## Facts

- Delano T. Starr operated a manufacturing business in Monrovia, California.
- Starr’s plant required a fire sprinkler system, which was installed by Automatic Sprinklers of the Pacific, Inc.
- The parties used a document labeled a “Lease Form of Contract” providing for five annual “rental” payments of $1,240 (total $6,200).
- The contract gave the lessee an option to renew for an additional five years at $32 per year if all terms were performed; if the lessee did not renew, the lessor had six months to remove the system.
- Comparable systems generally sold for about $4,960, and the installed system was custom-fitted with little salvage value if removed.
- The taxpayer deducted the $1,240 annual payments as rent under § 23(a)(1)(A) of the Internal Revenue Code of 1939.
- The Commissioner disallowed the rent deductions, treating the payments as capital expenditures for acquisition of a capital asset subject to depreciation.
- The Tax Court sustained the Commissioner’s characterization as capital expenditures rather than deductible rent.

## Issues

1. Whether the annual payments under the “lease” were deductible as “rentals or other payments” for property not owned by the taxpayer under § 23(a)(1)(A) of the 1939 Code.
2. Whether, based on the transaction’s economic substance, the arrangement should be treated as an installment purchase (capital expenditure) rather than a true lease.
3. If treated as a purchase, whether the Tax Court had to account consistently for related deductions, including interest and depreciation.

## Decision

- The Ninth Circuit agreed that the arrangement, despite lease terminology, was in substance akin to a sale, making the payments capital in nature rather than deductible rent.
- The court emphasized that federal tax characterization turns on practical realities, not solely the document’s label or the absence of an express title-transfer clause.
- The court remanded to the Tax Court to address the tax consequences consistent with sale treatment, including potential interest and depreciation items.

## Legal Principles

- Federal tax law applies substance-over-form analysis; the Commissioner and courts may recharacterize a transaction labeled a “lease” as a sale when economic facts show a financed acquisition.
- Indicators supporting sale treatment include payments comparable to or exceeding typical purchase price, a nominal renewal/retention feature, expected long-term use, and minimal salvage value making repossession unlikely.
- When a transaction is recast from lease to sale, the resulting tax treatment must be applied coherently, potentially allowing depreciation and requiring consideration of interest components rather than denying rent deductions alone.

## Conclusion

The Ninth Circuit treated the sprinkler-system “lease” as a sale in substance, so the payments were capital expenditures rather than deductible rent, and it remanded for the Tax Court to determine consistent tax consequences, including possible interest and depreciation deductions.


Estate of Starr v. Commissioner, 274 F.2d 294 (9th Cir. 1959)