Midland's basement (where they
cured meat), kept getting flooded by a river (that was contaminated with
oil). Health inspectors suggested that Midland seal their basement for
health reasons. They did.
The sealing costs almost
Midland deducted the costs for
the sealing as a business expense
on their taxes.
Midland felt that the
sealing was an ordinary and necessary
cost of doing business, and so it was deductible under §23(a)
of the Tax Code (now §26 U.S.C. §162(a)).
The IRS denied the deduction.
The IRS argued that the
expense was not a business expense
at all, but instead was a capital expenditure.
A capital expenditure is like when you buy a new building. That is
not immediately deductible as a business expense, but instead must be written off over several
years as depreciation (see
26 U.S.C. §263(a)).
The Tax Court reversed and
allowed the deduction.
The Tax Court found that Midland
made the repairs in question in order that it might continue to operate
its plant. Midland didn't gain capacity or improve their process, it
just allowed for continued operations.
Plus, the health inspectors
told them to do it.
"Repair is an expenditure
for the purpose of keeping the property in an ordinarily efficient
operating condition. It does not add to the value of the property nor
does it appreciably prolong its life." On the other hand,
depreciable capital expenditures are those "for replacements,
alterations, improvements, or additions which prolong the life of the
property, increase its value, or make it adaptable to a different
The IRS argued that even if
the sealing was 'necessary', it wasn't 'ordinary' because it was a unique
situation and not something Midland (or other businesses) did on a
regular basis. However, the Court found that taking steps to protect
one's property is a common, normal thing for businesses to do in general.
If the sealing had been done
when they originally built the building, then it would have been a capital
expenditure, and not a business
The court has to do a
functional analysis and determine whether or not the expense is designed
to just allow the continuation of a business as it had been previously
running, or to improve the business.