IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
No. 93-4269
SEALY POWER, LTD., DONALD E. RUTT,
Tax Matters Partner,
Petitioner-Appellant
Cross-Appellee
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee
Cross-Appellant.
Appeal from a Decision of the United States Tax Court
February 15, 1995
Before HIGGINBOTHAM and WIENER, Circuit Judges, and KAUFMAN*,
District Judge.
WIENER, Circuit Judge:
On the procedural level, Plaintiff-Appellant Sealy Power, Ltd.
(Sealy), a Texas limited partnership, appeals the Tax Court's
determination that the notice of Final Partnership Administrative
Adjustment (FPAA) issued by the Commissioner of Internal Revenue
(Commissioner) did not shift to the Commissioner the burden of
*
District Judge of the District of Maryland, sitting by
designation.
going forward with the evidence. On the substantive level, Sealy
appeals the Tax Court's denial of its claimed depreciation
deductions and energy and investment tax credits.
With respect to the FPAA, we affirm the Tax Court's
determination that such adjustment did not shift to the
Commissioner the burden of going forward with the evidence. In
determining that Sealy's property was placed in service in 1984, we
reverse the Tax Court's ruling on Sealy's entitlement to the
depreciation deductions and credits.
The Commissioner cross-appeals the Tax Court's refusal to
address the pre-operating expense issue concerning the
deductibility of certain of Sealy's expenses. As we conclude that
the Tax Court erred in finding that the Commissioner did not
properly raise the pre-operating expense issue prior to the Rule
155 computation proceeding, we reverse and remand on this point.
FACTS AND PROCEEDINGS
The parties submitted an extensive Stipulation of Facts and
Supplemental Stipulation of Facts which the Tax Court incorporated
by reference in its opinion. The facts necessary to resolve the
disputed issues are set forth below.
In 1983, Sealy engaged the engineering firm Energy
Advancement, Inc. (EAI) to build a power production facility in
Sealy, Texas (the City) on property leased from the City and
2
located next to the City's landfill.1 Sealy's plan was to generate
electricity by incinerating the solid waste deposited in the
landfill and then sell the electricity to Houston Lighting and
Power (HL&P). The electric generating project was an attractive
way for the City to avoid the rising costs of obtaining additional
landfill space, delegate the operation of the landfill, and foster
the creation of alternative energy sources in its community.
Tor Lileng, an EAI engineer, designed and supervised the
construction of the facility. Lileng's design involved acquiring
various ready-made manufacturer components with a certain capacity
rating, constructing foundations for these components, and
connecting them through wiring and piping. Construction began
early in 1983 and the facility was substantially completed that
same year at a cost of approximately $ 3,500,000. In 1984, Sealy
completed its agreement to sell its electricity to HL&P. From the
winter of 1983 through a portion of 1988, Sealy operated the
landfill adjacent to the facility, employing two gatekeepers and
receiving small tipping fees from commercial establishments for
garbage disposal. Under the terms of Sealy's ground lease with the
City, its residents could dispose of their garbage at the landfill
at no charge.
Sealy first operated the incinerator at the facility in 1983.
1
Both general partners of Sealy Power, Jim Connatser and
Donald Rutt, owned minority interests in EAI. Further, Jack
Reber was the President and a 72% shareholder of EAI as well as a
limited partner of Sealy Power, Ltd. EAI devised the Sealy
cogeneration plant project and Sealy provided the financing for
it.
3
Two pieces of equipment in the facility, the feed mechanism and the
ash conveyor, presented minor, correctable difficulties in the
operation of the facility. The most severe problem, however, was
the incinerator, the centerpiece of the facility. The function of
the primary chamber of the incinerator was to burn the garbage into
gases which in turn would be burned in a second chamber and passed
through the vaporizer, steam superheater, and steam turbines to
create energy. The manufacturer of the incinerator had claimed it
would generate 20 million BTUs per hour, but the incinerator never
reached its rated capacity of electricity generation because the
manufacturer had delivered a primary chamber considerably smaller
than the one EAI had specified for Sealy. These equipment
deficiencies prevented the facility from generating commercial
quantities of electricity, so Sealy tried to find investors
willing to provide the additional funds required to correct the
facility's operational problems. After all such efforts failed,
Sealy filed for bankruptcy on July 1, 1988.
A few months earlier, on March 30, 1988, the Commissioner had
issued a notice of Final Partnership Administrative Adjustment
(FPAA) determining that Sealy was not entitled to several
deductions and credits.2 Donald E. Rutt, Sealy's tax matters
partner, then filed a petition for readjustment of partnership
items. The Tax Court ruled against Sealy on all tried issues.
Pursuant to Rule 155 of the Tax Court Rules of Practice and
2
Another issue before the Tax Court, but not involved in
this appeal, was whether Sealy's partners were at-risk within the
meaning of I.R.C. § 465.
4
Procedure, the court required the parties to submit proposed
decision documents consistent with the court's opinion.
Sealy timely objected to the Commissioner's proposed
computation, disallowing deductions for certain expenses incurred
in 1983 and 1984 which the Commissioner deemed to be nondeductible
pre-operating expenses. Sealy maintained that it was entitled to
a deduction for its ordinary business expenses, insisting that the
Commissioner's computation was inconsistent with the Tax Court's
ruling on that point. The Tax Court agreed with Sealy and issued
an order requiring the entry of a new computation. Both Sealy and
the Commissioner timely appealed the respective portions of the
court's decision that were adverse to them.
II
ANALYSIS
A. STANDARD OF REVIEW
Our standard of review for appeals from the United States Tax
Court is the same as for civil actions decided by the district
courts.3 Thus, we review findings of fact under a clearly
erroneous standard and legal conclusions de novo.4
B. THE FPAA NOTICE
The Tax Court held that the nature of the FPAA notice did not
3
26 U.S.C. § 7482(a)(1)(1993)("United States Courts of
Appeals . . . shall have exclusive jurisdiction to review the
decisions of the Tax Court . . . in the same manner and to the
same extent as decisions of the district courts in civil actions
tried without a jury.").
4
See Estate of Clayton v. Commissioner, 976 F.2d 1486, 1490
(5th Cir. 1992).
5
shift to the Commissioner the burden of going forward with the
evidence. Sealy appeals this ruling, arguing that the Commissioner
issued an FPAA that was arbitrary and capricious, thereby meriting
a shift of the burden. Alternatively, Sealy argues that the FPAA
is invalid because it was not a considered determination and that
the Tax Court therefore lacked jurisdiction. The Tax Court did not
make a factual finding of whether the FPAA was arbitrary, but held
instead that Sealy continued to bear the burden of going forward
with the evidence because the FPAA did not involve unreported
illegal income. This presents a question of law which we review de
novo.
The FPAA sent to Sealy noted that the Commissioner had
determined adjustments to the partnership's 1983 and 1984 returns.
The Commissioner listed the adjustments, specifying the items on
the returns which were affected for the tax years in question. In
an attachment to the schedule of adjustments, the FPAA noted that
the Commissioner was disallowing the claimed deductions and credits
because Sealy had not established that its activity had any
economic substance, was engaged in for profit, constituted a trade
or business, or involved property held for the production of
income.
As the prerequisite for litigation over disputed items on a
partnership's return, an FPAA is the functional equivalent of a
notice of deficiency.5 Both the FPAA and the notice of deficiency
serve to notify affected taxpayers that the Commissioner has made
5
See Maxwell v. Commissioner, 87 T.C. 783, 788-89 (1986).
6
a final administrative determination of their liability for
particular tax years.6 We therefore analyze the FPAA here the same
way that we would analyze a notice of deficiency.
The Internal Revenue Code does not specify the form or content
of a valid notice of deficiency. Courts have held, however, that
the notice generally must advise the taxpayer that the Commissioner
has determined a deficiency for a particular year and must specify
the amount of the deficiency or provide the information necessary
to compute the deficiency.7 A determination of deficiency issued
by the Commissioner is generally given a presumption of
correctness, which operates to place on the taxpayer the burden of
producing evidence showing that the Commissioner's determination is
incorrect.8 Several courts have recognized, however, that they
need not give effect to the presumption of correctness and may
instead shift the burden from the taxpayer to the Commissioner when
the notice of deficiency is determined to be arbitrary or
6
See Seneca, Ltd. v. Commissioner, 92 T.C. 363, 368 (1989),
aff'd without opinion, 899 F.2d 1225 (9th Cir. 1990); Clovis I v.
Commissioner, 88 T.C. 980, 982 (1987).
7
See Portillo v. Commissioner, 932 F.2d 1128, 1132 (5th Cir.
1991); Donley v. Commissioner, 791 F.2d 383, 384 (5th Cir. 1986),
cert. denied, 479 U.S. 885, 107 S.Ct. 277, 93 L.Ed.2d 253 (1986).
8
See United States v. Janis, 428 U.S. 433, 441, 96 S.Ct.
3021, 3025, 49 L.Ed.2d 1046, (1976); Helvering v. Taylor, 293
U.S. 507, 514-15, 55 S.Ct. 287, 290-91, 79 L.Ed. 623, (1935);
Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed.
212, (1933); Portillo, 932 F.2d at 1133.
7
excessive.9 In these cases, the notice of deficiency involved a
determination of unreported income, whether from legal sources, as
in Portillo10, or from illegal sources, as in Jackson11.
We have previously recognized that the reason behind the
burden-shifting principle in an unreported income case is that the
taxpayer bears the difficult burden of proving the non-receipt of
income.12 The Commissioner's determination in such a case
necessarily involves reconstructing income that should have been
reported, potentially leading to questionable results.13 If the
9
See Williams v. Commissioner, 999 F.2d 760, 763-64 (4th
Cir. 1993), cert. denied 114 S.Ct. 442, 126 L.Ed.2d 376 (1993);
Portillo, 932 F.2d at 1133-34; Zuhone v. Commissioner, 883 F.2d
1317, 1325-26 (7th Cir. 1989); Anastasato v. Commissioner, 794
F.2d 884, 887 (3d Cir. 1986); Dellacroce v. Commissioner, 83 T.C.
269, 280, 287 (1984); Jackson v. Commissioner, 73 T.C. 394, 401
(1979). The Supreme Court in Janis recognized that the usual
presumption of correctness does not apply when the government's
assessment constitutes a "`naked' assessment without any
foundation whatsoever." See Janis, 428 U.S. at 441, 96 S.Ct. at
3026, 49 L.Ed.2d at .
Even while carving out this exception to the general rule of
presuming the determination correct, courts have reaffirmed their
reluctance to look behind the notice of deficiency to determine
whether the Commissioner's determination is arbitrary. See
Anastasato, 794 F.2d at 886-67; Dellacroce, 83 T.C. at 280
(1984).
10
932 F.2d at 1130-31, 1134 (subcontractor's unreported
income from contractor).
11
73 T.C. at 396-97, 402 (unreported income from drug
trafficking activities).
12
See Portillo, 932 F.2d at 1133-34; Carson v. United
States, 560 F.2d 693, 698 (5th Cir. 1977).
13
See Portillo, 932 F.2d at 1134 (notice based on unverified
"bald assertion" of third party); Weimerskirch v. Commissioner,
596 F.2d 358, 361-62 (9th Cir. 1979)(notice stemmed from IRS'
"naked assertion" that petitioner had received money from heroin
sales); Jackson, 73 T.C. at 403 ("elaborate construct set out in
the deficiency notice . . . turns out to be sheer gossamer").
8
Commissioner does not substantiate the notice's determination with
some predicate evidence, therefore, the taxpayer should be relieved
of the burden of going forward with the evidence. The issue we
must decide in the instant case is whether the same principle
applies when the notice of deficiency involves not unreported
income but a taxpayer's entitlement to deductions and credits.
In Gatlin v. Commissioner14, the Eleventh Circuit considered
whether the burden-shifting principle for unreported income cases
applies in deduction cases. It held that in a deduction case the
taxpayer at all times retains the burden of going forward with the
evidence that supports the claimed deductions and their amounts,
regardless of the nature of the Commissioner's notice of
deficiency.15 The Gatlin court observed that, unlike the taxpayer
in an unreported income case, the taxpayer with challenged
deductions has reported the full amount of income but has claimed
deductions, reducing the total tax due on the income.16 As the
taxpayer in Gatlin was "privy to the facts that substantiate a
deduction," the court ruled, the Commissioner's notice of
deficiency retained its presumption of correctness until the
taxpayer came forward with evidence to challenge its assessment.17
Several other courts have recognized the distinction between
deduction cases and unreported income cases for purposes of
14
754 F.2d 921 (11th Cir. 1985).
15
See id. at 923.
16
See id. at 924.
17
See id.
9
shifting the burden of production.18
We agree with these courts that the burden-shifting principle
for unreported income cases should not extend to cases in which the
Commissioner rejects deductions or credits claimed by a taxpayer.
The burden of overcoming the presumption of correctness in a
deduction case properly rests with the taxpayer, who is the best
source of information for determining entitlement to the claimed
deductions. In a deduction case, therefore, we apply the general
rule of not looking behind the notice of deficiency to determine
whether it is arbitrary. As the FPAA here challenged Sealy's
entitlement to deductions and credits, not Sealy's failure to
include taxable income, the Tax Court properly preserved the
presumption of correctness in requiring Sealy to continue to bear
the burden of going forward with the evidence.
Sealy also contends that the Commissioner's FPAA was void
ab initio, stripping the Tax Court of jurisdiction in the case,
because it was not a considered determination. Sections 6212(a)
and 6213(a) of the Internal Revenue Code provide that the Tax Court
only has jurisdiction when the Commissioner issues a valid
deficiency notice and the taxpayer files a petition for
18
United States v. Walton, 909 F.2d 915, 918-19 (6th Cir.
1990); LaBow v. Commissioner, 763 F.2d 125, 131-32 (2d Cir.
1985); Foster v. Commissioner, 756 F.2d 1430, 1439 (9th Cir.
1985), cert. denied, 474 U.S. 1055, 106 S.Ct. 793, 88 L.Ed.2d 770
(1986); Chaum v. Commissioner, 69 T.C. 156, 163-64 (1977). See
also Bennett Paper Corp. v. Commissioner, 699 F.2d 450, 453 (8th
Cir. 1983)(rejecting taxpayer's argument that assessment was
arbitrary, as burden of proof lies with taxpayer to show right to
claimed deduction).
10
redetermination.19 The partnership cites to Scar v. Commissioner20,
one of but a handful of cases in which a court of appeals has
invalidated a notice of deficiency upon finding that the
Commissioner had failed to make a considered determination.21
Sealy's reliance on Scar is misplaced. In Scar, the notice
referred to a tax shelter that had no connection to the taxpayers
or their return and stated that, because the taxpayers' return was
not available, the Commissioner was imposing the maximum tax rate
to the adjustment amount.22 This led the court to conclude that,
on its face, the purported notice of deficiency revealed that the
Commissioner had not examined the taxpayers' return for the year in
dispute and therefore had not made any determination of tax
deficiency.23
We have previously held that courts have interpreted the term
"determination" to mean, for purposes of Section 6212(a), a
"thoughtful and considered determination that the United States is
19
See Stamm Int'l Corp. v. Commissioner, 84 T.C. 248, 251-52
(1985).
20
814 F.2d 1363 (9th Cir. 1987).
21
The court in Scar found that the notice of deficiency did
not meet the requirement in Section 6212(a) that the Commissioner
"determine that a deficiency exists before issuing a notice of
deficiency." See Scar, 814 F.2d at 1370. As a valid notice of
deficiency is a necessary basis for Tax Court jurisdiction, the
court concluded that the Tax Court should have dismissed the
action for want of jurisdiction. See id.
22
See id. at 1365.
23
See id. at 1368-70.
11
entitled to an amount not yet paid.24" A review of the FPAA here
shows that, unlike the putative determination in Scar, the
Commissioner did consider Sealy's return in determining the
adjustments listed in the FPAA. The FPAA set out the adjustment
items for each year, enabling Sealy to determine its deficiency.
It also explained in an attachment the reasons for the
Commissioner's adjustments.25 Sealy's argument that the FPAA was
broadly drafted and that the Commissioner's review was faulty is
unavailing.26 The FPAA on its face reflects that the Commissioner
24
See Portillo v. Commissioner, 932 F.2d 1128, 1132 (5th
Cir. 1991)(quoting Scar, 814 F.2d at 1369).
25
The Commissioner later stipulated that Sealy had never
been a sham and that it had a valid business purpose during 1983
and at all times thereafter, contradicting two of its reasons
stated in the FPAA for disallowing Sealy's deductions and
credits. This does not affect our finding that the Commissioner
issued a "thoughtful and considered determination," however. The
Commissioner, in considering a taxpayer's return and
"determining" a deficiency, may challenge items for reasons that
the parties can later clarify or correct when they confer and
exchange necessary facts and documents. See Foster v.
Commissioner, 80 T.C. 34, 230
(1983)(noting usefulness of parties informally conferring to
narrow issues), aff'd and vacated on other grounds, 756 F.2d 1439
(9th Cir. 1985).
A notice of deficiency, which merely serves as a warning to
the taxpayer that the Commissioner has assessed a deficiency and
plans to hail the taxpayer into court, need not give any reasons
for the assessment of a deficiency. See Scar, 814 F.2d at 1367;
Clapp v. Commissioner, 875 F.2d 1396, 1403 (9th Cir. 1989). On
rare occasions, as in Scar, however, the reason given on the face
of the notice reveals that the Commissioner failed to make a
determination. The Commissioner's grounds for making the
adjustments in Sealy's FPAA, unlike the erroneous explanation and
imposition of an arbitrary tax rate in Scar, do not reveal that
the Commissioner failed to make a "determination" for purposes of
the Tax Court's jurisdiction.
26
See Riland v. Commissioner, 79 T.C. 185, 199-201
(1982)(notice valid despite Commissioner's violation of internal
procedures); Estate of Brimm v. Commissioner, 70 T.C. 15, 22-23
12
made a "determination" for purposes of the Tax Court's
jurisdiction.27
As the FPAA constituted a valid determination entitled to a
presumption of correctness, we conclude that the Tax Court properly
required Sealy to bear the burden of going forward with the
evidence after it challenged the Commissioner's adjustments in the
FPAA to Sealy's deductions and credits.
C. "PLACED IN SERVICE"
Sealy claimed a biomass energy tax credit and an investment
tax credit in 1983, as well as depreciation deductions in 1983 and
1984. The Commissioner disallowed these items in the FPAA and
Donald Rutt, as Sealy's tax matters partner, filed a petition in
Tax Court for readjustment of partnership items. The Tax Court
upheld the Commissioner's determination, finding that the property
(1978)(notice valid even though taxpayer argued that Commissioner
perfunctorily performed review functions and used flawed
procedures); Greenberg's Express, Inc. v. Commissioner, 62 T.C.
324, 327-30 (1974)(notice valid despite allegation that
Commissioner discriminatorily selected taxpayer for audit).
27
Sealy also refers to our decision in Pearce v.
Commissioner, No. 91-4178 (5th Cir. 1991)(unpublished opinion),
in which we held that the Tax Court lacked jurisdiction because
the notices were void ab initio. The notices reflected "gross
ineptitude" on the part of the Commissioner because they ignored
the filing status designation on the taxpayer's return, applied
an incorrect tax rate, and ignored claimed exemptions.
The facts of the instant case differ greatly. As we have
noted, the FPAA sent to Sealy did not reveal a lack of a
considered determination because it referred to disputed items in
Sealy's return and explained the Commissioner's reasons for the
adjustments. We rejected a similar argument in Portillo where,
as here, the Commissioner had considered information directly
relating to the taxpayer's income tax return and had investigated
whether a deficiency existed. See Portillo v. Commissioner, 932
F.2d 1128, 1132 (5th Cir. 1991).
13
in Sealy's facility was never "placed in service"SQnot in 1983, not
in 1984, not everSQand that, therefore, Sealy was not entitled to
its claimed depreciation deductions and investment tax credits.
Several provisions of the Internal Revenue Code are implicated
in this appeal. Section 167(a)28 provides that a depreciation
deduction is allowed for property used in the taxpayer's trade or
business or for property held for the production of income.
Section 38(a) allows for investment and energy tax credits; Section
46 outlines the calculation of the investment tax credit amount,
and Section 48 defines property eligible for the credits. The
pertinent portions of Section 48 state that the credits are
available for certain "biomass property29" and for "tangible
personal property" and "other tangible property," but only if the
"other tangible property" is used as an integral part of a
qualifying activity.30
Treasury Regulation 1.167(a)-11(e)(1)(i)31 states that property
is first placed in service for purposes of the depreciation
deduction when it is "placed in a condition or state of readiness
and availability for a specifically assigned function, whether in
a trade or business, in the production of income, in a tax-exempt
activity, or in a personal activity." For purposes of the
28
All section references are to the Internal Revenue Code of
1954 as amended and in effect during the years in issue.
29
See I.R.C. § 48(l)(15)(1984).
30
See I.R.C. §§ 48(a)(1)(A); 48(a)(1)(B)(1984).
31
(1984).
14
investment tax credit, Treasury Regulation 1.46-3(d)(1)(ii)32
defines the time that Section 38 property is "placed in service" as
the taxable year in which such property is "placed in a condition
or state of readiness and availability for a specifically assigned
function, whether in a trade or business, in the production of
income, in a tax-exempt activity, or in a personal activity."
Courts have interpreted the regulations' identically-worded "placed
in service" tests for depreciation deductions and tax credits in
the same manner.33
1. Component Parts v. Facility as a Whole
The Tax Court properly ruled that the component assets of
Sealy's facility were all tangible personal property within the
meaning of Section 48(a)(1)(A) as well as Section 38 property
qualifying for depreciation and the energy and investment tax
credits if and when placed in service.34 Sealy asserts that the
"placed in service" test should apply separately to each of these
components of the facility rather than to the facility as a whole.35
32
(1984).
33
See Armstrong World Indus., Inc. v. Commissioner, 974 F.2d
422, 431-36 (3d Cir. 1992); Oglethorpe Power Corp. v.
Commissioner, 60 T.C.M. (CCH) 850, 859 (1990); Consumers Power
Co. v. Commissioner, 89 T.C. 710, 723 (1987).
34
The Tax Court listed the facility as containing a hopper
with a screw/auger feeder, an incinerator, a tractor, a conveyor,
and various pieces of equipment such as a vaporizer, steam
superheater, separator, expander, and steam turbines. These are
all in the nature of machinery and equipment, which the
Regulation deems to be "tangible personal property." See Treas.
Reg. § 1.48-1(c).
35
Sealy argues in the alternative that it is entitled to
depreciation and investment tax credits because its tangible
15
As each of the items of machinery and equipment comprising the
facility was in a condition of being "ready and available for a
specifically assigned function" in the facility, Sealy argues, the
partnership was entitled to depreciation and investment tax credits
on these items even if the facility is deemed not to have been
operational. This approach, however, does not conform to the
analysis of Revenue Rulings and cases dealing with the "placed in
service" requirement.
In Revenue Ruling 73-51836, the Commissioner stated that a
major electrical transmission line was not placed in service, even
though it was complete, until the substations at the end of the
line were completed and the line could be energized. As the
substations were parts of the system and were necessary for the
transmission of electricity, both the transmission line and the
substations were first placed in service when the whole system was
first available for service. Revenue Ruling 76-23837 adopted a
similar approach in noting that individual units of production
machinery and equipment acquired for use in a factory were not
personal property is subject to a different "placed in service"
test than "other tangible property." The partnership refers to
the distinction between § 48(a)(1)(A), "tangible personal
property," which qualifies for the investment tax credit
"irrespective of whether it is used as an integral part" of a
qualified activity, and § 48(a)(1)(B), "other tangible property,"
which qualifies for the credit only if it used as an integral
part of a qualifying activity. See Treas. Reg. § 1.48-1(c), (d).
In view of our disposition of this case, we need not and
therefore do not reach the merits of this argument.
36
1973-2 C.B. 54.
37
1976-1 C.B. 55.
16
placed in service until they were installed in the production line
and the entire production line had been completed. This ruling
further observed that on the completion of the entire production
line, the "line was available for the production of an acceptable
product, notwithstanding later testing to eliminate defects which
prevented attainment of planned production levels or the meeting of
acceptable quality control parameters.38" Both rulings indicate
that components are not to be considered placed in service
separately from the system of which they are an essential part.
The Tax Court in several cases has embraced the Revenue
Rulings' approach of examining, for purposes of the "placed in
service" test, property in a project as a whole when a number of
interdependent components are designed to operate as a system. In
these cases, the Tax Court has found that an individual component,
incapable of contributing to the system in isolation, is not
regarded as placed in service until the entire system reaches a
condition of readiness and availability for its specifically
assigned function.39 Other circuit courts have used the same
38
See id.
39
See, e.g., Siskiyou Communications, Inc. v. Commissioner,
60 T.C.M. (CCH) 475, 478-79 (1990)(telephone switching equipment
and toll carriers not placed in service even though capable of
performing individual functions because wiring for system not
completed and employees not trained in system's use); Consumers
Power Co. v. Commissioner, 89 T.C. 710, 725-26 (1987)(upper
reservoir component of pumped storage hydroelectric plant not
placed in service until entire plant placed in service because
physical plant and reservoir operated simultaneously as one
integrated unit to produce electrical power).
17
approach as the Tax Court.40 We agree with these courts' approach
and find that the Tax Court appropriately treated the assets of
Sealy's facility as functionally forming a single property for
purposes of the "placed in service" determination.
As our focus is on Sealy's facility as a whole, it is
necessary to determine the type or kind of facility involved.
Sealy contends that in determining whether the facility has been
placed in service, it should be treated as a waste disposal
facility rather than an electric generating facility. Sealy refers
to the parties' stipulation that the partnership's stated purpose
was to "acquire, fund, and operate a unique waste disposal facility
and the adjacent landfill" and emphasizes that the stipulation does
40
See, e.g., Hawaiian Indep. Refinery, Inc. v. United
States, 697 F.2d 1063, 1069 (Fed. Cir. 1983), cert. denied 464
U.S. 816, 104 S.Ct. 73, 78 L.Ed.2d 86 (1983)(two offsite
components not considered separately from refinery in determining
applicable construction date because all were designed and
constructed as single unit and together they functionally formed
single property); Public Serv. Co. v. United States, 431 F.2d
980, 983-84 (10th Cir. 1970)(component assets of electric power
plant not considered separately for "placed in service"
determination because no one of them would serve any useful
purpose until fitted together to constitute a complete unit).
The Hawaiian and Public Service cases dealt with the date of
acquisition or construction of qualifying property under the
investment tax credit provisions and not the "placed in service"
date of qualifying property as in the instant case. We note,
however, that the concepts are sufficiently similar to serve as
an analogue for the "placed in service" determination.
The Third Circuit in Armstrong World Indus., Inc. v.
Commissioner, 974 F.2d 422, 432-35 (3d Cir. 1992), reviewed the
caselaw relevant to the "placed in service" test for a railroad
project with individual components and concluded that unlike the
component parts of the projects in Consumers, Siskiyou, Hawaiian,
and Public Serv., each completed train track segment in Armstrong
had independent utility and was placed in service prior to the
time all of the project components were completed and available
for use.
18
not mention the generation of electricity. Like the Tax Court
before us, however, we are not persuaded by this argument. Clearly
the substance of Sealy's intended business activity was to make a
profit from the sale of electricity generated from incinerating the
landfill's solid waste. Electricity generation was the feature
that made the facility "unique" as described in the stipulation.
The small tipping fees Sealy collected from commercial businesses
which were disposing of their waste were insignificant relative to
Sealy's investment in the facility. Further, Sealy's waste
disposal activitySQmaintaining a fuel sourceSQwas merely a
tangential part of the primary function of its trade or business,
producing electricity. The "placed in service" analysis,
therefore, is properly focused on the property's contribution to
Sealy's objective of generating electricity in its facility.
2. The Tax Court's Interpretation of the "Placed in
Service" Regulations
The Tax Court stated that it did not need to decide whether
the facility as a whole satisfied each of the five "placed in
service" factors outlined in various Revenue Rulings. It instead
looked to its prior decisions in Oglethorpe Power Corp. v.
Commissioner41 and Consumers Power Co. v. Commissioner42, two other
cases involving electric generating facilities, and ruled that
Sealy's facility was not placed in service because, having failed
ever to achieve its anticipated electricity output levels, it never
41
60 T.C.M. (CCH) 850 (1990).
42
89 T.C. 710 (1987).
19
operated on a regular basis.
a. Consumers Power Co. v. Commissioner
In Consumers, the Tax Court found that a unit contained in a
pumped storage hydroelectric plant was not placed in service in
1972, the year for which the taxpayer had claimed depreciation
deductions and investment tax credits.43 In that year, the unit had
not yet completed the preoperational testing phase required by the
Federal Power Commission and had not been formally accepted from
the contractor.44 The Consumers court also observed that even
though the unit had pumped water into the reservoir and generated
electrical power during the testing phase in 1972, the amount of
electrical power generated was "insufficient to establish that the
. . . [p]lant was available for full operation on a regular basis
in 1972."45 It concluded that the unit was not in a state of
readiness and availability for its specifically assigned function
until it had completed all phases of the governmentally mandated
preoperational testing.
The Tax Court in Consumers did not rest its opinion on the low
43
The court explained that a pumped storage plant provides
supplemental electrical power during periods of peak energy
demands by releasing water from an elevated reservoir to another
reservoir below. The water flows through a turbine generator on
the way down, thereby producing electrical power. See Consumers,
89 T.C. at 716-17 (quoting Stanley Works v. Commissioner, 87 T.C.
389, 391 (1986)). In Consumers, Lake Michigan served as the
lower reservoir for the plant and the unit that was the subject
of the opinion was composed of a tunnel, pumphouse, and a pump-
turbine generator. See id. at 717.
44
See id. at 717-19, 724.
45
See id. at 724.
20
amount of power generated from the unit. Rather, it held that the
unit was not placed in service until after it had successfully
completed testing. Yet in referring to the small amount of power
output as support for its conclusion, the court implicitly adopted
the Commissioner's argument that the unit was not placed in service
in 1972 because, inter alia, it did not show sustained, regular
generation of electrical power. The opinion does not reveal the
source of the Tax Court's adoption of this standard. It merely
cites to the Tax Court's previous decisions in Noell v.
Commissioner46 and Madison Newspapers, Inc. v. Commissioner47, both
of which are distinguishable and inapposite.
The Tax Court in Noell had held that a new airport runway was
not placed in service until it was paved and available for regular
use, even though some pilots occasionally took the risk and used
the rocky strip for landings prior to the runway's completion.48
Unlike the fully-constructed unit in Consumers, however, the runway
in Noell was under construction and never completed in the year for
which the taxpayer had claimed the investment credit.49
Likewise, the Consumers court's reliance on Madison Newspapers
sheds no light on the Tax Court's insistence on a facility's
46
66 T.C. 718 (1976).
47
47 T.C. 630 (1967), acq., 1975-2 C.B. 2.
48
See Noell, 66 T.C. at 729.
49
See id. The Tax Court in the instant case cited to Noell
as support for its conclusion as well, even though Sealy's
electric generating facility was completed in 1983 except for a
few minor pieces of heat-recovering equipment.
21
ability regularly to achieve its anticipated output before it may
qualify for the investment tax credit and depreciation. In Madison
Newspapers, the Tax Court held that the taxpayer was entitled to
the investment tax credit for three units of an eight-unit printing
press, even though those three units were on the taxpayer's
premises before the entitlement period for the credit began,
because the taxpayer "acquired" the units only when they were
installed and accepted by the taxpayer as ready for commercial
operation under the contract.50 The Tax Court in Consumers
mischaracterized the holding in Madison Newspapers as implying that
publishing newspapers on a regular basis had been a prerequisite
for its finding that three units of a printing press were placed in
service.51 In truth, though, installation and readiness had been
the controlling factors for the acquisition date in Madison
Newspapers.
b. Oglethorpe Power Corp. v. Commissioner
In the only other Tax Court opinion involving the "placed in
service" determination for an electric generating facility,
Oglethorpe Power Corp. v. Commissioner52, the Tax Court did look to
50
See Madison Newspapers, 47 T.C. at 637. The taxpayers in
Madison Newspapers wanted a later date of acquisition because
under the controlling statute at the time, the investment tax
credit only applied to their property if it was acquired after
December 31, 1961. See id. at 634.
51
See Consumers, 89 T.C. at 723.
52
60 T.C.M. (CCH) 850 (1990).
22
the Revenue Ruling factors for guidance.53 The Tax Court's analysis
of the factors, however, was clearly influenced by its earlier
insistence in Consumers on a facility's ability to sustain power
generation near rated capacity before it could be deemed to have
been placed in service. The Tax Court held that the taxpayer's
unit was placed in service in 1982, and not 1981 as the
Commissioner had argued, because in 1982 the unit completed the
testing required by the Georgia Public Service Commission.54 The
Commission would not consider the unit for rate-making purposes
unless it had completed testing. Further, under the terms of the
taxpayer's operating agreement with Georgia Power, which
constructed the unit, the taxpayer would not have control or the
right to income from the unit until it was declared to be in
"commercial operation" after completion of testing.55
Even though the Oglethorpe unit had been synchronized and was
producing power during test period operation in 1981, it was not in
53
The Revenue Ruling factors as cited by the Tax Court are:
1) having obtained the necessary permits and licenses for
operating; 2) having performed all critical tests necessary for
proper operation; 3) placing the unit in the control of the
taxpayer; 4) having synchronized the unit with the transmission
grid; and 5) daily operation of the unit. See id. at 860. We
discuss these factors' application to Sealy later in this
opinion.
54
See id. at 859, 864. The property of the Oglethorpe plant
was transferred in safe harbor leases, making the "placed in
service" date a crucial issue. The petitioner, Oglethorpe Power,
wanted the later date because under Section 168(f)(8) of the
Code, the property had to have been leased within three months
after such property was placed in service to be deemed "qualified
leased property." See id. at 859.
55
See id.
23
the control of the taxpayer, did not have the necessary permits,
and was still undergoing testing.56 The Tax Court did not rest its
opinion on the balance of these Revenue Ruling factors, however.
Relying on Consumers, the court in Oglethorpe stated that the unit
was not deemed to be placed in service in 1981 because it was not
available for its specifically assigned function, which the court
defined as consistently sustaining generation levels near its rated
capacity.57
Adopting and extending its prior approaches in Oglethorpe and
Consumers, the Tax Court in the instant case totally disregarded
the Revenue Ruling factors and instead placed great weight on the
purpose stated in Sealy's Certificate of Limited Partnership, i.e.,
that the facility was designed to generate 38,400 kilowatt hours of
electricity per day. The court noted that, because Sealy's
facility only generated a small amount of electricity while it was
operational, it did not fulfill its specifically assigned function
of generating the projected amount of electricity and therefore was
never placed in service. This narrow interpretation of the "placed
in service" standard contravenes the policy behind the investment
56
See id. at 855-57.
57
See id. at 861. We find interesting the fact that the
Commissioner argued in Oglethorpe that the facility should be
considered to have been placed in service in 1981, even though it
had not completed testing then, because it met its specifically
assigned function of producing electricity in that year and had
been synchronized. We agree with the Commissioner's then-
unsuccessful argument in Oglethorpe that the Treasury Regulation
would have no meaning if "operational" were defined as
"functioning perfectly or near perfectly" and that the production
of income is not necessary to find that a unit is placed in
service. See id. at 862-63.
24
tax credit and the applicable Regulation examples as well.
We conclude that the Tax Court erred in applying an unduly
restrictive "placed in service" test that requires regular
operation as measured by the amount generated. The appropriate
method for determining the year that an electric generating
facility is placed in service is to analyze a taxpayer's fact
situation, using a common-sense approach in the context of the
policy behind the investment tax credit, the Treasury Regulations
defining "placed in service," and the Revenue Ruling factors. As
we disagree with the Tax Court's interpretation of the legal
standards defining when an asset is placed in service, our review
of the "placed in service" determination for Sealy's facility is de
novo.
3. The Meaning of "Placed in Service"
The legislative history related to the investment credit
indicates that, contrary to the Tax Court's interpretation of the
"placed in service" requirement, Congress did not intend to impose
the stringent requirement of regular achievement of anticipated
production levels when it created the credit. In addition, the
Commissioner's own regulations interpreting the relevant statutory
provisions support our interpretation of the phrase "placed in
service." These regulations do not require that property entitled
to depreciation and credits must first meet expected output goals
before it may be deemed to have been placed in service58; to the
58
Treasury Regulations 1.167(a)-11(e)(1)(i) and 1.46-
3(d)(1)(ii) merely state property is placed in service when it is
"placed in a condition or state of readiness and availability for
25
contrary, these regulations reveal that defectively or
disappointingly performing property may still be considered to have
been placed in service. For these reasons, we reject the Tax
Court's narrow analyses of the "placed in service" determination in
Oglethorpe and Consumers.
Congress enacted the investment tax credit to stimulate the
economy by encouraging investment in machinery, equipment, and
certain other property.59 In the legislative history related to the
Energy Tax Act of 1978, Congress stated that the purpose of the
energy tax credit was to encourage taxpayers' expenditures towards
the use of renewable, alternative energy sources.60
These credits provide an incentive to acquire property such as
machinery and equipment by lowering the effective after-tax
acquisition cost of the qualified property, which in turn increases
the rate of return on these assets. The legislative history
dealing with the investment tax credit noted that the increased
cash flow would be particularly important for new and smaller
firms, like Sealy, which did not have ready access to the capital
a specifically assigned function, whether in a trade or business,
in the production of income, in a tax-exempt activity, or in a
personal activity."
59
See S. Rep. No. 1881, 87th Cong., 2d Sess. 11 (1962),
reprinted in 1962 U.S.C.C.A.N. 3297, 3304, 3313. See also
Comdisco, Inc. v. United States, 756 F.2d 569, 572 (7th Cir.
1985)("legislative history . . . reveals the hope of Congress
that the credit would stimulate economic growth by providing
substantial incentive to undertake capital investment projects").
60
S. Rep. No. 529, 95th Cong., 2d Sess. 1, 6-11 (1978),
reprinted in 1978 U.S.C.C.A.N. 7942, 7945-49.
26
markets.61 The credit would lower the profit risk that these firms
faced in starting out a new venture and therefore would facilitate
their investment decisions.62
Courts have often recognized the notion that the "investment
tax credit should be construed liberally in light of its
purposes."63 The Tax Court's reading of "specifically assigned
function" as achieving ideal or near ideal production levels,
however, demands a hindsight approach to the success of a
taxpayer's investment expenditures which undermines the very focus
of the credits' incentive, the initial investment decision.
Further, the Commissioner's own interpretations of the
statute in the relevant Regulations support a less restrictive
examination of the contribution of property to the business for the
"placed in service" determination. This common-sense approach
stops short of requiring a new business to achieve a certain level
of production in order to qualify for the credit. In defining
"placed in service," Treasury Regulation 1.46-3(d)(1)(ii)64 neither
states nor implies that the property must produce an anticipated or
projected amount before it may be considered ready and available
61
See S. Rep. No. 1881, reprinted in 1962 U.S.C.C.A.N. at
3314.
62
See id.
63
See Morrison, Inc. v. Commissioner, 891 F.2d 857, 864
(11th Cir. 1990); Illinois Power Co. v. Commissioner, 792 F.2d
683, 685 (7th Cir. 1986); Illinois Cereal Mills, Inc. v.
Commissioner, 789 F.2d 1234, 1239 (7th Cir. 1986), cert. den.,
479 U.S. 995, 107 S.Ct. 600, 93 L.Ed.2d 600.
64
(1984).
27
for a specifically assigned function. Neither do the examples in
Treasury Regulation § 1.46--3(d)(2)(ii) and (iii)65SQillustrating
when property acquired for use in a trade or business or for the
production of income is placed in serviceSQsupport the Tax Court's
unduly strict construction of the statute.
One Regulation example of property placed in service for a
taxable year is operational farm equipment acquired during the
taxable year but not used because it is not practicable to use such
equipment for its specifically assigned function in the taxpayer's
business of farming until the following year.66 This example does
not imply that the farming operation has to produce crops at or
near its expected level in order for the equipment to be placed in
service. To the contrary, this example contemplates that it may
not be practicable to use some assets acquired for the farming
business if the business' output does not present a need for the
additional equipment at the present time.
Another Regulation example of property placed in service is
equipment acquired for a specifically assigned function which is
operational but is undergoing testing to eliminate any defects.67
This example acknowledges that defective performanceSQpresumably
performance below that which was anticipated or projectedSQdoes not
65
(1984)
66
See Treas. Reg. §1.46-3(d)(2)(ii)(1984).
67
See Treas. Reg. § 1.46-3(d)(2)(iii)(1984).
28
bar an asset's "placed in service" designation.68
4. The Sealy Facility Was Placed in Service in 1984
Our de novo review of the "placed in service" determination
for Sealy's facility in light of the relevant legislative history,
Treasury Regulations, and Revenue Rulings leads us to conclude that
the facility was placed in service in 1984 for purposes of
depreciation and the energy and investment tax credits.
a. The Revenue Ruling Factors
The Commissioner has issued several Revenue Rulings dealing
with the "placed in service" requirement for electric generating
facilities and these have described five factors to be considered
in determining whether property has been placed in service for
purposes of depreciation and tax credits. As the factors have
evolved from examining specific facts related to each ruling's
particular facility, they are only indicative of "placed in
service" or "operational" status and are not all necessary to a
finding that a facility has been placed in service.69 Unlike
68
Rev. Rul. 76-428, 1976-2 C.B. 47, provides additional
support for this approach. The electric generating unit in this
ruling was deemed to have been placed in service in the year when
"all equipment was performing its specifically assigned function,
that is, operating as a unit even though equipment was still
undergoing testing to eliminate any defects and to demonstrate
reliability."
69
See Rev. Rul. 84-85, 1984-1 C.B. 10 (stating that although
another Revenue Ruling found taxpayer's facility had been placed
in service when it was able to operate at rated capacity without
failure, this level of operation was not prerequisite but merely
fact demonstrative of operational status). See Oglethorpe Power
Corp. v. Commissioner, 60 T.C.M. (CCH) 850, 860
(1990)(recognizing that "placed in service" determination
29
Treasury Regulations, Revenue Rulings do not have the presumptive
force and effect of law but are merely persuasive as the
Commissioner's official interpretation of statutory provisions.70
As noted earlier, the Revenue Ruling factors are: 1) whether
the necessary permits and licenses for operation have been
obtained; 2) whether critical preoperational testing has been
completed; 3) whether the taxpayer has control of the facility; 4)
whether the unit has been synchronized with the transmission grid;
and 5) whether daily or regular operation has begun.71 Considering
and balancing these factors as applied to the items of personal
property in Sealy's facility convinces us that the facility did
become "operational" and was placed in service, and that 1984 was
the year in which that occurred.
i. Permits and Licenses
A review of the pertinent documents in the record, which the
parties stipulated were authentic, reveals that by 1983 Sealy had
obtained the necessary permits and licenses for operation of its
electric generating facility. The Texas Department of Health in
1982 authorized EAI to operate the facility as an energy recovery
requires consideration and balancing of all factors).
70
See Foil v. Commissioner, 920 F.2d 1196, 1201 (5th Cir.
1990); Stubbs, Overbeck & Assocs., Inc. v. United States, 445
F.2d 1142, 1146-47 (5th Cir. 1971); Macey's Jewelry Corp. v.
United States, 387 F.2d 70, 72 (5th Cir. 1967).
71
See Rev. Rul. 84-85, 1984-1 C.B. 10; Rev. Rul. 79-203,
1979-2 C.B. 94; Rev. Rul. 79-98, 1979-1 C.B. 103; Rev. Rul. 79-
40, 1979-1 C.B. 13; Rev. Rul. 76-428, 1976-2 C.B. 47; Rev. Rul.
76-256, 1976-2 C.B.46.
30
site.72 In 1983, the Texas Air Control Board notified EAI by letter
that Sealy's facility would be exempt from its permit requirements
because of the Board's determination that the incinerator would not
make a significant contribution of air contaminants to the
atmosphere.
ii. Critical Preoperational Testing
As for the second factor, Lileng, the EAI engineer who
designed Sealy's facility, testified that no testing was necessary
because the facility's components were ready-made parts that would
function appropriately in the system if they were not defective.
Lileng's testimony was not contradicted at trial. In acquiring the
components for Sealy's facility, EAI provided the manufacturers
with the specific rating levels and capacities required for EAI's
design. Unlike the highly complex component systems in Revenue
Ruling 76-25673, therefore, the components used in the Sealy
facility did not have to pass a critical testing stage before the
facility could operate. Similarly, Sealy's facility did not need
to undergo a preoperational testing program as did the facility in
Revenue Ruling 76-428.74
iii. Control of the Facility
Sealy met the indicia of physical and legal control of the
72
EAI constructed, managed, and operated the facility on
behalf of Sealy under its management agreement with the
partnership.
73
1976-2 C.B. 46.
74
1976-2 C.B. 47.
31
electric generating facility by 1984.75 In 1982, the partnership
entered into an agreement with the City for the site property and
the lease was signed at the end of 1983. In 1983, Sealy acquired
the component parts and hired EAI to assemble them according to
EAI's design of the facility. EAI completed construction of the
facility for Sealy in the same year. Under Sealy's management
agreement with EAI, Sealy retained the risk of loss while EAI
constructed, managed and operated the facility on behalf of Sealy.
EAI was obligated to indemnify Sealy and hold it harmless from any
liabilities or obligations arising from the malfunction of the
facility due to EAI's gross negligence or willful misconduct. The
agreement also specified that EAI would contract for insurance at
Sealy's expense, insuring Sealy and EAI for any loss or damage to
the facility, for products liability, and for general liability.
Sealy had title to the facility at all times and had the legal
right to enforce the warranties that EAI obtained from the
manufacturers of the equipment for the facility. Sealy also
obtained a license for the use of EAI's patented high-pressure
75
Rev. Rul. 76-428, 1976-2 C.B. 47, stated that the taxpayer
met this "placed in service" factor because it had physical
control of the unit as well as the legal attributes of ownership
such as title, risk of loss, and liability. In Rev. Rul. 79-98,
1979-1 C.B. 103, however, a taxpayer who had not yet formally
accepted the unit from the contractor and therefore did not carry
the risk of loss nevertheless qualified for the credit. The
taxpayer had title to the material and equipment incorporated in
the unit and had agreed to obtain nuclear liability insurance,
property insurance applicable to all nonnuclear occurrences, and
an agreement of indemnification for public liability claims. The
contractor had agreed to maintain insurance for occurrences prior
to unit acceptance involving its materials and equipment and the
taxpayer's property.
32
vaporizing process.
iv. Synchronization Into the HL&P Grid
Synchronization of an electric generating facility refers to
the stage at which alternating current systems, generating units,
or a combination thereof are connected and operate at the same
frequency so that the voltages between the systems remain
constant.76 Some Revenue Rulings have used the date of a facility's
synchronization as a "placed in service" indicator.77 The Tax
Court made no factual finding as to what year Sealy's facility was
synchronized into the HL&P grid, and the trial testimony was
conflicting as to this fourth Revenue Ruling factor. Lileng
testified that Sealy's facility was connected to HL&P in 1983 to
enable HL&P to monitor the electricity output and that there was no
need for synchronization at the facility because, through the use
of induction generators, it automatically mirrored the voltage and
phase of HL&P. The "synchronization factor" would then be
irrelevant here as the Sealy facility would be distinguishable from
the facilities described in the Revenue Rulings which required
synchronization as a prerequisite to generating electricity for
another system.
Lileng's testimony was contradicted by that of IRS agent
Leanna Cantu, who testified from notes taken when she interviewed
76
See Oglethorpe Power Corp. v. Commissioner, 60 T.C.M. 850,
853 (1990).
77
See Rev. Rul. 76-256, 1976-2 C.B. 46; Rev. Rul. 76-428,
1976-2 C.B. 47; Rev. Rul. 79-98, 1979-1 C.B. 103; Rev. Rul. 79-
203, 1979-2 C.B. 94.
33
Sealy partner Donald Rutt as part of the IRS audit. Her notes
reflected that, as of the date of the interview in 1985, the
facility had not yet been synchronized into the HL&P grid. Rutt,
however, testified that he had never used the term "synchronized"
in his conversation with Agent Cantu.
As the Tax Court failed to make a factual finding on this
point, we cannot on appeal make a factual finding in the first
instance.78 Even so, as we have stated previously, neither the
presence nor absence of any one of the Revenue Ruling factors is
dispositive of the "placed in service" determination. In the
instant case, we find that the remaining Revenue Ruling factors
plus additional factual circumstances relevant to the Sealy
facility supply sufficient indicia of Sealy's operational status in
1984.
v. Daily or Regular Operation of Facility
As for this final factor, the parties do not dispute that the
electric generating operation was conducted regularly in 1984 even
though its performance was sporadic and the volume of its output
was disappointing. According to the undisputed testimony at trial,
the power facility was run on a regular basis by several EAI
employees. In addition to operating the landfill's gate and
collecting tipping fees, these employees monitored the performance
of the plant from the facility's control room, which contained a
78
See Landry v. Air Line Pilots Ass'n Int'l AFL-CIO, 901
F.2d 404, 423 (5th Cir. 1990), cert. denied, 498 U.S. 895, 111
S.Ct. 244, 112 L.Ed.2d 203 (1990); Commonwealth Mortgage Corp. v.
First Nationwide Bank, 873 F.2d 859, 869 (5th Cir. 1989), reh'g
denied, 881 F.2d 1071 (5th Cir. 1989)(en banc).
34
computer and equipment for measuring pressure and temperature
levels for the various components of the facility. The employees
took notes on the plant's performance and copied them onto the
computer printouts, creating daily reports of the facility's
generating operations. Although it is not clear from the record
whether the facility was operated on a daily basis, its operation
on a regular basis suffices to demonstrate this aspect of the
facility's "placed in service" status.79
b. Legislative History and Regulations
The legislative history and Regulations indicate that it is
sufficient for purposes of the "placed in service" test that
Section 38 property be ready and available to play its role in an
operating facility, regardless of the level of production attained.
The goal of Sealy's plan was for the facility to generate
electricity, and Sealy presented evidence that the facility did
generate electricity, starting in 1984. The Tax Court's statement
that it found no evidence to support Sealy's contention that the
facility was generating electricity in 1984 is clearly erroneous.
Lileng testified that the facility generated electricity as early
as 1984, even though the first readings from HL&P's records were in
1985. He explained that it was likely that the electricity output
79
In Rev. Rul. 76-256, 1976-2 C.B. 46, daily operation of a
generating unit was one indicator that it had been placed in
service. Rev. Rul. 79-98, 1979-1 C.B. 103, stated that a "'state
of readiness and availability for a specifically assigned
function,' such as 'daily operation'" determined when a facility
was placed in service. The more recent Rev. Rul. 84-85, 1984-1
C.B. 10, however, found that a facility operating on a regular
basis had been placed in service even though it was experiencing
operational problems.
35
in 1984 was not registered in HL&P's records because the amounts of
electricity generated in that year were small. Further, Sealy
entered into an agreement with HL&P in 1984 under which it would
sell its electricity output to the power company. That the
facility was unable to generate electricity at its rated capacity
does not obviate the fact that it met its specifically assigned
function of generating electricity.80
Moreover, the inability of Sealy's facility to achieve or
sustain anticipated levels of production stemmed from the alleged
malfeasance of the incinerator's manufacturer. The incinerator
that it fabricated and delivered to Sealy turned out to have far
less capacity than Sealy had specified in its order, crippling the
effectiveness of a key component of the facility. Albeit
unsuccessful, Sealy made a good-faith effort to correct the
facility's operational problems by seeking out new investors to
fund a replacement incinerator; and, in the end, the partnership's
misfortunes caused by the faulty incinerator ultimately forced
Sealy to declare bankruptcy. Its activities in acquiring and
operating an electric generating facility and entering into an
agreement with HL&P constituted the operation of a business even
though the facility experienced insurmountable operational problems
80
In Rev. Rul. 84-85, 1984-1 C.B. 10, the Commissioner
stated that operating at rated capacity was not a prerequisite
for a facility's operational status. This Revenue Ruling
involved an electric generating facility, similar to Sealy's,
which converted solid waste into steam energy. The facility was
deemed "placed in service" when it first became operational even
though it operated well below its rated capacity and was
experiencing operational problems.
36
that prevented its ever achieving success.
In Piggly Wiggly Southern, Inc. v. Commissioner81, the Tax
Court held that refrigeration equipment acquired for new
supermarkets was not placed in service until they were open for
business, but that equipment for remodeled stores was placed in
service when purchased. The distinction was based on the concept
that property qualifying as "placed in service" had to be acquired
for an existing trade or business.82 Using Piggly Wiggly as an
analogue, we conclude that Sealy's electric generating facility was
"open for business" in 1984: it was operating as a unit, it was
generating electricity, and Sealy had completed the sale agreement
with HL&P for its output. That Sealy's commercial enterprise made
hardly any "sales" because of substantial functional difficulties
with an essential component in the facility does not affect the
determination that the facility as a whole was placed in service.83
As discussed previously, the energy and investment tax credits
were designed to stimulate private investment in qualifying
property by allowing taxpayers with environmentally desirable
projects to implement them at a reduced cost. The partnership's
81
84 T.C. 739, 745 (1985), aff'd 803 F.2d 1572 (11th Cir.
1986).
82
See id. at 745-48.
83
As support for its "placed in service" argument, Sealy
cites to Piggly Wiggly and other "idle asset" cases in which
courts have held that property not yet in use because of
circumstances beyond the taxpayer's control may nevertheless be
considered to have been placed in service. In light of our
conclusion that the facility as a whole was operating in 1984, we
need not address the applicability of these cases to Sealy's
property.
37
attempt to create, through the purchase of various items of
tangible personal property, a unique electric generating facility
that would have the dual benefit to the community of processing and
converting its solid waste into an alternative affordable energy
source is the very type of activity Congress intended to encourage
through the energy and investment tax credit statutes. Sealy's
misfortune in acquiring an incinerator that failed to perform at
the level of Sealy's specifications and the manufacturer's
(mis?)representations does not preclude the designation of Sealy's
property as having been placed in service in 1984, the first year
in which the entire facility was operational and generating
electricity, for purposes of depreciation deductions and the energy
and investment tax credits.
D. PRE-OPERATING EXPENSE ISSUE
Having found that the property of Sealy's facility was placed
in service in 1984, we turn to the issue raised by the Commissioner
on cross-appeal. The Commissioner argues that the Tax Court erred
in not considering the challenge to the deductibility, under
Section 16284, of certain of Sealy's expenses. Based on the
procedural posture of the Commissioner's argument, we conclude that
a remand to the Tax Court is necessary for a factual determination
as to when Sealy was carrying on a trade or business for purposes
of deducting expenses under § 162.
84
Section 162(a) states that "[t]here 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."
38
The Tax Court's opinion stated that a decision would be
entered under Rule 155 of the Tax Court Rules of Practice and
Procedure.85 The Commissioner then submitted a proposed decision
document disallowing Sealy's expenses for local taxes, legal fees,
accounting fees, interest, and various other items, based on the
Commissioner's position that these expenses were nondeductible pre-
operating expenses.86 Sealy objected, arguing that the
Commissioner's computation was inconsistent with the Tax Court's
opinion and with the parties' Stipulation of Facts.
In response to the Commissioner's Motion for Entry of
Decision, the Tax Court issued a post-computation Order stating
that the Commissioner did not raise the issue of pre-opening
expenses at the trial and thus was inappropriately "bootstrapping"
the issue after the court's "placed in service" determination. It
held that the Commissioner's argument in support of its proposed
computation raised a new issue which the court would not consider
at that late date.87 Our review of the record, however, reveals
that the Tax Court clearly erred in finding that the Commissioner
85
Rule 155 provides that the Tax Court, after entering its
opinion on the issues, may withhold entry of its decision to
allow the parties to propose computations pursuant to the court's
determination of the issues. See Paccar, Inc. v. Commissioner,
849 F.2d 393, 399 (9th Cir. 1988).
86
The Commissioner, consistent with the Tax Court's opinion,
also disallowed the depreciation deductions and credits in the
proposed computation.
87
The court in a post-trial proceeding may hear arguments
regarding any disagreements between the parties as to the amount
of the deficiency, but no argument is permitted as to any new
issue. See Knowlton v. Commissioner, 791 F.2d 1506, 1511 & n.4
(11th Cir. 1986).
39
had not raised the pre-operating expense issue at trial.
In the FPAA sent to Sealy, the Commissioner listed the
itemized expenses and stated that one of the reasons for the
assessed deficiency was that Sealy had failed to substantiate that
the amounts claimed "constitute[d] ordinary and necessary business
expenses and were not capital in nature." This statement, although
broadly worded and arguably vague in the context of the
Commissioner's initial sham theory, was sufficient to have placed
the taxpayer on notice that the pre-operating expense theory would
possibly be one of the Commissioner's arguments at trial.88
The Commissioner's trial memorandum to the Tax Court further
reveals that the issue was raised at trial. The memorandum
explicitly states that one of the issues in dispute is "[w]hether,
during any of the years in issue, the Partnership was conducting
the trade or business for which it organized, or was engaged in
pre-opening activities. I.R.C. §§ 195, 709." That memorandum also
cited Richmond Television Corp. v. United States89, a case
recognized as the progenitor of the pre-operating expense doctrine
88
See Abatti v. Commissioner, 644 F.2d 1385, 1389-90 (9th
Cir. 1981)(stating that "if a deficiency notice is broadly worded
and the Commissioner later advances a theory not inconsistent
with that language, the theory does not constitute new matter");
Reese v. Commissioner, 615 F.2d 226, 233 (5th Cir. 1980)(finding
that when the determination "is made in general and indefinite
terms, the taxpayer is reasonably placed on notice that the basic
elements of a claimed deduction, including its fact, amount and
character, are in dispute").
89
345 F.2d 901 (4th Cir. 1965), vacated on other grounds,
382 U.S. 68, 86 S.Ct. 233, 15 L.Ed. 2d 143 (1965)(per curiam).
40
under Section 162.90
Moreover, Sealy acknowledged the pre-operating expense issue
in its own trial memorandum, stating that the issues included
"[w]hether petitioner was engaged in a trade or business and/or an
activity engaged in for profit during 1983 and 1984" and "[w]hether
the amounts claimed by Petitioner in 1983 and 1984 constitute
ordinary and necessary business expenses or were . . . capital in
nature." Sealy's trial memorandum also asserted that Sealy had
properly classified its expenditures as ordinary or capital.
Finally, the record reveals that the Commissioner's opening
argument at trial noted the pre-operating expense theory as an
issue.91 In light of the foregoing, we find that the court erred
in stating that the Commissioner failed to raise the expense issue
at trial and conclude that the Tax Court should have reached the
factual issue whether Sealy's expenses were incurred while engaged
in a trade or business.
Although the facts considered for both the "placed in service"
issue and the pre-operating expense issue substantially overlap,
90
See Fishman v. Commissioner, 837 F.2d 309, 312 (7th Cir.
1988), cert. denied 487 U.S. 1235, 108 S.Ct. 2902, 101 L.Ed.2d
935 (1988); Johnsen v. Commissioner, 794 F.2d 1157, 1160 (6th
Cir. 1986).
91
The Commissioner's opening argument stated that "the
operating expenses were disallowed under [a] pre-opening expense
theory" and that the second major issue, in addition to the
"placed in service" issue, was "whether during any of the years
at issue the partnership was conducting a trade or business for
which it was organized before being engaged in pre-opening
activities." The Commissioner also told the court that the
determination of this issue "mainly affect[ed] the deductibility
of claimed operating expenses."
41
the issues call for separate determinations under different
sections of the Internal Revenue Code. The Tax Court recognized
the discreteness of the two issues in its post-computation Order
when it rejected the Commissioner's proposed disallowance of
Sealy's expenses under the pre-operating expense theory. As we
cannot make such a factual finding in the first instance, and the
Tax Court failed to address whether Sealy was engaged in a trade or
business when it incurred the challenged expenses, we must remand
this issue to the Tax Court.
In doing so, however, we note that the facts available to us
in the record to date strongly militate in favor of a finding that
Sealy was engaged in a trade or business sometime in 1983.92 The
record shows that in that year, Sealy operated the landfill,
accepted tipping fees for waste disposal, leased the property on
which it built and operated the facility, obtained the necessary
permits and licenses for operating the facility, completed
construction of the facility, and operated the incinerator. In
light of cases addressing the question whether a taxpayer is
engaged in a trade or business, these facts seem sufficient to
support a finding that Sealy was not engaged in pre-opening
activity in late 1983, but instead was carrying on a trade or
92
In Commissioner v. Lincoln Savs. & Loan Assoc., 403 U.S.
345, 32, 91 S.Ct. 1893, 1898, 29 L.Ed.2d 519, (1971), the
Supreme Court stated that "[t]o qualify as an allowable deduction
under Section 162(a) . . . an item must (1) be 'paid or incurred
during the taxable year,' (2) be for 'carrying on any trade or
business,' (3) be an 'expense,' (4) be a 'necessary' expense, and
(5) be an 'ordinary' expense." The second requirement is at
issue in the instant case.
42
business.93 Further, the parties stipulated that Sealy had a valid
business purpose and had never been a sham, satisfying the
threshold "profit motive" requirement of Section 162.94 On remand
the Tax Court must determine when Sealy's start-up period ceased
and its activity of operating a trade or business began, and must
then examine each of the disallowed expenses to determine whether
any are capital in nature.95 As stated previously, we leave the
93
See Aboussie v. United States, 779 F.2d 424, 428 (8th Cir.
1985)(affirming district court's finding that partnership was not
carrying on a business until its housing project was
substantially ready for rental); Blitzer v. United States, 684
F.2d 874, 880-81, 231 Ct.Cl. 236, (Cl. Ct. 1982)(per
curiam)(corporation may be considered to be engaging in business
when it begins business operations even if income production has
not begun); Richmond Television Corp. v. United States, 345 F.2d
901, 905 (4th Cir. 1965)(television station not carrying on trade
or business because had not yet obtained license or begun
broadcasting), vacated on other grounds, 382 U.S. 68, 86 S.Ct.
233, 15 L.Ed.2d 143 (1965)(per curiam).
94
See Commissioner v. Groetzinger, 480 U.S. 23, 35, 107
S.Ct. 980, 987, 94 L.Ed.2d 25, (1987)("we accept the fact
that to be engaged in a trade or business, the taxpayer must be
involved in the activity with continuity and regularity and that
the taxpayer's primary purpose for engaging in the activity must
be for income or profit"); Hayden v. Commissioner, 889 F.2d 1548,
1552 (6th Cir. 1989); Brannen v. Commissioner, 722 F.2d 695, 704
(11th Cir. 1984); Cooper v. Commissioner, 88 T.C. 84, 108-109
(1987).
95
See Lincoln Savs. & Loan Assoc., 403 U.S. at 354, 91 S.Ct.
at 1899, 29 L.Ed.2d at (controlling feature of capital
payment is that it serves to create or enhance separate and
distinct additional asset); Fishman v. Commissioner, 837 F.2d
309, 312 (7th Cir. 1988)(expenses incurred before taxpayer's
trade or business begins to operate are not deductible); El Paso
Co. v. United States, 694 F.2d 703, 714 (Fed. Cir.
1982)(recognizing that § 162 deduction may be available to
corporation not yet carrying on revenue producing operations);
Blitzer, 684 F.2d at 880 (expenses before start of revenue
producing operations deductible under § 162 if not "in the nature
of start-up costs nor intended to provide benefits extending
beyond the year in question").
43
task of fact-finding to the Tax Court given its failure to address
the pre-operating expense issue when the Commissioner raised it at
trial.
III
CONCLUSION
For the foregoing reasons, we reverse the Tax Court's finding
regarding the "placed in service" determination and hold that, for
purposes of depreciation and the energy and investment tax credits,
the property in Sealy's electric generating facility was placed in
service in 1984. Accordingly, we remand the case to the Tax Court
for a calculation of Sealy's tax liability for 1983 and 1984 not
inconsistent with this opinion. We also remand for a finding as to
when Sealy was carrying on a trade or business for purposes of
deducting its expenses under § 162. Finally, we affirm the Tax
Court's ruling on the FPAA issue.
44
Sealy Power, Ltd. v. Commissioner
Court: Court of Appeals for the Fifth Circuit
Date filed: 1995-02-15
Citations: 46 F.3d 382
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