Rev. Rul. 80-37

What is the proper treatment for sales of equipment to leasing customers by a taxpayer who is regularly engaged in the dual business of renting and selling such equipment and who has, during the rental period, elected to depreciate such equipment under the Class Life Asset Depreciation Range (CLADR) system?

FACTS

The taxpayer is a corporation engaged in manufacturing, leasing, and selling electronic data processing equipment.

The taxpayer elected the CLADR system as provided by section 1.167(a)-11 of the Income Tax Regulations and the leased equipment was included in the appropriate guideline class. All of this equipment is subject to lease agreements to a minimum period of one year, and the rental is expressed as a monthly rate.

An addendum to the lease agreement gives the lessee the option to acquire the equipment at the established price in effect on the date of purchase. A portion of the rental payments may be applied against the purchase price.

LAW AND ANALYSIS

Section 167(a) of the Internal Revenue Code provides there shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear of property used in a trade or business or for property used for the production of income.

Section 167(m) of the Code provides that in the case of a taxpayer who has made an election to use the CLADR system, the term "reasonable allowance" means only an allowance based on lives prescribed by the Secretary that reasonably reflect the anticipated useful life of that class of property to the industry.

Section 1.167(a)-11(a) of the regulations provides an asset depreciation range and class life system for designated classes of assets placed in service after December 31, 1970. The system is optional with the taxpayer, and the taxpayer must make an annual election. Generally, an election for a taxable year must apply to all additions of eligible property during the taxable year of election.

Section 1.167(a)-11(b)(2) of the regulations defines "eligible property" as tangible property that is subject to the allowance for depreciation provided by section 167(a) of the Code but only if--

(i) an asset guideline class and asset guideline period are in effect for such property for the taxable year of election,

(ii) the property is either section 1245 property as defined in section 1245(a)(3) or section 1250 property as defined in section 1250(c).

Section 1.167(a)-11(d)(3)(i) of the regulations provides for the treatment of retirements from vintage accounts. An asset in a vintage account is retired when such asset is permanently withdrawn from use in a trade or business or in the production of income by the taxpayer. A retirement may occur as a result of a sale or exchange, by another act of the taxpayer amounting to a permanent disposition, or by physical abandonment of an asset. A retirement may also occur by transfer of an asset to supplies or scrap.

Section 1.167(a)-11(d)(3)(ii) of the regulations defines ordinary and extraordinary retirements. The term "ordinary retirement" means any retirement of section 1245 property from a vintage account that is not treated as an "extraordinary retirement" under this subparagraph. The retirement of an asset from a vintage account in a taxable year is an "extraordinary retirement" if the asset is section 1250 property or the asset is section 1245 property retired as a direct result of a cessation, termination, curtailment, or disposition of a business.

Section 1.167(a)-11(d)(3)(iii) of the regulations provides for the nonrecognition of loss upon an ordinary retirement from a vintage account. All proceeds from ordinary retirements are to be added to the depreciation reserve of the vintage account from which the asset is retired.

Section 1.167(a)-11(d)(3)(ix) of the regulations provides that in the case of a vintage account for section 1245 property, gain is to be recognized for each taxable year to the extent of the excess of the depreciation reserve over the unadjusted basis of such account.

Such gain shall constitute section 1245 gain to the extent that it does not exceed the total amount of depreciation allowances in the related year-end depreciation reserve reduced by previously recognized section 1245 gain. Any excess over such total amount so reduced may constitute gain to which section 1231 of the Code applies.

At the time section 167(m) of the Code was enacted and the regulations were promulgated, a body of case law had been developed with respect to dual purpose property. The cases, including Recordak Corporation v. United States, 325 F.2d 460 (Ct. Cl. 1963), Continental Can Company, Inc. v. United States, 422 F.2d 405 (Ct. Cl. 1970), cert. den. 400 U.S. 819 (1971), and International Shoe Machine Corporation v. United States, 491 F.2d 157 (1st Cir 1974), cert. den., 419 U.S. 834 (1974), interpreted the term "primarily" as invoking a contrast between sales made in the ordinary course of business and those made in the liquidation of inventory rather than between sale and lease. This interpretation is viewed by the courts as being consistent with the decision in Malat v. Riddell, 383 U.S. 569 (1966), Ct. D. 1906, 1966-1 C.B. 184, in which the Supreme Court of the United States held that "primarily" means "of first importance" or "principally." The sale-and-rent cases cited above hold that when a manufacturer is regularly engaged in the dual business of selling and renting the equipment it manufactures, then income resulting from either activity satisfies the "primarily" concept since both activities are part of the normal stream of the taxpayer's business. Hence, sales of such leased equipment are not sales of depreciable property at the time of sale and capital gains treatment is forbidden.

In the present case, because the leased asset does not cease to be depreciable property until the year of sale, it is treated, during the rental period, as are all assets in the vintage account for property used in the trade or business of the taxpayer. During this period CLADR provisions are applicable to the dual purpose asset. However, on the date of sale of the dual purpose asset, the asset becomes property held by the taxpayer for sale to customers in the ordinary course of business. The CLADR regulations cease to have any applicability, and the tax treatment of the asset is determined under the case law and statutory provisions dealing with gain from the sale of assets held for sale in the ordinary course of business. See section 1231(b)(1)(B) of the Code.

Under the CLADR regulations, sales of dual purpose property cannot, by definition, be considered to be extraordinary retirements. Similarly, sales of dual purpose property cannot be treated as ordinary retirements because the retirements discussed in sections 1.167(a)-11(d)(3)(iii) and (ix) of the regulations are necessarily retirements of property held for use in the taxpayer's trade or business, and as of the date of sale, dual purpose assets have ceased to be so held. Since, on the date of sale, the asset is held for sale to customers in the ordinary course of business it must, at that time, be removed from the depreciation vintage account. Further, in order not to distort the depreciation deduction on the balance of the vintage account as well as to compute properly the ordinary income on the sale of the equipment now held primarily for sale in the ordinary course of business, the depreciation attributable to such property must be removed from the depreciation reserve. Also, the salvage value of the account should be adjusted for salvage of the asset removed from the account.

HOLDINGS

The gain from the sale of this dual purpose property is part of the taxpayer's normal business operations and is ordinary income for the year of sale notwithstanding that the property had been held for the dual purpose of rent or sale and had, in fact, been depreciated in accordance with the taxpayer's election to apply the CLADR system of depreciation.

The unadjusted basis of the property sold is to be removed from the vintage account, the accrued depreciation is to be removed from the reserve for depreciation, and the salvage value of the vintage account is to be adjusted by removal of the salvage value of the property sold.