Case Name: FRIBOURG NAVIGATION COMPANY, Inc., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Court: United States Court of Appeals for the Second Circuit
Jurisdiction: United States
Decision Date: 1964-07-15
Citations: 335 F.2d 15
Docket Number: No. 72, Docket 28165
Parties: FRIBOURG NAVIGATION COMPANY, Inc., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Judges: 
Reporter: Federal Reporter 2d Series
Volume: 335
Pages: 15–23

Head Matter:
FRIBOURG NAVIGATION COMPANY, Inc., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
No. 72, Docket 28165.
United States Court of Appeals Second Circuit.
Argued Jan 16, 1964.
Decided July 15, 1964.
Moore, Circuit Judge, dissented.
James B. Lewis, New York City (Theodore Ness, Michael J. Nassau and Paul, Weiss, Rifkind, Wharton & Garrison, New York City, on the brief), for petitioner.
William A. Friedlander, Atty. Dept, of Justice, Washington, D. C. (Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson and Harry Baum, Dept, of Justice, Washington, D. C., on the brief), for respondent,
Before SWAN, MOORE and SMITH, Circuit Judges.

Opinion:
J. JOSEPH SMITH, Circuit Judge,
The sole issue presented by this appeal is whether a taxpayer is entitled to a depreciation deduction for the year in which a depreciable asset is sold at more than its depreciated cost. The Tax Court sustained the Commissioner's dis-allowance of the deduction, and the taxpayer has appealed to this court. We agree with the Tax Court's determination and affirm the judgment. J
The taxpayer, Fribourg Navigation Co., operated two cargo ships in foreign commerce. One of these was the S. S. Feuer, a Liberty ship purchased in December of 1955 for $469,000. Just prior to purchasing the Feuer, the taxpayer secured a letter ruling from the Engineering and Valuation Branch of the Internal Revenue Service advising that it would accept straight line depreciation of the ship over a useful economic life of three years, subject to change if warranted by subsequent experience. The letter ruling also advised that the Internal Revenue Service would accept a salvage value of $54,000 on the Feuer. This estimate of the Feuer's useful economic life and salvage value, concededly reasonable in December of 1955, was thrown out of kilter by a scarcity of ships resulting from the Suez Crisis of 1956-57, which sharply inflated the values of ships normally considered obsolete. In June of 1957 the taxpayer accepted an offer to sell the Feuer for $700,000, $231,000 more than it had paid for the ship a year and a half before. When the Feuer was delivered to its new owner on December 23,1957, the contract terms were slightly modified, reducing the purchase price to $695,500.
Relying on the letter ruling, the taxpayer deducted the $54,000 estimated salvage value from the $469,000 cost and spread the $415,000 equally over a three year useful life — from December 21,1955 to December 21, 1958. This resulted in a daily depreciation of about $378.65. On its income tax returns, the taxpayer claimed the following depreciation deductions for the Feuer:
Calendar Year Period of Ownership Depreciation
1955 10 days $ 3,786.50
1956 366 days 138,585.77
1957 357% days 135,367.24
Total $277,739.51
On March 7, 1957, prior to the sale of the Feuer, the taxpayer adopted a plan of complete liquidation, which was carried out within 12 months. Since the liquidation came within the sanctuary of Section 337 of the Internal Revenue Code, the taxpayer incurred no tax liability on the capital gain from the sale of the Feuer. For information purposes only, the taxpayer reported a capital gain of $504,239.51 (the difference between the selling price and the adjusted basis after taking a depreciation allowance for 357% days of 1957). The taxpayer reported a gross income (after cost of operations) of $391,811.31 in 1957. This was reduced to $141,193.35 after deductions of $250,617.96, including $135,367.24 for the depreciation of the Feuer in 1957.
The Commissioner disallowed the $135,367.24 deduction in full, taking the position that a taxpayer cannot depreciate an asset during the year its sale reveals that it has not depreciated. At the start of 1957 the Feuer had an adjusted basis of $326,627.73. In December of 1957 it was sold for $695,500. The Commissioner claims Congress never intended to permit further depreciation under such circumstances, and that a depreciation deduction claimed when the taxpayer knows with certainty that the asset has appreciated rather than depreciated must be disallowed as unreasonable. The Commissioner does not seek to recapture the depreciation deductions allowed for 1955 and 1956. He is content with contending only that depreciation disallowance should be limited to the year in which an asset is sold for more than its adjusted basis.
Though perhaps logically inconsistent, this position is strongly suggested by the opinion of the Sixth Circuit in Cohn v. United States, 259 F.2d 371 (1958), which first permitted the Commissioner to disallow depreciation deductions on assets sold for more than their adjusted basis. In 1941-42 the taxpayers in Cohn began to operate three flying schools to train pilots under the Army Air Corps Contract Flying School Program. The taxpayers determined that their contracts for operation of the schools would terminate at the end of 1944, and the equipment they had purchased to operate the schools should be depreciated over a useful economic life ending on December 31, 1944. In computing their depreciation deductions, the taxpayers neglected to place any salvage value on the equipment, though operators of similar flying schools used an estimated salvage value of ten percent in establishing their depreciation schedules. One of the schools ceased its operations on August 4, 1944, and its equipment was sold at auction during that month. The property of the other two schools was auctioned off in November of 1944. Because of wartime shortages, the equipment brought substantial sums, exceeding the adjusted basis of the assets at the beginning of 1944. The Commissioner disallowed the depreciation deductions for all the years as excessive and unreasonable. The District Court found that a salvage value of 10% of the original cost should have been used in computing the depreciation schedules and that the actual sales price should have been substituted for the salvage value in the year in which the asset was sold. Only the latter holding was appealed to the Sixth Circuit, which affirmed the District Court.
The holding of Cohn has been variously construed. Some have taken a very narrow view, reading Cohn as holding only that on the peculiar facts the District Court's finding that the salvage value should be redetermined in the year of the assets' sale to reflect the sales price was not clearly erroneous. Others have considered it to lay down a rule of law that the depreciation deduction for the year in which an asset is sold must be adjusted to limit the deduction to the amount, if any, by which the adjusted basis at the start of the year exceeds the sales price. Compare Motorlease Corp. v. United States, 215 F.Supp. 356, 361-64 (D.C.Conn.1963) (rev'd on appeal, 2 Cir., 334 F.2d 617, 1964) and Note, 41 Ore.L.Rev. 159, 165-66 (1962) with Randolph D. Rouse, 39 T.C. 70 (1962); Rev. Rul. 62-92, 1962-1 C.B. 29; and Note, 37 Tex.L.Rev. 787 (1959).
Though it could have been more explicit, we think that the Cohn case adequately supports the Commissioner's position and supports affirmance of the Tax Court's decision in this case. Section 167 (a) of the Internal Revenue Code states as a general rule: "There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) of property used in the trade or business Thus the dispute centers about whether it is reasonable to allow a deduction for depreciation in the year in which an asset is sold for more than its adjusted basis. We think such an allowance unreasonable, for it contravenes the basic purpose of the depreciation deduction.
Basically, our income tax is a tax on net income, and the expenses of generating income are normally considered deductible from gross income. The purpose of the depreciation allowance is to enable the taxpayer to recover the net cost of a wasting asset used in his trade or business by charging the diminution in the asset's value each year against the gross income of that year. Because our income tax system is based on annual reporting and liability and the taxpayer normally holds wasting assets for more than a year, the proper amount of depreciation to be taken each year must depend on estimates. The proper depreciation allowance "is that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate), so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the property, equal the cost of the property " Treasury Regulations, § 1.167(a) — 1. See also United States v. Ludey, 274 U.S. 295, 300-301, 47 S.Ct. 608, 71 L.Ed. 1054 (1927).
The Commissioner does not claim that the depreciation schedule adopted by the taxpayer in 1955 when the Feuer was purchased was unreasonable. Rather his claim is that it is unreasonable to follow an estimate when one knows that estimate is incorrect. The Commissioner's position finds support in § 1.167(b)-0 (a) of the Regulations in force during 1957 •
"Any reasonable and consistently applied method of computing depreciation may be used or continued in use under section 167. Regardless of the method used in computing depreciation, deductions for depreciation shall not exceed such amounts as may be necessary to recover the un-recovered cost or other basis less salvage during the remaining useful life of the property. 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."
We think the Regulations make it plain that the relevant time for assessing the reasonableness of the depreciation deduction is the end of the period for which the return is made. At the end of 1957 it hardly seems reasonable to claim that the value of the Feuer had declined below its adjusted basis.
To be sure, the Regulations also provide that the depreciation allowance "shall not reflect amounts representing a mere reduction in market value." § 1.167(a)-l. If depreciation schedules had to be revised each time an asset's market value rose or declined, an intolerable strain would be placed on accounting methods. But no such practical difficulty presents itself here. All that is required is a comparison of the asset's selling price with its adjusted basis. A sale which indicates that an estimated decline in an asset's value is greatly out of line is not a "mere fluctuation in market value," but "a single and final adjustment in the closing of the books on the asset involved." Cohn v. United States, supra, 259 F.2d at 378.
Though the increment in the Feuer's value resulted from a fortuity normally associated with capital gain, the depreciation allowance is measured by the net cost of the asset to the taxpayer. If an asset costs a taxpayer nothing for a year, the economic factors responsible for the lack of expense to the taxpayer should be of no concern in arriving at the depreciation allowance. Here the sale established with mathematical certainty that the entire cost of the ship had been recovered by the sale. No injustice results from denying the taxpayer an allowance he knows to be fictional at the time he claims it.
Little support for the taxpayer's position can be derived from Congressional passage in 1962 of § 1245 of the Internal Revenue Code. Section 1245 is addressed to a much broader problem than disallowance of depreciation deductions for the year of an asset's sale. The Cohn case refused to permit the Commissioner to recapture depreciation in years other than that of an asset's sale. Section 1245 permits recapture of depreciation allowed in years prior to an asset's sale by treating gain on the transfer of certain specified property to the extent of depreciation taken after 1961 as ordinary income instead of capital gains. See generally, Schapiro, Recapture of Depreciation and Section 1245 of the Internal Revenue Code, 72 Yale L.J. 1483 (1963).
The judgment of the Tax Court is affirmed.