# UNITED STATES TAX COURT

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## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## Text

T.C. Memo. 2002-231

UNITED STATES TAX COURT

MICHAEL A. MCGRATH AND FRANCES Y. MCGRATH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 126-99.

Filed September 18, 2002.

In 1995, Ps leased (as lessee) retail space in a
shopping center to operate a bakery. When Ps entered into
the lease, the leased space was nothing more than a dirt
floor enclosed by temporary walls; the leased space was not
serviced by any utilities. The lease obligated Ps to make
substantial permanent improvements to the leased space at
their own expense. Other than trade fixtures, the permanent
improvements Ps made to the leased space became the property
of the lessor upon installation.
Ps did not make a sec. 179, I.R.C. 1986, election on
their timely filed tax return for either 1995 or 1996. Ps
did not file a timely amended tax return for either 1995 or
1996.
1. Held: Ps’ expenditures for the permanent
improvements they made to the leased space constitute
capital expenditures that are not currently deductible.
Sec. 263, I.R.C. 1986. Ps’ cost recovery for the years in

- 2 issue is by way of depreciation, as allowed in the notice of
deficiency.
2. Held, further, Ps may not now elect to expense any
sec. 179 property they placed in service in either 1995 or
1996, because the period for making valid sec. 179 elections
for the years in issue has expired. Sec. 179(c), I.R.C.
1986.

Michael A. McGrath and Frances Y. McGrath, pro sese.
Emile L. Hebert III, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION
CHABOT, Judge: Respondent determined deficiencies in
individual income tax against petitioners as follows:
Year

Deficiency

1995

$28,590

1996

3,026

After concessions by both sides, the issues for decision1
are as follows:
(1)

Whether petitioners may deduct under section 1622

the costs they incurred in 1995 in making permanent

1

The following adjustments are computational, i.e., they
depend on resolution of the issues for decision: (1) Earned
income credit for 1996, and (2) itemized deductions for 1995 and
1996.
2

Unless indicated otherwise, all section and chapter
references are to sections and chapters of the Internal Revenue
Code of 1986 as in effect for the years in issue.

- 3 improvements to property they leased (as “tenant”) to
operate a bakery.
(2)

Whether petitioners may elect to expense section

179 property they placed in service in 1995 and 1996.
FINDINGS OF FACT
Some of the facts have been stipulated; the stipulations and
the stipulated exhibits are incorporated herein by this
reference.
Petitioners, Michael A. McGrath (hereinafter sometimes
referred to as Michael) and Frances Y. McGrath, resided in
Slidell, Louisiana, when they filed the petition in the instant
case.
In 1995 petitioners executed three agreements relevant to
the instant case: (1) A lease (hereinafter sometimes referred to
as the Lease), (2) a T.J. Cinnamons Unit Franchise Agreement
(hereinafter sometimes referred to as the Franchise Agreement),
and (3) a Standard Form of Agreement Between Owner and Contractor
(hereinafter sometimes referred to as the Construction
Contract).3

3

So stipulated. Both the Franchise Agreement and the
Construction Contract show only Michael’s name and signature,
while the Lease shows the names and signatures of both
petitioners. The Schedule C, Profit or Loss From Business, on
petitioners’ 1995 tax return shows only Michael as proprietor,
while the 1996 tax return Schedule C shows both petitioners as
proprietor. The parties do not appear to believe that any issue
in the instant case is affected by whether the business was owned
solely by Michael or was owned jointly by both petitioners.

- 4 A.

The Lease
On or about August 21, 1995, petitioners, as “tenant”,

entered into the Lease with TUP 130 Company Limited Partnership,
a Kentucky limited partnership (hereinafter sometimes referred to
as TUP 130), as “landlord”.

Under the Lease, TUP 130 agreed to

lease to petitioners space number 115 at the Mall at Barnes
Crossing shopping center in Tupelo, Mississippi, for a 5-year
term.

(This space is hereinafter sometimes referred to as the

Store Space.)

Petitioners leased the Store Space in order to

operate a T.J. Cinnamons franchised bakery, hereinafter sometimes
referred to as the Bakery.

The Bakery was to engage in the

retail sale of cinnamon rolls, gourmet coffee, muffins, bagels,
coffee cakes, and other related items incidental to a typical
T.J. Cinnamons menu.
When petitioners entered into the Lease, the Store Space had
a dirt floor, no utilities, and no permanent walls.

The Lease

obligated petitioners to complete construction of the Store Space
at their own expense before they could occupy the space for the
Bakery.

The construction that petitioners were obligated to

complete was as follows: (1) Excavation of the Store Space; (2)
installation of a concrete slab floor and a floor covering
therefor; (3) installation of a ceiling system; (4) installation
of a return air plenum; (5) installation of partition walls; (6)
installation of doors, frames, and hardware therefor; (7)

- 5 installation of a storefront, entrance doors, entrance grille
bulkhead, entrance vestibule finish, show window platforms, show
window, and vestibule ceilings, show window background and sign
background; (8) installation of a fire sprinkler system; (9)
installation of all electrical conduits and equipment required
for a complete electrical installation; (10) installation of an
extension of gas service from a metering point to the Store
Space; (11) installation of ventilation or air purification
systems; (12) installation of toilet room fixtures; (13)
installation of all store fixtures; (14) installation of all
required safety and emergency equipment; (15) installation of all
required equipment for aiding the handicapped; (16) installation
of insulation and interior finish on the exterior walls of the
Store Space; (17) painting; and (18) wallpapering; the foregoing
are hereinafter sometimes collectively referred to as the
Improvements.
Under the Lease, petitioners were to remain the owners of
(1) the trade fixtures they installed and (2) their merchandise;
however,
The storefront, partitions, heating and cooling equipment
and all other permanent installations attached to the
* * * [Store Space] shall become a part of the real estate,
shall belong to * * * [TUP 130] at the moment of
installation and shall be unencumbered by * * *
[petitioners].
The term of the Lease was 5 years.

The fixed minimum rent

for the store space was $26,312 per year, payable in equal

- 6 installments and due on the first day of each month at the rate
of $2,192.67 per month.

Petitioners were not obligated to pay

the fixed minimum rent until 6 months after the day the Bakery
was first opened for business to the public.
In addition to their obligation to pay the fixed minimum
rent, petitioners were also obligated to pay to TUP 130 various
other charges such as real estate taxes (estimated as $276.47 per
month), common area (estimated as $476.67 per month), insurance
(estimated as $10.49 per month), water and sewer service ($16.80
per month), and merchants’ association or marketing fund charges
($166.83 per month).
month.

These other charges totaled $947.26 per

Other than the water and sewer charge, petitioners’

obligation to pay these charges did not begin until 6 months
after the day the Bakery was first opened for business to the
public; petitioners’ obligation to pay water and sewer charges
did not include the 6-month delay language.
As a result, the Lease’s 6-month delay language applied to a
total of $3,123.13 per month ($2,192.67 fixed minimum, plus
$947.26 other charges, less $16.80 water and sewer services), or
$18,738.78 for the 6 months.
The Lease further obligated petitioners to maintain
throughout the term thereof and at their own expense, (1) public
liability insurance covering the store space and their use
thereof, and (2) “fire and extended coverage” insurance.

- 7 Petitioners, TUP 130, and TUP 130's management company were to be
insureds under the public liability policy.

Petitioners were

also responsible for paying all municipal, county, State, and
Federal taxes assessed against their leasehold interest,
fixtures, furnishings, equipment, stock-in-trade, and other
personal property of any kind owned, installed, and existing in
the Store Space.
B.

The Franchise Agreement
On August 23, 1995, petitioners and T.J. Cinnamons, Inc.,

executed the Franchise Agreement, authorizing petitioners to
operate a T.J. Cinnamons franchised bakery at the Store Space.
The initial term of the Franchise Agreement was 10 years.
Pursuant to the Franchise Agreement, petitioners paid to T.J.
Cinnamons, Inc., an initial franchise fee of $17,500.
(Petitioners concede that the $17,500 franchise fee must be
capitalized and amortized over a period of 15 years, as in the
notice of deficiency.)
C.

The Construction Contract
As of November 1, 1995, petitioners and Regional Development

& Building Inc., executed the Construction Contract for the
Improvements.

Petitioners performed the construction required

under the Lease during the period from September through December
1995.

- 8 Petitioners incurred and paid expenditures for work on and
for the Store Space during 1995 as shown in table 1.
Table 1
Amount

Payee
(1)

Gaffney Cabinets

$1,800

(2)

Taylor Cabinet Shop (cabinet with counter)

(3)

Sign Craft

428

(4)

Tull Brothers

240

(5)

Mid-South Signs

3,935

(6)

Chroma Copy

1,719

(7)

Duncan Signs

483

(8)

Taylor Cabinet Shop (door frames & baseboards)

13,500

(9)

Corinth Carpets

3,509

7,267

(10) Universal Manufacturing

1,150

(11) Regional

90,630

(12) Sherwin Williams

406

(13) Joey Wilhite
Total

2,000
127,067

Items 1 through 7 in table 1, supra (totaling $15,872), were
paid for furniture, fixtures, and equipment for the Bakery, and
not for leasehold improvements.

(The parties agree that these

expenditures must be capitalized and depreciated under the
modified accelerated cost recovery system (hereinafter sometimes

- 9 referred to as MACRS) as 7-year property, using the 200-percent
declining balance method and the midquarter convention.)4
The remaining $111,195 ($127,067 less $15,872) of
expenditures that petitioners paid for construction work on the
Store Space was for the (1) excavation of the site, (2)
installation of a concrete floor slab and floor coverings
therefor, (3) installation of electrical service and fixtures,
(4) installation of plumbing service and fixtures, (5)
construction, painting, and wallpapering of permanent walls and
partitions, and (6) installation of windows and doors.

All of

the $111,195 of expenditures that petitioners paid were for the
performance of the Improvements as set forth in the Lease.
Of the remaining $111,195, $18,739 were payments made in
lieu of the monthly payments due under the Lease for the 6-month
period December 1995 through May 1996.
listing of 6-month delay items.

See supra A. Lease,

The parties disagree as to the

4

In 1995, petitioners bought $42,855 of equipment for the
Bakery, in addition to the $15,872 discussed in the text. Some
part of this $42,855 is in addition to the amounts dealt with in
petitioners’ 1995 tax return and respondent’s notice of
deficiency.
As we interpret the parties’ stipulation, any part of the
$42,855 that petitioners are not allowed to expense under sec.
179(a) (subject to the limitations of sec. 179(b)), discussed
infra under II. Section 179 Election, shall be capitalized and
depreciated under MACRS as 7-year property, using the 200-percent
declining balance method and the midquarter convention.
As a result, a Rule 155 computation will be required
regardless of how we rule on the issues for decision.
Unless indicated otherwise, all Rule references are to the
Tax Court Rules of Practice and Procedure.

- 10 tax treatment of the remaining cost of the Improvements, $92,456
($127,067 less $15,872 (furniture, fixtures, and equipment) and
less $18,739 (payments made in lieu of rent)).
Also in 1995, petitioners (1) bought cash registers for the
Bakery for $3,475, and (2) placed in service a computer (75percent business usage) in which petitioners had a basis of
$2,865.

Petitioners classified the cash registers and the

computer as 5-year property on their 1995 tax return and claimed
depreciation deductions in respect thereof for 1995 and 1996
using the 200-percent declining balance method and the midquarter
convention over a recovery period of 5 years.

Respondent does

not dispute either petitioners’ classification of, or the amount
of, claimed depreciation deductions, for either the cash
registers or the computer.
In 1996, petitioners bought $5,059 of equipment for the
Bakery.5

5

So stipulated. As we interpret the parties’ stipulation,
any part of the $5,059 that petitioners are not allowed to
expense under sec. 179(a) (subject to the limitations of sec.
179(b)), discussed infra under II. Section 179 Election, shall be
capitalized and depreciated under MACRS as 7-year property, using
the 200-percent declining balance method and the midquarter
convention.
However, in the notice of deficiency, respondent determined
that on Dec. 30, 1996, petitioners placed in service equipment
(continued...)

- 11 Petitioners opened the Bakery in December 1995 and operated
it until some time in February 1997.

On or about April 7, 1997,

petitioners sold the Bakery including the furniture, fixtures,
equipment, inventory, and supplies therefor.6
D.

1995 Tax Return
Petitioners timely filed their joint 1995 income tax return.

On this tax return they claimed a refund in the amount of
$25,658.

They did not elect on this tax return to treat any

property they placed in service in 1995 as section 179 property,
because they believed such an election would not affect the
amount of the 1995 tax refund to which they were entitled.
E.

1996 Tax Return
Petitioners timely filed their joint 1996 income tax return.

On this tax return they claimed a refund in the amount of $3,571,
of which $3,026 was earned income credit.

They did not elect on

5

(...continued)
with a cost or other basis in the amount of $5,267. On opening
brief, respondent notes this discrepancy and concludes that
petitioners have conceded the $208 differential, but apparently
only if petitioners lose on the sec. 179 issue. On answering
brief, petitioners state that “In the respondent’s opening brief,
the respondent agrees that the petitioners purchased * * * $5,267
of Section 179 equipment in 1996.”
The parties are to resolve this matter in the proceedings
under Rule 155.
6

The record does not show whether petitioners claimed as
basis in determining their gain or loss on the 1997 sale any
amount that they deducted on their 1995 or 1996 tax returns. The
record also does not show what became of the Lease.

- 12 this tax return to treat any property they placed in service in
1996 as section 179 property.
_____________________________________
No more than $18,739 of petitioner’s capital expenditures
for the Improvements constitutes a substitute for rent.
OPINION
I.

Deducting the Cost of Improvements

Petitioners contend that, under section 162(a)(3), they may
deduct the cost of the Improvements because they (1) were
required to pay for and make the Improvements, and (2) did not
acquire either title to, or an equity interest in, the
Improvements.

Petitioners’ contention closely tracks the

statutory language.

Petitioners’ contention also appears to be

based on assumed economic realities; i.e., that the Improvements
that the lessee was required to make would increase the Store
Space’s value, that this expected value increase implicitly
reduced the amount of the rent obligations, and that, to the
extent of the reduction, the cost of the Improvements is
deductible rent expense under section 162(a)(3).

Respondent

contends that petitioners must capitalize and depreciate the cost
of the Improvements because they are nondeductible capital
expenditures under section 263.

We agree with respondent’s

conclusion and much of respondent’s analysis.

- 13 In general, section 162(a)7 authorizes current deductions
for ordinary and necessary expenses of a trade or business.
However, sections 1618 and 2619 have the effect of subordinating
provisions such as section 162(a) to provisions such as section
263(a)(1),10 thereby disallowing the current deductions of

7

Sec. 162(a) provides, in pertinent part, as follows:

SEC. 162.

TRADE OR BUSINESS EXPENSES.

(a) In General.--There shall be allowed as a deduction
all the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or
business, including-(1) a reasonable allowance for salaries or other
compensation for personal services actually rendered;
(2) traveling expenses * * * while away from home
in the pursuit of a trade or business; and
(3) rentals or other payments required to be made
as a condition to the continued use or possession, for
purposes of the trade or business, of property to which
the taxpayer has not taken or is not taking title or in
which he has no equity.
8

SEC. 161.

ALLOWANCE OF DEDUCTIONS.

In computing taxable income under section 63, there
shall be allowed as deductions the items specified in this
part, subject to the exceptions provided in part IX (sec.
261 and following, relating to items not deductible).
9

SEC. 261.

GENERAL RULE FOR DISALLOWANCE OF DEDUCTIONS.

In computing taxable income no deduction shall in any
case be allowed in respect of the items specified in this
part.
10

Sec. 263(a)(1) provides, in pertinent part, as follows:
(continued...)

- 14 capital expenditures that otherwise would have been currently
deductible trade or business expenses.

See, e.g., Commissioner

v. Idaho Power Co., 418 U.S. 1 (1974).

Unless some other special

rules apply (see, e.g., the subparagraphs of sec. 263(a)(1)), the
taxpayer’s deductions for capital expenditures (if allowable at
all) generally come by way of amortization or depreciation; i.e.,
the capital expenditure is deductible over a period of time.
See, e.g., secs. 167, 168, and 169.
Ordinarily, depreciation or amortization is thought of as a
deduction available to an owner of an asset with respect to that
owner’s basis in the asset.
determinative.

However, a lack of ownership is not

We described the analysis in Currier v.

Commissioner, 51 T.C. 488, 492 (1968), as follows:
The allowance for depreciation is designed to permit
the person who invests in a wasting asset a means of
recouping, tax free, his investment in that property. To
have the benefit of this deduction the taxpayer has the
burden of proving that he has a depreciable interest in the
property as to which he seeks a depreciation allowance. See
Barnes v. United States, 222 F.Supp. 960 (D. Mass. 1963),
affirmed sub nom. Buzzell v. United States, 326 F.2d 825
(C.A. 1, 1964), and the cases cited therein.
Where the owner of real property enters into a longterm lease, under the terms of which the lessee is to

10

(...continued)
SEC. 263. CAPITAL EXPENDITURES.
(a) General Rule.--No deduction shall be allowed for-(1) Any amount paid out for new buildings or for
permanent improvements or betterments made to increase
the value of any property or estate. * * *

- 15 construct at his own cost a building on the property, the
lessee, not the lessor, is entitled to a deduction for the
depreciation of the building. See Reisinger v.
Commissioner, 144 F.2d 475 (C.A. 2, 1944), affirming a
Memorandum Opinion of this Court; Friend v. Commissioner,
119 F.2d 969 (C.A. 7, 1941), affirming a Memorandum Opinion
of this Court; Commissioner v. Pearson, 188 F.2d 72 (C.A. 5,
1951), reversing and remanding on other grounds 13 T.C. 851;
First Nat. Bank of Kansas City v. Nee, 190 F.2d 61 (C.A. 8,
1951); Goelet v. United States, 266 F.2d 881 (C.A. 2, 1959);
Schubert v. Commissioner, 286 F.2d 573 (C.A. 4, 1961),
affirming 33 T.C. 1048.
The lessee, who is obligated to make improvements to
the realty, is entitled to recover his capital outlay by
deductions for depreciation. His right to the deductions is
not altered by the fact that, under doctrines of local law,
legal title to the improvements may reside in the lessor.
In such situations it is the lessee, not the lessor, who
suffers the economic loss as the property deteriorates, and
who is entitled to the statutory allowance. Helvering v.
Lazarus & Co., 308 U.S. 252 (1939); First Nat. Bank of
Kansas City v. Nee, supra. The party claiming depreciation
must have some investment in the wasting asset. Detroit
Edison Co. v. Commissioner, 319 U.S. 98 (1943).
To the same effect, see sec. 1.162-11(b), Income Tax Regs.11

11

Sec. 1.162-11.
*

Rentals.-*

*

*

*

*

*

(b) Improvements by lessee on lessor’s property.--(1)
The cost to a lessee of erecting buildings or making
permanent improvements on property of which he is the lessee
is a capital investment, and is not deductible as a business
expense. * * * [Emphasis added.]
The balance of this provision has been superseded by the
enactment of sec. 168, in particular, sec. 168(i)(8)(A).
However, the statutory language does not affect the continued
validity of that part of the regulation set forth in this note.
For an example of this continued validity, see Nelson v.
Commissioner, T.C. Memo. 2000-212.

- 16 Applying the foregoing to the instant case, we conclude that
(1) petitioners’ expenditures dealt with in this issue are
capital expenditures and (2) (unless some other provision or rule
leads to a different result) petitioners’ deductions on account
of these expenditures are determined under sections 167 and 168,
and not under section 162(a)(3).
There is a nonstatutory exception to the foregoing that
applies to the instant case.

Where a lessee makes a capital

expenditure in lieu of some rent, then the expenditure will be
treated as rent and not as a capital expenditure by the lessee.
This exception’s rationale is explained, and its application is
illustrated, in Your Health Club, Inc. v. Commissioner, 4 T.C.
385, 389-390 (1944), as follows:
The second question relates to the deductibility of
rent in the amount of $4,250 in the fiscal year ended March
31, 1940. The facts show that petitioner had obligated
itself to pay rental for that year in the amount of $4,250,
but that a clause in the lease provided that petitioner
might make certain improvements to the premises, the cost of
which to the extent of $1,500 might be applied to the
contractual rental. Petitioner expended $1,374.96 in making
such improvements, applying this amount as a credit against
the total rent due, and paid the lessor the difference,
$2,875.04. The Commissioner determined that only the latter
amount was deductible as rent and disallowed the deduction
of the amount of $1,374.96, adding it to capital and making
proper adjustment for amortization. Petitioner contends
that the disallowed item was properly deductible as rent.
Petitioner does not question the general rule that the
cost borne by a lessee in making permanent improvements upon
leased property is a capital expenditure, but contends that
the outlay in this instance was no more than an indirect
payment of a part of the stipulated rental, inasmuch as it
was agreed that the cost of the improvements should be

- 17 applied as a credit against the rent for the current year.
This appears to us to be a correct interpretation of the
facts. Actually, petitioner paid nothing for the
improvements; the cost thereof was borne by the lessor
through the credit applied against the agreed rental.
Consequently, petitioner has no capital investment to
amortize or depreciate. The transaction is no different
than if the lessor had paid directly for the improvements
and the lessee directly paid the full agreed rent. On this
issue, therefore, we hold that the determination of the
Commissioner is erroneous.
In order for this exception to apply, the lessor and the
lessee must intend that some or all of the lessee’s capital
expenditures are rent, and this intent must be plainly disclosed.
In Cunningham v. Commissioner, 28 T.C. 670, 680 (1957), affd. 258
F.2d 231 (9th Cir. 1958), we described the situation as follows:
In M.E. Blatt Co. v. United States, supra [305 U.S.
267, 277 (1938)], the Supreme Court has clearly stated that
whether the value of such improvements constitutes rent
depends upon the intention of the parties, and that even
when the improvements are required by the terms of the lease
this value will not be deemed rent unless the intention that
it shall be such is plainly disclosed. Such intent in our
opinion is to be derived not only from the terms of the
lease but from the surrounding circumstances. This is
recognized by the respondent in his published ruling I.T.
4009, 1950-1 C.B. 13.

- 18 To the same effect, see sec. 1.61-8(c), Income Tax Regs;12 see
also sec. 109.
The parties have stipulated that this exception applies to
allow petitioners rent expense deductions of $3,123 for 1995 and
$15,616 for 1996, for otherwise capital expenditures.

This is

founded on the parties’ stipulation that “$18,739.00 of the
expenditures * * * were in lieu of rental payments * * * to be
made by petitioners over the six (6) month period of December,
1995 through May, 1996, inclusive.”

This latter part of the

stipulation is, in turn, founded on the provisions of the Lease
with regard to petitioners’ rent obligations and construction
obligations, as described supra in the Findings of Fact.
We now consider whether any amount in addition to the
stipulated $18,739 was intended to be payments made in lieu of
rent.

12

Sec. 1.61-8(c), Income Tax Regs., provides, in pertinent
part, as follows:
Sec. 1.61-8
*

Rents and Royalties.–*

*

*

*

*

*

(c) Expenditures by lessee. As a general rule, if a
lessee pays any of the expenses of his lessor such payments
are additional rental income of the lessor. If a lessee
places improvements on real estate which constitute, in
whole or in part, a substitute for rent, such improvements
constitute rental income to the lessor. Whether or not
improvements made by a lessee result in rental income to the
lessor in a particular case depends upon the intention of
the parties, which may be indicated either by the terms of
the lease or by the surrounding circumstances. * * *

- 19 The Lease does not show that petitioners and TUP 130
intended to treat the entire cost of the Improvements as a rent
substitute.

The Lease contains provisions which give petitioners

a rent holiday for the first 6 months after the day the Bakery
was first opened for business to the public; these provisions
underlie the parties’ stipulation as to the $18,739.

Beyond

these provisions, however, the Lease is silent as to whether
petitioners and TUP 130 intended to treat the remaining cost of
the Improvements as a rent substitute.
The surrounding circumstances also do not show that
petitioners and TUP 130 intended to treat the cost of the
Improvements as a rent substitute beyond the 6-month rent
holiday.

Rather, petitioners’ 1995 tax return, certain of

petitioners’ proposed findings of fact and statements on brief,
and a portion of Michael’s testimony belie petitioners’
contention that they should be allowed to deduct the cost of the
Improvements under section 162(a)(3) as rent expense.
Petitioners did not report any rent or lease expenses on the
Schedule C attached to their 1995 tax return.

Petitioners

claimed a deduction of $103,388 for “repairs and maintenance” on
the Schedule C attached to the 1995 tax return; the $103,388

- 20 deduction represented what petitioners thought was the cost of
the improvements.13
On brief, petitioners proposed the following findings of
fact:
8. The petitioners were granted six months rent-free use of
the retail space at The Mall at Barnes Crossing as a
condition of Articles IV and V of their lease agreement in
consideration for costs incurred by the petitioners in the
build-out of the retail space. * * *
9. The petitioners performed $127,067 of work on the
retail space at The Mall at Barnes Crossing, and
$18,739 of those expenditures were in lieu of rental
payments to be made equally over a six month period by
the petitioners. Those rental payments were for the
period of December 1995 through May 1996.
On opening brief, petitioners state, in pertinent part, as
follows:
The petitioners received, from their lessor,
credit equal to 6 months rent as consideration for the
permanent improvements made to the lessor’s real
property. Upon the completion of the first 6 months of
occupancy, the petitioners commenced paying full rent,
with no additional consideration for the improvements
made.
On answering brief, petitioners state, in pertinent part, as
follows:
The petitioners received, from their lessor,
credit equal to 6 months rent as consideration for the
permanent improvements made to the lessor’s real
property. Upon the completion of the first 6 months of
occupancy, the petitioners commenced paying full rent
on the improved property, as if the improvements had
been paid for by the lessor, with no additional

13

The parties agree, and we have found, that the cost of
the Improvements was $127,067, not $103,388.

- 21 consideration for the improvements made. At that point
in time, with the exception of the 6 months rent
credit, the lessor realized the full benefit of the
improvements, while the petitioners realized none.
After Michael testified that he could not “get a competitive
bid” for the Improvements because of the lack of a local
contractor who could do the work, he testified:
And it was important for us in the business to be
established before the Christmas rush, so we agreed to
go ahead and pay the amount over and above, knowing
that we were only going to get consideration for the
total of the $18,000 in rent credit.
The additional amount, the additional $92,000, we
just assumed that that was cost of obtaining the site
and possessing the retail space.
The above-quoted portions of petitioners’ opening and
answering briefs and Michael’s testimony show that petitioners
did not intend to treat the entire cost of the Improvements as a
rent substitute.

The only consideration for the Improvements, in

petitioners’ own words, was a “credit equal to 6 months rent”.
Moreover, petitioners’ statement on brief that they “commenced
paying full rent, with no additional consideration for the
improvements made” (emphasis added) after the 6-month rent
holiday ended undercuts any contention that the cost of the
Improvements reduced their monthly rent obligations under the
Lease after the rent holiday.

Based on the foregoing, we

conclude that petitioners did not intend to treat as a substitute
for rent the cost of the Improvements beyond the $18,739 as
stipulated.

- 22 The only evidence regarding TUP 130's intention is the
Lease, which, as set forth above, manifests an intent consistent
with petitioners’; namely, that only $18,739 of the cost of the
Improvements is a rent substitute.
On the basis of the preponderance of the evidence, we
conclude that the Improvements are a rent substitute to the
extent of $18,739 only.
Section 162(a)(3) addresses more than just “rentals”; it
also addresses “other payments”.

In light of Michael’s testimony

and petitioners’ above-quoted statements on brief, it may be that
petitioners implicitly contend that the cost of the Improvements
is deductible under section 162(a)(3) as “other payments”.

We

previously concluded that the Improvements are capital
expenditures.

Capital expenditures made for betterments and

additions to leased premises do not fall within the phrase “other
payments”.

Duffy v. Central R.R., 268 U.S. 55, 64 (1925).14

14

The statutory language being construed in Duffy v.
Central R.R., 268 U.S. 55, 61 (1925), was sec. 12(a) (First) of
the Revenue Act of 1916, ch. 463, 39 Stat.767, which states, in
pertinent part, as follows:
First. All the ordinary and necessary expenses paid
within the year in the maintenance and operation of its
business and properties, including rentals or other payments
required to be made as a condition to the continued use or
possession of property to which the corporation has not
taken or is not taking title, or in which it has no equity.
The Supreme Court analyzed the situation as follows (268 U.S. at
63-64):
(continued...)

- 23 Accordingly, the cost of the Improvements, to the extent it
is not a rent substitute, is not deductible as “other payments”.
Petitioners’ cost recovery is by way of depreciation, as allowed
in the notice of deficiency.
In light of the foregoing, it is evident that petitioners
must capitalize the cost of the Improvements under section 263
and depreciate them in accordance with sections 167 and 168 even
though (1) the Lease required petitioners to make the
Improvements at their own expense, and (2) petitioners did not
hold title to, or otherwise acquire an equity interest therein.
Petitioners raise an additional contention to support their
claim that they may deduct the cost of the Improvements.

On

opening brief, petitioners state, in pertinent part, as follows:
IRC § 110 (a) states: “Gross income of a lessee
does not include any amount received in cash (or
treated as a rent reduction) by a lessee from a lessor
- (1) under a short-term lease of retail space, and (2)
for the purpose of such lessee’s constructing or
improving qualified long-term real property for use in
such lessee’s trade or business at such retail space”.
Clearly, it is the intent of the IRC to not include as

14

(...continued)
Expenditures, therefore, like those here involved, made [by
the lessee] for betterments and additions to leased
premises, cannot be deducted under the term “rentals”, in
the absence of circumstances fairly importing an exceptional
meaning; and these we do not find in respect of the statute
under review. Nor do such expenditures come within the
phrase “or other payments”, which was evidently meant to
bring in payments ejusdem generis with “rentals,” such as
taxes, insurance, interest on mortgages, and the like,
constituting liabilities of the lessor on account of the
leased premises which the lessee has covenanted to pay.

- 24 income any credit a lessee receives from his lessor for
permanent improvements to the lessor’s property under a
short-term lease. It follows that the income expended
by a lessee for permanent improvements to the lessor’s
property are deductible from the lessee’s gross income.
Section 11015 does not apply in the instant case.

Firstly,

section 110 applies only to leases entered into after August 5,
1997.

Sec. 1213(e) of the Taxpayer Relief Act of 1997, Pub. L.

105-34, 111 Stat. 788, 1001.

The lease in the instant case was

entered into on or about August 21, 1995.

Thus, section 110 does

not apply in the instant case.
Secondly, even if the Lease were subject to section 110, it
would not apply in the instant case given the nature of the
parties’ dispute.

Section 110 is an income exclusion provision.

Respondent is not charging petitioners with income on account of
any TUP 130 payment or the 6-month rent holiday that TUP 130

15

Sec. 110 provides, in pertinent part, as follows:

SEC. 110.

QUALIFIED LESSEE CONSTRUCTION ALLOWANCES FOR
SHORT-TERM LEASES.

(a) In General.–-Gross income of a lessee does not
include any amount received in cash (or treated as a rent
reduction) by a lessee from a lessor–(1) under a short-term lease of retail space, and
(2) for the purpose of such lessee’s constructing
or improving qualified long-term real property for use
in such lessee’s trade or business at such retail
space,
but only to the extent that such amount does not exceed the
amount expended by the lessee for such construction or
improvement.

- 25 granted to petitioners in respect of the Improvements petitioners
made.
Thirdly, we have already concluded that there was not any
rent reduction, apart from the 6-month rent holiday, and so the
requirement imposed by the opening flush language of section
110(a) has been satisfied only to that extent in the instant
case.
Petitioners’ position is not advanced by their section 110
contention.
We hold for respondent on this issue.
II.

Section 179 Election

Petitioners contend that if we sustain respondent’s
determination on the section 162 issue, which we have, then they
will need to file amended tax returns.

Petitioners further

contend that if amended tax returns are required, then
petitioners must be allowed to make section 179 elections on such
tax returns.

Petitioners explain that they did not make section

179 elections on their tax returns for 1995 and 1996, because
“such election would have no effect on the amount of the refund
due the petitioners, assuming the construction costs deducted
were determined to be allowable.”

In contending that they should

now be allowed to make valid elections under section 179,

- 26 petitioners apparently now believe that section 179 elections
will reduce their tax liabilities for the years in issue.16
Respondent contends that petitioners are not entitled to
make section 179 elections for 1995 and 1996 because they failed
to make section 179 elections on their tax returns for those
years.

16

We agree with respondent.

It has been suggested that the limitation imposed by
sec. 179(b)(3) might cause a sec. 179 election for either of the
years in issue to not affect the amount of any deficiency. In
the instant case, the Court has proceeded to decide the issue
presented because it is within our jurisdiction, and neither side
has formally contended that the sec. 179 election issue is moot.
In future cases, we may consider requiring the appropriate party
to demonstrate that the issue in dispute is not moot. See, e.g.,
Foster v. Commissioner, 80 T.C. 34, 236-237 (1983), affd. in part
and vacated in part 756 F.2d 1430 (9th Cir. 1985).

- 27 Section 179(c)(1)17 delegates to the Secretary the authority
to prescribe by regulations the manner in which a taxpayer makes
a valid election under section 179.

Section 1.179-5, Income Tax

Regs., provides, in pertinent part, as follows:
Sec. 1.179-5. Time and manner of making election.–(a) Election. * * * The election under section 179
and section 1.179-1 to claim a section 179 expense deduction
for section 179 property shall be made on the taxpayer’s
first income tax return for the taxable year to which the
election applies (whether or not the return is timely) or on
an amended return filed within the time prescribed by law
(including extensions) for filing the return for such
taxable year. * * *
As applied to the instant case, section 1.179-5, Income Tax
Regs., precludes petitioners from making valid section 179

17

SEC. 179.
*

ELECTION TO EXPENSE CERTAIN DEPRECIABLE
BUSINESS ASSETS.
*

*

*

*

*

*

(c) Election.-(1) In general.--An election under this
section for any taxable year shall–(A) specify the items of section 179
property to which the election applies and
the portion of the cost of each of such items
which is to be taken into account under
subsection (a), and
(B) be made on the taxpayer’s return of
the tax imposed by this chapter [chapter 1
relating to normal taxes and surtaxes] for
the taxable year.
Such election shall be made in such manner as the
Secretary may by regulations prescribe.

- 28 elections for 1995 and 1996.

Petitioners did not make a section

179 election on their tax return for either 1995 or 1996.
Both of those tax returns were timely filed.

The time for filing

amended tax returns has long since expired.

Under these

circumstances, it is too late to make a valid section 179
LaPoint v. Commissioner, 94 T.C. 733, 735-736 (1990).

election.

Apparently at the heart of petitioners’ contention that
respondent’s audit has created the need to file amended returns
on which they should be allowed to make valid section 179
elections for 1995 and 1996 are beliefs that (1) respondent’s
adjustments created a situation when an election under section
179 would “change the bottom line”, and (2) preventing
petitioners from making the elections would not be equitable.
We addressed a similar contention in Patton v. Commissioner,
116 T.C. 206, 211 (2001).

The taxpayer in Patton classified and

deducted the entire cost of certain items as “materials” or
“supplies”.

Id. at 207, 210.

The Commissioner determined, and

the taxpayer did not dispute, that the items the taxpayer
classified as “materials” or “supplies” were depreciable
property.

Id. at 210.

The Commissioner also determined that the

taxpayer failed to report $135,638 of gross receipts from the
taxpayer’s business.

Id. at 207.

If the taxpayer in Patton had

been permitted to amend the prior section 179 election to have
that election apply to the reclassified items, then the taxpayer

- 29 would have been able to offset part of the profit the
Commissioner determined for the taxpayer’s business.

Id. at 208.

We concluded in Patton that it was the taxpayer’s
misclassification of assets (and not the Commissioner’s
determinations) that created the need to “revoke (modify)” the
taxpayer’s section 179 election.

Id. at 210.

Consequently, we

held in Patton that it was not an abuse of discretion for the
Commissioner to refuse to allow the taxpayer to “revoke (modify)”
his section 179 election.

Id. at 211.

Although petitioners are asking to make rather than “revoke
(modify)” a section 179 election, the reasons underlying our
decision in Patton apply also to the instant case.

Like the

taxpayer in Patton, petitioners’ perceived need to file section
179 elections stems from petitioners’ misunderstanding of the
proper tax treatment of particular items and the understatement
of the amounts they paid for section 179 property during the
years in issue.

We shall not carve out an exception to the

general requirements of section 1.179-5(a), Income Tax Regs., to
permit petitioners to make an otherwise untimely section 179
election.

- 30 We hold for respondent on this issue.
In order to take account of respondent’s concessions,

Decision will entered
under Rule 155.

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aa11fec1f7a4fb410. Public record. Not legal advice.