                      T.C. Memo. 2002-231



                 UNITED STATES TAX COURT



MICHAEL A. MCGRATH AND FRANCES Y. MCGRATH, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



 Docket No. 126-99.                Filed September 18, 2002.



      In 1995, Ps leased (as lessee) retail space in a
 shopping center to operate a bakery. When Ps entered into
 the lease, the leased space was nothing more than a dirt
 floor enclosed by temporary walls; the leased space was not
 serviced by any utilities. The lease obligated Ps to make
 substantial permanent improvements to the leased space at
 their own expense. Other than trade fixtures, the permanent
 improvements Ps made to the leased space became the property
 of the lessor upon installation.

       Ps did not make a sec. 179, I.R.C. 1986, election on
 their timely filed tax return for either 1995 or 1996. Ps
 did not file a timely amended tax return for either 1995 or
 1996.

      1. Held: Ps’ expenditures for the permanent
 improvements they made to the leased space constitute
 capital expenditures that are not currently deductible.
 Sec. 263, I.R.C. 1986. Ps’ cost recovery for the years in
                                 - 2 -

     issue is by way of depreciation, as allowed in the notice of
     deficiency.

           2. Held, further, Ps may not now elect to expense any
     sec. 179 property they placed in service in either 1995 or
     1996, because the period for making valid sec. 179 elections
     for the years in issue has expired. Sec. 179(c), I.R.C.
     1986.



     Michael A. McGrath and Frances Y. McGrath, pro sese.

     Emile L. Hebert III, for respondent.




                MEMORANDUM FINDINGS OF FACT AND OPINION

     CHABOT, Judge: Respondent determined deficiencies in

individual income tax against petitioners as follows:

                Year                          Deficiency
                 1995                           $28,590
                 1996                             3,026

     After concessions by both sides, the issues for decision1

are as follows:

          (1)    Whether petitioners may deduct under section 1622

     the costs they incurred in 1995 in making permanent




     1
        The following adjustments are computational, i.e., they
depend on resolution of the issues for decision: (1) Earned
income credit for 1996, and (2) itemized deductions for 1995 and
1996.
     2
        Unless indicated otherwise, all section and chapter
references are to sections and chapters of the Internal Revenue
Code of 1986 as in effect for the years in issue.
                               - 3 -

     improvements to property they leased (as “tenant”) to

     operate a bakery.

          (2)   Whether petitioners may elect to expense section

     179 property they placed in service in 1995 and 1996.

                         FINDINGS OF FACT

     Some of the facts have been stipulated; the stipulations and

the stipulated exhibits are incorporated herein by this

reference.

     Petitioners, Michael A. McGrath (hereinafter sometimes

referred to as Michael) and Frances Y. McGrath, resided in

Slidell, Louisiana, when they filed the petition in the instant

case.

     In 1995 petitioners executed three agreements relevant to

the instant case: (1) A lease (hereinafter sometimes referred to

as the Lease), (2) a T.J. Cinnamons Unit Franchise Agreement

(hereinafter sometimes referred to as the Franchise Agreement),

and (3) a Standard Form of Agreement Between Owner and Contractor

(hereinafter sometimes referred to as the Construction

Contract).3




     3
        So stipulated. Both the Franchise Agreement and the
Construction Contract show only Michael’s name and signature,
while the Lease shows the names and signatures of both
petitioners. The Schedule C, Profit or Loss From Business, on
petitioners’ 1995 tax return shows only Michael as proprietor,
while the 1996 tax return Schedule C shows both petitioners as
proprietor. The parties do not appear to believe that any issue
in the instant case is affected by whether the business was owned
solely by Michael or was owned jointly by both petitioners.
                                - 4 -

A.   The Lease

      On or about August 21, 1995, petitioners, as “tenant”,

entered into the Lease with TUP 130 Company Limited Partnership,

a Kentucky limited partnership (hereinafter sometimes referred to

as TUP 130), as “landlord”.    Under the Lease, TUP 130 agreed to

lease to petitioners space number 115 at the Mall at Barnes

Crossing shopping center in Tupelo, Mississippi, for a 5-year

term.   (This space is hereinafter sometimes referred to as the

Store Space.)    Petitioners leased the Store Space in order to

operate a T.J. Cinnamons franchised bakery, hereinafter sometimes

referred to as the Bakery.    The Bakery was to engage in the

retail sale of cinnamon rolls, gourmet coffee, muffins, bagels,

coffee cakes, and other related items incidental to a typical

T.J. Cinnamons menu.

      When petitioners entered into the Lease, the Store Space had

a dirt floor, no utilities, and no permanent walls.    The Lease

obligated petitioners to complete construction of the Store Space

at their own expense before they could occupy the space for the

Bakery.   The construction that petitioners were obligated to

complete was as follows: (1) Excavation of the Store Space; (2)

installation of a concrete slab floor and a floor covering

therefor; (3) installation of a ceiling system; (4) installation

of a return air plenum; (5) installation of partition walls; (6)

installation of doors, frames, and hardware therefor; (7)
                              - 5 -

installation of a storefront, entrance doors, entrance grille

bulkhead, entrance vestibule finish, show window platforms, show

window, and vestibule ceilings, show window background and sign

background; (8) installation of a fire sprinkler system; (9)

installation of all electrical conduits and equipment required

for a complete electrical installation; (10) installation of an

extension of gas service from a metering point to the Store

Space; (11) installation of ventilation or air purification

systems; (12) installation of toilet room fixtures; (13)

installation of all store fixtures; (14) installation of all

required safety and emergency equipment; (15) installation of all

required equipment for aiding the handicapped; (16) installation

of insulation and interior finish on the exterior walls of the

Store Space; (17) painting; and (18) wallpapering; the foregoing

are hereinafter sometimes collectively referred to as the

Improvements.

     Under the Lease, petitioners were to remain the owners of

(1) the trade fixtures they installed and (2) their merchandise;

however,

     The storefront, partitions, heating and cooling equipment
     and all other permanent installations attached to the
     * * * [Store Space] shall become a part of the real estate,
     shall belong to * * * [TUP 130] at the moment of
     installation and shall be unencumbered by * * *
     [petitioners].

     The term of the Lease was 5 years.   The fixed minimum rent

for the store space was $26,312 per year, payable in equal
                               - 6 -

installments and due on the first day of each month at the rate

of $2,192.67 per month.   Petitioners were not obligated to pay

the fixed minimum rent until 6 months after the day the Bakery

was first opened for business to the public.

     In addition to their obligation to pay the fixed minimum

rent, petitioners were also obligated to pay to TUP 130 various

other charges such as real estate taxes (estimated as $276.47 per

month), common area (estimated as $476.67 per month), insurance

(estimated as $10.49 per month), water and sewer service ($16.80

per month), and merchants’ association or marketing fund charges

($166.83 per month).   These other charges totaled $947.26 per

month.   Other than the water and sewer charge, petitioners’

obligation to pay these charges did not begin until 6 months

after the day the Bakery was first opened for business to the

public; petitioners’ obligation to pay water and sewer charges

did not include the 6-month delay language.

     As a result, the Lease’s 6-month delay language applied to a

total of $3,123.13 per month ($2,192.67 fixed minimum, plus

$947.26 other charges, less $16.80 water and sewer services), or

$18,738.78 for the 6 months.

     The Lease further obligated petitioners to maintain

throughout the term thereof and at their own expense, (1) public

liability insurance covering the store space and their use

thereof, and (2) “fire and extended coverage” insurance.
                                 - 7 -

Petitioners, TUP 130, and TUP 130's management company were to be

insureds under the public liability policy.   Petitioners were

also responsible for paying all municipal, county, State, and

Federal taxes assessed against their leasehold interest,

fixtures, furnishings, equipment, stock-in-trade, and other

personal property of any kind owned, installed, and existing in

the Store Space.

B.   The Franchise Agreement

      On August 23, 1995, petitioners and T.J. Cinnamons, Inc.,

executed the Franchise Agreement, authorizing petitioners to

operate a T.J. Cinnamons franchised bakery at the Store Space.

The initial term of the Franchise Agreement was 10 years.

Pursuant to the Franchise Agreement, petitioners paid to T.J.

Cinnamons, Inc., an initial franchise fee of $17,500.

(Petitioners concede that the $17,500 franchise fee must be

capitalized and amortized over a period of 15 years, as in the

notice of deficiency.)

C.   The Construction Contract

      As of November 1, 1995, petitioners and Regional Development

& Building Inc., executed the Construction Contract for the

Improvements.   Petitioners performed the construction required

under the Lease during the period from September through December

1995.
                                 - 8 -

      Petitioners incurred and paid expenditures for work on and

for the Store Space during 1995 as shown in table 1.

                               Table 1

                         Payee                            Amount
(1)   Gaffney Cabinets                                    $1,800
(2)   Taylor Cabinet Shop (cabinet with counter)             7,267
(3)   Sign Craft                                              428
(4)   Tull Brothers                                           240
(5)   Mid-South Signs                                        3,935
(6)   Chroma Copy                                            1,719
(7)   Duncan Signs                                            483
(8)   Taylor Cabinet Shop (door frames & baseboards)       13,500
(9)   Corinth Carpets                                        3,509
(10) Universal Manufacturing                                 1,150
(11) Regional                                              90,630
(12) Sherwin Williams                                         406
(13) Joey Wilhite                                            2,000
   Total                                                  127,067

      Items 1 through 7 in table 1, supra (totaling $15,872), were

paid for furniture, fixtures, and equipment for the Bakery, and

not for leasehold improvements.    (The parties agree that these

expenditures must be capitalized and depreciated under the

modified accelerated cost recovery system (hereinafter sometimes
                              - 9 -

referred to as MACRS) as 7-year property, using the 200-percent

declining balance method and the midquarter convention.)4

     The remaining $111,195 ($127,067 less $15,872) of

expenditures that petitioners paid for construction work on the

Store Space was for the (1) excavation of the site, (2)

installation of a concrete floor slab and floor coverings

therefor, (3) installation of electrical service and fixtures,

(4) installation of plumbing service and fixtures, (5)

construction, painting, and wallpapering of permanent walls and

partitions, and (6) installation of windows and doors.    All of

the $111,195 of expenditures that petitioners paid were for the

performance of the Improvements as set forth in the Lease.

     Of the remaining $111,195, $18,739 were payments made in

lieu of the monthly payments due under the Lease for the 6-month

period December 1995 through May 1996.   See supra A. Lease,

listing of 6-month delay items.   The parties disagree as to the


     4
        In 1995, petitioners bought $42,855 of equipment for the
Bakery, in addition to the $15,872 discussed in the text. Some
part of this $42,855 is in addition to the amounts dealt with in
petitioners’ 1995 tax return and respondent’s notice of
deficiency.

     As we interpret the parties’ stipulation, any part of the
$42,855 that petitioners are not allowed to expense under sec.
179(a) (subject to the limitations of sec. 179(b)), discussed
infra under II. Section 179 Election, shall be capitalized and
depreciated under MACRS as 7-year property, using the 200-percent
declining balance method and the midquarter convention.

     As a result, a Rule 155 computation will be required
regardless of how we rule on the issues for decision.

     Unless indicated otherwise, all Rule references are to the
Tax Court Rules of Practice and Procedure.
                               - 10 -

tax treatment of the remaining cost of the Improvements, $92,456

($127,067 less $15,872 (furniture, fixtures, and equipment) and

less $18,739 (payments made in lieu of rent)).

     Also in 1995, petitioners (1) bought cash registers for the

Bakery for $3,475, and (2) placed in service a computer (75-

percent business usage) in which petitioners had a basis of

$2,865.    Petitioners classified the cash registers and the

computer as 5-year property on their 1995 tax return and claimed

depreciation deductions in respect thereof for 1995 and 1996

using the 200-percent declining balance method and the midquarter

convention over a recovery period of 5 years.    Respondent does

not dispute either petitioners’ classification of, or the amount

of, claimed depreciation deductions, for either the cash

registers or the computer.

     In 1996, petitioners bought $5,059 of equipment for the

Bakery.5


     5
        So stipulated. As we interpret the parties’ stipulation,
any part of the $5,059 that petitioners are not allowed to
expense under sec. 179(a) (subject to the limitations of sec.
179(b)), discussed infra under II. Section 179 Election, shall be
capitalized and depreciated under MACRS as 7-year property, using
the 200-percent declining balance method and the midquarter
convention.

     However, in the notice of deficiency, respondent determined
that on Dec. 30, 1996, petitioners placed in service equipment
                                                   (continued...)
                              - 11 -

      Petitioners opened the Bakery in December 1995 and operated

it until some time in February 1997.   On or about April 7, 1997,

petitioners sold the Bakery including the furniture, fixtures,

equipment, inventory, and supplies therefor.6

D.   1995 Tax Return

      Petitioners timely filed their joint 1995 income tax return.

On this tax return they claimed a refund in the amount of

$25,658.   They did not elect on this tax return to treat any

property they placed in service in 1995 as section 179 property,

because they believed such an election would not affect the

amount of the 1995 tax refund to which they were entitled.

E.   1996 Tax Return

      Petitioners timely filed their joint 1996 income tax return.

On this tax return they claimed a refund in the amount of $3,571,

of which $3,026 was earned income credit.   They did not elect on


      5
      (...continued)
with a cost or other basis in the amount of $5,267. On opening
brief, respondent notes this discrepancy and concludes that
petitioners have conceded the $208 differential, but apparently
only if petitioners lose on the sec. 179 issue. On answering
brief, petitioners state that “In the respondent’s opening brief,
the respondent agrees that the petitioners purchased * * * $5,267
of Section 179 equipment in 1996.”

     The parties are to resolve this matter in the proceedings
under Rule 155.

      6
        The record does not show whether petitioners claimed as
basis in determining their gain or loss on the 1997 sale any
amount that they deducted on their 1995 or 1996 tax returns. The
record also does not show what became of the Lease.
                                 - 12 -

this tax return to treat any property they placed in service in

1996 as section 179 property.

           _____________________________________

     No more than $18,739 of petitioner’s capital expenditures

for the Improvements constitutes a substitute for rent.

                                OPINION

                I.   Deducting the Cost of Improvements

     Petitioners contend that, under section 162(a)(3), they may

deduct the cost of the Improvements because they (1) were

required to pay for and make the Improvements, and (2) did not

acquire either title to, or an equity interest in, the

Improvements.    Petitioners’ contention closely tracks the

statutory language.     Petitioners’ contention also appears to be

based on assumed economic realities; i.e., that the Improvements

that the lessee was required to make would increase the Store

Space’s value, that this expected value increase implicitly

reduced the amount of the rent obligations, and that, to the

extent of the reduction, the cost of the Improvements is

deductible rent expense under section 162(a)(3).     Respondent

contends that petitioners must capitalize and depreciate the cost

of the Improvements because they are nondeductible capital

expenditures under section 263.     We agree with respondent’s

conclusion and much of respondent’s analysis.
                                - 13 -

     In general, section 162(a)7 authorizes current deductions

for ordinary and necessary expenses of a trade or business.

However, sections 1618 and 2619 have the effect of subordinating

provisions such as section 162(a) to provisions such as section

263(a)(1),10 thereby disallowing the current deductions of


     7
          Sec. 162(a) provides, in pertinent part, as follows:

     SEC. 162.    TRADE OR BUSINESS EXPENSES.

          (a) In General.--There shall be allowed as a deduction
     all the ordinary and necessary expenses paid or incurred
     during the taxable year in carrying on any trade or
     business, including--

                 (1) a reasonable allowance for salaries or other
            compensation for personal services actually rendered;

                 (2) traveling expenses * * * while away from home
            in the pursuit of a trade or business; and

                 (3) rentals or other payments required to be made
            as a condition to the continued use or possession, for
            purposes of the trade or business, of property to which
            the taxpayer has not taken or is not taking title or in
            which he has no equity.
     8
          SEC. 161.   ALLOWANCE OF DEDUCTIONS.

          In computing taxable income under section 63, there
     shall be allowed as deductions the items specified in this
     part, subject to the exceptions provided in part IX (sec.
     261 and following, relating to items not deductible).
     9
          SEC. 261.   GENERAL RULE FOR DISALLOWANCE OF DEDUCTIONS.

           In computing taxable income no deduction shall in any
     case be allowed in respect of the items specified in this
     part.
     10
          Sec. 263(a)(1) provides, in pertinent part, as follows:

                                                      (continued...)
                              - 14 -

capital expenditures that otherwise would have been currently

deductible trade or business expenses.   See, e.g., Commissioner

v. Idaho Power Co., 418 U.S. 1 (1974).   Unless some other special

rules apply (see, e.g., the subparagraphs of sec. 263(a)(1)), the

taxpayer’s deductions for capital expenditures (if allowable at

all) generally come by way of amortization or depreciation; i.e.,

the capital expenditure is deductible over a period of time.

See, e.g., secs. 167, 168, and 169.

     Ordinarily, depreciation or amortization is thought of as a

deduction available to an owner of an asset with respect to that

owner’s basis in the asset.   However, a lack of ownership is not

determinative.   We described the analysis in Currier v.

Commissioner, 51 T.C. 488, 492 (1968), as follows:

          The allowance for depreciation is designed to permit
     the person who invests in a wasting asset a means of
     recouping, tax free, his investment in that property. To
     have the benefit of this deduction the taxpayer has the
     burden of proving that he has a depreciable interest in the
     property as to which he seeks a depreciation allowance. See
     Barnes v. United States, 222 F.Supp. 960 (D. Mass. 1963),
     affirmed sub nom. Buzzell v. United States, 326 F.2d 825
     (C.A. 1, 1964), and the cases cited therein.

          Where the owner of real property enters into a long-
     term lease, under the terms of which the lessee is to


     10
      (...continued)
     SEC. 263. CAPITAL EXPENDITURES.

          (a) General Rule.--No deduction shall be allowed for--

               (1) Any amount paid out for new buildings or for
          permanent improvements or betterments made to increase
          the value of any property or estate. * * *
                              - 15 -

     construct at his own cost a building on the property, the
     lessee, not the lessor, is entitled to a deduction for the
     depreciation of the building. See Reisinger v.
     Commissioner, 144 F.2d 475 (C.A. 2, 1944), affirming a
     Memorandum Opinion of this Court; Friend v. Commissioner,
     119 F.2d 969 (C.A. 7, 1941), affirming a Memorandum Opinion
     of this Court; Commissioner v. Pearson, 188 F.2d 72 (C.A. 5,
     1951), reversing and remanding on other grounds 13 T.C. 851;
     First Nat. Bank of Kansas City v. Nee, 190 F.2d 61 (C.A. 8,
     1951); Goelet v. United States, 266 F.2d 881 (C.A. 2, 1959);
     Schubert v. Commissioner, 286 F.2d 573 (C.A. 4, 1961),
     affirming 33 T.C. 1048.

          The lessee, who is obligated to make improvements to
     the realty, is entitled to recover his capital outlay by
     deductions for depreciation. His right to the deductions is
     not altered by the fact that, under doctrines of local law,
     legal title to the improvements may reside in the lessor.
     In such situations it is the lessee, not the lessor, who
     suffers the economic loss as the property deteriorates, and
     who is entitled to the statutory allowance. Helvering v.
     Lazarus & Co., 308 U.S. 252 (1939); First Nat. Bank of
     Kansas City v. Nee, supra. The party claiming depreciation
     must have some investment in the wasting asset. Detroit
     Edison Co. v. Commissioner, 319 U.S. 98 (1943).

To the same effect, see sec. 1.162-11(b), Income Tax Regs.11



     11

     Sec. 1.162-11.   Rentals.--

               *      *   *    *   *    *    *

          (b) Improvements by lessee on lessor’s property.--(1)
     The cost to a lessee of erecting buildings or making
     permanent improvements on property of which he is the lessee
     is a capital investment, and is not deductible as a business
     expense. * * * [Emphasis added.]

     The balance of this provision has been superseded by the
enactment of sec. 168, in particular, sec. 168(i)(8)(A).
However, the statutory language does not affect the continued
validity of that part of the regulation set forth in this note.
For an example of this continued validity, see Nelson v.
Commissioner, T.C. Memo. 2000-212.
                               - 16 -

     Applying the foregoing to the instant case, we conclude that

(1) petitioners’ expenditures dealt with in this issue are

capital expenditures and (2) (unless some other provision or rule

leads to a different result) petitioners’ deductions on account

of these expenditures are determined under sections 167 and 168,

and not under section 162(a)(3).

     There is a nonstatutory exception to the foregoing that

applies to the instant case.   Where a lessee makes a capital

expenditure in lieu of some rent, then the expenditure will be

treated as rent and not as a capital expenditure by the lessee.

This exception’s rationale is explained, and its application is

illustrated, in Your Health Club, Inc. v. Commissioner, 4 T.C.

385, 389-390 (1944), as follows:

          The second question relates to the deductibility of
     rent in the amount of $4,250 in the fiscal year ended March
     31, 1940. The facts show that petitioner had obligated
     itself to pay rental for that year in the amount of $4,250,
     but that a clause in the lease provided that petitioner
     might make certain improvements to the premises, the cost of
     which to the extent of $1,500 might be applied to the
     contractual rental. Petitioner expended $1,374.96 in making
     such improvements, applying this amount as a credit against
     the total rent due, and paid the lessor the difference,
     $2,875.04. The Commissioner determined that only the latter
     amount was deductible as rent and disallowed the deduction
     of the amount of $1,374.96, adding it to capital and making
     proper adjustment for amortization. Petitioner contends
     that the disallowed item was properly deductible as rent.

          Petitioner does not question the general rule that the
     cost borne by a lessee in making permanent improvements upon
     leased property is a capital expenditure, but contends that
     the outlay in this instance was no more than an indirect
     payment of a part of the stipulated rental, inasmuch as it
     was agreed that the cost of the improvements should be
                             - 17 -

     applied as a credit against the rent for the current year.
     This appears to us to be a correct interpretation of the
     facts. Actually, petitioner paid nothing for the
     improvements; the cost thereof was borne by the lessor
     through the credit applied against the agreed rental.
     Consequently, petitioner has no capital investment to
     amortize or depreciate. The transaction is no different
     than if the lessor had paid directly for the improvements
     and the lessee directly paid the full agreed rent. On this
     issue, therefore, we hold that the determination of the
     Commissioner is erroneous.

     In order for this exception to apply, the lessor and the

lessee must intend that some or all of the lessee’s capital

expenditures are rent, and this intent must be plainly disclosed.

In Cunningham v. Commissioner, 28 T.C. 670, 680 (1957), affd. 258

F.2d 231 (9th Cir. 1958), we described the situation as follows:

          In M.E. Blatt Co. v. United States, supra [305 U.S.
     267, 277 (1938)], the Supreme Court has clearly stated that
     whether the value of such improvements constitutes rent
     depends upon the intention of the parties, and that even
     when the improvements are required by the terms of the lease
     this value will not be deemed rent unless the intention that
     it shall be such is plainly disclosed. Such intent in our
     opinion is to be derived not only from the terms of the
     lease but from the surrounding circumstances. This is
     recognized by the respondent in his published ruling I.T.
     4009, 1950-1 C.B. 13.
                                - 18 -

To the same effect, see sec. 1.61-8(c), Income Tax Regs;12 see

also sec. 109.

     The parties have stipulated that this exception applies to

allow petitioners rent expense deductions of $3,123 for 1995 and

$15,616 for 1996, for otherwise capital expenditures.       This is

founded on the parties’ stipulation that “$18,739.00 of the

expenditures * * * were in lieu of rental payments * * * to be

made by petitioners over the six (6) month period of December,

1995 through May, 1996, inclusive.”       This latter part of the

stipulation is, in turn, founded on the provisions of the Lease

with regard to petitioners’ rent obligations and construction

obligations, as described supra in the Findings of Fact.

     We now consider whether any amount in addition to the

stipulated $18,739 was intended to be payments made in lieu of

rent.


     12
        Sec. 1.61-8(c), Income Tax Regs., provides, in pertinent
part, as follows:

     Sec. 1.61-8     Rents and Royalties.–-

                 *     *    *    *    *       *   *

          (c) Expenditures by lessee. As a general rule, if a
     lessee pays any of the expenses of his lessor such payments
     are additional rental income of the lessor. If a lessee
     places improvements on real estate which constitute, in
     whole or in part, a substitute for rent, such improvements
     constitute rental income to the lessor. Whether or not
     improvements made by a lessee result in rental income to the
     lessor in a particular case depends upon the intention of
     the parties, which may be indicated either by the terms of
     the lease or by the surrounding circumstances. * * *
                              - 19 -

     The Lease does not show that petitioners and TUP 130

intended to treat the entire cost of the Improvements as a rent

substitute.   The Lease contains provisions which give petitioners

a rent holiday for the first 6 months after the day the Bakery

was first opened for business to the public; these provisions

underlie the parties’ stipulation as to the $18,739.    Beyond

these provisions, however, the Lease is silent as to whether

petitioners and TUP 130 intended to treat the remaining cost of

the Improvements as a rent substitute.

     The surrounding circumstances also do not show that

petitioners and TUP 130 intended to treat the cost of the

Improvements as a rent substitute beyond the 6-month rent

holiday.   Rather, petitioners’ 1995 tax return, certain of

petitioners’ proposed findings of fact and statements on brief,

and a portion of Michael’s testimony belie petitioners’

contention that they should be allowed to deduct the cost of the

Improvements under section 162(a)(3) as rent expense.

     Petitioners did not report any rent or lease expenses on the

Schedule C attached to their 1995 tax return.   Petitioners

claimed a deduction of $103,388 for “repairs and maintenance” on

the Schedule C attached to the 1995 tax return; the $103,388
                             - 20 -

deduction represented what petitioners thought was the cost of

the improvements.13

     On brief, petitioners proposed the following findings of

fact:

     8. The petitioners were granted six months rent-free use of
     the retail space at The Mall at Barnes Crossing as a
     condition of Articles IV and V of their lease agreement in
     consideration for costs incurred by the petitioners in the
     build-out of the retail space. * * *

     9. The petitioners performed $127,067 of work on the
     retail space at The Mall at Barnes Crossing, and
     $18,739 of those expenditures were in lieu of rental
     payments to be made equally over a six month period by
     the petitioners. Those rental payments were for the
     period of December 1995 through May 1996.

     On opening brief, petitioners state, in pertinent part, as

follows:

           The petitioners received, from their lessor,
     credit equal to 6 months rent as consideration for the
     permanent improvements made to the lessor’s real
     property. Upon the completion of the first 6 months of
     occupancy, the petitioners commenced paying full rent,
     with no additional consideration for the improvements
     made.

     On answering brief, petitioners state, in pertinent part, as

follows:

          The petitioners received, from their lessor,
     credit equal to 6 months rent as consideration for the
     permanent improvements made to the lessor’s real
     property. Upon the completion of the first 6 months of
     occupancy, the petitioners commenced paying full rent
     on the improved property, as if the improvements had
     been paid for by the lessor, with no additional


     13
        The parties agree, and we have found, that the cost of
the Improvements was $127,067, not $103,388.
                                - 21 -

     consideration for the improvements made. At that point
     in time, with the exception of the 6 months rent
     credit, the lessor realized the full benefit of the
     improvements, while the petitioners realized none.

     After Michael testified that he could not “get a competitive

bid” for the Improvements because of the lack of a local

contractor who could do the work, he testified:

          And it was important for us in the business to be
     established before the Christmas rush, so we agreed to
     go ahead and pay the amount over and above, knowing
     that we were only going to get consideration for the
     total of the $18,000 in rent credit.

          The additional amount, the additional $92,000, we
     just assumed that that was cost of obtaining the site
     and possessing the retail space.

     The above-quoted portions of petitioners’ opening and

answering briefs and Michael’s testimony show that petitioners

did not intend to treat the entire cost of the Improvements as a

rent substitute.   The only consideration for the Improvements, in

petitioners’ own words, was a “credit equal to 6 months rent”.

Moreover, petitioners’ statement on brief that they “commenced

paying full rent, with no additional consideration for the

improvements made” (emphasis added) after the 6-month rent

holiday ended undercuts any contention that the cost of the

Improvements reduced their monthly rent obligations under the

Lease after the rent holiday.    Based on the foregoing, we

conclude that petitioners did not intend to treat as a substitute

for rent the cost of the Improvements beyond the $18,739 as

stipulated.
                              - 22 -

     The only evidence regarding TUP 130's intention is the

Lease, which, as set forth above, manifests an intent consistent

with petitioners’; namely, that only $18,739 of the cost of the

Improvements is a rent substitute.

     On the basis of the preponderance of the evidence, we

conclude that the Improvements are a rent substitute to the

extent of $18,739 only.

     Section 162(a)(3) addresses more than just “rentals”; it

also addresses “other payments”.   In light of Michael’s testimony

and petitioners’ above-quoted statements on brief, it may be that

petitioners implicitly contend that the cost of the Improvements

is deductible under section 162(a)(3) as “other payments”.      We

previously concluded that the Improvements are capital

expenditures.   Capital expenditures made for betterments and

additions to leased premises do not fall within the phrase “other

payments”.   Duffy v. Central R.R., 268 U.S. 55, 64 (1925).14


     14
        The statutory language being construed in Duffy v.
Central R.R., 268 U.S. 55, 61 (1925), was sec. 12(a) (First) of
the Revenue Act of 1916, ch. 463, 39 Stat.767, which states, in
pertinent part, as follows:

          First. All the ordinary and necessary expenses paid
     within the year in the maintenance and operation of its
     business and properties, including rentals or other payments
     required to be made as a condition to the continued use or
     possession of property to which the corporation has not
     taken or is not taking title, or in which it has no equity.

The Supreme Court analyzed the situation as follows (268 U.S. at
63-64):
                                                   (continued...)
                               - 23 -

     Accordingly, the cost of the Improvements, to the extent it

is not a rent substitute, is not deductible as “other payments”.

Petitioners’ cost recovery is by way of depreciation, as allowed

in the notice of deficiency.

     In light of the foregoing, it is evident that petitioners

must capitalize the cost of the Improvements under section 263

and depreciate them in accordance with sections 167 and 168 even

though (1) the Lease required petitioners to make the

Improvements at their own expense, and (2) petitioners did not

hold title to, or otherwise acquire an equity interest therein.

     Petitioners raise an additional contention to support their

claim that they may deduct the cost of the Improvements.   On

opening brief, petitioners state, in pertinent part, as follows:

          IRC § 110 (a) states: “Gross income of a lessee
     does not include any amount received in cash (or
     treated as a rent reduction) by a lessee from a lessor
     - (1) under a short-term lease of retail space, and (2)
     for the purpose of such lessee’s constructing or
     improving qualified long-term real property for use in
     such lessee’s trade or business at such retail space”.
     Clearly, it is the intent of the IRC to not include as


     14
      (...continued)
     Expenditures, therefore, like those here involved, made [by
     the lessee] for betterments and additions to leased
     premises, cannot be deducted under the term “rentals”, in
     the absence of circumstances fairly importing an exceptional
     meaning; and these we do not find in respect of the statute
     under review. Nor do such expenditures come within the
     phrase “or other payments”, which was evidently meant to
     bring in payments ejusdem generis with “rentals,” such as
     taxes, insurance, interest on mortgages, and the like,
     constituting liabilities of the lessor on account of the
     leased premises which the lessee has covenanted to pay.
                                   - 24 -

        income any credit a lessee receives from his lessor for
        permanent improvements to the lessor’s property under a
        short-term lease. It follows that the income expended
        by a lessee for permanent improvements to the lessor’s
        property are deductible from the lessee’s gross income.

        Section 11015 does not apply in the instant case.    Firstly,

section 110 applies only to leases entered into after August 5,

1997.        Sec. 1213(e) of the Taxpayer Relief Act of 1997, Pub. L.

105-34, 111 Stat. 788, 1001.       The lease in the instant case was

entered into on or about August 21, 1995.        Thus, section 110 does

not apply in the instant case.

     Secondly, even if the Lease were subject to section 110, it

would not apply in the instant case given the nature of the

parties’ dispute.        Section 110 is an income exclusion provision.

Respondent is not charging petitioners with income on account of

any TUP 130 payment or the 6-month rent holiday that TUP 130


        15
              Sec. 110 provides, in pertinent part, as follows:

        SEC. 110.     QUALIFIED LESSEE CONSTRUCTION ALLOWANCES FOR
                       SHORT-TERM LEASES.

             (a) In General.–-Gross income of a lessee does not
        include any amount received in cash (or treated as a rent
        reduction) by a lessee from a lessor–-

                     (1) under a short-term lease of retail space, and

                     (2) for the purpose of such lessee’s constructing
                or improving qualified long-term real property for use
                in such lessee’s trade or business at such retail
                space,

        but only to the extent that such amount does not exceed the
        amount expended by the lessee for such construction or
        improvement.
                                 - 25 -

granted to petitioners in respect of the Improvements petitioners

made.

     Thirdly, we have already concluded that there was not any

rent reduction, apart from the 6-month rent holiday, and so the

requirement imposed by the opening flush language of section

110(a) has been satisfied only to that extent in the instant

case.

        Petitioners’ position is not advanced by their section 110

contention.

        We hold for respondent on this issue.

                       II.   Section 179 Election

        Petitioners contend that if we sustain respondent’s

determination on the section 162 issue, which we have, then they

will need to file amended tax returns.     Petitioners further

contend that if amended tax returns are required, then

petitioners must be allowed to make section 179 elections on such

tax returns.     Petitioners explain that they did not make section

179 elections on their tax returns for 1995 and 1996, because

“such election would have no effect on the amount of the refund

due the petitioners, assuming the construction costs deducted

were determined to be allowable.”     In contending that they should

now be allowed to make valid elections under section 179,
                               - 26 -

petitioners apparently now believe that section 179 elections

will reduce their tax liabilities for the years in issue.16

     Respondent contends that petitioners are not entitled to

make section 179 elections for 1995 and 1996 because they failed

to make section 179 elections on their tax returns for those

years.    We agree with respondent.




     16
        It has been suggested that the limitation imposed by
sec. 179(b)(3) might cause a sec. 179 election for either of the
years in issue to not affect the amount of any deficiency. In
the instant case, the Court has proceeded to decide the issue
presented because it is within our jurisdiction, and neither side
has formally contended that the sec. 179 election issue is moot.
In future cases, we may consider requiring the appropriate party
to demonstrate that the issue in dispute is not moot. See, e.g.,
Foster v. Commissioner, 80 T.C. 34, 236-237 (1983), affd. in part
and vacated in part 756 F.2d 1430 (9th Cir. 1985).
                                - 27 -

     Section 179(c)(1)17 delegates to the Secretary the authority

to prescribe by regulations the manner in which a taxpayer makes

a valid election under section 179.       Section 1.179-5, Income Tax

Regs., provides, in pertinent part, as follows:

     Sec. 1.179-5. Time and manner of making election.–-

          (a) Election. * * * The election under section 179
     and section 1.179-1 to claim a section 179 expense deduction
     for section 179 property shall be made on the taxpayer’s
     first income tax return for the taxable year to which the
     election applies (whether or not the return is timely) or on
     an amended return filed within the time prescribed by law
     (including extensions) for filing the return for such
     taxable year. * * *

     As applied to the instant case, section 1.179-5, Income Tax

Regs., precludes petitioners from making valid section 179



     17
          SEC. 179.   ELECTION TO EXPENSE CERTAIN DEPRECIABLE
                      BUSINESS ASSETS.

               *      *     *   *     *      *    *

          (c) Election.--

               (1) In general.--An election under this
          section for any taxable year shall–-

                    (A) specify the items of section 179
               property to which the election applies and
               the portion of the cost of each of such items
               which is to be taken into account under
               subsection (a), and

                    (B) be made on the taxpayer’s return of
               the tax imposed by this chapter [chapter 1
               relating to normal taxes and surtaxes] for
               the taxable year.

          Such election shall be made in such manner as the
          Secretary may by regulations prescribe.
                                 - 28 -

elections for 1995 and 1996.     Petitioners did not make a section

179 election on their tax return for either 1995 or 1996.

Both of those tax returns were timely filed.      The time for filing

amended tax returns has long since expired.      Under these

circumstances, it is too late to make a valid section 179

election.   LaPoint v. Commissioner, 94 T.C. 733, 735-736 (1990).

     Apparently at the heart of petitioners’ contention that

respondent’s audit has created the need to file amended returns

on which they should be allowed to make valid section 179

elections for 1995 and 1996 are beliefs that (1) respondent’s

adjustments created a situation when an election under section

179 would “change the bottom line”, and (2) preventing

petitioners from making the elections would not be equitable.

     We addressed a similar contention in Patton v. Commissioner,

116 T.C. 206, 211 (2001).     The taxpayer in Patton classified and

deducted the entire cost of certain items as “materials” or

“supplies”.   Id. at 207, 210.    The Commissioner determined, and

the taxpayer did not dispute, that the items the taxpayer

classified as “materials” or “supplies” were depreciable

property.   Id. at 210.    The Commissioner also determined that the

taxpayer failed to report $135,638 of gross receipts from the

taxpayer’s business.      Id. at 207.   If the taxpayer in Patton had

been permitted to amend the prior section 179 election to have

that election apply to the reclassified items, then the taxpayer
                              - 29 -

would have been able to offset part of the profit the

Commissioner determined for the taxpayer’s business.     Id. at 208.

We concluded in Patton that it was the taxpayer’s

misclassification of assets (and not the Commissioner’s

determinations) that created the need to “revoke (modify)” the

taxpayer’s section 179 election.   Id. at 210.   Consequently, we

held in Patton that it was not an abuse of discretion for the

Commissioner to refuse to allow the taxpayer to “revoke (modify)”

his section 179 election.   Id. at 211.

     Although petitioners are asking to make rather than “revoke

(modify)” a section 179 election, the reasons underlying our

decision in Patton apply also to the instant case.     Like the

taxpayer in Patton, petitioners’ perceived need to file section

179 elections stems from petitioners’ misunderstanding of the

proper tax treatment of particular items and the understatement

of the amounts they paid for section 179 property during the

years in issue.   We shall not carve out an exception to the

general requirements of section 1.179-5(a), Income Tax Regs., to

permit petitioners to make an otherwise untimely section 179

election.
                        - 30 -

We hold for respondent on this issue.

In order to take account of respondent’s concessions,



                                   Decision will entered

                              under Rule 155.
