O'Shaughnessy v. Commissioner

United States Court of Appeals
FOR THE EIGHTH CIRCUIT
___________
No. 02-1532
___________
Roger O’Shaughnessy, as Tax Matters *
Person for Cardinal IG Company, *
*
Appellee, *
*
v. *
*
Commissioner of Internal Revenue, *
*
Appellant. *
___________
Appeals from the United States
No. 02-1603 District Court for the
___________ District of Minnesota.
Roger O’Shaughnessy, as Tax Matters *
Person for Cardinal IG Company, *
*
Appellant, *
*
v. *
*
Commissioner of Internal Revenue, *
*
Appellee. *
___________
Submitted: February 14, 2003
Filed: June 13, 2003
___________
Before WOLLMAN, HEANEY, and MELLOY, Circuit Judges.
___________
WOLLMAN, Circuit Judge.
Roger O’Shaughnessy, as tax matters person for Cardinal IG Company
(Cardinal), a subchapter S corporation, initiated this action against the Internal
Revenue Service (IRS) under 26 U.S.C. § 6226, contesting the IRS’s readjustments
of partnership items filed by Cardinal during tax years 1994 and 1995. The IRS
appeals the district court’s grant of partial summary judgment that Cardinal was
entitled to depreciate under the provisions of 26 U.S.C. §§ 167, 168 molten tin used
to manufacture flat glass. Cardinal cross-appeals the district court’s grant of partial
summary judgment in favor of the IRS on the issue of whether the IRS’s reallocation
of certain of Cardinal’s assets from one defined asset grouping to another constituted
a change in Cardinal’s method of depreciation accounting under 26 U.S.C. § 446(e).
We affirm in part and reverse in part.
I. Background
Cardinal has manufactured flat glass at its plant in Menomonie, Wisconsin,
since its purchase from AFG Industries, Incorporated (AFG) in 1992. Cardinal
manufactures glass using the “float” process, in which limestone, sand, soda ash, and
other materials are melted to yield liquid glass, which then is “floated” across the
surface of molten tin in a structure referred to as a “tin bath.” There must be a
predetermined volume of molten tin in the bath for the system to operate. In the bath,
the liquid glass forms a continuous sheet or ribbon. This ribbon then flows out of the
tin bath, entering an “annealing lehr,” in which it cools and hardens into glass. Once
cooled, the glass is cut and shipped elsewhere for processing and assembly into
insulated glass units, which Cardinal sells to window manufacturers.
-2-
While the liquid glass is in the tin bath, the molten tin reacts with oxygen,
sulfur, iron, and other elements and compounds in the glass to yield tin oxide and tin
sulfide. These by-products are impurities referred to as “dross” and must be removed
periodically from the tin bath to prevent damage to or clouding of the glass. The
presence of impurities in the tin bath accelerates the degradation of the tin:
“specifically, sulfur impurities cause vaporization of tin that is eventually exhausted
from the tin bath during blow-down of condensed compounds of tin[;] oxygen
impurities cause diffusion of tin into the glass that is transported out of the tin bath
by the moving ribbon of float glass.” The volume of tin in the bath is reduced by
these reactions, by general evaporation, as well as by the removal of the dross from
the bath. When Cardinal began operations at the Menomonie plant in 1992, it placed
approximately 168 tons of tin into the bath. Cardinal estimates that, to maintain the
necessary volume of tin therein, it added approximately sixty-two tons, or between
one and one and one-half tons per month, of new molten tin into the bath between
1992 and the filing of this case in 1997.
Cardinal treated the initial volume of 168 tons of tin as a depreciable capital
asset with a basis of $1,720,808.00 on its federal income tax returns filed from 1992
to 1995. Pursuant to § 168, Cardinal has used the modified accelerated cost recovery
system (MACRS) to depreciate tangible assets, including the initial installation of tin.
On its 1994 and 1995 tax returns Cardinal also deducted as repair and maintenance
expenses under 26 U.S.C. § 162 the costs of tin added to the bath to maintain the
necessary volume. The IRS determined that Cardinal should not have depreciated the
168 tons of tin initially placed in the bath because under Revenue Ruling 74-491,
molten tin, as used in glass manufacturing, is not a depreciable asset. The district
court granted summary judgment in favor of Cardinal on this issue, allowing the
depreciation deductions.
Prior to Cardinal’s purchase of the Menomonie, Wisconsin, manufacturing
plant from AFG, AFG hired the accounting firm of Deloitte & Touche to perform a
-3-
cost segregation study allocating the purchase price among plant assets in accordance
with the MACRS method of depreciation accounting. Cardinal used the asset groups
assigned by Deloitte & Touche to compute MACRS depreciation expenses on its
income tax returns from 1992 through 1995.1 The IRS disputed Cardinal’s asset
allocation on its 1994 and 1995 federal income tax returns and reallocated those
assets from one asset group to another accordingly.2 The IRS characterized the asset
reallocation as a change of Cardinal’s method of accounting, which requires Cardinal
to submit an accounting adjustment under § 481. Cardinal does not dispute the asset
reallocation, but challenges the district court’s determination that the reallocation
constituted a change in Cardinal’s method of accounting under § 446(e).
II. Standard of Review
We review the district court’s grant of summary judgment de novo. Brassard
v. United States, 183 F.3d 909, 910 (8th Cir. 1999) (citation omitted). A grant of
1
1245 property 5-year $ 313,726.00
1245 property 7-year 53,680,135.00
1250 property 15-year 3,167,218.00
1250 property 31.5-year 5,213,921.00
startup costs 3,703,790.00
supplies 846,210.00
$66,925,000.00
2
Agreed / Unagreed
1245 property 5-year $ 225,000.00
1245 property 7-year 50,247,782.00 / 1,720,808.00
1250 property 15-year 2,343,911.00
1250 property 31.5-year 7,837,499.00
-4-
summary judgment is appropriate when there is no genuine issue of material fact and
the prevailing party is entitled to judgment as a matter of law. Id.; see Fed. R. Civ.
P. 56(c). Because the parties do not dispute the material facts, we address, as a matter
of law, whether Cardinal was entitled to depreciate molten tin used to manufacture
flat glass under 26 U.S.C. §§ 167 and 168, and whether the IRS’s reallocation of
certain of Cardinal’s assets from one defined asset grouping to another constituted a
change in Cardinal’s method of depreciation accounting under 26 U.S.C. § 446(e).
III. Appeal: Depreciation
A. Depreciability of Molten Tin
The IRS contends that Cardinal cannot claim a depreciation deduction for the
cost of 168 tons of tin initially installed in the tin bath because the tin is not subject
to exhaustion or wear and tear within the meaning of 26 U.S.C. § 167(a) and therefore
does not constitute property for which a depreciation deduction may be taken. See
26 U.S.C. § 168 (providing applicable depreciation method for depreciation
deduction authorized by § 167). The IRS argues that because the tin is consumed
during the manufacturing process, its cost may be deducted instead under 27 U.S.C.
§ 162, as an expense of operation.
Section 167(a) of the Internal Revenue Code authorizes a depreciation
deduction of a “reasonable allowance for the exhaustion, wear and tear . . . of
property used in the trade or business . . . .” 26 U.S.C. § 167(a); Treas. Reg. §
1.167(a)-2. Unlike § 162, which provides a deduction for expenses that are “ordinary
and necessary” and are “paid or incurred during the taxable year in carrying on any
trade or business,” the depreciation deduction authorized by § 167 encompasses only
capital expenditures or assets, which are amortized and depreciated over time.
INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 83-84 (1992).
-5-
[I]f a taxpayer can prove with reasonable accuracy that an
asset used in the trade or business or held for the
production of income has a value that wastes over an
ascertainable period of time, that asset is depreciable under
§ 167. . . . “Whether or not . . . a tangible asset, is
depreciable for Federal income tax purposes depends upon
the determination that the asset is actually exhausting, and
that such exhaustion is susceptible of measurement.”
Newark Morning Ledger Co. v. United States, 507 U.S. 546, 566 (1993) (citing Rev.
Rul. 68-483, 1968-2 Cum.Bull.91-92). Cardinal, therefore, must show only that the
tin “was subject to exhaustion and wear and tear.” Liddle v. Comm’r, 65 F.3d 329,
335 (3d Cir. 1995); Simon v. Comm’r, 68 F.3d 41, 46 (2d Cir. 1995) (holding that,
for the purposes of § 168, “‘property subject to the allowance for depreciation’
means property that is subject to exhaustion, wear and tear, or obsolescence”). As the
district court noted, the burden of demonstrating that an asset is depreciable is
undemanding: “even imperceptible physical changes in or impact[s] upon the
particular item of property during its usage [are] sufficient to qualify the property in
question as depreciable.” O’Shaughnessy v. Comm’r, 2001 U.S. Dist. LEXIS 22738
at * 15 (D. Minn. 2001) (citing, generally, Simon, 68 F.3d 41; Liddle, 65 F.3d 329);
see also INDOPCO, 503 U.S. at 84 (stating a presumption in favor of capitalization:
“The notion that deductions are exceptions to the norm of capitalization finds support
in various aspects of the Code.”).
As indicated above, Cardinal initially installed 168 tons of tin in the tin bath
in 1992. The quality and quantity of tin installed in the bath were diminished during
the manufacturing process by evaporation and other chemical reactions, specifically
the formation of tin oxide and tin sulfide. Accordingly, Cardinal added tin to the bath
to maintain the volume required to keep the float glass manufacturing system
functioning— approximately sixty-two tons during its first seven years of operation.
The tin installed initially in the bath declined in volume and purity as a result of its
-6-
use in the glass manufacturing process, undergoing “exhaustion, wear and tear”
within the meaning of § 167. Because the tin as installed initially qualified as
depreciable capital property, and because the property was placed in service after
December 31, 1986, Cardinal appropriately depreciated the tin by claiming a MACRS
deduction under § 168: “property of a character subject to the allowance for
depreciation” under § 167. 26 U.S.C. § 168(c)(1); Kurzet v. Comm’r, 222 F.3d 830,
843 (10th Cir. 2000) (citing Hosp. Corp. of Am. v. Comm’r, 109 T.C. 21, 42, 1997
WL 412127 (1997)).
B. Deference Due Revenue Rulings
The IRS contends that the district court’s holding that molten tin may be
depreciated directly contradicts revenue ruling 75-491, upon which the IRS’s
arguments in opposition to the depreciation deduction primarily are based. Revenue
ruling 75-491 advised that the initial installation of tin used in the float process
manufacture of flat glass is not “depreciable property qualifying as ‘section 38
property’ for investment credit purposes.” Rev. Rul. 75-491, 1975-2 C.B. 19. The
IRS asserts that because the ruling reasonably interprets 26 U.S.C. §§ 162 and 167
and the regulations promulgated to implement those sections with respect to the issue
of molten tin, the ruling should be accorded deference under United States v. Mead
Corp., 533 U.S. 218, 22 (2001).
The Supreme Court held in Mead that although a “tariff classification ruling
by the United States Customs Service . . . has no claim to judicial deference under
Chevron [U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837
(1984)], there being no indication that Congress intended such a ruling to carry the
force of law[,]. . . . under Skidmore v. Swift & Co., 323 U.S. 134 (1944), the ruling
is eligible to claim respect according to its persuasiveness.” Mead, 533 U.S. at 221.
The IRS reads Mead as instructing that revenue rulings are due deference
-7-
commensurate with “the degree of the agency’s care, its consistency, formality, and
relative expertness . . . .” Mead, 533 U.S. at 228.
The Supreme Court has refrained from deciding whether revenue rulings are
entitled to deference. In United States v. Cleveland Indians Baseball Co., 532 U.S.
200, 220 (2001), the Court stated, “We need not decide whether the Revenue Rulings
themselves are entitled to deference. In this case, [which addresses the year to which
back-pay awards should be attributed for tax purposes,] the Rulings simply reflect the
agency’s longstanding interpretation of its own regulations. Because that
interpretation is reasonable, it attracts substantial judicial deference.” 532 U.S. at 220
(citing Thomas Jefferson Univ. v. Shalala, 512 U.S. 504, 512 (1994)).
The Court accorded deference to the IRS’s revenue rulings in Cleveland
Indians largely because the rulings reflected the “agency’s steady interpretation of its
own 61-year-old regulation implementing a 62-year-old statute. ‘Treasury regulations
and interpretations long continued without substantial change, applying to
unamended or substantially reenacted statutes, are deemed to have received
congressional approval and have the effect of law.’” Id. (quoting Cottage Sav. Ass’n.
v. Comm’r, 499 U.S. 554, 561 (1991) (citation omitted)). Revenue ruling 75-491, at
issue here, does not reflect a similarly longstanding or consistent interpretation of an
“unamended or substantially reenacted statute.” As the district court explained, the
revenue ruling, which analyzed whether molten tin qualified as depreciable property,
predates the “‘substantial restructuring’ of the depreciation rules” effected by the
adoption of the Accelerated Cost Recovery System (ACRS) (1981) and the Modified
Accelerated Cost Recovery System (MACRS) (1986). See Liddle, 65 F.3d at 332-33,
n.3 (“[Under ACRS,] the entire cost or other basis of eligible property is recovered[,]
eliminating the salvage value limitation of prior depreciation law. ”) (quoting General
Explanation of the Economic Recovery Tax Act of 1981 at 1450); see also Kurzet,
222 F.3d at 842-43.
-8-
The statutory framework on which the agency’s analysis in revenue ruling 75-
491 was based has changed significantly. Additionally, revenue ruling 75-491, unlike
that at issue in Cleveland Indians, until now has not been tested in the courts or
otherwise reconsidered by the IRS. See Cleveland Indians, 532 U.S. at 220; see also
Davis v. United States, 495 U.S. 472, 482-84 (1990) (giving weight to the IRS’s
interpretation of “for the use of” where it had been in “long use” as was confirmed
by several revenue rulings and judicial decisions). Accordingly, we conclude that the
district court did not err in declining to treat revenue ruling 75-491 as controlling or
persuasive authority. See Keller v. Comm’r, 725 F.2d 1173, 1182 (8th Cir. 1984)
(“[W]hile they are entitled to some evidentiary weight, the Commissioner’s private
letter rulings and Revenue Rulings are not controlling authority and do not persuade
this court in the present case.”) (citation omitted); Oetting v. United States, 712 F.2d
358, 362 (8th Cir. 1983); see also True Oil Co. v. Comm’r, 170 F.3d 1294, 1304 (10th
Cir. 1999).
IV. Cross-Appeal: Change in Accounting Method
On cross-appeal, Cardinal contends that the district court erred in holding that
the IRS’s reallocation of certain of Cardinal’s plant assets from one asset category to
another for the purposes of MACRS depreciation, see 26 U.S.C. § 168, constituted
a change in accounting method under § 446(e). 26 U.S.C. § 446(e); 26 C.F.R. §
1.446-1(e). Cardinal argues that the reclassification of certain plant assets did not
constitute a change in accounting method under § 446(e), thereby requiring a § 481(a)
adjustment. Instead, Cardinal asserts that the IRS merely corrected the assets’
classifications by reassigning assets within the asset-groupings and cost recovery
periods that Cardinal consistently had used under the MACRS method of
depreciation. See notes 1, 2 supra. By shifting assets, Cardinal argues, the IRS did
not change Cardinal’s accounting method but rendered the asset categorization
internally consistent within Cardinal’s existing accounting method. See H. E. Butt
Grocery Co. v. United States, 108 F. Supp. 2d 709, 714 (W.D. Tex. 2000) (stating
-9-
“the correction of an internal inconsistency is not a change in the method of
accounting”) (citing Lasater v. Scofield, 52-1 U.S. Tax Cas. (CCH) 9255 (W.D. Tex.
Jan. 29, 1952); N. States Power Co. v. United States, 151 F.3d 876, 884 (8th Cir.
1998) (holding that a power company effectively had committed a posting error and
did not change its method of accounting when it filed a refund claim seeking to
deduct contract losses as it consistently had other losses)). Cardinal also contends
that the reclassification of assets did not change a “material item.”
Title 26 U.S.C. § 446(e) requires that a taxpayer obtain the Secretary’s consent
to “change ‘the method of accounting on the basis of which he regularly computes his
income in keeping his books . . .’” N. States Power Co., 151 F.3d at 883 (citing
Treas. Reg. § 1.446-1(a)(1)); 26 U.S.C. § 446(e)). Method of accounting is defined
by the applicable regulations by reference: “[a] taxpayer changes his or her method
of accounting when he or she changes either the ‘overrall plan of accounting for gross
income or deductions or . . . the treatment of any material item used in such overall
plan.’” Id. (citing 26 C.F.R. § 1.446-1(a)(1), (e)(2)(ii)(a)). The regulations define a
material item as “any item which involves the proper time for the inclusion of the
item in income or the taking of a deduction.” Id.; see also 26 C.F.R. § 1.446-
1(e)(2)(ii)(b) (enumerating types of adjustments that are not to be characterized as
changes in accounting method).
The dispositive issue before us is whether a change in asset categorization that
changes the recovery period under MACRS constitutes a change in Cardinal’s method
of accounting. The regulations implementing § 446 explicitly exclude certain types
of adjustments from being characterized as changes in accounting method. 26 C.F.R.
§ 1.446-1(e)(2)(ii)(b).
A change in method of accounting does not include
correction of mathematical or posting errors, or errors in
the computation of tax liability. Also, [it] does not include
-10-
adjustment of any item of income or deduction which does
not involve the proper time for the inclusion of the item of
income or the taking of a deduction.
....
In addition, a change in the method of accounting does not
include . . . an adjustment in the useful life of a depreciable
asset.
Id. Notwithstanding the Commissioner’s conclusion that the “recovery period for
ACRS or MACRS property (depreciable property placed in service after 1980)”
cannot be changed, Kurzet v. Comm’r, 222 F.3d at 844 (citing I.R.S. Pub. 538
(1993)), the Court of Appeals for the Fifth Circuit recently determined that if a
change in the allocation of assets within MACRS categories falls under the “useful
life” exception of the regulations, it cannot “constitute a material alteration for
purposes of IRC § 446(e),” Comm’r v. Brookshire Bros. Holding, Inc., 320 F.3d 507,
510 (5th Cir. 2003). See also § 1.446-1(e)(2)(ii)(b). Although “useful life” is no
longer the standard by which depreciation deductions are claimed pursuant to § 167,
Liddle, 65 F.3d at 333 (citing General Explanation of the Economic Recovery Tax
Act of 1981 at 1450), “analogizing the treatment of useful life as an exception
pursuant to the never-repealed, pre-MACRS regulation better accords with the overall
regulatory scheme of the Tax Code and regulations than would the denial of the
exception on the slender reed of that apparent linkage,” Brookshire Bros. Holding,
320 F.3d at 511. We agree.
“[T]he applicable regulations were meant to allow taxpayers to make temporal
changes in their depreciation schedules without prior consent of the Commissioner.”
Id. Reallocating an asset into an existing asset category for the purposes of MACRS
depreciation more closely resembles a correction of a reporting error or inconsistency
than a wholesale change in accounting method. Although an asset reallocation, such
as that which occurred in this case, may change the “timing” of the asset’s
depreciation, we conclude that the reallocation falls within the regulation’s explicit
-11-
exemption for “an adjustment in the useful life of a depreciable asset” and thus does
not constitute a change in accounting method within the meaning of § 446(e).
Accordingly, we conclude that the district court erred by granting summary judgment
in favor of the IRS on this issue.
The judgment of the district court is affirmed in part and reversed in part. The
case is remanded to the district court for the entry of judgment consistent with the
views set forth in this opinion.
A true copy.
Attest:
CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.
-12-