Zumwalt v. Commissioner

I. G. ZUMWALT, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Zumwalt v. Commissioner Docket No. 6883. United States Board of Tax Appeals 25 B.T.A. 566; 1932 BTA LEXIS 1502; February 23, 1932, Promulgated *1502 1. Whether or not there has been an abandonment of property depends on the intention of the owner, coupled with the act of abandonment, both to be ascertained and determined from all the surrounding facts and circumstances. 2. Mere nonuser does not constitute abandonment. 3. A lessee who places on leased property improvements which can not be removed after the expiration of the lease is entitled to amortize the cost of such improvements over the life of the lease. O. R. Folsom-Jones, Esq., and F. E. Youngman, Esq., for the petitioner. H. A. Cox, Esq., for the respondent. VAN FOSSAN *566 This proceeding involves a redetermination of a deficiency in income tax for the year 1919 amounting to $57,988.71. The issue is whether or not the petitioner is entitled to a deduction of all or any part of the sum of $153,028.46 which was the cost of an irrigation system constructed by him during the taxable year. In his petition the petitioner prays that the Board find that he has overpaid his tax for the year 1919 and also requests the Board to determine the amount of such overpayment. *567 FINDINGS OF FACT. During the years*1503 hereinafter mentioned the petitioner was a resident of Colusa County, California. Prior to the year 1919 and thereafter the petitioner owned approximately 2,200 acres of land in Colusa County. This county is located in the valley of the Sacramento River and the land owned by the petitioner is situated about six miles west of the river. Petitioner's land consisted of three different plots separated from each other by land not owned by him. The Sacramento River runs in a generally southerly direction into San Francisco Bay and is paralleled by the coast range of mountains lying approximately 20 miles west of the river. The river runs along a ridge built up by deposits left by successive overflows. Water overflowing the banks of the river runs in a westerly direction for five of six miles, where it meets water draining from the coast range of mountains. The water from both sources drains off through a depression in the valley between the mountains and the river. This depression is from eight to twelve feet lower than the banks of the river and is generally called the "trough." The trough lies to the eastward of the lands owned by petitioner in 1919, and subsequently, and the drainage*1504 water flowing through it was used by him for the irrigation of his land and other lands in the neighborhood which were leased to him as hereinafter stated. About the year 1915 it was discovered that rice could be grown successfully in Colusa County and neighboring sections of the Sacramento River Valley. For two or three years prior to 1919 petitioner had cultivated rice on a part of his land in Colusa County. Ricegrowing requires a large quantity of water which must be available at all times during the rice-growing season. As the growing of rice on lands to the north of petitioner's property increased the water used for the irrigation of such rice-growing lands drained off and flowed southerly through the trough along petitioner's property and was used by him for the irrigation of his rice fields. In 1918 petitioner built a dam across the trough and by the use of a small pump, operated by a tractor, obtained and stored drainage water in sufficient quantity to irrigate the part of his land planted to rice that year. At various times between November, 1917, and April, 1919, petitioner leased, either directly from the owners thereof or by assignment to him of the unexpired*1505 term under existing leases, several plots of land located in the Sacramento River Valley and containing all together in excess of 5,000 acres. The annual cash rentals provided for in these lease agreements were substantial in amount. The leases varied in the duration of the term granted thereby. Some of them contained no provisions for renewal. One lease, covering a plot of 1,120 acres, ran for two years, commencing in 1919, gave petitioner *568 the right to renew for one year and contained an option for the purchase of the acreage by petitioner at the expiration of the lease for the sum of $100 per acre. The largest proportion of the acreage was leased for three years beginning with the year 1919. Each of the plots leased to petitioner was either contiguous to lands owned by him or was contiguous to other land leased to him. The lease agreements granted petitioner the right to grow rice and to irrigate the land leased. Most of them provided that at the end of the term granted petitioner should fill in and level the irrigation ditches. On February 18, 1919, petitioner entered into an agreement with David Freedman whereby petitioner agreed, in return for the right*1506 to construct irrigation canals across a 320-acre tract owned by Freedman, to build a canal of sufficient capacity to furnish water for the Freedman land. In this contract it was agreed that, if petitioner should construct the canal as stated, Freedman would endeavor to lease the land to a tenant or tenants for the purpose of growing rice thereon in the year 1919. It was further agreed that if the land was so leased, the petitioner should receive half the rent thereof and that Freedman would pay half the cost of the construction of the canal on his land, the cost of his half not to exceed the sum of $1,250. The Freedman land was a connecting link between land owned by petitioner and some of the land leased to him as aforesaid. In March, 1919, the petitioner and Freedman, as lessors, leased part of the Freedman land to John Delpapa and Pete Bartolomei for a period ending December 1, 1919, for a crop rent of 32 sacks out of every 100 sacks of rice harvested. A sack of rice weighs approximately 100 pounds. In the latter agreement the petitioner agreed to furnish water to irrigate the Freedman land. By agreement executed in May, 1919, by the petitioner and R. A. and C. E. Pryor*1507 the petitioner was granted an easement for the term of one year "to run water for the purpose of irrigation" through a certain ditch or canal then on property owned by the Pryors. This ditch became a part of the distribution system hereinafter referred to. By this agreement petitioner undertook to furnish water for the raising of rice on such of the land owned by the Pryors as was conveniently situated for the irrigation thereof by gravity and it was stipulated that petitioner was to receive half of the "rent received from said rice." It was also agreed by the petitioner and the Pryors that the agreement might be extended for one year if petitioner should secure a similar extension of the contract by which he was permitted to carry water by canal over Freedman's land as aforesaid. By a separate agreement executed by petitioner and the Pryors petitioner agreed to furnish water for the irrigation of certain land leased to third parties by the Pryors for the ricecrop *569 season of 1919. The land owned by the Pryors was contiguous to the most southerly plot of land owned by the petitioner and also to land leased to petitioner for the purpose of rice cultivation. On January 29, 1919, the*1508 petitioner leased to M. H. Lee and Chew Fook 2,200 acres consisting both of land owned by him and land leased to him. The land was leased to Lee and Fook for the sole purpose of growing rice thereon and the lease was for a term expiring January 1, 1920. The lessees agreed to pay a rental of $40 per acre, totaling $88,000 for the year. Of that sum $54,000 was to be paid on or before March 15, 1919. This lease contained the following provisions, among others: That the aforesaid fifty-four thousand dollars and the whole thereof shall be used by the lessor for purchase of rights of way and the necessary labor, materials, pumps, motors and machinery necessary in the construction and completion of an irrigation system to be built and installed by the lessor to properly irrigate said leased lands and the whole thereof. In consideration of the payments to be made by the lessees as herein provided, the lessor agrees to furnish to the lessees sufficient water under a system properly constructed to irrigate said leased lands and the whole thereof, and to have said water ready for use and a sufficiency thereof on or before the 5th day of May, 1919, to properly irrigate and keep irrigated*1509 said lands and the whole thereof; * * * The lessor also agrees in as much as the lessees have paid in excess of one-half of their rent to be paid in advance, to faithfully secure the performance of the terms, conditions, and agreements of this lease to be kept and performed by the lessor; that the lessor will contemporaneously herewith duly make, execute and deliver to the lessees or to one of them, a promissory note for the sum of $54,000 and to secure the same will duly make, execute and deliver a mortgage upon the following described real property, situate, lying and being in the County of Colusa, in the State of California, to wit: * * *. Thereafter during the early part of 1919 by various leases and subleases the petitioner leased to several persons, for the purpose of growing rice, about 2,700 acres of land at a total rental of $22,000, plus a crop rental of one-third of the rice harvested. All of these leases to tenants were for a term ending in December, 1919, except that one of them which covered 280 acres of land was for a term of two years after the date thereof. In all of these agreements with his tenants petitioner undertook to furnish water in quantities adequate*1510 for irrigation purposes and in two of them which jointly covered upwards of 2,000 acres of land it was agreed that petitioner should pay certain penalties in the event of his failure to furnish adequate water to the leased premises by May 5, 1919. In 1919, after the execution of the various leases and subleases hereinbefore referred to, petitioner proceeded to construct an irrigation canal from the Sacramento River to a point in the so-called trough in the northerly boundary of petitioner's property at which *570 he had theretofore constructed a dam across the trough as herein previously stated. Petitioner also installed a pumping plant at the Sacramento River at the head of his canal, having already filed application for the right to take water from the river. Upon the completion of the canal and pumping plant, water could be pumped from the river into the canal and carried to the petitioner's reservoir in the trough. It was necessary to pump the water about 25 feet from the river into the canal. The pumping plant and canal were built on land not owned by him over which petitioner had purchased from the owners a right-of-way for the construction of the canal. The canal*1511 was constructed cheaply. For a distance of between three and four miles the grading along the line of an abandoned railway was used without much additional construction. Old levees and old drainage ditches were utilized, and secondhand material was purchased and installed in the pumping plant at the Sacramento River. Petitioner also constructed a supplementary irrigation system west of the trough for distribution of water through his property and through property leased to him. This supplementary system consisted of several miles of distribution ditches and three booster plants which were installed at points where it was necessary to lift the water to a higher level. The larger portion of the distribution system was in the land leased to petitioner. Only about 740 acres of land owned by petitioner could be served by the distribution ditches after the termination of the leases made to him. The canal and pumping plant were completed, ready for operation, about May 1, 1919. The cost of constructing the main canal and distribution ditches was $118,367.57 and the cost of constructing the pumping plant and booster pumps was $34,660.89, making a total cost of $153,028.46. The*1512 cost of the main canal from the river to the trough, including the cost of the pumping plant, was $64,000 and the cost of the distribution system, including the booster plants, was $89,028.46. The cost of the pumping plant was $28,000 and the total cost of the booster plants was $6,660.89. The cost of the main canal, exclusive of the pumping plant, was $36,000 and the cost of the distribution ditches, exclusive of the cost of the booster plants, was $82,367.57. During the rice-growing season of 1919 sufficient water for petitioner's lands came from the drainage from the west and from waste water draining through the trough from rice lands to the north. Petitioner therefore used the main canal and pumping plant for a period of only about 10 days during 1919. The distribution ditches, however, were used continuously throughout that year and during the subsequent years of rice cultivation by petitioner and his tenants. In March, 1920, petitioner warned certain of his tenants of a probable shortage of water for the year 1920 "in view of the State Water *571 Commissioner's ruling against taking water from the trough." That year, however, petitioner had sufficient waste water*1513 from the trough for the cultivation of his lands but the water from the trough was insufficient for use in the rice-growing section to the south of petitioner's land known as the "Williams Irrigation District." Therefore, petitioner leased his main canal and pumping plant to the Williams Irrigation District to carry water from the river to that district during the rice-growing season of 1920. In growing rice in the Sacramento River Valley the rice was planted about the middle of the month of April or the first of May and the cultivation season lasted about 140 days from the date of the planting, the rice being harvested in September or October. At the beginning of 1919 rice growing in this district was still in its infancy and methods of cultivation were in a somewhat experimental stage. In the first year of cultivation a maximum crop of rice was produced. In the second year the production averaged not more than three-fifths of the first year's crop and in the third year the crop produced was not more than two-fifths of the first year's production. Production during the second and third years was increasingly expensive. The water put on the rice carried the seeds of a plant*1514 called "water grass." Water grass is similar to rice in appearance but is more hardy. During the first year of rice cultivation the seeds of the water grass germinated, and the water grass grew luxuriantly in the second and third years of cultivation. In 1919 and the years immediately subsequent thereto water grass had to be pulled and removed by hand. No other method of control was then known. Pulling the water grass by hand was an expensive operation. The soil in this district is alkaline in character and during the first year of cultivation the alkali comes to the surface and injuriously affects the rice crop during the second and third year. During the first year of cultivation a plant called "tule" germinated in the ditches and grew to a height of several feet by the second year of cultivation. It was necessary to cut this plant from the ditches to enable the water to flow freely and this operation was an added expense of rice cultivation during the second and third years. Because of these conditions rice growers preferred to cultivate new land each year if it were obtainable, and there was an abundance of new land in this district in 1919 It was customary not to cultivate*1515 rice land for more than three successive years. After the third year the land was not used again for rice-growing for several years. In 1919, and in 1920 before the planting season, the price of rice was at its peak. During this period the price ranged from 4 to 10 *572 cents per pound. Before the rice was harvested in 1920, however, the price markedly declined and the petitioner cultivated his rice lands in 1920 at a loss. Petitioner's lands, including his leased lands, were planted to rice in 1919, 1920 and 1921. He again planted his own land to rice in 1923 and 1925. In 1923 Reclamation District No. 27 of the State of California removed petitioner's dam previously constructed in the trough, as hereinbefore stated, and destroyed his reservoir for the storage of waste drainage water. In 1923 petitioner used the main canal and his river pumping plant for irrigation purposes and in 1925 again used the main canal for such purposes. In 1920 petitioner acquired by lease 1,280 additional acres of land, on which he cultivated rice. In a credit statement made to his bank, dated June 14, 1920, he valued his rice crop rental from 7,000 acres at $350,000. In the same*1516 statement the petitioner set out as an asset "Zumwalt Irrigation District, $200,000." In April, 1920, petition filed his income-tax return for the calendar year 1919, stating therein a tax liability of $17,084.15, which amount has been paid. Among the deductions in his return was the sum of $132,425, which deduction he explained, in substance, as the part of the total cost of his irrigation system allocable to lands under lease to him. The respondent disallowed all of this deduction except the sum of $3,466.09, which sum the respondent allowed as depreciation of the pumping plant and equipment at the rate of 10 per cent per annum. The main canal and distribution ditches had no salvage value. The pumping plant had a salvage value of $1,500, and the salvage value of the three booster plants was not in excess of $2,500. OPINION. VAN FOSSAN: The petitioner contends that the total cost of the irrigation system described in the findings of fact should be allowed as a deduction from income for the year 1919, on the ground that such cost was a usual and necessary expenses of business in that year. In the alternate, he contends that he abandoned the main canal and pumping plant*1517 in 1919 and that, therefore, he should be allowed to deduct their cost as a loss incurred during the year, and in addition thereto should be permitted to deduct the cost of the distribution ditches and booster plants from his 1919 income as a usual and necessary expense of business. In our opinion the evidence does not support these contentions. The evidence shows that in the early part of 1919 the petitioner entered upon a large project of rice cultivation. Rice-growing in the *573 part of California in which the petitioner's land was situated was in an experimental state. It appears from the proof that an adequate supply of water to cover the rice at the various stages of its growth was an essential factor in its successful cultivation and that a lack of a sufficient supply of water was fatal to the crop. The petitioner had added to his own land a large acreage which had been leased to him for rice-growing purposes. Leases by which he acquired the additional acreage ran for an average period of three years, namely, on the average, for the crop years 1919, 1920 and 1921. The annual rent reserved in the leases amounted to a substantial sum of money. The leases granted*1518 to petitioner the right to grow rice and to irrigate the land leased to him. The petitioner had leased to tenants, for rice cultivation, parts of his own land, and for the same purpose had subleased to tenants parts of the land leased to him. These leases and subleases to petitioner's tenants obligated him to furnish them an adequate supply of water for the cultivation of a rice crop. One of these leases to the petitioner's tenants ran for a term of two years. The petitioner had cultivated rice on a part of his land prior to 1919 and for such cultivation had used waste water draining through the so-called trough described in the findings of fact. But the evidence discloses that he had no knowledge as to whether or not in 1919 and subsequent years there would be sufficient waste water draining through the trough or sufficient water coming from the mountains to the west of his acreage to furnish an adequate supply either for his own use or for the use of his tenants. He admitted during his cross-examination at the hearing that he could not compel rice growers to the north of his property to allow waste water from their operations to flow through the trough. From these facts*1519 we must conclude that the petitioner constructed his irrigation system, consisting of a main canal, pumping plant, distribution ditches and booster plaints, for the purpose of assuring at all necessary times an adequate supply of water for rice cultivation on his own land, on the land leased to him, and on the land leased by him to tenants. Obviously, such expenditures are capital expenditures. It is true that the petitioner testified that when he built the irrigation system he intended to use it only for a year, namely, for the year 1919 But in answer to further interrogation he stated in substance that at the time of construction he did not know how long he should use the irrigation system. And although he stated that the first year of cultivation was the "big year and the big money," he admitted that he cultivated his own and his leased lands in 1919, 1920, and 1921, stating in respect thereto as follows: I had these leases tied up and had paid cash for the land and had to pay rent anyway and I got something off it to pay the cash rent * * *. *574 The facts show clearly that the cost of the construction of the main canal, pumping plant, distribution ditches and booster*1520 plants was a capital expense and not an ordinary and necessary expense of business for the year 1919. Nor are we impressed with the contention that the petitioner abandoned the main canal and pumping plant in 1919 and that the total cost should be allowed as a loss. The testimony indicates, and we have found as a fact, that petitioner did not use them for more than ten days in 1919. That year there was a sufficient flow of waste water through the trough and of water from the mountains to the west to furnish an adequate supply of water both for the petitioner's own land and also for his leased lands. It appears also that the operation of pumping water from the Sacramento River to the canal was an expensive one and was not justified if sufficient water for the cultivation of the rice crop could be secured otherwise. For these reasons petitioner had little need to use the main canal and pumping plant during the crop year of 1919. But mere nonuser does not constitute abandonment. In , we said: "Whether or not there has been an abandonment * * * depends on the intention of the owner, coupled with the act of abandonment, both to be*1521 ascertained and determined from all the surrounding facts and circumstances." See also . Although the petitioner did not use the main canal for more than ten days in 1919, he used it in 1920 when he leased it to the Williams Irrigation District, as stated in the findings of fact. He used it again in 1923 and 1925 for the irrigation of his land and at all times it was ready for his use in the event of a failure of waste water in the trough. The evidence does not sustain the petitioner's contention that he abandoned the main canal and pumping station in 1919. It follows that he is not entitled to deduct the total cost as a loss incurred during that year. It is our opinion also that the evidence fails to support a contention that the useful life of the main canal and pumping station was limited to the life of the several leases made to the petitioner. The main canal, which was constructed on a right-of-way owned by petitioner, ran from the Sacramento River about six miles to a point in the petitioner's own land. This land consisted of a large acreage suitable for rice-growing purposes. The pumping plant and canal could and*1522 did furnish the petitioner with water for rice-growing on his own land for several years after the leases referred to had expired, and we are satisfied from the evidence that they were constructed for the purpose of creating a permanent source of water supply for rice cultivation on the petitioner's land at any time when the conditions were suitable for such cultivation. Assuming that the main canal and pumping plant were both subject to depreciation, there *575 is nothing in the record from which we can determine the amount of depreciation of the main canal in 1919 or from which we can say that the rate of 10 per cent a year for depreciation of the pumping plant which was allowed by the respondent is insufficient. The construction of the distribution ditches and booster plants, however, was made necessary by the terms of the agreements entered into by the petitioner with his lessors and lessees. After the expiration of the leases running to him the petitioner had no right to use this secondary irrigation system constructed on land leased by him. Under the terms of several of the leases the petitioner had obligated himself to fill in the ditches upon the expiration of*1523 the term granted thereby. In every case, upon the expiration of the lease, the ownership of the ditches located on leased land would pass to the owner of that land. Therefore, at the expiration of the leases the useful life of the secondary irrigation system would terminate and the booster plants would be worth only their salvage value. It does appear, however, that a part of the distribution ditches served, or could serve, a relatively small acreage of land owned by the petitioner and usable for rice cultivation, but this portion of the ditches was necessary to connect the main canal with the distribution ditches serving the large acreage leased to the petitioner and was an essential link in the distribution ditches required by the petitioner's agreements with his lessors and lessees. It is our opinion, therefore, that the useful life of the distribution ditches was commensurate with the life of the leases to the petitioner. We have held in numerous cases that a lessee who places on leased property improvements which can not be removed after the expiration of the lease is entitled to amortize the cost of such improvements over the life of the lease. *1524 ; ; ; . This principle is applicable to the present proceeding in respect to the cost of the distribution ditches and booster plants. The money expended in their construction was expended for the entire term covered by the leases running to the petitioner and was not a necessary expense of business in the year 1919. The cost of the ditches and booster plants should, therefore, be recovered by the petitioner over the term granted by the leases. While the life of the several leases varied in duration, a fair average life was three crop years, beginning with the crop year of 1919. In our opinion, therefore, it is reasonable and equitable for the petitioner to amortize the cost of the distribution ditches and booster plants over the years 1919, 1920 and 1921, one-third of such cost being deductible from income in each year. It appears that the cost of the distribution *576 ditches and booster plants was $89,028.46 and that the cost of the booster*1525 plants alone was $6,660.59. Of this latter sum one-tenth, or $666, has been allowed by the respondent as a deduction from income for the year 1919. The salvage value of the booster plants was $2,500 and the distribution ditches had no salvage value. The deficiency for the year 1919 will be redetermined in accordance with this opinion. Judgment will be entered under Rule 50.