Court Opinion

ID: 4487227
Source: CourtListenerOpinion
Date Created: 2020-01-17 22:00:38.898907+00
Date Added: 2024-06-11T15:04:21.715376
License: Public Domain

*20OPINION.
Trammell :
The question presented is whether the taxpayer had a right to deduct from his gross income during the taxable periods in question a reserve set up out of earnings during the respective periods for the purpose of satisfying his anticipated liability to the lessor to maintain and restore on the termination of the lease the movable chattels included therein in as good condition as when received.
If it be held that the taxpayer is entitled to a deduction of a reasonable allowance for the wear and tear and exhaustion of the property used in his business under the lease, it was conceded by the Commissioner at the hearing that the amounts claimed for the respective periods are correct.
The taxpayer had no title to the physical property which he used in his business under the lease. He merely had a leasehold estate. This gave him only the use and possession of the property under the terms and conditions stated in the lease. The allowance of a deduction on account of the wear and tear and exhaustion of property, commonly known as depreciation, is based upon the principle of allowing a taxpayer a return of the capital invested in his business before subjecting his earnings therefrom to tax. Recognition is given to the fact that physical assets are constantly being reduced m value on account of wear, tear, and exhaustion thereof in the business. A taxpayer, however, is permitted to have returned to him only the capital which he has invested. What the lessor, or any other person than the taxpayer, had invested in the property is immaterial. It has no necessary relation to the investment of the lessee. Items of expense,, whether rentals, amounts required to be paid for *21the continued use of property to which, the taxpayer has no title, or is not acquiring title, or in which he has no equity, or amounts required by contract to he paid in the ordinary course of business which do not represent payments for property, are not capital investments. Since the taxpayer had no investment of capital in the chattels or the leasehold in this case, there is no basis upon which an allowance for wear, tear, and exhaustion could be based.
The question remains as to whether the taxpayer in this case was entitled to accrue and take as a deduction in the respective periods included in this appeal a liability which it was known would arise when the leased property would be required to be returned to the lessor as good as when received. Since the taxpayer kept his books on the accrual basis, all deductions allowable in determining his net income should be on that basis, including his contractual obligation under the terms of the lease. In order that an item may be accrued, however, a liability must actually be incurred in the taxable year. Schuster & Co. v. Williams, 283 Fed., 115. The statute recognized the accrual basis of making returns by providing for the deduction of expenses incurred but not paid. It is apparent that no liability in praesenti was incurred under the terms of the lease in question in the years 1918 and 1919 however well known it might have been that a liability in some amount would be incurred at some time in the future. The liability to restore chattels as good as new or as good as when received when a lease is ultimately canceled or surrendered at some indefinite or indeterminate time in the future is not a present actual liability, and is not the actual incurring of an expense or liability.
While it might have been sound business practice on the part of the taxpayer to set up a reserve out of his income to meet a future liability, such a reserve is not deductible in determining net income. The revenue laws prior to the 1921 Act have never recognized reserves as being deductible from gross income in determining net income except in the case of insurance companies. In the Revenue Act of 1921 specific provision was made for the deduction of reserves for bad debts. If reserves had been deductible under the general provisions of the Act it would not have been necessary to make specific provision for the deduction of particular reserves in the case of insurance companies or for bad debts. The statute specifies what deductions are allowable and, except in the case of insurance companies, no provision is made in the 1918 Act for the deduction of a reserve as such. Items of expense must actually have been paid or liability therefor incurred in order to be deductible under that Act.
The taxpayer was unable to maintain and restore the property at the expiration of the lease in as good condition as when received except by renewals and replacements. Renewals and replacements when actually made by an owner are not allowable deductions in determining taxable income, nor can a reserve set up for such purposes be allowed as a deduction from income. Expenditures made for the purpose of renewals and replacements in the case of an owner constitute capital items. In the case of a lessee of chattels who is required by the terms of the lease to make such renewals or replacements as are necessary to keep the property in as good condi*22tion as when received as additional rental or as a condition to the continued use of the property to which he has no title and is acquiring none, they are deductible, if at all, as expenses paid or incurred in carrying on a trade or business. Reserves for future unincurred expenses are not allowable as deductions under the Revenue Act of 1918.
Sternhagen concurs.
Trussell dissents.