CHAPTER XVII

THE INCOME TAX

DEPRECIATION OF PHYSICAL PROPERTY.

264.-DEPRECIATION DEFINED.

The income tax law allows a deduction from gross income on account of the depreciation of physical property due to exhaustion, wear and tear in the use of the property in the business or businesses of the taxpayer. It also allows a deduction on account of obsolescence, which will be explained hereinafter.

The deduction for depreciation, made and claimed in a return of annual net income, is supposed to be the amount of the loss, incurred during the year for which the return is made, in the value of the property-a loss which has not been made good by expenditures for ordinary repairs and maintenance during the year-a loss representing an appreciable deterioration in value as a business property, even though such property may have been repaired from time to time to keep it in operation.

265.-BASIS OF DEPRECIATION.

Manifestly a deduction on account of depreciation is an estimate, but if instructions are followed this estimate may be made very nearly accurate. The claim for allowance should be based upon the assumed life of the property, its cost and the use to which it is put. First must be considered the cost, as it is this cost which the law contemplates shall be covered eventually by the aggregate of annual allowances; then, should be ascertained the probable number of years constituting the life of the property, for it is over such a period that the loss due to depreciation is sustained. In other words, the cost of the property, for the purpose of arriving at a proper deduction for depreciation, should be ratably spread over its life.

That the position of the Treasury Department may be set forth clearly with respect to this allowance, the ruling made in an official letter of the Department is quoted. Such ruling is as follows:

The amount of the allowable depreciation deduction should be credited to a depreciation reserve account, against which account will be charged the cost of renewing or replacing the property with respect to which the depreciation is claimed.

It is not contemplated that such ordinary incidental repairs as keep the property in an operating condition shall be charged to this depreciation reserve but such cost may be charged to the expense of operation and maintenance. In other words, the depreciation deduction is intended to provide a fund out of which the loss due to depreciation occasioned by use, wear and tear, may be made good.

This office recognizes the fact that a building or a piece of machinery or other equipment, as a whole, may deteriorate in value and usefulness by reason of wear and tear, regardless of the fact that certain minor component parts may be renewed, restored or replaced. The depreciation deduction authorized by the law therefore contemplates the creation of a fund that will renew, restore or replace the original property when it has become worn out or exhausted, regardless of the renewal and restoration of parts that may have been made in the meantime.

Hence it is held that in addition to the depreciation deduction intended to cover the cost of the property as a whole, the expense of incidental repairs which do not add to the value of the property but merely keep it in an operating condition, may be allowably deducted from gross income as an expense of operation and maintenance.

It is barely possible in some instances that worn-out parts of a machine or similar equipment may be renewed one after another until the original machine or equipment is swallowed up in the renewed parts and the machine or equipment is then in as good operating condition as it originally was. In this case, if the cost of renewal parts is charged to operating expense, no deduction on account of depreciation should be claimed or allowed as to such machine or equipment.

This would appear to be true in the case of pipe lines, worn-out pipe covering and similar articles of equipment. By replacing one joint of pipe after another, all may be replaced, and if the expense is deducted as an operating expense, any depreciation fund that may have been reserved for the purpose of restoring the pipe line as a whole will remain unused.

So that in cases of this kind, if a depreciation reserve is set up to cover property that may be renewed or restored part by part, until the whole is renewed, the cost of the renewed parts should be charged to the depreciation reserve fund and will not be considered incidental expenses within the meaning of the regulations.

"Incidental repairs" refers only to those repairs which are, as the term signifies, only incidental to the operation of the property and which will not, if continued as the component parts wear out and are restored, make permanent the property.

Hence the depreciation deduction allowable with respect to any property, is such an amount as, in the aggregate, when the property as a whole is worn out, will replace it or return to the corporation (or individual) the capital invested in it. That is to say, the depreciation deduction allowable under the law and the regulations, should be only such an amount as will take care of loss due to the general wear and tear, and which is to no extent compensated by expenditures made for repairs.

It is the opinion of this office that expenditures for replacing wornout parts such as gears, bolts, nuts, valves, etc., so long as such replacements are not pursued to the extent and for the purpose of finally restoring the machinery or equipment as a whole, constitute incidental

repairs, and expenditures of this character are deductible from gross income as an operating expense, the depreciation deduction with respect to the property so repaired being reserved to replace the machinery, equipment or building when, as an entirety, it is worn out or is worthless for the purpose for which it is intended.

Such is the statement of the Department's position, and it is strictly adhered to by both the auditing and the investigating officers under whose scrutiny returns of income must pass. It is a general regulation with respect to all physical property employed in business.

There will, however, arise problems that cannot be solved by application of general rules. The percentage system is not a part of the law; it is merely prescribed by Departmental rules. And so, in circumstances when the rules are not applicable, it is suggested that the taxpayer may fall back upon the provision of law allowing a reasonable deduction for depreciation. If the taxpayer can show that his deduction is reasonable, he is within his legal rights, and cannot be penalized for asserting them.

266.-OBSOLESCENCE.

However, with respect to deterioration in value on account of obsolescence a different rule must be followed. That loss is sustained by such deterioration cannot be denied. Such a loss, however, is deductible as a loss and not according to the rule of annually claiming a year's percentage of the cost of the property. Regarding a loss of this kind the Department has plainly stated its position as follows:

It is not possible in advance to determine when a piece of machinery, equipment, or even a building will become obsolete. In other words, obsolescence cannot be anticipated and an annual deduction to take care of possible obsolescence cannot be allowed.

The rules of this office contemplate that annual deductions for depreciation may be made to provide for loss due to wear and tear, the amount of such deduction to be determined upon the basis of the probable life of the property. If it shall occur that the property becomes obsolete or worthless before its estimated probable life shall have expired, a deduction representing the difference between the cost of the property and the amount previously charged off on account of depreciation may be deducted as a loss, this amount being a deduction due to the obsolescence of the property.

267.-MUST APPEAR ON BOOKS.

There has been a great deal of controversy between taxpayers. and the Government relative to a requirement in the rulings of the Treasury Department to the effect that the annual allowance for depreciation shall be charged off on the books of the taxpayer (corporation or individual) so as to constitute a liability against assets. Certain corporations have contended that there is nothing in the lawand that legally nothing can be written into departmental regula

tions-requiring that a corporation keep its accounts by any particular method.

In extensive correspondence the Department has argued that the loss allowed for depreciation is supposed to be a real loss, and, as such, must, of reason, be taken regularly into the accounts of the taxpayer; that, if it is not a loss entitled to such consideration, it is not of the character that constitutes a legitimate deduction in a return of income. In effect, says the Department to the officers of a corporation, if the loss you claim on account of depreciation is not real enough to reflect to your stockholders, it is not real enough to have the approval of the Government as a charge against gross income.

And so the Department, in its instructions to field officers has ruled that where a claim for loss on account of depreciation is found to be reasonable but not to have been entered upon the books of the taxpayer, opportunity should be given the taxpayer to reopen the books and make proper entries to the end that the amount of the annual depreciation shall constitute a liability against the assets of the taxpayer and a charge against the income of the year for which the return is made. If the taxpayer refuses to make the proper entries, field officers are directed to disallow the amount claimed as a deduction on account of depreciation.

Moreover, the Department holds that a mere Journal entry is not sufficient, insisting upon a general ledger entry of the amount charged off and the reflection of the amount so charged in the annual Balance Sheet and in the report to stockholders.

268.-NO FIXED PERCENTAGES.

The law does not fix the annual percentage of depreciation with respect to any kind of physical property; neither do the regulations of the Department. But the Department does reserve to itself, the right to pass upon the reasonableness of every deduction for depreciation under the requirement of the statute that the deduction shall be for a "reasonable allowance."

And, likewise, the taxpayer has a right to express his opinion with regard to what is reasonable.

The estimated life of the property (the probable number of years it will remain so as to be usable for the general purposes for which it was intended) is one consideration; the other, the cost.

Only so far do the regulations of the Department go.

During the early years of income tax administration certain estimated percentages of depreciation announced by the San Francisco

Real Estate Board were followed by Internal Revenue Officers in checking returns filed in California, and were approved by the Treasury Department. However, when the Department began the final audit of the returns filed for the year 1915 it reduced the percentage claimed by a great many taxpayers-reduced the percentage, in numerous cases, until the allowance was rankly unreasonable, as far as the rights of the taxpayer were concerned.

The estimated rates of depreciation fixed by the San Francisco Real Estate Board, above referred to, are as follows:

Class A buildings.

99 B 99

99

C"

269.-SUGGESTION TO TAXPAYER.

.2 per cent per annum. .212 per cent per annum. .312 per cent per annum.

It is suggested that the, taxpayer, bearing in mind the factors of cost and probable life, claim what seems right and fair and "reasonable." There can be no penalty imposed for such an assertion of what one believes to be his right. Subsequently the Department may disagree and disapprove, but even then the taxpayer still has the right of argument.

If the deduction on account of depreciation is reduced by the Department to an amount so small as to appear to the taxpayer unreasonable, and if as a result of the alteration of the return increased assessment is made, the taxpayer may again present his contention in the form of a claim for the abatement of the assessment. (See "Claims for Abatement and Refund.")

270.-COURT DEFINITION OF DEPRECIATION.

In order that the taxpayer may have the benefit of a judicial statement on this subject the opinion of the Court in the case of Hyman Cohen v. John Z. Lowe, Collector, in the District Court of the United States for the Southern District of New York (234 Fed. 474) is herewith quoted. Said the Court:

The plaintiff was allowed 3 per cent for depreciation on an apartment house owned by him. This allowance is for the wear and tear suffered by the building during the tax year, which means the physical deterioration that the building suffered during that period. It does not take into account depreciation in value due to a loss in rental value because of the construction of more modern buildings with improved facilities, or due to a change in the neighborhood. It is to be based upon the life of the building in the sense of the number of years the building would remain in a condition to be habitable for the use for which it was constructed and used, and which was in the instant case for an apartment house, and not merely the number of years it would