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The depreciation charge permitted as a deduction from the gross income in determining the taxable income of a business for any year represents the reduction, during the year, of the capital assets through wear and tear of the plant used. The amount of the allowance for depreciation is the sum which should be set aside for the taxable year, in order that, at the end of the useful life of the plant in the business, the aggregate of the sums set aside will (with the salvage value) suffice to provide an amount equal to the original cost.
Prior to acquiring a used Liberty ship for $ 469,000 in December 1955, Fribourg obtained a letter ruling from the Internal Revenue Service that it would accept straight-line depreciation of the ship over a useful economic life of three years, with a salvage value of $ 54,000. Fribourg claimed ratable depreciation deductions from date of purchase to the end of 1955 and for the year 1956 in its income tax returns, which were not challenged by respondent. After Egypt seized the Suez Canal in 1956, ship prices rose and Fribourg sold the ship, which it delivered to the purchaser on December 23, 1957, for $ 695,500. Prior to the sale Fribourg adopted a plan of complete liquidation pursuant to § 337 of the Internal Revenue Code of 1954, which it carried out within 12 months and thus incurred no tax liability on the gain from the ship's sale. By December 1957 the shipping shortage had abated and Liberty ships were being scrapped for the predicted salvage value. Fribourg’s 1957 income tax return showed a deduction from gross income of depreciation for 357 1/2 days of 1957, and computation of capital gain by subtraction of the adjusted basis, including 1957 depreciation, from the sales price of the ship. The Commissioner of Internal Revenue (CIR) did not question the original ruling as to useful life and salvage value of the vessel, but disallowed depreciation for 1957. The CIR argued that depreciation deductions are meant to give deductions equal to the taxpayer's "actual net cost" of the asset, and since the sales price exceeded the adjusted basis at the start of the year the ship's use during 1957 "cost" Fribourg "nothing." The CIR’s position was sustained by the Tax Court and the Court of Appeals.
Does the sale of a depreciable asset for an amount in excess of its adjusted basis at the beginning of the year of sale bar deduction of depreciation for that year?
Tax law has long recognized the accounting concept that depreciation is a process of estimated allocation which does not take account of fluctuations in valuation through market appreciation. It is, of course, undisputed that the Commissioner may require redetermination of useful life or salvage value when it becomes apparent that either of these factors has been miscalculated. The fact of sale of an asset at an amount greater than its depreciated basis may be evidence of such a miscalculation. But the fact alone of sale above adjusted basis does not establish an error in allocation. That is certainly true when, as here, the profit on sale resulted from an unexpected and short-lived, but spectacular, change in the world market. In Massey and Hertz we held that when a taxpayer, at the time he acquires an asset, reasonably expects he will use it for less than its full physical or economic life, he must, for purposes of computing depreciation, employ a useful life based on the period of expected use. We recognized in those cases that depreciation is based on estimates as to useful life and salvage value. Since the original estimates here were admittedly reasonable and proved to be accurate, there is no ground for disallowance of depreciation.