Midland Empire Packing Co. v. Commissioner
14 T.C. 635 (1950).
Facts
Midland Empire Packing would keep meat in the basement for curing. This was a practice they used for over 25 years. Water would seep into the walls but this was not a problem. Later, oil seeped into the basement from the walls based on a nuisance from a neighboring plant. This caused extensive hazards requiring the company to find a solution or risk closing. So, they spent about 5,000 on an oil sealant. This kept out both the water and the oil.
The company sought to deduct this cost as an expense, the IRS sought to classify it as a capital expenditure.
Analysis
Although this was not a repair normally done by the company, this was a repair. To determine whether a repair is an expense, the court will consider the purpose of the repair. For instance, if the purpose is to “improve, better, extend, or increase” the plant, then the cost is an expenditure. However, if the purpose is to put the plant back in operation as it had been before the injury, then the cost is an expense.
Here, although a novel issue for the company, the purpose was to put the plant back in operation as it had done before. Although the repair also prevented water, water had not bothered the company. The expense was necessary to continue operations at all. The plant was not enlarged and did not add value to the life of the property over time. All these things show that the cost was an expense and could therefore be duducted.
Additional Notes
This is ultimately a question of whether this is a repair or restoration. The distinction is important because a deduction as an expense can be taken immediately for a repair while a restoration adds to the basis and the deduction is deferred for a restoration.
Mt. Morris Drive-In Theatre Co. v. Commissioner
25 T.C. 272 (1955).
Facts
The drive-in theatre purchased property that sloped towards the neighbors. Additionally, the theatre owner knew of the topography and the potential risks. Once the vegitation was removed from the property, rainfall would run into the neighbors and cause extensive damage. Under threat of lawsuit, the theatre and neighbors settled where the theatre was to partially pay for the installation of a drainage system.
The drainage system was installed and the theatre sought to take depreciation and deduct from their taxes as an expense. On the other hand, the IRS stated the drainage system was a capital expenditure and could therefore not be deducted.
Analysis
This case is different from other cases finding the cost was an expense. Here, there was no sudden catastrophic loss by an undetected fault in the property; there was no unforeseeable external factors, and this was not a repair of a previous asset. Instaed, this is a new asset, one that should have been included with the original construction of the theatre. Without the drainage system, the theatre could not be seen as complete. As such, this was not an expense, but instead a capital expenditure.
The dissent argues this is an expense because it did nothing to “improve, better, extend, increase, or prolong the useful life of its property.” This installation was not a cure, but only a bandaid on the issue. As such, the dissent believes this is an expense.
Additional Notes
Costs Related to Intangible Assets
See §§ 263(a) and 263A.
INDOPCO, Inc. v. Commissioner
503 U.S. 79 (1992).
Facts
National Starch was a supplier of and being aquired by Unilever. Due to the complex nature of the aquisition (shareholders would not agree unless to the transaction unless it could be done tax free), the legal fees and costs were extraordinarily high. The following year, National Starch claimed a deduction of more than 2.2 million (about the size of the fees) as an ordinary business expense. Upon an audit, the IRS disallowed the deduction, claimed the cost was a capitalized gain, and issued a notice of deficiency to National Starch. The following lawsuit ensued.
Analysis
The court refused to limit the definition of a capital expenditure to first require the creation or enhancement of additional assets. Instead, the test created in Lincoln Savings is only one way a capital investment could occur. Here, the court formed a new test: If a business cost creates a significant future benefit—that is, a benefit that extends past the taxable year—then the cost is a capitalized expenditure.
Here, there are several benefits National Starch received: Access to resources, synergy with the aquiring company, simplicity of structure (going from 3,500 shareholders to 1) and other administrative costs (no need to report expensive disclosures or deal with derivative suits). These types of costs are not “ordinary and necessary business expenses.” As such, National Starch should not have taken a deduction on the costs and fees of the aquisition.
