Short tax year depreciation and subsidiaries.

• Author: Campbell, Geoffrey W.

Jack Kent Cooke, Inc., 4th Cir., 6/26/97, addresses the question of whether a full year of depreciation is allowed when property is placed in service by a subsidiary with a short tax year.

Jack Kent Cooke, Inc. (Cooke) purchased the common stock of Elmendorf Farm Inc. (EFI), an incorporated horse farm, on Dec. 28, 1984. This made EFI a wholly owned subsidiary of Cooke. Along with the stock purchase, other assets, including 353 horses, were also purchased; these were not corporate assets of EFI but were used on the farm.

The transaction closed on Dec. 28, 1984, at which time the horses were placed on Cooke's books. The tax year-end for the consolidated group was Dec. 31, 1984. On Jan. 15, 1985, Cooke's directors passed a resolution to place the horses on EFI's books and remove them from Cooke, retroactive to the date of acquisition. The accounting books of both Cooke and EFI were changed to reflect this resolution.

On Sept. 15, 1985, Cooke and its subsidiaries, including EFI, filed a consolidated tax return. The return included EFI's depreciation schedule, claiming a full year of depreciation on the horses. This deduction created a net operating loss of over $5 million, which, when carried back to 1981, resulted in a refund of more than $2 million for Cooke.

The IRS audited the 1984 consolidated return and disallowed most of the 1984 depreciation. Because the assets being depreciated were EFI's, and because EFI had a short year, the Service argued that EFI was not entitled to a full year of depreciation on the horses. The district court agreed. EFI had placed the horses in service on Dec. 29, 1984 and its tax year ended on Dec. 31, 1984; therefore, EFI was only entitled to one month's worth of depreciation.

The district court decision was affirmed by the Fourth Circuit, which reaffirmed that taxpayers can handle things as they wish, but must face the consequences for having done so. Citing National Alfalfa Dehydrating & Milling Co., 417 US 134 (1974), the court stated that taxpayers create their own economic reality. They are free to structure their business affairs as they see fit. The chosen structure may minimize...