## Facts

- Mt. Morris Drive-In Theatre Co. bought 13 acres near Flint, Michigan in 1947 to build a drive-in movie theater.
- In developing the site, the company removed vegetation, changed the grade, and constructed gravel ramps and aisles.
- These construction changes caused excessive rainwater to drain onto adjacent land owned by David and Mary Nickola, damaging crops and roadways.
- After complaints, the Nickolas sued in 1948 seeking damages and an injunction requiring correction of the drainage condition.
- The parties settled in July 1950; the company agreed to install an agreed drainage system.
- The drainage system was completed in October 1950 at a cost of $8,224.
- The company deducted the $8,224 on its 1950 return as an ordinary and necessary business expense (litigation settlement) or, alternatively, as a loss.
- The Commissioner disallowed the deduction, treating the cost as a capital expenditure; the Tax Court sustained the Commissioner, and the Sixth Circuit affirmed.

## Issues

1. Whether the $8,224 paid to construct a drainage system to resolve runoff caused by theater construction was deductible as an ordinary and necessary business expense.
2. Whether the $8,224 was deductible as a loss in the year paid.
3. Whether the $8,224 instead was a capital expenditure required to be capitalized as part of the cost of the theater property.

## Decision

- The courts held the $8,224 drainage-system cost was a capital expenditure and not currently deductible.
- The drainage work was treated as a cost of properly completing and improving the theater property, not a recurring operational expense.
- The litigation settlement did not change the character of the expenditure because the liability arose from the construction activity and required a permanent corrective improvement.
- The expenditure was not a deductible loss because it was not triggered by a sudden, unforeseeable, or catastrophic event.

## Legal Principles

- Expenditures that permanently correct a condition created by construction and relate to what should have been included in the original capital project must be capitalized.
- The tax characterization of a payment is determined by the nature and origin of the obligation giving rise to the payment, not merely by the fact it was paid to settle litigation.
- A payment is not treated as a deductible loss where the expense reflects a foreseeable consequence of the taxpayer’s own development decisions rather than a casualty-type event.
- Timing (incurring the cost in a later year) does not convert a completion or improvement cost of a capital asset into a current deduction.

## Conclusion

The drainage-system cost, though paid to settle neighboring landowners’ litigation, was a non-deductible capital outlay because it permanently remedied a foreseeable construction-related defect and represented part of the cost of completing and improving the theater property.


Mt. Morris Drive-In Theatre Co. v. Commissioner, 238 F.2d 85 (6th Cir. 1956)