## Facts

- Jack F. Kitchin and related corporations leased heavy construction machinery to customers under contracts styled as leases with purchase options.
- The machinery was typically used for short-term construction projects, generally no longer than 24 months.
- Contracts required periodic payments during the term and granted the customer an option to buy the equipment, often with the option price affected by prior payments.
- The taxpayers treated the payments as not currently taxable (or not currently classifiable) until the customer either exercised the purchase option or allowed it to lapse.
- The Commissioner determined the payments were taxable in the year received and asserted deficiencies.
- The Tax Court sustained current-year inclusion, treating the payments as rental income in the years paid.
- A Fourth Circuit panel initially allowed deferral, but the court granted rehearing en banc to reconsider the broader economic and administrative consequences of that rule.

## Issues

1. Whether payments made under short-term machinery lease-option contracts must be included in income in the year received, with their character determined based on the transaction’s substance at that time.
2. Whether taxpayers may hold such payments in abeyance and postpone income recognition until the option is exercised or lapses.

## Decision

- The en banc Fourth Circuit withdrew its prior panel decision and rejected deferral of tax treatment until option exercise or lapse.
- The court held that payments under the lease-option contracts must be treated as income in the years received, rather than suspended pending the customer’s later option decision.
- The court sustained the Commissioner’s position on timing, effectively restoring the Tax Court’s approach requiring current-year inclusion.

## Legal Principles

- Federal income taxation generally follows the annual accounting system; income recognition should not be postponed when present classification is feasible.
- Payments under lease-option arrangements must be characterized according to economic reality, not contract labels; substance controls over form.
- Deferral practices developed in some real-property option contexts do not automatically apply to equipment lease-option contracts where the transactions’ economics permit current treatment.
- Broad rules permitting deferral in lease-option transactions risk significant administrative burdens and distortion of annual income measurement.

## Conclusion

The Fourth Circuit held that payments received under short-term equipment lease-option contracts are includible in income when received and may not be deferred until the option is exercised or lapses; classification turns on the transaction’s substance under the annual accounting principle.


Kitchin v. Comm’r, 353 F.2d 13 (4th Cir. 1965) (en banc)