C. 20044

 

 

TABLE OF CONTENTS

 

 

Request for oral argument

 

Jurisdictional statement

 

Statement of the issues

 

Statement of the case

 

Statement of facts

 

Summary of argument

 

Argument:

 

 

I. The Tax Court correctly held that taxpayer's license and

 

insurance payments must be capitalized and recovered ratably

 

over the taxable years to which they relate

 

 

Standard of Review

 

 

A. Introduction

 

 

1. Capitalization is the norm, and the taxpayer bears the

 

burden to prove an expenditure is currently deductible

 

2. Capital expenditures include expenditures creating

 

any substantial future benefit; it is not necessary

 

that any separate asset be created

 

 

B. The Tax Court correctly determined that, because

 

taxpayer's expenditures created future benefits extending

 

substantially into the subsequent taxable year, it was

 

required to capitalize its expenses

 

 

C. Taxpayer cannot establish that its license and insurance

 

expenses did not provide benefits extending substantially

 

beyond the taxable year

 

 

1. There is no well-established one-year rule for

 

distinguishing capital expenditures from ordinary

 

business expenses

 

 

2. To the extent a one-year rule exists, it is

 

inapplicable to the period costs here

 

 

3. If there is a one-year rule, it is inapplicable to an

 

accrual basis taxpayer

 

 

II. Taxpayer's method of accounting does not clearly reflect its

 

income

 

 

Standard of review

 

 

Conclusion

 

Certificate of Compliance with Type Volume Limitation

 

Addendum

 

 

CITATIONS

 

 

CASES:

 

 

A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d 482 (7th Cir. 1997)

 

Acer Realty Co. v. Commissioner, 132 F.2d 512 (8th Cir. 1942)

 

All Steel Equipment v. Commissioner, 54 T.C. 1749 (1970), aff'd in

 

relevant part and rev'd in part, 467 F.2d 1184 (7th Cir. 1972)

 

American Dispenser Co. v. Commissioner, 396 F.2d 137 (2d Cir. 1966)

 

Bell v. Commissioner, 13 T.C. 344 (1949)

 

Bilar Tool & Die Corp. v. Commissioner, 530 F.2d 708 (6th Cir. 1976)

 

Black Hills Corp. v. Commissioner, 73 F.3d 799 (8th Cir. 1996)

 

Bloedel's Jewelry, Inc. v. Commissioner, 2 B.T.A. 611 (1925)

 

Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2d Cir. 1973)

 

Brooks-Massey Dodge, Inc. v. Commissioner, 60 T.C. 884 (1973)

 

Burck v. Commissioner, 533 F.2d 768 (2d Cir. 1976)

 

Cabintaxi Corp. v. Commissioner, 63 F.3d 614 (7th Cir. 1995)

 

Capitol Federal Savings & Loan Ass'n v. Commissioner, 96 T.C. 204

 

(1991)

 

Chandler Trailer Convoy, Inc. v. Commissioner, 32 T.C.M. (CCH) 1372

 

(1973)

 

Chevy Chase Motor Co. v. Commissioner, 36 T.C.M. (CCH) 942 (1977)

 

Clark Oil and Refining Co., 473 F.2d 1217 (7th Cir. 1973)

 

Commissioner v. Boylston Market Ass'n, 131 F.2d 966 (1st Cir. 1942)

 

Commissioner v. Idaho Power Co., 418 U.S. 1 (1974)

 

Commissioner v. Lincoln Savings and Loan Ass'n, 403 U.S. 345 (1971)

 

Commissioner v. Van Raden, 650 F.2d 1046 (9th Cir. 1981)

 

Cravens v. Commissioner, 272 F.2d 895 (10th Cir. 1959)

 

Dunlap v. Commissioner, 74 T.C. 1377 (1980), rev'd on other grounds,

 

670 F.2d 785 (8th Cir. 1982)

 

Dustin v. Commissioner, 467 F.2d 47 (9th Cir. 1972)

 

Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212 (7th

 

Cir. 1982)

 

FMR Corp. v. Commissioner, 110 T.C. 402 (1998)

 

Fall River Gas Appliance Co. v. Commissioner, 349 F.2d 515 (1st Cir.

 

1965)

 

Fishman v. Commissioner, 837 F.2d 309 (7th Cir. 1988)

 

Ford Motor Co. v. Commissioner, 102 T.C. 87 (1994), aff'd, 71 F.3d

 

209 (6th Cir. 1995)

 

Frysinger v. Commissioner, 645 F.2d 523 (5th Cir. 1981)

 

Galatoire Bros. v. Lines, 23 F.2d 676 (5th Cir. 1928)

 

Garth v. Commissioner, 56 T.C. 610 (1971)

 

General Bancshares Corp. v. Commissioner, 326 F.2d 712 (8th Cir.

 

1964)

 

Helvering v. Winmill, 305 U.S. 79 (1938)

 

Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566 (1927)

 

Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370 (1983)

 

Hotel Kingkade v. Commissioner, 180 F.2d 310 (10th Cir. 1950)

 

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992)

 

Interstate Transit Lines v. Commissioner, 319 U.S. 590 (1943)

 

Jack's Cookie Co. v. United States, 597 F.2d 395 (4th Cir. 1979)

 

Jephson v. Commissioner, 37 B.T.A. 1117 (1938)

 

Johnson v. Commissioner, 108 T.C. 448 (1997), aff'd in part and rev'd

 

in part on other grounds, 184 F.3d 786 (1999)

 

Kauai Terminal, Ltd. v. Commissioner, 36 B.T.A. 893 (1937)

 

Keller v. Commissioner, 79 T.C. 7 (1982), aff'd, 725 F.2d 1173 (8th

 

Cir. 1984)

 

Kenney v. Commissioner, 65 T.C.M. (CCH) 2152 (1993)

 

Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th

 

Cir. 1984)

 

Mennuto v. Commissioner, 56 T.C. 910 (1971)

 

Mortensen v. Commissioner, 49 T.C.M. (CCH) 94 (1984)

 

North Central Life Ins. Co. v. Commissioner, 92 T.C. 254 (1989)

 

PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822 (3d Cir. 2000)

 

Peters v. Commissioner, 4 T.C. 1236 (1945)

 

RLC Industries Co. v. Commissioner, 98 T.C. 457 (1992), aff'd, 58

 

F.3d 413 (9th Cir. 1995)

 

Resser v. Commissioner, 74 F.3d 1528 (7th Cir. 1996)

 

Sorrell v. Commissioner, 53 T.C.M. (CCH) 1362 (1987), rev'd on other

 

grounds, 882 F.2d 484 (11th Cir. 1989)

 

Steger v. Commissioner, 113 T.C. 227

 

Surety Ins. Co. v. Commissioner, 39 T.C.M. (CCH) 1220 (1980)

 

Two-L Realty Co. v. Commissioner, 14 T.C.M. (CCH) 1147 (1955)

 

United States v. Akin, 248 F.2d 742 (10th Cir. 1957)

 

United States v. Anderson, 269 U.S. 422 (1926)

 

United States v. Hugh Properties, 476 U.S. 593 (1986)

 

United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968)

 

University Properties, Inc. v. Commissioner, 45 T.C. 416 (1966),

 

aff'd, 378 F.2d 83 (9th Cir. 1967)

 

Van Raden v. Commissioner, 71 T.C. 1083 (1979), aff'd, 650 F.2d 1046

 

(9th Cir. 1981)

 

WHEC, Inc. v. Commissioner, 37 T.C. 821 (1962)

 

Waldheim Realty and Investment Co. v. Commissioner, 245 F.2d 823 (8th

 

Cir. 1957)

 

Wells Fargo & Co. v. Commissioner, ___ F.3d ___, 2000 WL 1219430 (8th

 

Cir. Aug. 29, 2000)

 

Wood v. Commissioner, 34 T.C.M. (CCH) 817 (1975)

 

Woodward v. Commissioner, 397 U.S. 572 (1970)

 

Zaninovich v. Commissioner, 616 F.2d 429

 

 

STATUTES:

 

 

Internal Revenue Code (26 U.S.C.):

 

 

Section 161

 

Section 162

 

Section 162(a)

 

Section 261

 

Section 263

 

Section 263(a)

 

Section 446

 

Section 446(b)

 

Section 6213

 

Section 7442

 

Section 7482

 

Section 7482(b)(1)(B)

 

Section 7483

 

 

MISCELLANEOUS:

 

 

Black's Law Dictionary (5th ed. 1979)

 

Fed. R. App. P. 13(a)

 

Federal Rules of Evidence, Rule 401

 

H.R. Rep. No. 98-801 at 871 (1984), 1984-3 C.B. (Vol. 2)

 

1 B. Bittker, L. Lokken, Federal Taxation of Income, Estates and

 

Gifts, section20.4.1 (3d ed. 1999)

 

Rev. Rul. 65-13, 1965-1 C.B. 87

 

Rev. Rul. 68-643, 1968-2 C.B. 76, modified by Rev. Rul. 69-582, 1969-

 

2 C.B. 29

 

Rev. Rul. 69-81, 1969-1 C.B. 137

 

Rev. Rul. 69-582, 1969-2 C.B. 29

 

Rev. Rul. 70-413, 1970-2 C.B. 103

 

Rev. Rul. 78-382, 1978-2 C.B. 111

 

Rev. Rul. 89-62, 1989-1 C.B. 78

 

Rev. Rul. 92-80, 1992-2 C.B. 57

 

Rev. Rul. 94-12, 1994-1 C.B. 36

 

Rev. Rul. 95-32, 1995-1 C.B. 8

 

Rev. Rul. 96-62, 1996-2 C.B. 9

 

Rev. Rul. 2000-4, 2000-4 I.R.B 331

 

Treasury Regulations (26 C.F.R.):

 

Section 1.118-1

 

Section 1.263(a)-2

 

Section 1.263(a)-2(a)

 

Section 1.461-1(a)

 

Section 1.461-1(a)(2)

 

Section 1.461-4(g)(8)

 

Webster's New World Compact School and Office Dictionary (1982)

 

 

REQUEST FOR ORAL ARGUMENT

[1] Counsel for the Commissioner of Internal Revenue respectfully inform the Court that they believe oral argument would be helpful to the Court in resolving this appeal.

JURISDICTIONAL STATEMENT

[2] Pursuant to Circuit Rule 28(b), the Commissioner of Internal Revenue respectfully informs the court that the jurisdictional statement included in the opening brief of US Freightways Corporation and its subsidiaries (collectively, "taxpayer") is correct, but it is not complete in that it does not state, as required by Circuit Rule 28(a)(1), taxpayer's state of incorporation and the state in which taxpayer has its principal place of business. Accordingly, the Commissioner provides the following complete and correct jurisdictional statement.

[3] On October 19, 1997, the Commissioner of Internal Revenue issued a statutory notice of deficiency to USFreightways Corporation and its subsidiary corporations (collectively, "taxpayer"), determining deficiencies in taxpayer's federal income tax for its taxable year ended January 1, 1994. (App. 18-21, paragraphs 2-4, 31- 33.) 1 US Freightways Corporation is a Delaware corporation with its principal place in the State of Illinois. (App. 18, paragraph 1.) A complete list of the addresses of US Freightways Corporation's subsidiaries who joined in filing a consolidated federal income tax return for the tax year at issue is contained in the stipulation of facts. (App. 19, paragraph 2.)

[4] On January 8, 1998, taxpayer timely filed a petition in the United States Tax Court seeking a redetermination of the deficiencies. (Doc. 1.) 2 The Tax Court had jurisdiction over the case pursuant to Sections 6213 and 7442 of the Internal Revenue Code (26 U.S.C.). Following concessions, the Tax Court upheld the Commissioner's determination that taxpayer's expenditures for licenses, permits, fees, and insurance for periods extending into the subsequent taxable year were not currently deductible, but rather must be capitalized and deducted ratably over the period to which the expenditures related. (App. 15.) On March 27, 2000, the court entered a final decision that disposed of all claims with respect to all parties. (App. 16-17.)

[5] On June 22, 2000, taxpayer filed its notice of appeal, which was timely filed within the 90-day period provided in 26 U.S.C. section 7483 and Fed. R. App. P. 13(a). This Court has jurisdiction over this appeal pursuant to 26 U.S.C. section 7482. Venue in this matter is conferred on this Court pursuant to 26 U.S.C. section 7482(b)(1)(B).

STATEMENT OF THE ISSUES

[6] 1. Whether the Tax Court correctly held that taxpayer, an accrual basis taxpayer, could not deduct in the year of payment its expenditures for licenses, permits, fees, and insurance, where those expenditures created benefits extending beyond the tax year in which payment was made, but rather must capitalize those costs and deduct them ratably over the taxable years to which they relate.

[7] 2. Whether the Commissioner correctly determined that taxpayer's method of accounting, under which it deducted in the year of payment the costs of licenses, permits, fees, and insurance, even though those expenditures created benefits spanning two tax years, did not clearly reflect its income.

STATEMENT OF THE CASE

[8] On October 9, 1997, the Commissioner of Internal Revenue issued to taxpayer a notice of deficiency determining a deficiency in income tax for taxpayer's tax year ended January 1, 1994 (the "1993 tax year") in the amount of $1,712,070. On January 8, 1998, taxpayer timely petitioned the Tax Court seeking a redetermination of the deficiency. Following concessions and settlements by the parties (Doc. 32), the sole issue remaining before the Tax Court was whether taxpayer, an accrual basis taxpayer, could not deduct its expenditures for licenses, permits, fees, and insurance incurred in operation of its interstate trucking business in the year paid, or, rather, must capitalize those costs and deduct them ratably over the taxable years to which they relate. (App. 4.) On a stipulated factual record, the Tax Court upheld the Commissioner's determination that taxpayer's expenditures for licenses, permits, fees, and insurance must be capitalized. (App. 15.) The Tax Court, in its final decision entered on March 27, 2000 (App. 16-17), determined a deficiency in the amount of $1,102,154.00 for taxpayer's taxable year ended January 1, 1994. This appeal followed.

STATEMENT OF FACTS

[9] During and prior to 1993, US Freightways and its subsidiaries operated an interstate trucking business, which they continued to operate in subsequent years. ( App. 21, section 7); Supp. App. 2, 4.) 3 For its taxable year ended January 1, 1994 (the "1993 tax year"), US Freightways Corporation and its subsidiary corporations (collectively, "taxpayer") timely filed a consolidated federal income tax return (Form 1120) with the IRS. 4

[10] Taxpayer's trucks transport freight for hire throughout the United States. (App. 2.) In connection with operation of this business, state and local government authorities require taxpayer to obtain licenses, permits, and fees (collectively, "licenses") before its trucks may be legally operated in the issuing jurisdiction. These licenses have a specified term, and taxpayer must make recurring payments in order to maintain the right to operate legally in each jurisdiction. Although none of the licenses had an effective period in excess of one year, the licenses at issue had terms extending into the taxable year following the year of payment. (App. 3; App. 24, paragraph 17; App. 35.) Taxpayer also purchased insurance during its 1993 tax year that provided coverage for the one year period from July 1, 1993, to June 30, 1994. (App. 3; App. 25-26, paragraphs 18- 20.)

[11] For purposes of federal income taxes, book accounting, and financial reporting, taxpayer generally uses the accrual method of accounting. (App. 3.) On its federal income tax return for the 1993 tax year, taxpayer claimed a deduction for all amounts paid for licenses and insurance in 1993. (App. 22, paragraph 10; App. 26, paragraph 19.) For purposes of its financial books and records for 1993, taxpayer allocated the license and insurance costs paid in 1993 for coverage extending into 1994 ratably over years to which the costs applied. (App. 3-4.) Amounts not allocated to 1993 were reflected on taxpayer's 1993 balance sheet as prepayments for 1994. (App. 4.) On its financial books, taxpayer also applied to 1993 its license expenses paid in 1992 and providing coverage in 1993. (Br. 5; App. 22, section 10.) Similarly, on its 1993 federal income tax return, taxpayer deducted the full amount it had paid for insurance in 1993 (App. 26, paragraph 20), but on its books allocated its insurance premiums ratably between 1993 and 1994. (App. 26, paragraph 20).

[12] The Commissioner determined in his notice of deficiency that, because the licenses and insurance that taxpayer paid for in 1993 provided benefits extending substantially into the 1994 tax year, taxpayer must capitalize those expenses and deduct them ratably over the tax periods to which they pertain. Following concessions, the case was submitted to the Tax Court on a stipulated record. The parties agreed that, if the court upheld the Commissioner's position that taxpayer must capitalize its license and insurance expenses, it would result in an increase in taxpayer's taxable income for 1993 in a total amount of $2,984, 197. (App. 27, paragraphs 23, 25).

[13] Taxpayer contended in the Tax Court that its license and insurance expenses were not required to be capitalized under Code Section 263, but rather that those expenses could be currently deducted under Section 162. Taxpayer claimed that, because the expenses in question extended less than one year into the following tax period, the expenses did not relate to property having a useful life substantially beyond the taxable year and thus need not be capitalized. (App. 4.) Taxpayer further contended that, despite the difference in its tax and financial accounting methods, taxpayer's method of accounting clearly reflected its income within the meaning of Code Section 446. (App. 4.)

[14] The Tax Court rejected taxpayer's arguments, and instead found that the Commissioner had correctly determined that the expenditures for licenses and insurance in 1993 did result in benefits extending substantially beyond the taxable year. Accordingly, the Tax Court held that taxpayer's license and insurance expenses must be capitalized and recovered ratably over the tax periods to which they related. (App. 13-14.)

[15] The Tax Court noted that timing of the deductions is the primary difference between treatment of capital expenditures and ordinary business expenses. Although Section 162(a) permits current deduction of all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, an expense defined as a capital expense under Code Section 263(a) must be amortized over the life of the relevant asset. (App. 6-7.) The Tax Court held that for the expense to be one that must be capitalized, the creation or enhancement of a separate and distinct asset was unnecessary. Rather, the Tax Court held that in distinguishing between capital expenses and ordinary business expenses, the main factor is whether the payment creates a future benefit that is more than incidental. (App. 8-9.)

[16] Taxpayer argued that Treasury Regulation section 1.263(a)- 2(a), which defines capital expenditures as being expenditures for acquisition of property having a "useful life substantially beyond the taxable year," should be interpreted to mean that expenditures creating a benefit having a useful life extending less than twelve months into the subsequent tax period need not be capitalized and are currently deductible. The court rejected that contention because many of the cases taxpayer relied on did not expressly support such a rule or even address the situation where a benefit with a useful life of one year or less spanned two tax years. (App. 9-10.) Moreover, the Tax Court concluded that, even if the one-year rule taxpayer advocated were widely recognized, it would not apply to an accrual method taxpayer. (App. 12.) The Tax Court accordingly concluded that, because the license and insurance taxpayer paid for in 1993 provided coverage for a substantial portion of 1994, the payments in 1993 provided benefits extending substantially beyond the close of the 1993 taxable year and therefore must be capitalized.

[17] Because it determined that taxpayer's current deduction of its license and insurance costs was improper under Section 263, the Tax Court held that it need not reach the question whether the Commissioner had correctly determined that taxpayer's tax method of accounting failed to clearly reflect its income. (App. 14.)

SUMMARY OF ARGUMENT

[18] 1. Taxpayer, a trucking concern, purchased licenses and permits in 1993 that expired in 1994. Similarly, it purchased insurance policies in 1993 that expired in 1994. On its 1993 return, taxpayer deducted the full amount of its licenses and insurance costs as an ordinary and necessary business expense under Section 162 of the Internal Revenue Code. The Commissioner determined, however, that, because taxpayer's expenses create substantial future benefits, it was required under Section 263 of the Code to capitalize the expenditures and amortize them ratably over the taxable periods to which they relate. In the alternative, the Commissioner determined that taxpayer's accounting method of currently deducting its licensing fees and insurance costs did not clearly reflect its income.

[19] The Tax Court agreed with the Commissioner that taxpayer was required to capitalize the expenses in issue. As the court correctly held, the decisions of the Supreme Court make clear that expenditures that otherwise would be currently deductible as ordinary business expenses must be capitalized if they create for the taxpayer a benefit that extends substantially into subsequent taxable years. That is the situation in the present case. The insurance policies purchased by taxpayer in 1993 provided insurance coverage well into 1994. Similarly, the licenses and permits purchased by taxpayer in 1993 had terms that carried into 1994. In these circumstances, taxpayer was required to write off its expenses ratably over the taxable periods to which they related and was not entitled to accelerate its deductions by writing off the entire cost of the licenses and insurance on its 1993 return.

[20] The Tax Court correctly rejected taxpayer's claim that all taxpayers are entitled to an immediate deduction for business expenditures if the benefit created by the expenditures lasts twelve months or less, without regard to whether such benefit spans more than one taxable year. The so-called one-year rule espoused by taxpayer is not found in the Internal Revenue Code or the regulations promulgated thereunder. Nor has it been recognized by the Supreme Court. Moreover, to the extent lower courts have used a one-year rule as a rough guideline for distinguishing ordinary expenses from capital expenditures, they have done so in the context of cash basis taxpayers, not accrual method taxpayers such as taxpayer here is.

[21] Finally, whatever merit the one-year rule might have in the situation where the duration of the benefit resulting from the expenditure in question cannot be precisely determined, but is estimated to be in the range of twelve months or so, there is no justification for the application of such a rule in the case of period costs as are involved here. The duration of the future benefits created by the expenditures in this case is not a matter of speculation. On the contrary, the extent to which the insurance purchased by taxpayer in 1993 provided coverage in 1994 is precisely shown by the record. The same is true as to the licenses purchased by taxpayer in 1993 that expired in 1994. Since the record here permits a precise allocation of taxpayer's costs between 1993 and 1994, there is no reason for the application of a rough guideline that would allow taxpayer to deduct all of its expenses in 1993.

[22] 2. Although the Tax Court did not reach the issue, the record confirms the correctness of the Commissioner's alternative determination that taxpayer's accounting method of currently deducting its license and insurance expenses did not clearly reflect its income. By failing to match its expenditures with the income related to those expenditures, taxpayer's method of accounting caused a distortion in taxpayer's taxable income. The Commissioner properly exercised his broad authority under Section 446 of the Code in changing taxpayer's method of accounting to a method which does clearly reflect taxpayer's income.

ARGUMENT

 

 

I

 

THE TAX COURT CORRECTLY HELD THAT TAXPAYER'S LICENSE AND INSURANCE

 

PAYMENTS MUST BE CAPITALIZED AND RECOVERED RATABLY OVER THE TAXABLE

 

YEARS TO WHICH THEY RELATE

 

 

Standard of Review

 

 

[23] Whether taxpayer's license and insurance expenses that covered periods beyond the 1993 taxable year are capital expenditures is a question of law subject to de novo review. Resser v. Commissioner, 74 F.3d 1528, 1525 (7th Cir. 1996).

A. INTRODUCTION

[24] Section 162(a) of the Internal Revenue Code (26 U.S.C.) allows the deduction of "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business" in the year incurred. On the other hand, Section 263(a) provides that "no deduction shall be allowed for . . . [a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." See Woodward v. Commissioner, 397 U.S. 572, 574 (1970); see also Commissioner v. Idaho Power Co., 418 U.S. 1, 17 (1974) (capitalization requirement takes precedence over provisions allowing deductions for business expenses); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); H.R. Rep. No. 98-801 at 871 (1984), 1984-3 C.B. (vol. 2) at 125. A capital expenditure must be recovered over the life of the asset with which the expenditure is associated, or, where no specific asset or useful life can be ascertained, it is recovered upon the sale of the asset or dissolution of the enterprise. INDOPCO, 503 U.S. at 84.

[25] The basic distinction between currently deductible business expenses and capital expenditures is that capital expenditures "yield benefits in future years in the taxpayer's business or income-producing activities." 1 B. Bittker, L. Lokken, Federal Taxation of Income, Estates and Gifts, section20.4.1, p. 20- 70 (3d ed. 1999).; see INDOPCO, 503 U.S. at 83-88. An expense must be capitalized if it creates benefits extending "substantially beyond the taxable year." I.R.C. section 263; Treas. Reg. sections 1.263(a)- 2; 1.461-1(a). The goal behind the amortization of capital expenditures is "to match expenses with the revenues of the taxable period to which they are properly attributable," thereby more accurately reflecting the taxpayer's income. INDOPCO, 503 U.S. at 84; see also A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d 482, 493 (7th Cir. 1997) ("goal of the Tax Code in this area is to match outlays with revenues").

1. CAPITALIZATION IS THE NORM, AND THE TAXPAYER BEARS THE

 

BURDEN TO PROVE AN EXPENDITURE IS CURRENTLY DEDUCTIBLE

 

 

[26] To effect this matching, an expense that otherwise would be an ordinary and necessary business expense deductible under section 162 must be capitalized if it is also a capital expense; capitalization takes precedence over current deduction. FMR Corp. v. Commissioner, 110 T.C. 402 (1998); see also INDOPCO, 503 U.S. at 84. "In exploring the relationship between deductions and capital expenditures," the Supreme Court has noted the "'familiar rule'" guiding the courts' analysis: deductions are matters of "'legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer.'" Id. (quoting Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943)). Capitalization, not current deductibility, is the norm:

[t]he notion that deductions are exceptions to the norm of

 

capitalization finds support in various aspects of the Code.

 

Deductions are specifically enumerated and thus are subject to

 

disallowance in favor of capitalization. See [I.R.C.] sections

 

161 and 261. Nondeductible capital expenditures, by contrast,

 

are not exhaustively enumerated in the Code; rather than

 

providing a "complete list of nondeductible expenditures,"

 

Lincoln Savings, 403 U.S. at 348 . . . , section 263 serves as a

 

general means of distinguishing capital expenditures from

 

current expenses.

 

 

INDOPCO, 503 U.S. at 84. Thus, a taxpayer does not satisfy his burden by showing that the expenditures at issue "possess some characteristics different from the more commonly accepted capital expenditures." General Bancshares Corp. v. Commissioner, 326 F.2d 712, 716 (8th Cir. 1964) (citing Welch v. Helvering, 290 U. S. 111 (1933); Interstate Transit Lines. v. Commissioner, 319 U.S. 590 (1943)).

2. CAPITAL EXPENDITURES INCLUDE EXPENDITURES CREATING ANY

 

SUBSTANTIAL FUTURE BENEFIT; IT IS NOT NECESSARY THAT ANY

 

SEPARATE ASSET BE CREATED

 

 

[27] It has long been established that expenses that create a separate and distinct asset that will last beyond the current taxable year are capital. See Commissioner v. Lincoln Savings and Loan Ass'n, 403 U.S. 345 (1971). Until the Supreme Court's decision in INDOPCO, 503 U.S. 79, however, some courts had interpreted Lincoln Savings, 403 U.S. 345, as requiring that an expense result in the creation of a separate asset in order to compel capitalization of the expense. See, e.g., Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2d Cir. 1973); INDOPCO, 503 U.S. at 83 n.3 (certiorari granted to resolve conflict regarding whether an expenditure must create or enhance a separate asset to be subject to capitalization). In INDOPCO, 503 U.S. at 87, the Supreme Court specifically held that creation or enhancement of a separate and distinct asset was not necessary to require capitalization of an expense. Instead, the court determined, the reference to "permanent improvements or betterments" in Section 263(a)(1) "envisions an inquiry into the duration and extent of the benefits realized by the taxpayer." INDOPCO at 88. The Court concluded that the concept that an expenditure need not result in the creation of a separate asset is inherent in the "matching" rationale upon which the capitalization requirement is based. See id. at 84. Thus, although the presence of an "incidental future benefit -- 'some future aspect'" -- may not alone warrant capitalization, the realization of benefits beyond the taxable year in which the expenditures is made "is undeniably important" in determining whether the expenditures may be currently deducted or instead must be capitalized. Id. at 87 (quoting United States v. Mississippi Chemical Corp., 405 U.S. 298, 310 (1972)).

[28] Accordingly, under INDOPCO, the predominant factor here for consideration is whether taxpayer's payment of licensing and insurance expenses covering periods with terms extending well into the next taxable year creates a future benefit that is more than incidental. Id. at 87. An additional factor weighing in favor of capitalization arises where "the purpose for which the expenditure is made has to do with the corporation's operations and betterment . . . for the duration of its existence or for the indefinite future or for a time somewhat longer than the current taxable year." Id. at 90.

B. THE TAX COURT CORRECTLY DETERMINED THAT, BECAUSE TAXPAYER'S

 

EXPENDITURES CREATED FUTURE BENEFITS EXTENDING SUBSTANTIALLY

 

INTO THE SUBSEQUENT TAXABLE YEAR, IT WAS REQUIRED TO

 

CAPITALIZE ITS EXPENSES

 

 

[29] Contrary to taxpayer's assertion (Br. 9-10), analysis of recent cases applying INDOPCO's analysis supports the Tax Court's conclusion that the expenses at issue here must be capitalized. The Eighth Circuit in Wells Fargo & Co. v. Commissioner, ___ F.3d ___, 2000 WL 1219430 (8th Cir. Aug. 29, 2000), recently clarified, in light of INDOPCO, the analysis that should govern in determining whether an expenditure must be capitalized. The Wells Fargo court held that, although INDOPCO rejected the idea that only expenditures that create a separate capital asset can be capital expenditures, Lincoln Savings' holding that an expenditure is capital if it directly creates a separate capital asset remains true. Wells Fargo, 2000 WL 1219430, *7, 9. Thus, the "inquiry may end once it is determined that the expenditure did create a separate and distinct asset." Id. at *8. Numerous cases have held that insurance premiums providing coverage in future years are capital assets that must be amortized over the years for which coverage was provided. See Commissioner v. Boylston Market Ass'n, 131 F.2d 966, 968 (1st Cir. 1942) (prepayments of insurance must be prorated because "the life of the asset extends beyond the taxable year"); Jephson v. Commissioner, 37 B.T.A. 1117 (1938) (sustaining disallowance of deduction for portion of three-year premium that pertained to coverage beyond the taxable year); Rev. Rul. 70-413, 1970-2 C.B. 103 ("payment in advance of insurance premiums by a taxpayer filing returns on the cash receipts and disbursements basis results in the creation of an asset, prepaid insurance, that is used up ratably over the period covered . . . "). Courts also have required capitalization of expenditures for licenses that provide benefits extending into subsequent tax years. See Surety Ins. Co. v. Commissioner, 39 T.C.M. (CCH) 1220 (1980) (fees incurred in obtaining certificates of authority to conduct insurance business were capital assets even though licenses had to be renewed annually, because licenses granted authority to do business so long as company complies with regulatory scheme and makes annual payments); Chandler Trailer Convoy, Inc. v. Commissioner, 32 T.C.M. (CCH) 1372 (1973) (certificate of indefinite duration authorizing transport of goods over particular route was intangible capital asset). 5 Furthermore, Example 6 of Treasury Regulation section 1.461-4(g)(8) states that prepaid insurance must be taken into account under the capitalization rules "because the insurance contract is an asset having a useful life extending substantially beyond the close of the taxable year." These authorities support the conclusion that taxpayer's prepayment of licenses and insurance contracts resulted in acquisition of assets with a useful life extending beyond the taxable year. Under the decision in Wells Fargo, the creation of such separate assets could ipso facto require capitalization of taxpayer's expenses.

[30] Even assuming, however, that taxpayer did not obtain or create a separate capital asset when it purchased the licenses and the insurance here, the decision in INDOPCO that expenditures may be capital if they provide future benefits (even if they do not create a separate asset) requires a determination as to whether taxpayer's expenditures created a future benefit that was more than incidental. Wells Fargo, 2000 WL 1219430 at *9-10, 12. The Eighth Circuit stated in Wells Fargo that, capitalization is not required solely "because the cost is 'incidentally connected' with some future benefit, " id. at *10, but the expenses should be capitalized if they are directly related to the transaction that produced the long term benefit. Id. at *12.

[31] As ordinarily used, "incidental" means "happening in connection with a more important thing" or "secondary or minor." Webster's New World Compact School and Office Dictionary (1982); see also Black's Law Dictionary (5th ed. 1979) ("[d]epending upon or pertaining to something else as primary"). The administrative pronouncements of the Internal Revenue Service that taxpayer cites (Br. 26) are consistent with the Eighth Circuit's reasoning in Wells Fargo. These pronouncements hold that capitalization is not necessary where the primary purpose of the expenditure is to produce a current benefit, and any future benefit is secondary. See, e.g., Rev. Rul. 2000-4, 2000-4 I.R.B. 331 (any future benefits of repeat business or market share from ISO certification were incidental to primary purpose of expanding current sales); Rev. Rul. 96-62, 1996-2 C.B. 9 ("[t]raining costs must be capitalized only in the unusual circumstance where the training is intended primarily to obtain future benefits significantly beyond those traditionally associated with training provided in the ordinary course of a taxpayer's trade or business"); Rev. Rul. 94-12, 1994-1 C.B. 36 ("incidental repairs" to maintain equipment in operating condition for use in current business need not be capitalized so long as the repairs neither materially add to value of property or appreciably prolong its life); Rev. Rul. 92-80, 1992-2 C.B. 57 (advertising costs generally currently deductible despite secondary benefit of goodwill, but exception exists where advertising is directed toward obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising). In making this evaluation, the administrative pronouncements have found future benefits to be incidental when there is a current business purpose for the expenditure and the future benefit is speculative. See Rev. Rule 95- 32, 1995-1 C.B. 8 (utility's implementation of energy conservation and load management programs that was helpful and appropriate in current business but also might reduce future costs was not required to be capitalized).

[32] In the instant case, however, the future benefits that were produced by taxpayer's expenditures hardly were incidental or speculative. On the contrary, when taxpayer purchased licenses and permits in 1993 that had terms that extended well into 1994, the benefits created for that later year were direct and concrete. The same conclusion obtains with respect to the insurance policies that taxpayer purchased in 1993 whose terms provided coverage in 1994 as well. In these circumstances, the Tax Court correctly held that taxpayer's licensing and insurance expenses must be capitalized and amortized ratably over the taxable periods to which they related. See Steger v. Commissioner, 113 T.C. 227, 229 n. 3 (1999) ("insurance premiums that constitute prepayment of future insurance coverage provide significant benefits to the taxpayer beyond the year in issue and therefore constitute a capital expenditure"); see also Black Hills Corp. v. Commissioner, 73 F.3d 799, 806 (8th Cir. 1996) (prepayments of insurance premiums were capital expenditures where the premiums produced significant benefits beyond the tax years in question and where the benefits were not incidental or secondary); Johnson v. Commissioner, 108 T.C. 448, 488 ("payments for multi-year insurance coverage generally are capital expenditures"), aff'd in part and rev'd in part on other grounds, 184 F.3d 786 (1999); T.A.M. 9402004, 1993 WL 551454 (Jan. 14, 1994) (accrual basis taxpayer must amortize prepaid insurance over life of policy); Rev. Rul. 70-413, 1970-2 C.B. 13 (finding no basis to distinguish prepayment of insurance from other types of advance payments such as advance rentals).

[33] Unlike the situation in Wells Fargo, moreover, where the services provided were completed in the year of payment and the court had to determine whether the services were of such a nature that they created a future benefit, in the instant case it is undisputed that the expenses at issue created future benefits in the form of licensing and insurance coverage that extended beyond the taxable year in which the expenses were incurred. (App. 25-27.)

[34] In the same vein, taxpayer's reliance on the recent decision in PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822 (3d Cir. 2000), is misplaced. The issue in PNC Bancorp was whether the taxpayer-bank was required to capitalize its direct expenses of originating loans. The Tax Court had found that the bank loans were separate assets in the bank's business and that the expenses in question were costs of creating those assets and, as such, were required to be capitalized. The Third Circuit, however, disagreed with the Tax Court's determination that the loans were separate assets and with its further finding that the expenses in issue had created the loans. The court therefore concluded that the taxpayer properly had treated its loan origination fees as ordinary and necessary business expenses.

[35] Neither a showing that the expenses at issue here were recurring in nature or that they meet Section 162's definition of an ordinary business expenses establishes that the expenses were not capital expenditures. Indeed, taxpayer concedes (Br. 16) that deductibility of the license and insurance provisions "requires consideration of section 263, which has statutory precedence over section 162 and mandates capitalization if the expenses satisfy both provisions." The Third Circuit recently made the same observation in PNC Bancorp, 212 F.3d 822, 827 (3d Cir. 2000), noting that it is possible that an expense might appear to be deductible under Section 162, but nonetheless have to be capitalized "because it also properly falls under the description provided by section 263(a)." Id. "If an expense were to fall under the language of section 263(a), that section would 'trump' the deductibility provision of section 162(a) and the expense would have to be capitalized." Id.; see also INDOPCO, 503 U.S. at 84; Commissioner v. Idaho Power Co., 418 U.S. 1, 17 (1974). Thus, although courts may first conduct an analysis under Section 162 to evaluate whether a costs is an ordinary and necessary business expense under Section 162, as did the court in PNC Bancorp, it remains to be determined whether Section 263 nevertheless "trump[s]" Section 162, thus requiring capitalization. See PNC Bancorp, 212 F.3d at 827-29. Although in PNC Banccorp the particular recurring expenses at issue were held not to be capital expenditures, nothing in PNC Bancorp precludes a recurring expense from being treated as capital. Id.

[36] The courts consistently have recognized that recurring costs that otherwise might be currently deductible ordinary and necessary business expenses under Section 162 nonetheless must be capitalized if they create a separate asset or provide a substantial future benefit. Indeed, the Supreme Court made this clear long ago. In Helvering v. Winmill, 305 U.S. 79, 84 (1938), the Court held that brokerage commissions incurred by a taxpayer in purchasing securities must be capitalized as part of the acquisition cost of the securities even as to a taxpayer for whom they were a regular and recurring expense in his business of buying and selling securities. More recently, the Court in Woodward v. Commissioner, 397 U.S. 572, 575 (1970), cited Winmill with approval in holding that certain expenses incurred in purchasing shares of stock were required to be capitalized. See also Acer Realty Co. v. Commissioner, 132 F.2d 512 (8th Cir. 1942) (requiring capitalization of salaries of officers who performed all the services necessary in managing construction of new building); Dunlap v. Commissioner, 74 T.C. 1377, 1425-1428 (1980), rev'd on other grounds, 670 F.2d 785 (8th Cir. 1982) ("when one company acquires a separate and distinct company, the costs of taking it over, including the salaries of employees who spend some of their time working on the acquisition, are capital expenditures"); Chevy Chase Motor Co. v. Commissioner, 36 T.C.M. (CCH) 942 (1977) (requiring capitalization of salary of president-shareholder of real estate development firm to the extent the president devoted time to supervising construction).

[37] In light of case law, including decisions of the Supreme Court, making clear that the recurring or otherwise ordinary nature of an expense does not preclude its being a capital expenditure, this Court's statement in Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212, 217 (7th Cir. 1982), that whether expenses are recurring may serve as a "crude but perhaps serviceable demarcation" does not make the recurring nature of the expenses the dispositive factor that taxpayer contends. (See Br. 20.) In Encyclopaedia Britannica, this Court held that the expenses associated with creating a new Dictionary of Natural Sciences were not "ordinary" within the meaning of Section 162, because they were incurred for creation of a new project, rather than as part of the taxpayer's normal, recurring business activities. In reaching this conclusion, this Court observed that "[m]ost" noncapital expenses are recurring, while "most" capital expenses are non-recurring, in that they involving stepping out of the taxpayer's normal method of doing business to create a new asset - a principle that can be relevant in evaluating whether an expenditure is capital or non-capital. Id. at 216-17. This court recognized, however, in Encyclopaedia Britannica, 685 F.2d at 217, that it looked to "the distinction between recurring and nonrecurring business expenses" as a rough guideline for distinguishing between capital and non-capital expenditures because it "provides a very crude but perhaps serviceable demarcation between those capital expenditures that can feasiblely be capitalized and those that cannot be."

[38] Thus, that the expenses in question are recurring is not controlling, although it is a factor that weighs in favor of current deductibility. That factor, however, is far outweighed in the instant case by the fact that taxpayer's expenditures created substantial future benefits the exact duration of which was known and which extended well into the year subsequent to the year in which the expenses were incurred. See Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566 (1927) (taxpayer required to capitalize prepaid insurance premiums). Because, as demonstrated in detail below, the future benefit provided here extends "substantially beyond" the current tax year, the expenditures at issue here must be capitalized, as the Tax Court correctly held. See Black Hills, 73 F.3d at 806.

C. TAXPAYER CANNOT ESTABLISH THAT ITS LICENSE AND INSURANCE

 

EXPENSES DID NOT PROVIDE BENEFITS EXTENDING SUBSTANTIALLY

 

BEYOND THE TAXABLE YEAR

 

 

[39] Taxpayer in this case seeks full deduction in its 1993 tax year of licensing and insurance costs that provided greater benefits in 1994 than in the claimed year of deduction. (App. 24-25, paragraph 17; App. 27, section 25; App. 34.) There is no dispute that licenses and insurance taxpayer purchased in 1993 benefitted a significant portion of 1994. (App. 22, paragraph 11; App. 24, section 16-17; App. 26-27; App. 38-41.) Moreover, taxpayer's own financial accounting, wherein the expenses in question were capitalized, demonstrates the existence of the future benefits resulting from taxpayer's expenditures. See Lincoln Savings, 403 U.S. at 355 ("there is significance in the fact that all concerned here have recognized the presence and significance of this property interest" showing it as an asset on annual statements and balance sheets). Thus, the Tax Court correctly concluded that future benefits associated with the expenses at issue extended "substantially beyond the close of the taxable year" and must be capitalized.

[40] The standard in the Internal Revenue Code and its regulations provides that an expenditure must be capitalized when the future benefits resulting from the expenditure extend "substantially beyond" the close of the taxable year. I.R.C. section 263; Treas. Reg. sections 1.263(a)-2; 1.461-1(a). The record in this case shows that the insurance purchased by taxpayer in 1993 covered the later part of that year and the first half of 1994. (App. 25-26, paragraph 18.) The record similarly shows that the licenses and permits purchased by taxpayer in 1993 extended well into 1994 and, in some instances, extended to the end of 1994. (App. 24-25, paragraphs 16- 17; App. 38-41.) We submit that these future benefits extended "substantially beyond" 1993 and that, therefore, taxpayer was required to capitalize its expenses and recover them ratably over the taxable periods to which they related.

[41] Taxpayer, however, seeks to rely on a purported "one-year rule" under which expenditures need not be capitalized unless they provide a benefit extending more than one year after the close of the tax year in which payment is made. 6

1. THERE IS NO WELL-ESTABLISHED ONE-YEAR RULE FOR

 

DISTINGUISHING CAPITAL EXPENDITURES FROM ORDINARY

 

BUSINESS EXPENSES

 

 

[42] Taxpayer asserts that its "one year rule" - under which expenses that yield a benefit or an asset with a useful life of less than twelve months beyond the close of the current tax year are currently deductible - is "firmly grounded in administrative and judicial precedent." (Br. 8-9.) The "one-year rule" on which taxpayer relies, however, is not found in the Internal Revenue Code, the Treasury Regulations, or any Supreme Court decisions. This Court's decisions to which taxpayer cites (Br. 33-34) state only that, in general, an expenditure is a capital expenditure if it has a life extending beyond the one year period on which tax accounting is normally based, but do not address the specific issue here of whether pre-paid expenses covering a period of more than one taxable year can be deducted currently. See Fishman v. Commissioner, 837 F.2d 309, 312 (7th Cir. 1988) (start-up expenses were capital expenditures because they would not be exhausted in first tax year); Encyclopaedia Britannica, 685 F.2d at 217 (expenditures for research to prepare and edit science dictionary were capital); Clark Oil and Refining Co., 473 F.2d 1217, 1219-20 (7th Cir. 1973) (expenditure to acquire neighboring property in settlement of nuisance suit was capital expenditure because acquisition of the property was at the heart of the transaction). Indeed, this court specifically has recognized that the purpose of the capitalization rules is "to require the matching of expenses to income temporally, a major objective of efficient tax policy," Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 619 (7th Cir. 1995); see also Fishman, 837 F.2d at 312, an objective that taxpayer's one-year rule does not further.

[43] Moreover, even to the extent some cases have stated that expenditures creating a benefit with a duration in excess of one year must be capitalized, many of those cases only make general reference to the relevance of a one-year time frame, but do not specifically address the issue here - the proper treatment for expenditures that yield future benefits of 12 months or less duration, but which extend beyond the tax year in which the costs are incurred. See, e.g., Bilar Tool & Die Corp. v. Commissioner, 530 F.2d 708, 713 (6th Cir. 1976) (simply noting that the expenditure would "benefit the taxpayer for much more than one year"); Fall River Gas Appliance Co. v. Commissioner, 349 F.2d 515, 516-17 (1st Cir. 1965) (noting generally that a capital expenditure is one that secures an advantage with a life of more than one year, but no set formula will govern all cases); United States v. Akin, 248 F.2d 742, 744 (10th Cir. 1957) ("It is not always easy to find a verbal formula which readily supplies an unerring guide in drawing the boundary line between current expenses and capital outlays. But it may be said in general terms that an expenditure should be treated as one in the nature of a capital outlay if it brings about the acquisition of an asset having a period of useful life in excess of one year or if it secures a like advantage to the taxpayer which has a life of more than one year.") Hotel Kingkade v. Commissioner, 180 F.2d 310, 312 (10th Cir. 1950) (same); see also United States v. Wehrli, 400 F.2d 686, 689 (10th Cir. 1968) (one year rule is "a mere guidepost for resolution of the ultimate issue, not as an absolute rule").

[44] Several cases that discuss the one-year rule provide a definition of the rule that is contrary to taxpayer's position and, indeed, supports the Commissioner's position here that expenses for licenses and insurance of one-year or less in duration nevertheless cannot be deducted in the year paid if their benefits extend substantially into the subsequent tax period. For example, in Jack's Cookie Co. v. United States, 597 F.2d 395, 402 (4th Cir. 1979), the court stated that the one-year rule "treats an item as either a business expense, fully deductible in the year paid, or a capital expenditure, which is not, depending upon whether it secures for the taxpayer a business advantage which will be exhausted completely within the tax year." See also American Dispenser Co. v. Commissioner, 396 F.2d 137, 138 (2d Cir. 1966) ("'[t]he test for whether an item should be treated as a current expense or as a capital expenditure is whether the utility of the expenditure survives the accounting period'") (quoting Sears Oil Co. v. Commissioner, 359 F.2d 191, 197 (2d Cir. 1966)). Similarly, this Court's statement in Cabintaxi , 63 F.3d 614, 619 (7th Cir. 1995), that start-up expenses must be capitalized because they are not intended to produce income only in the first year of operations is consistent with the Commissioner's position in this case. These cases indicate that the proper inquiry is whether the life of the benefit created by the expenditure extends beyond the tax year in which it is incurred.

[45] Other decisions have flatly required capitalization of expenses that result in a benefit extending into a subsequent tax year. See Johnson v. Commissioner, 108 T.C. 448 (1997) (capitalization required for costs of insurance covering periods of one to seven years), aff'd in part and rev'd in part on other grounds, 184 F.3d 786 (8th Cir. 1999); Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566 (1927) (capitalization of prepaid insurance and interest costs required); Sorrell v. Commissioner, 53 T.C.M. (CCH) 1362 (1987) (fees paid in 1977 for leases which began in 1978 for periods of six months to a year must be amortized over the life of the leases to which the fees pertain), rev'd on other grounds, 882 F.2d 484 (11th Cir. 1989); Wood v. Commissioner, 34 T.C.M. (CCH) 817 (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); University Properties, Inc. v. Commissioner, 45 T.C. 416, 421 (1966) (prepaid rentals for use of property beyond year paid must be deducted ratably over years in which property is used), aff'd, 378 F.2d 83 (9th Cir. 1967); Galatoire Bros. v. Lines, 23 F.2d 676 (5th Cir. 1928) (when 45-month lease required extra payments of percent of profits and board to lessor in first year of lease only, lessee could only deduct ratable portion of those extra payments in first year of lease); see also Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370, 415 n.25 (1983) (Stevens, J., dissenting) (noting that the one-year rule adopted in Zaninovich v. Commissioner, 616 F2d 429 (9th Cir. 1980), is still being debated in the lower courts and has not been endorsed by the Commissioner or the Tax Court).

[46] In short, the one-year "rule" taxpayer advocates is far from widely accepted, and the Tax Court did not err in declining to apply it.

2. TO THE EXTENT A ONE-YEAR RULE EXISTS, IT IS INAPPLICABLE

 

TO THE PERIOD COSTS HERE

 

 

[47] In any event, to the extent a one year rule exists, it is not applicable to this case. Although the Tax Court focused largely on the cases limiting its application to cash basis taxpayers and, as we shall address, such a distinction is correct, perhaps an even more significant reason that a one-year rule is not applicable here is that such a rule is unnecessary in the context of the periodic costs at issue here.

[48] As this Court recognized in Encyclopaedia Britannica, 685 F.2d at 217, if capitalization were taken to its extreme as including everything that yields income beyond the current tax period, virtually every business expense would have to be capitalized. Accordingly, the courts have looked for lines of demarcation between those expenses that should be capitalized and those that should not be. Id. Where, however, the nature of the expenses is such that there is a clear division between payments pertaining to current benefits and payments pertaining to future benefits there is no reason to rely on a "crude" or "serviceable" demarcation. See id. Instead, in those circumstances, the expenses can and should be amortized ratably over the tax periods to which they relate.

[49] This distinction between the circumstance when rough lines of demarcation are needed to determine if expenses yielding benefits of indefinite duration must be capitalized and the circumstance where the period to which expenses pertain is clear, has led the courts to recognize a distinction between "periodic costs" and "product costs." See Keller v. Commissioner, 79 T.C. 7 (1982), aff'd, 725 F.2d 1173 (8th Cir. 1984); Van Raden v. Commissioner, 71 T.C. 1083 (1979), aff'd, 650 F.2d 1046 (9th Cir. 1981). Period costs "arise with respect to time intervals rather than the creation of products or rendition of services." Keller, 79 T.C. at 41. Period costs, such as rent, interest, and loan costs, as well as the licensing and insurance costs at issue here, can be accurately allocated among the taxable periods to which they relate, whereas product costs do not lend themselves to such easy allocation. See Boylston Market Ass'n, 131 F.2d at 968; Van Raden, 71 T.C. at 1108. In the situation of periodic expenditures that easily can be allocated among relevant tax periods, any justification for using a one-year rule vanishes.

[50] Many lower courts and administrative pronouncements have recognized the need for ease of allocation of product costs, and thus, in that context, have permitted current deductibility of expenditures that create benefits potentially spanning more than one taxable year. See, e.g., Kenney v. Commissioner, 65 T.C.M. (CCH) 2152, 2155 (1993) (tires with life of one year or less); Rev. Rul. 89-62, 1989-1 C.B. 78 (rental videocassettes); Rev. Rul. 78-382, 1978-2 C.B. 111 (rental uniforms with indefinite life of usually less than one year deductible in year placed in service) .

[51] In the context of periodic costs as here, however, the rationale for such an artificial line disappears. See Keller v. Commissioner, 79 T.C. 7 (1982), aff'd, 725 F.2d 1173 (8th Cir. 1984); Encyclopaedia Britannica, 685 F.2d at 217. These types of expenditures are precisely allocable to specific periods without resort to guesswork. See Boylston Market Ass'n, 131 F.2d at 968 (prepaid insurance easily allocated to the periods to which it pertains). Indeed, the ease of allocating the license and insurance costs incurred by taxpayer in the instant case to the specific periods to which they relate is demonstrated by the fact that taxpayer made such an allocation itself for financial accounting purposes. (App. 22, paragraphs 9, 10.) 7 As is apparent, if taxpayer purchases a 12-month insurance policy on July 1, 1993 that expires on June 30, 1994, it hardly is difficult to apportion the cost of the policy between those two years. The same is true with respect to the licenses and permits it purchased in 1993 that expired on a specified date in 1994. (See App. 38-41.) Since those expenses obviously relate in part to 1993 and 1994 and can be precisely apportioned between the two tax years, there is no justification for permitting taxpayer to deduct its entire cost for insurance and licenses in 1993.

3. IF THERE IS A ONE-YEAR RULE, IT IS INAPPLICABLE TO AN

 

ACCRUAL BASIS TAXPAYER

 

 

[52] Even if the one-year rule taxpayer urges were generally accepted and were applicable to period costs such as the one at issue here, the Tax Court correctly determined that it would be inapplicable to an accrual basis taxpayer like taxpayer here. The courts have distinguished between accrual and cash basis taxpayers in determining whether prepaid expenses must be capitalized. For example, in Zaninovich v. Commissioner, 616 F.2d 429, 431-32 & nn. 5- 6 (9th Cir. 1980), the Ninth Circuit allowed "a full deduction in the year of payment where an expenditure creates an asset having a useful life beyond the taxable year of twelve months or less." But this holding was based on concern that any other result would sacrifice "the simplicity of the cash basis method of accounting" and its "primary principle . . . that a deduction is appropriate when an expenditure is made." Id. at 432. In so holding, the court expressly distinguished cases involving accrual method taxpayers and approved the opposite result reached in Bloedel's Jewelry, Inc. v. Commissioner, 2 B.T.A. 611 (1925). Id. at 431 & n.5. In Bloedel's Jewelry, the expenditure at issue was a lease payment made in 1920 for a lease term running from September 1920 through August 1921. Distinguishing the lease to the accrual-basis taxpayer in Bloedel's Jewelry from the cash-basis taxpayer in Zaninovich, the Ninth Circuit stated:

The accrual method of accounting, unlike the cash basis method

 

aims to allocate to the taxable year expenses attributable to

 

income realized in that year. For this reason, it was

 

appropriate for the lessee in Bloedel's Jewelry, supra, to

 

prorate to the next year that portion of the rental payment

 

which could be matched with income realized in the next year.

 

Because the cash basis taxpayer is allowed to deduct items when

 

paid, regardless of when related income is realized, there is no

 

need for a prorated deduction here as a means of matching income

 

and expenses.

 

 

Zaninovich, 616 F.2d at 431 n.5. Compare Commissioner v. Boylston Market Ass'n, 131 F.2d 966 (1st Cir. 1942) (cash basis taxpayer who prepaid insurance premiums covering three years or more had to treat prepaid premiums as capital expenses) and Peters v. Commissioner, 4 T.C. 1236 (1945) (cash basis taxpayer could deduct in current year only portion of three-year policy that pertained to the current year) and Jephson v. Commissioner, 37 B.T.A. 1117 (1938) (cash basis taxpayer could deduct in current year only portion of three-year premium that pertained to current year) with Bell v. Commissioner, 13 T.C. 344 (1949) (cash basis taxpayer could deduct in current year payment for policy with term under one year, even though period of coverage extended into next taxable year) and Kauai Terminal, Ltd. v. Commissioner, 36 B.T.A. 893 (1937) (same); 8 but see Waldheim Realty and Investment Co. v. Commissioner, 245 F.2d 823, 827 (8th Cir. 1957) (holding cash-basis taxpayer could deduct all insurance premiums for coverage extending several years in year paid; to hold otherwise would be to impose accrual basis accounting for insurance payments).

[53] In contrast with the distinction generally drawn with respect whether the policy length is greater than a year in cases involving cash-basis taxpayers, where a taxpayer, as here, uses the accrual method, ratable deduction of premiums has been required, and no distinction based on policy length has been articulated. See Johnson v. Commissioner, 108 T.C. 448 (1997) (capitalization required for policies ranging in length from one to seven years), aff'd in part and rev'd in part on other grounds, 184 F.3d 786 (8th Cir. 1999); Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566 (1927); T.A.M. 9402004, 1993 WL 551454 (Jan. 14, 1994) (concluding, after INDOPCO, that accrual-method taxpayer must capitalize prepaid insurance and amortized cost over life of policy); see also Two-L Realty Co. v. Commissioner, 14 T.C.M. (CCH) 1147 (1955); Rev. Rul. 68-643, 1968-2 C.B. 76 (accrual basis taxpayers must deduct interest ratably over period to which it pertains, but for cash basis taxpayers previous position that all prepaid interest is deductible when paid is withdrawn and prepayments for a period more than 12 months beyond the close of the taxable year will be considered as materially distorting income and prepayments for 12 months or less beyond close of the taxable year will be examined on a case by case basis), modified by Rev. Rul. 69-582, 1969-2 C.B. 29 (mortgage points paid upon origination of loan were prepaid interest, but nonetheless were currently deductible for cash basis taxpayer).

[54] Taxpayer's reliance on what taxpayer argues is the implication of General Counsel Memorandum 13148, XIII-1 C.B. 67 (1934), that a one-year rule applies to accrual-basis taxpayers is misplaced. G.C.M. 13148's opening synopsis states "where insurance premiums are deductible as business expenses and are paid in advance for a period of more than one year, only the pro rata part of such payment is allowable a deduction each year, regardless of whether the income is reported on the cash receipts and disbursements basis or on the accrual basis." But when the entire memorandum is considered, all G.C.M. 13148 in fact did was to make clear that where insurance premiums are paid in advance for coverage for a period of more than one year, the payments must be amortized and deducted ratably. In any event, as taxpayer concedes (Br. 29), G.C.M. 13148 has been clarified and modified by subsequent administrative pronouncements. See GCM 13148, revoked by GCM 20307, 1938-1 C.B. 157, reinstated by G.C.M. 23587, 1943 C.B. 213, and superseded by Rev. Rul. 70-413, 1970-2 C.B. 103. And the IRS's most recent pronouncement, Revenue Ruling 70-413 makes clear that prepaid insurance - without any limitation as to the term of the insurance - must be amortized over the period to which the coverage pertains.

[55] Similarly, taxpayer mistakenly relies (Br. 30) on a speculative implication in citing Revenue Ruling 65-13, 1965-1 C.B. 87, which allowed current deduction of semi-annual costs of issuing annual reports for a taxpayer whose method of accounting was not specified. As in the corporate acquisition cases discussed, supra, it is not even clear that the semi-annual costs could be directly tied to a specific benefit in the next tax period. All the Revenue Ruling states is that the semi-annual expense could not be tied to benefits extending over more than one year, in contrast with the expense of a fee to a stock exchange for listing its stock which provided a long term benefit.

[56] The cases taxpayer cites (Br. 31) as examples where the Tax Court has permitted accrual basis taxpayers to deduct in the current year expenditures for items with a life of approximately one year also do not establish that a one-year rule should be applied to accrual basis taxpayers generally. Rather, these cases are examples where the courts, faced with products having indefinite lives, have permitted current deduction for ease of allocation. As we have discussed, however, the same rationale does not apply to the period costs here. Thus, Mennuto v. Commissioner, 56 T.C. 910, 922 (1971), involved a claimed deduction for the cost of building a temporary leeching pit designed to be functional only for about a year. It was built for temporary use (after an order to stop using a creek bed) only until the factory could be connected to the sewer line.

[57] Garth v. Commissioner, 56 T.C. 610 (1971), is similarly inapposite. There, the Tax Court's holding was that the hens were inventoriable property, the value of which taxpayers were entitled to include in computing their cost of goods sold under the farm price method. Id. at 623. Only in dicta, the court stated that, even if the hens were equipment used in the business, capitalization would not be necessary because the hens could be treated as not having a useful life extending substantially beyond the current tax year. Again, the court was faced with an indefinite product cost rather than clearly ascertainable period costs - the hens had a useful life span of one year, plus or minus a few months, such that the useful life of the flock did not expire at once and new inventory was constantly being added to the flock to replace hens no longer laying eggs.

[58] Taxpayer's other attempts to point to product cost cases to support the conclusion that a one-year rule applies to accrual basis taxpayers are likewise unavailing because the rationale behind drawing a clear line of demarcation does not apply outside the context of products with indefinite lives. See, e.g., Rev. Rul. 69- 81, 1969-1 C.B. 137 (accrual method laundry could deduct costs of towels in the year they were placed in service, where items had useful life of one year of less). Neither the cases nor the administrative pronouncements have recognized a one-year rule for accrual basis taxpayers generally, but only have applied a one-year period as a guideline in limited instances involving product costs in circumstances where the practicalities of allocation and a highly indefinite life span necessitates it. As we have already discussed, the rationale for such a bright-line, artificial rule disappears in the context of the period costs at issue here.

[59] As we also have discussed, supra, use of the accrual method of accounting is a key fact distinguishing this case from cases applying a one-year rule. E.g., Zaninovich v. Commissioner, 616 F.2d at 431 & n.5 . Such distinctions make sense because of the differing goals behind the cash and accrual methods.

[60] The accrual method seeks "to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period." United States v. Anderson, 269 U.S. 422, 440 (1926). In short, much in the same way the requirement of capitalization "endeavors to match expenses with the revenues of the taxable period to which they are properly attributable," INDOPCO, 503 U.S. at 84, the accrual method's goal is to match income with associated expenses. North Central Life Ins. Co. v. Commissioner, 92 T.C. 254, 281 (1989). Generalized application of a one-year rule to taxpayers using the accrual method would undermine the matching the accrual method is designed to achieve.

[61] In contrast, the cash method's focus is on achieving simplicity by taking deductions at the time of payment. Frysinger v. Commissioner, 645 F.2d 523 (5th Cir. 1981). And, unlike the matching achieved with the accrual method, courts have recognized that the goal of simplicity in the cash method can create distortion, but have accepted that "[t]he distortion created by the deduction is inherent in the cash method, which for the sake of accounting convenience does not attempt to accurately match expenses with income." Ibid. In light of this distinction, cases that have permitted current deduction of costs providing the taxpayer a benefit beyond the taxable year have expressly stressed the importance of use of the cash method of accounting. See Commissioner v. Van Raden, 650 F.2d 1046, 1050 (9th Cir. 1981) (permitting immediate deduction by cash basis farmer of costs for feed used beyond close of taxable year and making particular note of the taxpayer's use of cash method of accounting); Cravens v. Commissioner, 272 F.2d 895 (10th Cir. 1959) (same).

[62] Thus, although for cash basis taxpayers certain rules of convenience have been adopted, notwithstanding the resulting distortion of income, these rules of thumb do not apply to accrual basis taxpayers. This is particularly true in the case of period costs spanning more than one taxable year where an exact allocation of the costs to the periods to which they related may be easily made.

II

 

 

TAXPAYER'S METHOD OF ACCOUNTING DOES NOT CLEARLY REFLECT ITS INCOME

 

 

Standard of Review

 

 

[63] The Tax Court did not reach the Commissioner's alternative contention that taxpayer's method of accounting did not clearly reflect its income. Accordingly, in the event this Court were to consider this issue it would be considering the matter de novo.

[64] As we have already demonstrated, the Tax Court correctly upheld the Commissioner's deficiency determination on the ground that taxpayer's license and insurance expenses were capital expenditures. (App. 14.) Taxpayer's deduction of its license and insurance expenses in the year of payment also failed to clearly reflect its income, however, providing an additional ground for affirmance of the Tax Court's decision.

[65] Where the Commissioner determines that a taxpayer's method of accounting does not clearly reflect income, the Commissioner can require computation of taxable income be made under such method as in the Commissioner's opinion does clearly reflect income. I.R.C. section 446(b). The Commissioner possesses broad discretion in determining whether a particular method of accounting clearly reflects income. United States v. Hugh Properties, 476 U.S. 593, 603 (1986); RLC Industries Co. v. Commissioner, 98 T.C. 457, 491 (1992), aff'd, 58 F.3d 413 (9th Cir. 1995); Capitol Federal Savings & Loan Ass'n v. Commissioner, 96 T.C. 204, 209 (1991). The Commissioner's determination must be accepted unless it is found to be arbitrary and capricious and without sound basis in fact or law. Ford Motor Co. v. Commissioner, 102 T.C. 87, 92 (1994), aff'd, 71 F.3d 209 (6th Cir. 1995).

[66] Taxpayer relies (Br. 40) on cases holding that the IRS cannot require a taxpayer to change from a method that clearly reflects income to one that more clearly reflects income, and contends that the Commissioner cannot change its method of accounting simply to achieve a desired goal of perfect matching of income and expenses. Taxpayer also relies (Br. 40) on authority holding that a method of accounting that is specifically authorized by the Internal Revenue Code or its regulations is presumed to clearly reflect income and cannot be changed.

[67] As we have already discussed, taxpayer's method of accounting is not one that is specifically authorized by the Code or its regulations, because it violates the capitalization rules of Code Section 263. See Treas. Reg. section 1.461-1(a)(2). Taxpayer's method also is not one that clearly reflects income, so the restriction that the Commissioner cannot require a change from a method that clearly reflects income to one that more clearly reflects income is inapplicable.

[68] Not only did taxpayer's method not achieve the goal of matching the costs of licenses and insurance with the income they helped produce, taxpayer's method produced the improper effect of accelerating its deductions. Taxpayer's method lumped all the costs into the taxable year in which payment was made, matching them with income only from that year. Yet, more than half of the total costs should have been matched with income from the succeeding year, since more than half of the costs benefitted the succeeding year rather than the year in which taxpayer claimed the deduction. Specifically, $1,709,563 (40 percent) of taxpayer's total 1993 expenditures of $4,308,460 for licenses benefitted 1993, while the remaining $2,598,897 (60 percent) benefitted 1994. (App. 25, paragraph 18; App. 27, paragraph 25; App. 24-43.) Similarly, the $1,090,602 taxpayer paid for insurance coverage in the taxable year 1993 provided coverage extending from July 1, 1993, through June 30, 1994. (App. 25-26, paragraph 18.)

[69] Moreover, in evaluating whether a method of accounting clearly reflects income, the question is not accurately answered by a snapshot view of a single year. Rather, it is appropriate to make that determination over time. See Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781, 792 (11th Cir. 1984) ("clear reflection of income during a few interim years does not by itself prevent future losses" of revenue for the Government resulting from distortion). Consideration of a period of years in evaluating income is particularly relevant where, as here (Supp. App. 3, 5; App.19-20, section 3)), taxpayer is a growing company whose license and insurance costs are increasing, thus magnifying the distortion over times. See All Steel Equipment v. Commissioner, 54 T.C. 1749, 1757 (1970), aff'd in relevant part and rev'd in part, 467 F.2d 1184 (7th Cir. 1972) ("the continued use of an erroneous method involves the risk that it will produce a much greater error in a later year, especially if the petitioner's business should increase significantly").

[70] Because it did not address clear reflection of income issue, the Tax Court declined to address taxpayer's related evidentiary objection to the admissibility of financial data for years subsequent to 1993, which was offered by the Commissioner to show distortion of income resulting from taxpayer's method of accounting. (App. 14.) This data for subsequent years is relevant to the question whether taxpayer's method of accounting clearly reflects its income. Therefore, the evidence in the record regarding the distortion in taxpayer's subsequent years should be considered by this Court. See Fed. R. Evid. 401.

[71] When taxpayer's deductions under its payment method of accounting are compared with the deductions it should have claimed under a ratable amortization method, the resulting distortion in its income becomes apparent. For the years 1993 through 1997, taxpayer's total deductions for license and insurance expenses using its payment method exceeds the deductions the ratable amortization method would have allowed by $2,363,925. (App. 45, paragraph 33; App. 27, sections 23, 25.) This si a substantial distortion of taxpayer's income by any reasonable standard.

[72] The courts have refused to accept much smaller inaccuracies. See Brooks-Massey Dodge, Inc. v. Commissioner, 60 T.C. 884 (1973) ("an accounting method which fails to accurately report approximately $70,000 of income over a 2-year period does not clearly reflect income, and omissions of those proportions are certainly significant"). Indeed, acceleration of deductions by a single year may constitute a material distortion of income . E.g., Mortensen v. Commissioner, 49 T.C.M. (CCH) 94 (1984) (deduction of prepaid interest that accelerated deduction only one year materially distorted income). Thus, the Commissioner's change of taxpayer's accounting method under Section 446(b) cannot be categorized as arbitrary or an abuse of discretion.

CONCLUSION

[73] For the foregoing reasons, the Tax Court's decision should be affirmed.

Respectfully submitted,

 

 

LORETTA C. ARGRETT

 

Assistant Attorney General

 

 

RICHARD FARBER (202) 514-2959

 

ELLEN PAGE DELSOLE (202) 514-8128

 

Attorneys

 

Tax Division

 

Department of Justice

 

Post Office Box 502

 

Washington, D.C. 20044

 

 

OCTOBER 2000

 

 

CERTIFICATE OF COMPLIANCE WITH TYPE VOLUME LIMITATION

[74] I certify that this brief complies with the type volume limitation set forth in Rule 32(a)(7)(C) of the Federal Rules of Appellate Procedure and Circuit Rule 32(a). The brief contains 11,191 words.

ELLEN PAGE DELSOLE

 

Attorney

 

 

CERTIFICATE OF SERVICE

[75] It is hereby certified that service of the foregoing brief (as revised) has been made on counsel for the appellant and the amici on this 13th day of October, 2000, by mailing two copies thereof by Federal Express to each in envelopes properly addressed to them as follows:

Gerald A. Kafka, Esq.

 

Sanford W. Stark, Esq.

 

Joy C. Ruff, Esq.

 

McKee Nelson, Ernst & Young LLP

 

1150 18th Street, N.W., Suite 500

 

Washington, D.C. 20036

 

 

Lawrence S. Ebner, Esq.

 

Dudley M. Lang, Esq.

 

McKenna & Cuneo, L.L.P.

 

1900 K Street, N.W.

 

Washington, D.C. 20006

 

 

ELLEN PAGE DELSOLE

 

 

ADDENDUM

 

 

Internal Revenue Code (26 U.S.C.) Section 162(a)

 

Internal Revenue Code (26 U.S.C.) Section 263(a)

 

Treasury Regulations (26 C.F.R.) Section 1.263(a)-2

 

 

INTERNAL REVENUE CODE (26 U.S.C.):

 

 

Section 162. TRADE OR BUSINESS EXPENSES

 

 

(a) IN GENERAL.--There shall be allowed as a deduction all

 

the ordinary and necessary expenses paid or incurred during the

 

taxable year in carrying on any trade or business, including --

 

 

(1) a reasonable allowance for salaries or other

 

compensation for personal services actually rendered;

 

 

(2) traveling expenses (including amounts expended for

 

meals and lodging other than amounts which are lavish or

 

extravagant under the circumstances) while away from home in the

 

pursuit of a trade or business; and

 

 

(3) rentals or other payments required to be made as a

 

condition to the continued use or possession, for purposes of

 

the trade or business, of property to which the taxpayer has not

 

taken or is not taking title or in which he has no equity.

 

 

* * *

 

 

Section 263. CAPITAL EXPENDITURES

 

 

(a) GENERAL RULE.--No deduction shall be allowed for --

 

 

(1) Any amount paid out for new buildings or for permanent

 

improvements or betterments made to increase the value of any

 

property or estate. This paragraph shall not apply to --

 

 

(A) expenditures for the development of mines or deposits

 

deductible under section 616,

 

 

(B) research and experimental expenditures deductible under

 

section 174,

 

 

(C) soil and water conservation expenditures deductible

 

under section 175,

 

 

(D) expenditures by farmers for fertilizer, etc.,

 

deductible under section 180,

 

 

(E) expenditures for removal of architectural and

 

transportation barriers to the handicapped and elderly

 

which the taxpayer elects to deduct under section 190,

 

 

(F) expenditures for tertiary injectants with respect to

 

which a deduction is allowed under section 193;

 

 

(G) expenditures for which a deduction is allowed under

 

section 179; or

 

 

(H) expenditures for which a deduction is allowed under

 

section 179A.

 

 

(2) Any amount expended in restoring property or in making

 

good the exhaustion thereof for which an allowance is or has

 

been made.

 

 

* * *

 

 

TREASURY REGULATIONS (26 C.F.R.)

 

 

Section 1.263(a)-2. EXAMPLES OF CAPITAL EXPENDITURES

 

 

The following paragraphs of this section include examples of capital

 

expenditures:

 

 

(a) The cost of acquisition, construction, or erection of

 

buildings, machinery and equipment, furniture and fixtures, and

 

similar property having a useful life substantially beyond the

 

taxable year.

 

 

(b) Amounts expended for securing a copyright and plates,

 

which remain the property of the person making the payments. See

 

section 263A and the regulations thereunder for capitalization

 

rules which apply to amounts expended in securing and producing

 

a copyright and plates in connection with the production of

 

property, including films, sound recordings, video tapes, books,

 

or similar properties.

 

 

(c) The cost of defending or perfecting title to property.

 

 

(d) The amount expended for architect's services.

 

 

(e) Commissions paid in purchasing securities. Commissions

 

paid in selling securities are an offset against the selling

 

price, except that in the case of dealers in securities such

 

commissions may be treated as an ordinary and necessary business

 

expense.

 

 

(f) Amounts assessed and paid under an agreement between

 

bondholders or shareholders of a corporation to be used in a

 

reorganization of the corporation or voluntary contributions by

 

shareholders to the capital of the corporation for any corporate

 

purpose. Such amounts are capital investments and are not

 

deductible. See section 118 and section 1.118-1.

 

 

(g) A holding company which guarantees dividends at a

 

specified rate on the stock of a subsidiary corporation for the

 

purpose of securing new capital for the subsidiary and

 

increasing the value of its stockholdings in the subsidiary

 

shall not deduct amounts paid in carrying out this guaranty in

 

computing its taxable income, but such payments are capital

 

expenditures to be added to the cost of its stock in the

 

subsidiary.

 

 

(h) The cost of good will in connection with the

 

acquisition of the assets of a going concern is a capital

 

expenditure.

 

FOOTNOTES

 

 

1 "App." references are to the pages of the record appendix bound with taxpayer's brief.

2 "Doc." references are to the items on the Tax Court docket sheet as numbered by the clerk of the Tax Court.

3 "Supp. App." references are to the Supplemental Appendix filed with the Commissioner's answering brief.

4 The subsidiary corporations that joined in the filing of the consolidated federal income tax return are listed in paragraph 3 of the Stipulation of Facts. (App. 19-20.)

5 Many cases have held that licenses are capital assets but based their reasoning on the fact that the license was accompanied by a long-term right of renewal and only a limited number of licenses were issued. See, e.g., Dustin v. Commissioner, 467 F.2d 47 (9th Cir. 1972); WHEC, Inc. v. Commissioner, 37 T.C. 821 (1962). The Tax Court here did not reach the question whether taxpayer's licenses and permits at issue had such characteristics.

6 In setting forth their interest in the case, the amici imply that current deduction of license and insurance expenses is, and always has been, the practice of their constituents. Such a representation is inappropriate. There is no evidence of record suggesting that current deduction of license or insurance expenses is, or ever was, the norm. In fact, the record establishes that taxpayer itself amortized such costs for years prior to 1992. (Supp. App. 43-44.).

7 The amici's statement (Amicus Brief at 2) that the Tax Court's holding would impose significant and unnecessary tax reporting burdens on every business with annually recurring expenses . . ." ignores the facts on which the Tax Court's decision is based - facts involving easily allocable period costs which were already allocated by taxpayer for financial accounting purposes.

8 Along the same lines, Revenue Ruling 68-643 applied a one- year rule that allowed cash-basis taxpayers to deduct prepayment of interest for period not in excess of twelve months beyond close of taxable year, but reserved the right for IRS to require allocation of interest over the taxable years involved if immediate deduction materially distorted income. See also Burck v. Commissioner, 533 F.2d 768 (2d Cir. 1976) (applying Rev. Rul. 68-643 to require cash-basis taxpayer to allocate deduction for prepaid interest to tax periods in which the expense accrues, because to rule otherwise would materially distort income)

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Case Name
    USFREIGHTWAYS CORPORATION, FORMERLY TNT FREIGHTWAYSCORPORATION, AND SUBSIDIARIES, Petitioners-Appellants v. COMMISSIONER OF INTERNAL REVENUE Respondent-Appellee
  • Court
    United States Court of Appeals for the Seventh Circuit
  • Docket
    No. 00-2668
  • Institutional Authors
    U.S. Department of Justice
  • Cross-Reference
    USFreightways Corp., et al. v. Commissioner, 113 T.C. No. 23; No.

    459-98 (November 2, 1999) (For a summary of this opinion, see Tax

    Notes, Nov. 8, 1999, p. 754; for the full text, see Doc 1999-35231 (15

    original pages) or 1999 TNT 212-2 Database 'Tax Notes Today 1999', View '(Number'.)
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    accounting methods
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-27268 (65 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 221-18
Copy RID