Jake Z. Schrum Ruby E. Schrum Dannie L. Schrum Jeanette v. Schrum Donald L. Moore Judith A. Moore v. Commissioner of the Internal Revenue Service
Docket: 93-1814
Court: Court of Appeals for the Fourth Circuit; September 1, 1994; Federal Appellate Court
The case involves the appeal of Jake Z. Schrum and others against the Commissioner of the Internal Revenue Service regarding the qualification of self-service carwash facilities for an investment tax credit and depreciation treatment under an older version of the tax code. The tax court had previously upheld the Commissioner's determination that only a minor portion of the facilities qualified for these tax benefits. The court summarized the facts surrounding the appellants, who operated eight self-service carwash facilities in Virginia under Peninsula Enterprises, a general partnership.
These facilities, constructed primarily of metal, brick, and concrete, are designed for self-service use, featuring open bays (except for two with partial walls) and lacking doors. Customers can select water types and pressures, while a maintenance crew handles upkeep without direct customer interaction. The facilities are equipped with specialized water and electricity systems, larger drainage, and water supply lines. Vertical walls separate the bays to manage water flow and contain coin-operated mechanisms for customer payments. Structural beams and mounted equipment facilitate the washing process, with additional cosmetic features that do not contribute to watertight integrity. The court affirmed part of the tax court's ruling but vacated and remanded other aspects for further consideration.
Two underground tanks are installed beneath each carwash bay to collect and remove dirt and sediment from wastewater, ensuring compliance with local sewage system requirements. Sloped, reinforced concrete slabs with grates direct wastewater into these settling tanks. Each facility features a single equipment room of the same size as a bay, housing essential equipment such as pumps, electrical gear, water heaters, and tanks. These rooms lack insulation and air conditioning but provide minimal heating to prevent pipe freezing in winter, with no windows or ventilation, and no restrooms in the facilities.
During the 1984-1987 tax years, taxpayers claimed investment tax credits for their carwash investments and depreciated them over five years under the Accelerated Cost Recovery System (ACRS). The Commissioner disallowed much of the claimed credits, mandated longer depreciation periods, and imposed penalties for negligence and overstatement. The tax court upheld the Commissioner’s actions.
Taxpayers argued that their carwash facilities qualified as "section 38 property" under I.R.C. Sec. 38 and Sec. 48(a)(1). They contended that the facilities qualify as "tangible personal property" and, if not, as "other tangible property used as an integral part of water and sewage disposal services." The IRS has established guidelines for interpreting section 48 in Treasury Regulation Sec. 1.48-1, which is binding as a statute. The analysis follows two steps: first, evaluating whether the entire carwash facilities qualify as section 38 property, and second, determining if the tax court correctly upheld the Commissioner's finding that only certain portions do.
Taxpayers' facilities were evaluated to determine if they qualify as section 38 property under section 48(a)(1)(A), which defines "tangible personal property." According to Treasury Regulation Sec. 1.48-1(c), tangible personal property excludes land and permanent structures, including buildings and their structural components. Property that is machinery or attached to a building may qualify as tangible personal property. However, buildings and inherently permanent structures can only qualify if they are considered machinery. The carwash structures were found to be inherently permanent due to their design, including concrete foundations and brick walls, which indicate permanence. The court applied the inherent permanency test from Whiteco Industries, Inc., assessing factors such as mobility, intended permanence, removal difficulty, and affixation. The taxpayers did not provide sufficient evidence to demonstrate the facilities are not inherently permanent, as they lack mobility and would sustain significant damage if removed. Consequently, the carwash facilities do not qualify as section 38 property.
Taxpayers argue that the assessment of whether a structure is inherently permanent should include its 'economic permanence', defined as the structure's adaptability for other uses. They claim their carwash facilities are 'single-purpose' structures that would need to be demolished for alternative land use. Citing a precedent, taxpayers contend that the regulation's reference to "buildings and other inherently permanent structures" implies that economic permanence is relevant to this determination. However, the court disagrees, interpreting the regulation to mean that while all buildings are inherently permanent structures, not all inherently permanent structures are buildings. The court finds that using economic permanence as a criterion is unnecessary, as few non-building structures are easily convertible for other uses. The tax court's conclusion that the structures are inherently permanent is affirmed, and the court does not address whether the facilities qualify as "buildings."
Additionally, taxpayers argue their facilities qualify as "property in the nature of machinery," referencing a prior case where inherently permanent structures were deemed inseparable from machinery. They assert their carwash facilities function as integrated systems akin to vending machines. The court rejects this argument, indicating that the facilities do not meet the criteria for machinery classification.
The tax court found that the carwash machinery in question is not factually similar to the Weirick case, concluding that the machinery is not part of a single unit with the supporting structure. There was no indication that the machinery was designed to function with the structure nor that replacing it would necessitate replacing the entire structure simultaneously. The court noted that the machinery could operate independently of the supporting structure, leading to the determination that the facilities could not be classified as "property in the nature of machinery." This reasoning aligns with similar findings in previous cases, including the relationship between ski lift ramps and the ski lift mechanism, and the refrigeration equipment and its structural components in Munford, Inc. v. Commissioner. Consequently, the facilities do not qualify as section 38 property under section 48(a)(1)(A). The court will further evaluate whether the facilities qualify under section 48(a)(1)(B)(i), which pertains to tangible property not classified as buildings or structural components but used integrally in providing specified services. To qualify, the property must meet five criteria: it must be tangible, not a building or its structural components, used as an integral part of providing specific services, and utilized by someone engaged in such services.
The taxpayers' carwash facilities, while assumed not to be buildings, do not qualify as section 38 property under section 48(a)(1)(B) despite their claim of providing water and sewage disposal services. The analysis distinguishes between the primary business of the taxpayers and activities that are merely supportive. It is determined that wastewater disposal is incidental to the main business of offering self-service carwash facilities, as customers primarily seek to wash their cars rather than utilize sewage disposal services. Cited precedents support this view, illustrating that ancillary services do not define the core business.
The taxpayers further argued that their facilities should qualify as they are integral to furnishing water services. However, it is concluded that the carwash structures themselves are neither directly used in providing water services nor essential for their completeness, as the carwash equipment and plumbing independently fulfill the water service function. Consequently, the carwash facilities do not qualify as section 38 property under both sections 48(a)(1)(A) and 48(a)(1)(B). Thus, only a portion of the taxpayers' property is deemed to qualify as section 38 property.
Taxpayers argue that certain components of their carwash facilities qualify as section 38 property, even if the entire facilities do not. The Commissioner allocated construction costs for Peninsula's carwashes, assigning full costs of some components as carwash equipment and allocating 50% of labor costs, 60% of plumbing costs, and 50% of electrical costs to carwash equipment, with remaining costs classified under carwash structures. The tax court ruled that taxpayers failed to prove entitlement to a higher credit than that determined by the Commissioner, lacking sufficient evidence for the expenditures' qualification as tangible property for investment credit. Consequently, the court upheld the Commissioner's allocations.
For costs to qualify as equipment, they must meet criteria under section 48(a)(1)(A) or (B). Some components are determined to fit the definition of section 38 property under section 48(a)(1)(A). The court examined the appropriateness of the Commissioner's allocation, particularly focusing on plumbing and electrical expenses. Citing precedent from A.C. Monk. Co., the court clarified that a single electrical system cannot be partially classified as structural and as equipment. Therefore, the allocation of expenses by the Commissioner conflicts with this precedent. The Commissioner did not appeal this aspect, effectively conceding that the plumbing and electrical components should be fully recognized as section 38 property. As a result, the tax court's determination on this matter is vacated, and on remand, the court is directed to classify these components entirely as non-structural and reassess the allocation of labor costs for potential adjustments.
The allocation of costs for the carwashes purchased by Peninsula, as determined by the Commissioner, lacks clarity and cannot be verified against the standards set in A.C. Monk. Co. The tax court must reassess this allocation based on these standards. For any portion of the facilities to qualify as section 38 property under section 48(a)(1)(B), the taxpayers must demonstrate they are engaged in providing water services, and that the property is integral to those services and not merely a structural component of a building. Only the plumbing and electrical equipment from the carwash facilities may meet these criteria. Since these components qualify as section 38 property under section 48(a)(1)(A), further qualification under section 48(a)(1)(B) is unnecessary. The taxpayers' challenge to the cost allocation, aside from the discussed points, lacks merit. The court affirms in part and vacates in part the tax court's decision regarding property allocation for investment tax credit purposes, remanding for further proceedings.
Additionally, taxpayers assert entitlement to a five-year depreciation period for the carwash facilities. The Commissioner disputes the classification of these facilities as "section 1245 property." Section 1245 property is defined as property eligible for depreciation under section 167, excluding buildings and structural components, provided it is tangible and integral to services such as water. The definitions of section 38 and section 1245 properties are closely aligned, as indicated by Treasury regulations. Thus, the qualification of taxpayers' property as section 1245 property is contingent upon its qualification as section 38 property; if it does not qualify as section 38 property, it cannot be depreciated over a five-year period. The court affirms in part and vacates in part the tax court's findings on this matter, also remanding for further proceedings.
The Commissioner imposed a negligence tax addition against Dannie and Jeanette Schrum under I.R.C. Sec. 6653(a)(1)(A), which applies when any part of a tax underpayment is due to negligence, defined as a lack of due care. The burden of proving the Commissioner's negligence determination incorrect lies with the taxpayers. The tax court noted that while taxpayers are not mandated to seek professional tax advice, doing so could indicate reasonable behavior. However, there was no evidence that the Schrums consulted tax professionals. Although their submitted tax returns support their position, the tax court's imposition of a negligence penalty was vacated and remanded for further proceedings, with the possibility of adjusting the penalty based on the primary tax liability. Additionally, the Commissioner assessed an addition for substantial understatement of tax liability against the Schrums, which must be recalculated on remand in light of the revised primary tax liability. The taxpayers' challenge against this addition was found to lack merit. The tax court's judgment is affirmed in part and vacated in part, with the case remanded for further proceedings.
The court's decision is partially affirmed, vacated, and remanded. The general partners of Peninsula, who filed joint tax returns, include their wives, Ruby Schrum, Jeanette Schrum, and Judith Moore, as parties to this case. The taxpayers did not claim an investment tax credit for one of the constructed carwash facilities. References to the Internal Revenue Code and Treasury Regulations pertain to the applicable versions during the relevant years. I.R.C. Sec. 49(a), introduced by the Tax Reform Act of 1986, stipulates that the investment tax credit does not apply to property placed in service after December 31, 1985, yet the Commissioner did not contest claims for credits on such property.
The court notes a distinction between structural components of buildings, which cannot be classified as "tangible personal property," and machinery. A three-prong test from A.C. Monk. Co. assesses whether a structure qualifies as a "building" based on its physical resemblance to a building, its intended function, and its adaptability. The government argues that adaptability is relevant only to certain tax code sections but the court assumes it applies to both. Concerns are raised regarding the tax court's interpretation in Weirick, which may allow structural components of inherently permanent structures to qualify as machinery, contrary to regulations. However, the court concludes that the carwash structures are inherently permanent and do not qualify as machinery, making the validity of Weirick unnecessary to determine in this case. It is clarified that not all components must qualify as machinery for parts to be considered "property in the nature of machinery."
Weirick's methodology involves analyzing each component part of a facility to assess whether it qualifies as "property in the nature of machinery." The taxpayers fail to decompose the carwash facilities into their structural elements for their argument based on Weirick. The analysis indicates that the principles of Weirick do not apply to the facilities as wholes or their individual structural components. Revenue Ruling 79-406 classifies a self-service carwash structure as a "building" under section 38, emphasizing that it is not considered machinery or equipment. The tax court's narrow interpretation of "furnishing water or sewage disposal services" fails to capture Congress' intent, which is meant to reflect common meanings. The tax court's reliance on previous cases, Evans v. Commissioner and Westroads, Inc. v. Commissioner, is deemed misplaced. In Evans, the tax court denied the investment tax credit not for mere distribution but because the primary business was operating a motor home park. In Westroads, the tax court granted the credit for producing electricity rather than distributing it, but did not establish generation as a necessary condition for the credit. The interpretation of "furnishing water or sewage disposal services" remains unresolved. A test is proposed for determining if an electrical system is a structural component of a building, focusing on whether the system has broader applications beyond operating machinery; if adaptable for other uses, it is considered a structural component.
A key method of analysis involves assessing whether a manufacturer can adapt an existing system for a new process with reasonable modifications, or if a complete system replacement is necessary. The decision does not require an evaluation of the allocation of costs in the current case nor a direct application of the A.C. Monk. Co. test, which is meant for determining if electrical systems are structural components of a building. However, if it is established that the taxpayers' structures qualify as "buildings" and they provide water services, the A.C. Monk. Co. ruling is relevant. There is acknowledgment of differing opinions in other circuits regarding the A.C. Monk. Co. decision, particularly concerning whether taxpayers can claim investment tax credits for electrical systems on a percentage basis, a position supported by the court's precedent. It is clarified that labor costs may be allocated to both structures and equipment; however, erroneous allocations related to plumbing and electrical expenses necessitate adjustments. The tax court found that since taxpayers did not provide water or sewage services, no part of the facilities qualified as section 38 property under section 48(a)(1)(B). The definition of "personal property" includes "tangible personal property" as per relevant Treasury Regulations.
