Liddle v. Comm IRS

Opinions of the United

1995 Decisions States Court of Appeals

for the Third Circuit

9-8-1995

Liddle v Comm IRS

Precedential or Non-Precedential:

Docket 94-7733

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UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 94-7733

BRIAN P. LIDDLE; BRENDA H. LIDDLE

v.

COMMISSIONER OF THE INTERNAL REVENUE SERVICE,

Appellant

ON APPEAL FROM A DECISION OF

THE UNITED STATES TAX COURT

(No. 92-2126)

________________________________

Argued June 15, 1995

Before: STAPLETON, McKEE, Circuit Judges,

and ROSENN, Senior Circuit Judge

(Opinion filed: September 8, 1995 )

LORETTA C. AGRETT, ESQ.

Assistant Attorney General

GARY R. ALLEN, ESQ.

RICHARD FARBER, ESQ.

EDWARD T. PERELMUTER, ESQ. (Argued)

Attorneys

Tax Division

Department of Justice

P.O. Box 502

Washington, D.C. 20044

Attorneys for Appellant

DAVID LYLE SEGAL, ESQ. (Argued)

JEFFRY H. HOMEL, ESQ.

121 South Broad Street

Suite 1700

Philadelphia, PA 19107

Attorneys for Appellees

1

OPINION OF THE COURT

McKEE, Circuit Judge

In this appeal from a decision of the United States Tax

Court we are asked to decide if a valuable bass violin can be

depreciated under the Accelerated Cost Recovery System when used

as a tool of trade by a professional musician even though the

instrument actually increased in value while the musician owned

it. We determine that, under the facts before us, the taxpayer

properly depreciated the instrument and therefore affirm the

decision of the Tax Court.

I.

Brian Liddle, the taxpayer here, is a very accomplished

professional musician. Since completing his studies in bass

violin at the Curtis Institute of Music in 1978, he has performed

with various professional music organizations, including the

Philadelphia Orchestra, the Baltimore Symphony, the Pennsylvania

ProMusica and the Performance Organization.

In 1984, after a season with the Philadelphia Orchestra, he

purchased a 17th century bass violin made by Francesco Ruggeri

(c. 1620-1695), a luthier who was active in Cremona, Italy.

Ruggeri studied stringed instrument construction under Nicolo

Amati, who also instructed Antonio Stradivari. Ruggeri’s other

contemporaries include the craftsmen Guadanini and Guarneri.

These artisans were members of a group of instrument makers known

as the Cremonese School.

2

Liddle paid $28,000 for the Ruggeri bass, almost as much as

he earned in 1987 working for the Philadelphia Orchestra. The

instrument was then in an excellent state of restoration and had

no apparent cracks or other damage. Liddle insured the

instrument for its then-appraised value of $38,000. This

instrument was his principal instrument and he used it

continuously to earn his living, practicing with it at home as

much as seven and one-half hours every day, transporting it

locally and out of town for rehearsals, performances and

auditions. Liddle purchased the bass because he believed it

would serve him throughout his professional career -- anticipated

to be 30 to 40 years.

Despite the anticipated longevity of this instrument, the

rigors of Liddle's profession soon took their toll upon the bass

and it began reflecting the normal wear and tear of daily use,

including nicks, cracks, and accumulations of resin. At one

point, the neck of the instrument began to pull away from the

body, cracking the wood such that it could not be played until it

was repaired. Liddle had the instrument repaired by renown

artisans. However, the repairs did not restore the instrument's

"voice" to its previous quality. At trial, an expert testified

for Liddle that every bass loses mass from use and from oxidation

and ultimately loses its tone, and therefore its value as a

performance instrument decreases. Moreover, as common sense

would suggest, basses are more likely to become damaged when used

as performance instruments than when displayed in a museum.

Accordingly, professional musicians who use valuable instruments

as their performance instruments are exposed to financial risks

3

that do not threaten collectors who regard such instruments as

works of art, and treat them accordingly.

There is a flourishing market among nonmusicians for

Cremonese School instruments such as Mr. Liddle's bass. Many

collectors seek primarily the "label", i.e., the maker's name on

the instrument as verified by the certificate of authenticity. As

nonplayers, they do not concern themselves with the physical

condition of the instrument; they have their eye only on the

market value of the instrument as a collectible. As the quantity

of these instruments has declined through loss or destruction

over the years, the value of the remaining instruments as

collectibles has experienced a corresponding increase.

Eventually, Liddle felt the wear and tear had so

deteriorated the tonal quality of his Ruggeri bass that he could

no longer use it as a performance instrument. Rather than

selling it, however, he traded it for a Domenico Busan 18th

century bass in May of 1991. The Busan bass was appraised at

$65,000 on the date of the exchange, but Liddle acquired it not

for its superior value, but because of the greater tonal quality.

Liddle and his wife filed a joint tax return for 1987, and

claimed a depreciation deduction of $3,170 for the Ruggeri bass

under the Accelerated Cost Recovery System ("ACRS"), I.R.C.

§168.1 The Commissioner disallowed the deduction asserting that

the "Ruggeri bass in fact will appreciate in value and not

1

Because the bass viol was placed in service in 1984, the

Internal Revenue Code applicable to that year governs this case.

Thus, our analysis is governed by I.R.C. § 168 as it existed

prior to 1987.

4

depreciate." Accordingly, the Commissioner assessed a deficiency

of $602 for the tax year 1987. The Liddles then filed a petition

with the Tax Court challenging the Commissioner's assertion of

the deficiency. A closely divided court entered a decision in

favor of the Liddles. 103 T.C. 285 (1994). This appeal

followed.2

II.

The Commissioner originally argued that the ACRS deduction

under § 168 is inappropriate here because the bass actually

appreciated in value. However, the Commissioner has apparently

abandoned that theory, presumably because an asset can appreciate

in market value and still be subject to a depreciation deduction

under tax law. Fribourg Navigation Co. v. Commissioner, 383 U.S.

272, 277 (1966) ("tax law has long recognized the accounting

concept that depreciation is a process of estimated allocation

which does not take account of fluctuations in valuation through

market appreciation."); Noyce v. Commissioner, 97 T.C. 670 (1991)

(taxpayer allowed to deduct depreciation under § 168 on an

airplane that appreciated in economic value by 27 percent from

the date of purchase to the time of trial).

2

Our review of the Tax Court's conclusions of law is

plenary; however, we review the court's factual findings under a

clearly erroneous standard. Armstrong World Industries, Inc. v.

Commissioner, 974 F.2d 422, 430 (3d Cir. 1992); National Starch

and Chemical Corp. v. Commissioner, 918 F.2d 426, 432 (3d Cir.

1990), aff'd, 503 U.S. 79 (1992).

5

Here, the Commissioner argues that the Liddles can claim the

ACRS deduction only if they can establish that the bass has a

determinable useful life. Since Mr. Liddle's bass is already

over 300 years old, and still increasing in value, the

Commissioner asserts that the Liddles can not establish a

determinable useful life and therefore can not take a

depreciation deduction. In addition, the Commissioner argues

that this instrument is a "work of art" which has an

indeterminable useful life and is therefore not depreciable.

In United States v. Ludey, 274 U.S. 295 (1927), the Supreme

Court explained the depreciation deduction as follows:

The depreciation charge permitted as a

deduction from the gross income in

determining the taxable income of a business

for any year represents the reduction, during

the year, of the capital assets through wear

and tear of the plant used. The amount of

the allowance for depreciation is the sum

which should be set aside for the taxable

year, in order that, at the end of the useful

life of the plant in the business, the

aggregate of the sums set aside will (with

the salvage value) suffice to provide an

amount equal to the original cost.

274 U.S. at 300-301. Prior to 1981, Section 167 of the Internal

Revenue Code, 26 U.S.C. § 167, governed the allowance of

depreciation deductions with respect to tangible and intangible

personalty. Section 167 provided, in relevant part, as follows:

§ 167. DEPRECIATION

(a) General Rule. -- There shall be allowed

as a depreciation deduction a reasonable

allowance for the exhaustion, wear and tear

(including a reasonable allowance for

obsolescence) --

(1) of property used in the trade

or business, or

(2) of property held for the

production of income.

6

26 U.S.C. § 167(a). The regulations promulgated under § 167

provided that in order to qualify for the depreciation deduction,

the taxpayer had to establish that the property in question had a

determinable useful life. Treas. Reg. §§ 1.167(a) and (b). The

useful life of an asset was not necessarily the useful life

“inherent in the asset but [was] the period over which the asset

may reasonably be expected to be useful to the taxpayer in his

trade or business. . . .” Treas. Reg. § 1.167(b). Nonetheless,

under § 167 and its attendant regulations, a determinable useful

life was the sine qua non for claiming the deduction. See,

Harrah’s Club v. United States, 661 F.2d 203, 207 (Ct. Cl. 1981)

(“Under the regulation on depreciation, a useful life capable of

being estimated is indispensable for the institution of a system

of depreciation.”)

Under § 167, the principal method for determining the useful

life of personalty was the Asset Depreciation Range (“ADR”)

system. Personalty eligible for the ADR system was grouped into

more than 100 classes and a guideline life for each class was

determined by the Treasury Department. See, Treas. Reg.

§1.167(a)-11. A taxpayer could claim a useful life up to 20

percent longer or shorter than the ADR guideline life. Treas.

Reg. § 1.167(4)(b). The ADR system was optional with the

taxpayer. Tres. Reg. § 1.167(a)-11(a). For personalty which was

not eligible for ADR, and for taxpayers who did not choose to use

ADR, the useful life of an asset was determined according to the

unique circumstances of the particular asset or by an agreement

between the taxpayer and the Internal Revenue Service. STAFF OF THE

JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE ECONOMIC RECOVERY TAX

7

ACT OF 1981, 97th Cong., reprinted in INTERNAL REVENUE ACTS, 1980-

1981, at 1441 (1982).

In 1981, convinced that tax reductions were needed to ensure

the continued economic growth of the country, Congress passed the

Economic Recovery Tax Act of 1981, P.L. 97-34 (“ERTA”). Id. at

1391. It was hoped that the ERTA tax reduction program would

“help upgrade the nation’s industrial base, stimulate

productivity and innovation throughout the economy, lower

personal tax burdens and restrain the growth of the Federal

Government.” Id. Congress felt that prior law and rules

governing depreciation deductions need to be replaced “because

they did not provide the investment stimulus that was felt to be

essential for economic expansion.” Id. at 1449. Further,

Congress believed that the true value of the depreciation

deduction had declined over the years because of high inflation

rates. Id. As a result, Congress believed that a “substantial

restructuring” of the depreciation rules would stimulate capital

formation, increase productivity and improve the country’s

competitiveness in international trade. Id. Congress also felt

that the prior rules concerning the determination of a useful

life were “too complex”, “inherently uncertain” and engendered

“unproductive disagreements between taxpayers and the Internal

Revenue Service.” Id. To remedy the situation, Congress

decided

that a new capital cost recovery system

should be structured which de-emphasizes the

concept of useful life, minimizes the number

of elections and exceptions and is easier to

comply with and to administer.

Id.

8

Accordingly, Congress adopted the Accelerated Cost Recovery

System (“ACRS”) in ERTA. The entire cost or other basis of

eligible property is recovered under ACRS, eliminating the

salvage value limitation of prior depreciation law. GENERAL

EXPLANATION OF THE ECONOMIC RECOVERY TAX ACT OF 1981 at 1450. ACRS was

codified in I.R.C. § 168, which provided, in relevant part, as

follows:

§ 168. Accelerated cost recovery system

(a) Allowance of Deduction. -- There shall be

allowed as a deduction for any taxable year

the amount determined under this section with

respect to recovery property.

(b) Amount of Deduction. --

(1) In general.-- Except as otherwise

provided in this section, the amount of the

deduction allowable by subsection (a) for any

taxable year shall be the aggregate amount

determined by applying to the unadjusted

basis of recovery property the applicable

percentage determined in accordance with the

following table:

*********************************

(c) Recovery Property. -- For purposes of

this title --

(1) Recovery Property Defined. -- Except as

provided in subsection (e), the term

"recovery property" means tangible property

of a character subject to the allowance for

depreciation --

(A) used in a trade or business, or

(B) held for the production of income.

26 U.S.C. § 168. ACRS is mandatory and applied to “recovery

property” placed in service after 1980 and before 1987.3

3

In the Tax Reform Act of 1986, P. L. 99-514, § 201, Congress

made substantial changes to I.R.C. § 168. In particular,

9

Section 168(c)(2) grouped recovery property into five

assigned categories: 3-year property, 5-year property, 10-year

property, 15-year real property and 15-year public utility

property. Three year property was defined as § 1245 property4

with a class life of 4 years or less. Five year property is all

§ 1245 property with a class life of more than 4 years. Ten year

property is primarily certain public utility property, railroad

tank cars, coal-utilization property and certain real property

described in I.R.C. § 1250(c). Other long-lived public utility

property is in the 15-year class. 26 U.S.C. § 168(a)(2)(A), (B)

and (C). Basically, 3-year property includes certain short-lived

assets such as automobiles and light-duty trucks, and 5-year

property included all other tangible personal property that was

not 3-year property. Most eligible personal property was in the

5-year class.

The Commissioner argues that ERTA § 168 did not eliminate

the pre-ERTA § 167 requirement that tangible personalty used in a

trade or business must also have a determinable useful life in

order to qualify for the ACRS deduction. She argues that the

phrase “of a character subject to the allowance for depreciation"

demonstrates that the pre-ERTA § 167 requirement for a

determinable useful life is the threshold criterion for claiming

the § 168 ACRS deduction.

Congress deleted the “recovery property” concept from the

statute.

4

§ 1245 property is, inter alia, any personal property which is

or has been property of a character subject to allowance for

depreciation provided in § 167. 26 U.S.C. § 1245(3).

10

Much of the difficulty inherent in this case arises from two

related problems. First, Congress left § 167 unmodified when it

added § 168; second, § 168 contains no standards for determining

when property is "of a character subject to the allowance for

depreciation." In the absence of any express standards, logic

and common sense would dictate that the phrase must have a

reference point to some other section of the Internal Revenue

Code. Section 167(a) would appear to be that section. As stated

above, that section 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. . .

." The Commissioner assumes that all of the depreciation

regulations promulgated under § 167 must, of necessity, be

imported into § 168. That importation would include the

necessity that a taxpayer demonstrate that the asset have a

demonstrable useful life, and (the argument continues) satisfy

the phrase "tangible property of a character subject to the

allowance for depreciation" in § 168.

However, we do not believe that Congress intended the

wholesale importation of § 167 rules and regulations into § 168.

Such an interpretation would negate one of the major reasons for

enacting the Accelerated Cost Recovery System. Rather, we

believe that the phrase "of a character subject to the allowance

for depreciation" refers only to that portion of § 167(a) which

allows a depreciation deduction for assets which are subject to

exhaustion and wear and tear. Clearly, property that is not

subject to such exhaustion does not depreciate. Thus, we hold

that “property of a character subject to the allowance for

11

depreciation” refers to property that is subject to exhaustion,

wear and tear, and obsolescence. However, it does not follow that

Congress intended to make the ACRS deduction subject to the § 167

useful life rules, and thereby breathe continued life into a

regulatory scheme that was bewildering, and fraught with

problems, and required "substantial restructuring."

We previously noted that Congress believed that prior

depreciation rules and regulations did not provide the investment

stimulus necessary for economic expansion. Further, Congress

believed that the actual value of the depreciation deduction

declined over the years because of inflationary pressures. In

addition, Congress felt that prior depreciation rules governing

the determination of useful lives were much too complex and

caused unproductive disagreements between taxpayers and the

Commissioner. Thus, Congress passed a statute which "de-

emphasizes the concept of useful life." GENERAL EXPLANATION OF THE

ECONOMIC RECOVERY TAX ACT OF 1981 at 1449. Accordingly, we decline

the Commissioner's invitation to interpret § 168 in such a manner

as to re-emphasize a concept which Congress has sought to "de-

emphasize."

The Commissioner argues that de-emphasis of useful life is

not synonymous with abrogation of useful life. As a general

statement, that is true. However, the position of the

Commissioner, if accepted, would reintroduce unproductive

disputes over useful life between taxpayers and the Internal

Revenue Service. Indeed, such is the plight of Mr. Liddle.

Congress de-emphasized the § 167 useful life rules by

creating four short periods of time over which taxpayers can

12

depreciate tangible personalty used in their trade or business.

These statutory “recovery periods. . .are generally unrelated to,

but shorter than, prior law useful lives.” GENERAL EXPLANATION OF THE

ECONOMIC RECOVERY TAX ACT OF 1981 at 1450. The four recovery periods

are, in effect, the statutorily mandated useful lives of tangible

personalty used in a trade or business.

The recovery periods serve the primary purpose of ERTA. Once

a taxpayer has recovered the cost of the tangible personalty used

in a trade or business, i.e., once the taxpayer has written off

the asset over the short recovery period, his or her basis in

that asset will be zero and no further ACRS deduction will be

allowed. To avail himself or herself of further ACRS deductions,

the taxpayer will have to purchase a new asset. Thus, because

the recovery period is generally shorter that the pre-ERTA useful

live of the asset, the taxpayer’s purchase of the new asset will

increase capital formation and new investment and, as a result,

promote the Congressional objective for continued economic

expansion.

Thus, in order for the Liddles to claim an ACRS deduction,

they must show that the bass is recovery property as defined in

I.R.C. § 168(c)(1). It is not disputed that it is tangible

personalty which was placed in service after 1980 and that it was

used in Brian Liddle’s trade or business. What is disputed is

whether the bass is “property of a character subject to the

allowance for depreciation.” We hold that that phrase means that

the Liddles must only show that the bass was subject to

exhaustion and wear and tear. The Tax Court found as a fact that

the instrument suffered wear and tear during the year in which

13

the deduction was claimed. 103 T.C. 285, 294 (1994). That

finding was not clearly erroneous. Accordingly, the Liddles are

entitled to claim the ACRS deduction for the tax year in

question.

Similarly, we are not persuaded by the Commissioner's "work

of art" theory, although there are similarities between Mr.

Liddle's valuable bass, and a work of art. The bass, is highly

prized by collectors; and, ironically, it actually increases in

value with age much like a rare painting. Cases that addressed

the availability for depreciation deductions under § 167 clearly

establish that works of art and/or collectibles were not

depreciable because they lacked a determinable useful life. See,

Associated Obstetricians and Gynecologists, P.C. v. Commissioner,

762 F.2d 38 (6th Cir. 1985) (works of art displayed on wall in

medical office not depreciable); Hawkins v. Commissioner, 713

F.2d 347 (8th Cir.) (art displayed in law office not

depreciable); Harrah's Club v. United States, 661 F.2d 203 (Ct.

Cl. 1981) (antique automobiles in museum not depreciable). See

also, Rev. Rul. 68-232, 1968-1 C.B. 79 ("depreciation of works of

art generally is not allowable" because '[a] valuable and

treasured art piece does not have a determinable useful life.'").

We also realize that, in a similar case, a musical

instrument was held to not qualify for depreciation. See Browning

v. Commissioner, 890 F.2d 1084 (9th Cir. 1989). However,

Browning was decided on the basis of § 167(a) and depreciation

law as it existed before the enactment of ERTA and §168, and it

therefore provides little guidance to our inquiry. In addition,

the taxpayer in Browning failed to meet his burden that the

14

Stradivarius violins in question had only a useful life of 12

years under the ADR system then in effect. 890 F.2d at 1087.

Moreover, it appears from the Tax Court opinion that the taxpayer

may not have been using the instruments in his profession but

rather was acquiring them as collectibles. 55 T.C.M.(CCH) 1232,

1237 (1988)(“ [F]rom the record, we have no definite answer as to

how often the three antique violins were used, if ever. . . . In

fact, we suspect that petitioner was forming a collection of

antique violins not only as musical tools of the trade but as

antique collectibles.”) In Brian Liddle's professional hands, his

bass viol was a tool of his trade, not a work of art. It was as

valuable as the sound it could produce, and not for its looks.

Normal wear and tear from Liddle's professional demands took a

toll upon the instrument's tonal quality and he, therefore, had

every right to avail himself of the depreciation provisions of

the Internal Revenue Code as provided by Congress.

15

III.

Accordingly, for the reasons set forth above, we will affirm

the decision of the tax court.

16