Taxpayers Lose on Expensing Improvement Costs and Amending Returns

McGrath, TC Memo 2002-231, demonstrates the importance of properly determining whether acquisitions should be capitalized or expensed. Prior to trial, the litigants had resolved all issues, except whether they could:

1. Deduct as Sec. 162 ordinary and necessary business expenses the costs of permanently improving leased property in 1995; and

2. Elect to expense under Sec. 179 qualified property placed in service in 1995 and 1996.

Expensing vs. Capitalization

In 1995, the taxpayers executed a property lease, a franchise agreement to operate a bakery and a construction contract to improve the leased property.

The leased space, in a shopping mall, had a dirt floor, no utilities and no permanent walls. The lease required the tenant to perform all construction on the space to operate a bakery. It specifically stated “[t]he 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...[the owner] at the moment of installation and shall be unencumbered by...[petitioners].” Even though the taxpayers paid for all of the improvements to the space, they had no ownership rights.

The taxpayers argued that they could deduct the improvements under Sec. 162(a)(3), because they (1) were required to pay for and make the improvements and (2) did not acquire title to, or an equity interest in, the improvements.

The IRS claimed that the taxpayers had to capitalize and depreciate the improvements under Sec. 263.

The Tax Court agreed with the IRS, indicating that Secs. 161 and 261 subordinate provisions such as Sec. 162(a) to provisions such as Sec. 263(a)(1). Thus, the taxpayers had to capitalize and depreciate the improvement costs.

Election to Amend Returns

The taxpayers contended that they should have been allowed to make a Sec. 179 election on amended 1995 and 1996 returns. They indicated that they did not make timely elections on those returns because “...such election would have no effect on the amount of the refund due the petitioners, assuming the constructions costs deducted were determined to be allowable.” Regs. Sec. 1.179-5 provides that an election to expense assets must be made with the filing of a taxpayer's first return for a year, or on an amended return within the time prescribed by law. The IRS's position was that the taxpayers did not make a Sec. 179 election with the 1995 and 1996 returns (which were filed timely) and the time for filing amended returns had passed.

The Tax Court agreed with the IRS, citing Patton, 116 TC 206 (2001). The tax litigation did not provide the taxpayers an extension to file amended returns.

From Michael D. Koppel, CPA, Gray, Gray & Gray, LLP, Boston, MA