Comm'r of Internal Revenue

Tax Court of the United States.Aug 13, 1962
38 T.C. 605 (U.S.T.C. 1962)
38 T.C. 605T.C.

Docket No. 89827.



J. Gilmer Blackburn, Esq., for the petitioners. Homer F. Benson, Esq., for the respondent.

J. Gilmer Blackburn, Esq., for the petitioners. Homer F. Benson, Esq., for the respondent.

Cost of improvements made to leased premises by a lessee with an option to purchase held depreciable over the life of the improvements, rather than over the term of the lease (7 years) where it was the lessee's intention to exercise the option and indications were that he would do so.

This proceeding involves income tax deficiencies for 1956, 1957, and 1958 in the respective amounts of $1,867.45, $2,698.54, and $1,274.09. There is also asserted an addition to tax of $28.43 for failure to pay estimated income tax for 1956. The only question is as to the amount of depreciation deduction allowable on leasehold improvements.


The petitioners are husband and wife and are residents of Huntsville, Alabama. They filed joint income tax returns for the years 1956, 1957, and 1958 with the district director of internal revenue for Alabama. The term petitioner, as hereinafter used, will refer to the husband, Suil J. Moss.

For several years prior to 1956 petitioner owned and successfully operated a restaurant in Huntsville. On October 31, 1955, he leased a parcel of land on the Huntsville North-South bypass, South Memorial Parkway, just south of Huntsville, as a site for a new restaurant. Construction of the restaurant was begun in December 1955 and completed about April 1, 1956. The cost of construction of the building alone was $54,744.51, and the cost of the equipment installed, $31,886.36.

Petitioner invested $7,351.69 of his own money, all of his cash funds, in the venture. The balance of the funds required for the construction of the building and for the equipment was obtained as bank loans or credit extended by the suppliers. The restaurant, known as the Dwarf Restaurant, was opened for business soon thereafter and has continued in operation by petitioner up to the present time.

South Memorial Parkway had been recently opened up and the area adjacent was only partially developed when petitioner opened his restaurant. There were two other competitive restaurants in the vicinity, but petitioner's restaurant was successful from the beginning. The expansion of nearby Redstone Arsenal and the rapid business development on South Memorial Parkway contributed to petitioner's success.

The lease was for a term of 7 years from January 1, 1956, at a rental of $100 per month. The lease agreement contained no provision for renewal of the lease but did contain an option for the lessee to purchase the property at any time during the term of the lease for $25,000. There was no provision in the lease agreement to permit the removal by the lessee of any of the improvements on the premises during or upon termination of the lease. It was petitioner's purpose and intention from the beginning to purchase the land on which the restaurant was built.

Pursuant to the terms of the option agreement petitioner, on November 1, 1958, purchased the property at the option price of $25,000.

Petitioner reported profits from the operation of the restaurant of $8,478.33 in 1956, $14,186.51 in 1957, and $8,723.92 in 1958. These were the amounts shown after deductions for depreciation on the restaurant building and any other leasehold improvements computed on a life of 7 years.

The balance sheet of Dwarf Restaurant, as of December 31, 1956, shows the following:

+-----------------------------------------------------+ ¦ASSETS ¦ +-----------------------------------------------------¦ ¦Current Assets: ¦ ¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Cash on hand ¦$225.00 ¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Cash in bank ¦619.17 ¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Total cash ¦ ¦$844.17 ¦ ¦ +----------------------+---------+---------+----------¦ ¦Merchandise inventory ¦ ¦2,750.00 ¦ ¦ +----------------------+---------+---------+----------¦ ¦Employees' advances ¦ ¦186.90 ¦ ¦ +----------------------+---------+---------+----------¦ ¦Total current assets ¦ ¦ ¦$3,781.07 ¦ +----------------------+---------+---------+----------¦ ¦Fixed Assets: ¦ ¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Delivery equipment ¦$1,848.11¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Rest. depreciation ¦385.10 ¦$1,463.01¦ ¦ +----------------------+---------+---------+----------¦ ¦Other equipment ¦30,038.25¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Rest. depreciation ¦3,003.82 ¦27,034.43¦ ¦ +----------------------+---------+---------+----------¦ ¦Leasehold improvements¦54,744.51¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Rest. amortization ¦7,820.60 ¦46,923.91¦ ¦ +----------------------+---------+---------+----------¦ ¦Total fixed assets ¦ ¦ ¦$75,421.35¦ +----------------------+---------+---------+----------¦ ¦Other Assets: ¦ ¦ ¦ ¦ +----------------------+---------+---------+----------¦ ¦Utility deposits ¦ ¦ ¦115.00 ¦ +----------------------+---------+---------+----------¦ ¦Total assets ¦ ¦ ¦79,317.42 ¦ +-----------------------------------------------------+

LIABILITIES Current Liabilities: Accounts payable $31,167.57 Notes payable 16,441.49 Equipment obligations payable 13,547.37 Taxes withheld 796.14 Accrued taxes 1,534.83 Total liabilities 63,487.40

NET WORTH S. J. Moss, Prop. Original investment 7,351.69 1956 profit 8,478.33 15,830.02 Total liabilities and net worth 79,317.42

Respondent has determined that the cost of the leasehold improvements should be depreciated over the useful life of such improvements, rather than over the term of the lease, and has reduced petitioner's depreciation deductions accordingly. The cost of the improvements, the amount of depreciation claimed by petitioner, and the amount allowed by respondent, in each of the taxable years, are as follows:

+-------------------------------------------+ ¦ ¦Cost of ¦Depreciation¦Depreciation¦ +----+------------+------------+------------¦ ¦Year¦improvements¦claimed by ¦allowed by ¦ +----+------------+------------+------------¦ ¦ ¦ ¦petitioner ¦respondent ¦ +----+------------+------------+------------¦ ¦1956¦$54,744.41 ¦$7,820.60 ¦$1,231.74 ¦ +----+------------+------------+------------¦ ¦1957¦54,993.95 ¦7,862.23 ¦1,649.81 ¦ +----+------------+------------+------------¦ ¦1958¦55,057.22 ¦6,918.84 ¦1,651.72 ¦ +-------------------------------------------+


TURNER, Judge:

It is in our opinion settled law that depreciation deductions in respect of improvements made on leased premises where the lessee has an option either to renew the lease or to purchase the property are to be based on the useful life of the improvements rather than the period of the lease, if the lessee intends to, and there is reasonable probability that he will, exercise the option to renew the lease beyond the useful life of the improvements, or purchase the property under his option, and thus be assured of their continued use. Leonard Refineries, Inc., 11 T.C. 1000; Standard Tube Co., 6 T.C. 952; Harry Gleis, 24 T.C. 941, affd. 245 F.2d 237; Kerr-Cochran, Inc., 30 T.C. 69; Pittsburgh Union Stock Yards Co. v. Commissioner, 46 F.2d 464.

In the Leonard Refineries, Inc. case, we said:

Where it appears certain that an option to purchase leased premises will be exercised, over what period should assets on those premises be depreciated? Decisions pertinent to this question deal with a comparable situation where there is a reasonable certainty that a renewal provision in a lease will be exercised. Under those circumstances the courts have held the proper period for taking depreciation is the remaining life of the original term plus the renewal period. Pittsburgh Union Stock Yards Co. v. Commissioner, 46 Fed. (2d) 646; 1620 Broadway Corporation, 36 B.T.A. 149, 152; Standard Tube Co., 6 T.C. 952. By analogy, where it is apparently certain that the option to purchase leased land will be exercised, depreciation rates for assets located on such land should be based on their estimated physical lives. As was said in Rankin v. Commissioner, 60 Fed.(2d) 76, it is only necessary that it appear the lessee's use or occupancy will exceed the life of the improvement. If that requirement is met, then the depreciation should be spread over the full life of the asset.

Petitioner testified that he intended from the beginning to exercise the option to purchase the land if the restaurant proved successful and we are satisfied from the evidence that he was confident that the venture would be a success and that a term of 7 years would provide adequate time for effecting the purchase. It is most unlikely, we think, that he would have considered spending and obligating himself personally to the extent of $54,774.51 in improving the land and $31,886.36 for equipment, limited to an operation of 7 years. Furthermore the regulations have long provided that ‘the reasonableness of any claim for depreciation shall be determined upon the basis of conditions known to exist at the end of the period for which the return is made.’ Income Tax Regs., sec. 1.167(b)-O(a), and Leonard Refineries, Inc., supra, and the cases cited therein.

At December 31, 1956, the end of the taxable period which included the first 9 months of operation, the balance sheet of Dwarf Restaurant disclosed total assets of $79,317.42, which included current assets of $3,781.07, most of which was merchandise inventory, and fixed assets of $75,421.35, of which $28,497.44 was in equipment and $46,923.91 in the restaurant building and other leasehold improvements. Total liabilities were shown as $63,487.40 and net worth as $15,830.02, which latter amount consisted of petitioner's original investment of $7,351.69 and $8,478.33 shown as the net profits for the first 9 months of operation. In that connection it is to be noted that the $8,478.33 so shown was after the deduction of depreciation on the leasehold improvements on the basis of the 7-year term of the lease, rather than their useful life. It is to be noted also that with an investment of only $7,351.69 the amount owing on equipment and leasehold improvements had been reduced from $86,630.87, their cost, to, at the most, no more than $61,150.43, which was a reduction in the 9 months' period of 20 percent of total cost. In short, during the first 9 months of operation the business had not only supplied at least $18,123.75 for payment on liabilities incurred in the purchase of fixed assets, but had also supplied $3,781.07 in cash, inventory, and advances to employees.

We accordingly conclude that in entering into the lease it was petitioner's purpose and intention to acquire the land in question, that a term of 7 years was regarded as sufficient for effecting the purchase, and by December 31, 1956, such acquisition was a reasonable certainty.

We hold that the respondent has correctly determined that the leasehold improvements should be depreciated in each of the taxable years over their remaining useful life.

Decision will be entered under Rule 50.