Opinion
Docket No. 49542.
1955-11-18
MT. MORRIS DRIVE-IN THEATRE CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Richard Katcher, Esq., for the petitioner. James A. Scott, Esq., for the respondent.
Petitioner constructed an open-air theatre on sloping land formerly covered with vegetation without including in the construction any drainage system. In 1950 it spent $8,224 to construct a drainage system extending into and over adjacent land belonging to another in compromise of a pending lawsuit against it based upon allegations that petitioner's use of its own property had caused accelerated and concentrated drainage onto the adjacent land. Held, the cost of the drainage system was a capital expenditure and was not deductible either as an ordinary and necessary business expense or as a loss. Richard Katcher, Esq., for the petitioner. James A. Scott, Esq., for the respondent.
The Commissioner determined a deficiency in the petitioner's income and excess profits tax for 1950 in the amount of $3,150.13. The only issue for decision is whether the amount of $8,224 spent by the petitioner in 1950 to construct a drainage system was deductible either as an ordinary and necessary business expense or as a loss, as contended by the petitioner, or whether it was a nondepreciable capital expenditure, as determined by the Commissioner. An alternative issue raised by the petitioner that the cost of the drainage system should be amortized over a period of at least 5 years was expressly abandoned by it at the hearing.
FINDINGS OF FACT.
The petitioner is an Ohio corporation with its principal offices in Cleveland, Ohio. It filed an original and an amended Federal income and excess profits tax return for the calendar year 1950 with the collector of internal revenue for the eighteenth district of Ohio.
In 1947 petitioner purchased 13 acres of farm land located on the outskirts of Flint, Michigan, upon which it proceeded to construct a drive-in or outdoor theatre. Prior to its purchase by the petitioner the land on which the theatre was built was farm land and contained vegetation. The slope of the land was such that the natural drainage of water was from the southerly line to the northerly boundary of the property and thence onto the adjacent land, owned by David and Mary D. Nickola, which was used both for farming and as a trailer park. The petitioner's land sloped sharply from south to north and also sloped from the east downward towards the west so that most of the drainage from the petitioner's property was onto the southwest corner of the Nickolas' land. The topography of the land purchased by petitioner was well known to petitioner at the time it was purchased and developed. The petitioner did not change the general slope of its land in constructing the drive-in theatre, but it removed the covering vegetation from the land, slightly increased the grade, and built aisles or ramps which were covered with gravel and were somewhat raised so that the passengers in the automobiles would be able to view the picture on the large outdoor screen.
As a result of petitioner's construction on and use of this land rain water falling upon it drained with an increased flow into and upon the adjacent property of the Nickolas. This result should reasonably have been anticipated by petitioner at the time when the construction work was done.
The Nickolas complained to the petitioner at various times after petitioner began the construction of the theatre that the work resulted in an acceleration and concentration of the flow of water which drained from the petitioner's property onto the Nickolas' land causing damage to their crops and roadways. On or about October 11, 1948, the Nickolas filed a suit against the petitioner in the Circuit Court for the County of Genesee, State of Michigan, asking for an award for damages done to their property by the accelerated and concentrated drainage of the water and for a permanent injunction restraining the defendant from permitting such drainage to continue. Following the filing of an answer by the petitioner and of a reply thereto by the Nickolas, the suit was settled by an agreement dated June 27, 1950. This agreement provided for the construction by the petitioner of a drainage system to carry water from its northern boundary across the Nickolas' property and thence to a public drain. The cost of maintaining the system was to be shared by the petitioner and the Nickolas, and the latter granted the petitioner and its successors an easement across their land for the purpose of constructing and maintaining the drainage system. The construction of the drain was completed in October 1950 under the supervision of engineers employed by the petitioner and the Nickolas at a cost to the petitioner of $8,224, which amount was paid by it in November 1950. The performance by the petitioner on its part of the agreement to construct the drainage system and to maintain the portion for which it was responsible constituted a full release of the Nickolas' claims against it. The petitioner chose to settle the dispute by constructing the drainage system because it did not wish to risk the possibility that continued litigation might result in a permanent injunction against its use of the drive-in theatre and because it wished to eliminate the cause of the friction between it and the adjacent landowners, who were in a position to seriously interfere with the petitioner's use of its property for outdoor theatre purposes. A settlement based on a monetary payment for past damages, the petitioner believed, would not remove the threat of claims for future damages.
On its 1950 income and excess profits tax return the petitioner claimed a deduction of $822.40 for depreciation of the drainage system for the period July 1, 1950, to December 31, 1950. The Commissioner disallowed without itemization $5,514.60 of a total depreciation expense deduction of $19,326.41 claimed by the petitioner. In its petition the petitioner asserted that the entire amount spent to construct the drainage system was fully deductible in 1950 as an ordinary and necessary business expense incurred in the settlement of a lawsuit, or, in the alternative, as a loss, and claimed a refund of part of the $10,591.56 of income and excess profits tax paid by it for that year.
The drainage system was a permanent improvement to the petitioner's property, and the cost thereof constituted a capital expenditure.
The stipulation of facts and exhibits annexed thereto are incorporated herein by this reference.
OPINION.
KERN, Judge:
When petitioner purchased, in 1947, the land which it intended to use for a drive-in theatre, its president was thoroughly familiar with the topography of this land which was such that when the covering vegetation was removed and graveled ramps were constructed and used by its patrons, the flow of natural precipitation on the lands of abutting property owners would be materially accelerated. Some provision should have been made to solve this drainage problem in order to avoid annoyance and harassment to its neighbors. If petitioner had included in its original construction plans an expenditure for a proper drainage system no one could doubt that such an expenditure would have been capital in nature.
Within a year after petitioner had finished its inadequate construction of the drive-in theatre, the need of a proper drainage system was forcibly called to its attention by one of the neighboring property owners, and under the threat of a lawsuit filed approximately a year after the theatre was constructed, the drainage system was built by petitioner who now seeks to deduct its cost as an ordinary and necessary business expenses, or as a loss.
We agree with respondent that the cost to petitioner of acquiring and constructing a drainage system in connection with its drive-in theatre was a capital expenditure.
Here was no sudden catastrophic loss caused by a ‘physical fault’ undetected by the taxpayer in spite of due precautions taken by it at the time of its original construction work as in American Bemberg Corporation, 10 T.C. 361; no unforeseeable external factor as in Midland Empire Packing Co., 14 T.C. 635; and no change in the cultivation of farm property caused by improvements in technique and made many years after the property in question was put to productive use as in J. H. Collingwood, 20 T.C. 937. In the instant case it was obvious at the time when the drive-in theatre was constructed, that a drainage system would be required to properly dispose of the natural precipitation normally to be expected, and that until this was accomplished, petitioner's capital investment was incomplete. In addition, it should be emphasized that here there was no mere restoration or rearrangement of the original capital asset, but there was the acquisition and construction of a capital asset which petitioner had not previously had, namely, a new drainage system.
That this drainage system was acquired and constructed and that payments therefor were made in compromise of a lawsuit is not determinative of whether such payments were ordinary and necessary business expenses or capital expenditures. ‘The decisive test is still the character of the transaction which gives rise to the payment.’ Hales-Mullaly v. Commissioner, 131 F.2d 509, 511, 512.
In our opinion the character of the transaction in the instant case indicates that the transaction was a capital expenditure.
Reviewed by the Court.
Decision will be entered for the respondent.
RAUM, J. concurring:
The expenditure herein was plainly capital in nature, and, as the majority opinion points out, if provision had been made in the original plans for the construction of a drainage system there could hardly be any question that its cost would have been treated as a capital outlay. The character of the expenditure is not changed merely because it is made at a subsequent time, and I think it wholly irrelevant whether the necessity for the drainage system could have been foreseen, or whether the payment therefor was made as a result of the pressure of a law suit.
FISHER, J., agrees with this concurring opinion.
RICE, J. dissenting:
It seems to me that J. H. Collingwood, 20 T.C. 937 (1953), Midland Empire Packing Co., 14 T.C. 635 (1950), American Bemberg Corporation, 10 T.C. 361 (1948), aff'd. 177 F.2d 200 (C.A. 1949), and Illinois Merchants Trust Co., Executor, 4 B.T.A. 103 (1926), are ample authority for the conclusion that the expenditure which petitioner made was an ordinary and necessary business expense, which did not improve, better, extend, increase, or prolong the useful life of its property. The expenditure did not cure the original geological defect of the natural drainage onto the Nickolas' land, but only dealt with the intermediate consequence thereof. The majority opinion does not distinguish those cases adequately. And since those cases and the result reached herein do not seem to me to be able to ‘live together,‘ I cannot agree with the majority that the expenditure here was capital in nature.