Is Your Client’s Leased Property Depreciable? The IRS May Not Think So
Recently released Internal Revenue Service pronouncement has raised concerns over whether or under what circumstances depreciation of property which is leased is allowable if the taxpayer is engaged in the dual businesses of selling property and leasing or renting the same type of property.1 This issue is commonly described by reference to the property involved as the “dual purpose property” issue. The controversy in these cases generally arises when the IRS seeks to treat leased property as inventory held for sale, and thus not depreciable. Taxpayers that hold dual purpose property should be aware that their depreciation of leased property may be called into question and they need to understand the factors which may be relevant in that determination.
Field Service Advice 1999-1948
The FSA) involves a field auditor’s request for National Office advice on whether a taxpayer’s dual purpose property should be held in inventory or depreciated. The taxpayer maintained an inventory for its new and used property and depreciated the property which was leased. The FSA concludes that depreciation of the leased property is allowable while the property is out on lease but should be discontinued when the property comes off lease and is once again available for either sale or lease.
The FSA is based on IRC §1231 authority which does not support the conclusion with respect to depreciation set forth in the FSA. The FSA also implies that its conclusion with respect to the treatment of off-lease dual purpose property is supported by an authoritative treatise.2 However, the cited portion of the treatise refers to the applicability of IRC §1231 on a disposition of dual purpose property, not the depreciability of dual purpose property under IRC §167.3. Furthermore, the position set forth in the FSA conflicts with Revenue Ruling 80-374 which is directly on point and states with respect to dual purpose property that “the leased asset does not cease to be depreciable property until the year of sale.” These authorities and the factors which are relevant in dual purpose property cases are analyzed in this article.
Depreciation Generally
The Internal Revenue Code provides that “[t]here shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear. . . of property used in a trade or business.”5 The related Treasury Regulations provide that depreciation deductions are not allowed with respect to inventory.6 Neither the IRC nor the Treasury Regulations address how a taxpayer that is both a seller and lessor of the same type of property should determine when such property is used in the taxpayer’s trade or business or when such property is inventory.
It is clear that a taxpayer can simultaneously engage in the separate and distinct businesses of selling and leasing the same type of property.7 When a taxpayer simultaneously engages in the trade or business of selling property and the trade or business of leasing the same type of property, the taxpayer’s “primary purpose” with respect to each individual asset determines whether that asset is properly classified as an asset used in the taxpayer’s trade or business of leasing and, therefore, subject to depreciation under IRC §167 or as inventory and, therefore, not subject to depreciation under IRC §167.
The Primary Purpose Test
Whether a taxpayer’s primary purpose is to sell or lease an asset is a question of fact. As noted, there are no statutory or regulatory standards for dual purpose property. This has lead to a case-by-case approach to the resolution of the issue. Numerous cases have discussed the “primary purpose” test; however, none of these cases has specifically addressed whether or under what circumstances the taxpayer’s leased property is depreciable when the taxpayer also sells the same type of property from its inventory.8 Four private letter rulings9 ( PLRs) have applied the primary purpose test to the specific facts of certain taxpayers engaged in the dual businesses of selling and leasing similar property in order to determine if depreciation was allowable. Interestingly, none of these PLRs reach the “off lease” conclusion contained in the FSA.
In the cases where the dual purpose property issue has been litigated, the substantive issue has been whether gain recognized on the sale of previously leased property was eligible for IRC §1231 treatment when the taxpayer was also engaged in the business of selling such property from its inventory.10 Courts have consistently held that IRC §1231 was not applicable to such gains while acknowledging that depreciation is nevertheless allowable with respect to the leased property.11
Dual Purpose
Property Case Law
As noted, those cases where the dual purpose property issue has been considered involve issues under IRC §1231. The issue of the taxpayer’s pre-disposition depreciation of the dual purpose property is not directly considered in these cases and does not appear to have even been challenged by the Internal Revenue Service. A summary of these cases is presented to assist in understanding the scope of the dual purpose property issue under IRC §1231 and its relationship to the depreciability of such property under IRC §167.
In Recordak Corp. v. U.S., 325 F.2d 460 (Ct. Cl. 1963), the taxpayer was a seller and lessor of microfilming equipment. The court concluded that application of the “primary purpose” test for IRC §1231 purposes to a taxpayer conducting the dual business of selling and leasing the same type of property requires a comparison between selling in the ordinary course of business and selling outside the ordinary course of business, not between merely selling and leasing. Because the dual purpose property was regularly offered for sale to customers in the ordinary course of the taxpayer’s business, the court held that sales of previously leased property were in the ordinary course of business for purposes of IRC §1231, while acknowledging without question or challenge that the taxpayer had properly depreciated the dual purpose property during its use in the taxpayer’s leasing business.
The dichotomy between the IRC §1231 and IRC §167 treatment of dual purpose property is not addressed in detail in the case law. Both IRC §1231 and IRC §167 apply to “property used in the trade or business.”12 IRC §1231(b) contains a specific definition of this term which is applicable solely to IRC §1231. Under the IRC §1231(b) definition, property must generally satisfy two tests to be treated as property used in the trade or business for IRC §1231 purposes. First, the property must be of a character which is subject to depreciation under IRC §167 ( i.e., not inventory). Second, the property must not constitute “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”13 This specific definition under IRC §1231 essentially requires a threshold determination that the property is not inventory under IRC §167 ( i.e., that it is depreciable). Thereafter, if sales of such property are in the ordinary course of such business, the property is not eligible for IRC §1231 treatment although it remains depreciable. This result is reflected in the Recordak opinion where the court notes that the IRC §1231 analysis of dual purpose property required a comparison between whether the taxpayer was selling in the ordinary course of business or selling outside of the ordinary course of business. Implicit in this conclusion is a determination that the first prong of the IRC §1231(b) definition had been satisfied and the court was focusing only on the second prong in reaching its conclusion. The court acknowledged that it is not inconsistent for a property to be both depreciable under IRC §167 and not eligible for IRC §1231 treatment. Unfortunately, the FSA indicates that the IRS has not embraced the Recordak court’s conclusion or similar holdings of other courts.
In Greene-Haldeman v. Commissioner, 282 F.2d 884 (9th Cir. 1960), the taxpayer was an automobile dealer that sold new automobiles and rented automobiles for varying although generally not lengthy periods of time. The court held that the taxpayer was not entitled to IRC §1231 treatment on the disposition of rental automobiles, because it held the automobiles were for sale in the ordinary course of business; however, the taxpayer’s depreciation of leased automobiles was not challenged.
In S.E.C. Corp. v. U.S., 140 F. Supp. 717 (S.D.N.Y. 1956), the taxpayer was engaged in the business of selling and leasing electric water, beer, and frosted food coolers. The court held that the taxpayer was not entitled to IRC §1231 treatment on the disposition of leased coolers and the taxpayer was entitled to depreciate all such leased equipment.
In the most recent case to consider the dual purpose property issue, Honeywell Inc. v. Commissioner, 87 T.C. 624 (1986), the court stated that a “manufacturer regularly engaged in the dual business of selling and renting the equipment it manufactures can claim depreciation on property that is at all times available for sale. Proceeds from the sale, however, are treated as ordinary income even though the property might otherwise qualify for capital gain treatment under §1231.”14 Interestingly, the FSA cites Honeywell, but dismisses the opinion as “inapposite” to the issue under consideration in the FSA.
The dual purpose property cases discussed above confirm that dual purpose property is depreciable under IRC §167 even though such property is not generally eligible for IRC §1231 treatment. It is clear that the depreciation determination for dual purpose property is governed by the primary purpose test. Unfortunately, these cases do not address the primary purpose test as it applies to the depreciation of the property, focusing solely on the IRC §1231 characterization issue. The only published authorities applying the primary purpose test to the issue of depreciation of dual purpose property are a limited number of PLRs.
Dual Purpose Property Private Letter Rulings
• PLR 810700515 was the first private letter to directly address the dual purpose property issue. In PLR 8107005 the taxpayer was in the heavy equipment business, primarily sales, but also rental and leasing. The IRS concluded that since none of the factors which tend to show the existence of a sale ( i.e., inventory treatment) appeared to be present with respect to the taxpayer’s leased property, the leases should be treated as such and the property depreciated. The relevant factors are as follows:
1) Rental terms varied from one week to an indefinite duration;
2) Rates were specified for a given period, for a specific number of hours of usage;
3) For the period at issue, the taxpayer had 142 rental or lease agreements;
4) The average stated lease term was less than three months;
5) The average actual lease term was approximately five months;
6) The useful life of the property substantially exceeded the lease term;
7) The agreements were true leases for federal income tax purposes;
8) The taxpayer treated the rental payments it received as current income.
• In PLR 891703616 The taxpayer was engaged in the exploration for natural gas and the production, transmission, and storage of natural gas, which it sold to wholesale customers. The taxpayer stored natural gas in underground reservoirs. At all times during the operation of the reservoir, a constant volume of gas called “cushion gas” had to be injected into and remain in the reservoirs in order to provide the necessary pressure to withdraw “working gas” for sale to customers. Although not all of the cushion gas could ultimately be withdrawn and sold, substantially all of the cushion gas could be recovered and sold to customers.
Since the cushion gas served two purposes (provided the necessary pressure to operate a storage reservoir and was available for sale to customers), it was dual purpose property. The taxpayer’s primary purpose with respect to the cushion gas was determined to be holding it for sale ( i.e., inventory) to the extent it was recoverable ( i.e., saleable) and held for use in the taxpayer business ( i.e., depreciable) to the extent it was not recoverable.
• In PLR 944800417 The taxpayer regularly engaged in both selling and leasing equipment. The taxpayer included all of its equipment, including the leased equipment, in inventory. The PLR concludes that the taxpayer could continue to include its leased equipment in inventory because the taxpayer’s primary purpose was at all times to sell the machines. The PLR states that the taxpayer’s method of including the leased equipment in inventory is “permitted” because there is never “an indefinite, final or unqualified commitment to use the machines in the [leasing] business.” The relevant factors in PLR 9448004 are as follows:
1) The taxpayer consistently included all of its machines in inventory until the point of sale whether the machines were leased or not;
2) All machines were available for sale or rental;
3) Title to the leased machines remained with the taxpayer;
4) All leases could be unilaterally terminated by the taxpayer at any time;
5) Approximately 38 percent of the machines were leased prior to sale for, on average, a little over six months;
6) Leases were limited to no more than one year; and
7) Approximately 90 percent of the taxpayer’s revenues from machine transactions were received from sales proceeds and 10 percent from lease revenues.
ed equipment. The issue in this PLR was whether the taxpayer could depreciate all equipment it purchased. The PLR concludes that depreciation of all equipment was allowable, because the primary purpose of the equipment was demonstrated to be leasing. The relevant factors in this PLR are as follows:
1) Approximately 90 percent of the equipment was leased and 10 percent was sold;
2) The taxpayer often purchased equipment prior to arranging either a lease or a sale;
3) The equipment was subject to a substantial risk of obsolescence;
4) Because of the substantial risk of obsolescence, customers preferred to lease;
5) The taxpayer was generally known as a leasing company;
6) When a lease expired or terminated, the taxpayer would hold the equipment for varying lengths of time before being able to lease it again or sell it;
7) When equipment aged or became more difficult to lease or sell, it was held in storage and eventually scrapped or sold; and
8) At the time of purchase it was not generally known if the equipment would be sold or leased.
This PLR concludes that “the initial classification of taxpayer’s equipment should be based on whether the equipment is primarily held by taxpayer for use in its leasing business, or primarily held for sale to customers.” Because the significant majority of the taxpayer’s equipment was leased to customers after acquisition, the ruling concluded that the equipment should initially be classified as fixed assets subject to depreciation. However, if the taxpayer thereafter determined to hold a certain piece of equipment for sale to customers, the PLR continued, the taxpayer was required to reclassify that equipment as inventory.
Conclusion
A taxpayer can simultaneously engage in the separate and distinct businesses of leasing and selling the same type of property. To determine whether an asset is properly classified as used in a taxpayer’s trade or business of leasing or as inventory, the IRS and the courts examine the taxpayer’s “primary purpose” with respect to each individual asset. If the property is classified as used in the trade or business, then it is depreciable. If the property is classified as inventory held for sale it is not depreciable.
in a trade or business is sold, IRC §1231 applies. However, the aforementioned cases indicate that taxpayers with dual purpose property are generally not able to utilize IRC §1231 for sales of assets that were at one time leased and depreciated. If a taxpayer holds property as inventory for sale, then all sales of that type of property, even sales of property that was used in a trade or business of leasing, are tainted by the taxpayer’s simultaneous status as a seller of such property from inventory.
Proper depreciation of property brought off lease is described in Revenue Ruling 80-3719 which clearly permits the depreciation of dual purpose property once it is leased and thereafter until it is sold. However, despite a clear lack of authority, the FSA suggests that the IRS may take the position that depreciation should end when (and for as long as) dual purpose property is off lease.
Taxpayers holding dual purpose property should be aware that their depreciation of leased dual purpose property may be challenged. All evidence which supports the conclusion that the primary purpose with respect to such property is to use it in the taxpayer’s trade or business of leasing should be developed and maintained. Steps such as segregating assets for accounting and management purposes to clearly delineate those assets that are used in the trade or business of leasing as compared to those which are held for sale from inventory should be considered and implemented if the issue could be significant.
q
1 Field Service Advice 1999-948 (Mar. 31, 1999). This field service advice was prepared in 1993 but was not publicly released until 1999 as part of an Internal Revenue Service effort to put such pronouncements in the public domain.
2 Steven F. Gertzman, Federal Tax Accounting 6.05[1][e].
3 The difference between the treatment of dual purpose property under I.R.C. §167 and I.R.C. §1231 is discussed in detail in a latter section of this article. See supra notes 12 and 13 and accompanying text.
4 Rev. Rul. 80-37, 1980-1 C.B. 51.
5 I.R.C §167(a).
6 Treas. Reg. §1.167(a)-2.
7 See, e.g. , S.E.C. Corp. v. U.S. , 140 F. Supp. 717 (S.D.N.Y.1956); Greene- Haldeman v. Commissioner , 31 T.C. 1286 (1959); Recordak v. U.S. , 325 F.2d 460 (1963).
8 See, e.g., cases cited supra note 7.
9 Priv. Ltr. Rul. 8107005 (Oct. 28, 1980); Priv. Ltr. Rul. 8917036 (Apr. 28, 1989); Priv. Ltr. Rul. 9448004 (Aug. 19, 1994); Priv. Ltr. Rul. 9811004 (Nov. 18, 1997).
10 I.R.C. §1231 provides in general that net gains from the sale of property used in the taxpayer’s trade or business in excess of depreciation recapture (I.R.C. §1245 and §1250) are capital gains not ordinary income.The specific provisions of I.R.C. §1231 and the depreciation recapture rules of I.R.C. §1245 and §1250 are beyond the scope and space limitations of this article.
11 Honeywell Inc. v. Commissioner , 87 T.C. 624, 633 (1986). The court in Honeywell was referring to Hollywood Baseball Int l Shoe Mach. Corp. v. U.S. , 491 F.2d 157 (1st Cir. 1974); Association v. Commissioner , 423 F.2d 494 (9th Cir. 1970); Continental Can Co. v. U.S. , 422 F.2d 405(Ct. Cl. 1970); Recordak Corp. v. U.S. , 325 F.2d 460 (Ct. Cl. 1963).
12 I.R.C. §167(a)(1); I.R.C. §1231(b); see also I.R.C. §1231(a)(3)(A)(I).
13 I.R.C. §1231(b)(1)(B).
14 Honeywell , 87 T.C. at 633.
15 Priv. Ltr. Rul. 8107005 (Oct. 28, 1980).
16 Priv. Ltr. Rul. 8917036 (Nov. 18, 1997).
17 Priv. Ltr. Rul. 9448004 (Aug. 19, 1994).
18 Priv. Ltr. Rul. 9811004 (Apr. 28, 1989).
19 See supra note 4.
Edward E. Sawyer is a partner at the Miami office of White & Case LLP. He received his law degree and master of laws degree in taxation from the University of Florida.
Terrance A. Dee is an associate at the Miami office of White & Case LLP. He received his law degree from the University of Miami, where he served as editor-in-chief of Law Review , and his master of laws degree in taxation from New York University.
This column is submitted on behalf of the Tax Section, Marvin C. Gutter, chair, and Michael D. Miller and Lester B. Law, editors.
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