Liddle v. Comm IRS ( 1995 )

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Precedential or Non-Precedential: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