Massillon-Cleveland-Akron Sign Co. v. Commissioner

Massillon-Cleveland-Akron Sign Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Massillon-Cleveland-Akron Sign Co. v. Commissioner Docket Nos. 22161, 22162 United States Tax Court 15 T.C. 79; 1950 U.S. Tax Ct. LEXIS 124; July 31, 1950, Promulgated *124 Decisions will be entered under Rule 50. 1. Upon the facts, held, insurance proceeds received by petitioner in payment for buildings, machinery, and equipment destroyed by fire were expended in the acquisition of other property similar or related in service or use to the property destroyed within the meaning of section 112 (f) of the Internal Revenue Code. 2. Where petitioner received compensation for the loss of net profits because of the interruption by fire of its business activities, held, the insurance proceeds received in lieu of net profits are taxable as ordinary income under section 22 (a), and, therefore, are not excludible as capital gains from petitioner's excess profits tax net income under section 711 (a) (2) (D). Miller v. Hocking Glass Co., 80 Fed. (2d) 436, followed. L. Darrell Ake, Esq., I. B. Hart, Esq., and John E. O. Feller, Esq., for the petitioner. Lawrence R. Bloomenthal, Esq., for the respondent. Harron, Judge. HARRON *79 The Commissioner determined deficiencies in the petitioner's income tax and excess profits tax liabilities as follows: Income Excess profits Docket No. Year tax tax 22161 [1943] $ 4,890.32 $ 5,957.30 22162 [0] 16,179.95 Total $ 4,890.32 $ 22,137.25 The issues in Docket No. 22161 are: (1) Whether insurance proceeds received by petitioner during 1943 in payment for property *80 destroyed by fire were expended in the acquisition of other property similar or related in service or use to the property destroyed within the meaning of section 112 (f) of the Internal Revenue Code, and (2) whether insurance proceeds received by petitioner in payment for the loss of the use and occupancy of *126 buildings, machinery, and equipment are excludible as capital gains from petitioner's excess profits net income under section 711 (a) (2) (D), or whether the proceeds are taxable as ordinary income and therefore includible in petitioner's excess profits tax net income. The year 1944 is involved, in Docket No. 22162, because of the application to that year of a carryover from the year 1943 of an unused excess profits credit. The petitioner filed its returns with the collector for the eighteenth district of Ohio. The record in this proceeding consists of a stipulation of facts and various exhibits. FINDINGS OF FACT. The facts which have been stipulated are found as facts and are incorporated herein by this reference. Issue 1. Petitioner is a corporation, organized in 1904 under the laws of Ohio. It is engaged in the business of manufacturing paper, fiber, cloth, and metal advertising signs and posters. During the year 1943, petitioner insured its manufacturing plant, including buildings, machinery, and equipment under a single lump-sum payment policy covering all of its property. On June 18, 1943, buildings, machinery, and equipment owned by petitioner and used by it in the normal*127 course of carrying on its business were destroyed by fire. After negotiations with the insurance company, it was agreed that petitioner should receive under its policy $ 99,764.42, allocated on the basis of $ 60,711 for the buildings destroyed and $ 39,053.42 for the machinery and equipment destroyed. Payment to petitioner of the total proceeds of $ 99,764.42 was made by the insurance company on September 11, 1943, in the form of a single check for the replacement of its manufacturing plant, the buildings, machinery, and equipment. The petitioner placed the $ 99,764.42 in a special bank account entitled "The Massillon-Cleveland-Akron Sign Company, Building and Equipment Replacement Fund." On October 2, 1943, petitioner informed the Commissioner that because of shortages due to the war it would not be able immediately to complete the replacement of the buildings and equipment, and that, therefore, it was segregating the money received from the insurance company in a special fund to be used in such replacement in conformity with section 112 (f) of the Internal Revenue Code. Formal application to establish a replacement *81 fund was made by petitioner on December 20, 1943. This*128 application was approved on April 10, 1944, and a surety bond for the payment of any taxes which might be deferred was posted by petitioner. During the year 1943, petitioner expended $ 20,208.40 from the fund in the partial replacement of the machinery and equipment and the remaining $ 79,556.02 in the fund in the partial replacement of the buildings destroyed by the fire. In addition, petitioner expended $ 6,145.75 from its general funds in the replacement of the buildings. Subsequent to the year 1943, petitioner expended from its general funds $ 15,366.65 in the replacement of the buildings destroyed by fire, and $ 3,265.50 in the replacement of some of the machinery and equipment so destroyed. Some of the machinery and equipment destroyed by the fire was of a special design and nature and could not be immediately replaced, partly because petitioner was unable to secure the necessary priority ratings. The insurance proceeds received by petitioner during 1943 in payment for property destroyed by fire were expended in the acquisition of other property similar or related in service or use to the property destroyed. Issue 2. During the year 1943, petitioner contracted with the*129 Hartford Fire Insurance Company for use and occupancy insurance. The policy provided that the insurance company insured petitioner against all loss or damage to the extent of: $ 115,000 on the use and occupancy of the automatic sprinkler equipped buildings of their factory plant and/or machinery and/or equipment and/or raw stock contained therein, situated on land owned, leased and/or occupied by the insured on the northwest corner of Walnut Road, S. W. and First Street, S. W., Massillon, Ohio. * * * * The conditions of this contract are that if the buildings and structures described above and/or machinery and/or equipment and/or raw stock contained therein, be destroyed or damaged by fire occurring during the term of this policy so as to necessitate a total or partial suspension of business, this Company shall be liable under this policy for the actual loss sustained for not exceeding such length of time as would be required with the exercise of due diligence and dispatch, to rebuild, repair or replace such part of the property described as covered by this policy as has been destroyed or damaged commencing with the date of the fire and not limited by the date of expiration of *130 this policy, to-wit: I. Net profit which is thereby prevented from being earned and such charges and other expenses, including salaries of officers -- executives -- department managers -- employees under contract and other important employees, as must necessarily continue during a total or partial suspension of business, to the extent only that such charges and expenses would have been earned had no fire occurred.II. Expenses of necessary heat, light or power, the cost of which is prevented from being earned during the time of total or partial suspension of business caused by fire. III. Such expenses as are necessarily incurred for the purpose of reducing any loss under this policy, not exceeding, however, the amount by which the *82 loss covered is thereby reduced. However, if there is any use and occupancy insurance on said property covering any portion of the insured's ordinary payroll, the proportion of said expenses assumed by this company under this policy shall not exceed that proportion of said expenses that the amount of reduction of liability under this policy bears to the total reduction of liability under all policies. This policy does not cover any portion of the*131 insured's ordinary payroll. The amount of net profit and/or charges and expenses covered hereunder shall be determined, whether for the purpose of ascertaining the amount of loss sustained or for the application of the Contribution Clause, by giving due consideration to the experience of the business before the fire and the probable experience thereafter. * * * * As a direct result of the fire, petitioner was limited to partial operation of its plant from June 18, 1943, to approximately January 1, 1944. Pursuant to the terms of the insurance contract, the Hartford Fire Insurance Company paid $ 25,071.22 to petitioner for the loss sustained as the result of the partial suspension of petitioner's business. This loss was computed by estimating the net profit which petitioner would have been able to earn if there had been no fire, based on petitioner's actual sales, production, expenses, and other income for the five months preceding the fire. The $ 25,071.22 received by petitioner under a use and occupancy insurance contract to compensate it for the loss of net profits did not constitute the proceeds of an involuntary conversion. The payment so received was compensation for the loss*132 of net profits resulting from the interruption by fire of petitioner's business activities. OPINION. Issue 1. The question under this issue is whether respondent was correct in determining that a part of the involuntary conversion of petitioner's property did not occur within the provisions of section 112 (f) of the Internal Revenue Code. 1 Under section 112 (f), even though the proceeds of fire insurance exceed the adjusted basis of the property destroyed, if the proceeds are expended in the acquisition of other property similar or related to the property destroyed, the recognition of any gain will be limited to such portion of the proceeds as is not so expended. *133 *83 The basic facts are not in dispute. Petitioner owned and operated buildings, machinery, and equipment which were insured against destruction by fire in one lump-sum payment policy. Part of the buildings, machinery, and equipment was destroyed by fire in 1943. After negotiations with the insurance company, petitioner's loss was calculated to be $ 99,764.42, allocated on the basis of $ 60,711 because of the destruction of the buildings and $ 39,053.42 because of the destruction of the machinery and equipment. Payment of the total loss of $ 99,764.42 was made to petitioner by the insurance company in one check. Petitioner applied for and received from the Commissioner permission to segregate the $ 99,764.42 in one fund, to be used for the replacement of the assets destroyed. The fund was exhausted in 1943 by the expenditure of $ 20,208.40 for the partial replacement of the machinery and equipment which had been destroyed, and the expenditure of $ 79,556.02 for the partial replacement of the buildings which had been destroyed. The substance of respondent's contention is that, since the total of $ 99,764.42 received by petitioner because of the destruction of its buildings, *134 machinery, and equipment was arrived at by estimating separately the value of the buildings and the value of the machinery and equipment, in effect, two replacement funds were set up -- one to replace the buildings destroyed and the other to replace the machinery and equipment destroyed. If respondent is correct in his contention the excess of the amount received by petitioner because of the destruction of the machinery and equipment over the amount expended by it in the replacement of these assets was not "expended in the acquisition of other property similar or related in service or use to the property [involuntarily] converted," within the meaning of section 112 (f), and the gain upon the involuntary conversion of the machinery and equipment is taxable to that extent as capital gain under section 117 (j). We do not believe, however, that respondent's contention is correct. Section 112 (f) is a relief provision, which takes cognizance of the inequity of taxing a gain resulting from the involuntary conversion of property where the proceeds are used to replace the property, and should be liberally construed to effectuate its purpose. Washington Railway & Electric Co., 40 B. T. A. 1249;*135 Davis Regulator Co., 36 B. T. A. 437; Washington Market Co., 25 B. T. A. 576. We agree with petitioner that there was only one conversion of property, even though the manufacturing plant was made up of various individual assets. Petitioner insured the assets which comprised its manufacturing plant against fire in one contract of insurance. One premium was paid, which afforded protection to all the property. When fire destroyed petitioner's buildings and manufacturing equipment, insurance proceeds were paid by the insurer under one insurance contract *84 which gave joint, not separate, coverage to all the assets which comprised the manufacturing plant. Necessarily, the amount of this indemnification was arrived at by computing the loss suffered by the destruction of the individual assets, but one lump-sum payment of $ 99,764.42 was made by the insurer covering the total damage to petitioner's manufacturing plant. The proceeds from the fire insurance policy were placed by petitioner in one replacement fund entitled "The Massillon-Cleveland-Akron Sign Company, Building and Equipment Replacement Fund." Formal application*136 to establish this fund in order to restore the property destroyed, in conformity with section 112 (f), was made to respondent by petitioner, and respondent granted his approval of the segregation of the insurance proceeds in one fund to restore the manufacturing plant. No requirement was ever made that part of the proceeds be earmarked to replace the buildings and part be designated to replace the machinery and equipment. Nor does respondent make any argument that each individual machine or piece of equipment destroyed must be replaced by a similar machine or piece of equipment in order for the benefits contained in section 112 (f) to apply. If petitioner had used the insurance proceeds in question in the acquisition of control of a corporation owning buildings, machinery, and equipment similar to those which had been destroyed, section 112 (f) would apply regardless of whether or not the values of the assets owned by the newly purchased corporation were exactly in proportion to the values of the properties being replaced. Cf. Kimbell-Diamond Milling Co., 10 T. C. 7; see, also, Paul Haberland, 25 B. T. A. 1370. The result*137 would be the same even if the purchased corporation was immediately dissolved, in which case the entire transaction would be viewed as a purchase of assets rather than stock. Cf. Kimbell-Diamond Milling Co., 14 T. C. 74. In this proceeding, the petitioner made diligent efforts to restore its manufacturing capacity which had been destroyed by fire. As building materials and manufacturing equipment became available, petitioner replaced the component parts of its manufacturing plant by expenditures from the one replacement fund established for that purpose with the approval of respondent. In our view of the facts, petitioner expended the insurance proceeds in question in the acquisition of other property similar or related in service or use to the property destroyed. It is held that no part of the gain arising from the involuntary conversion of petitioner's buildings, machinery, and equipment is recognizable in the year 1943. Issue 2. The question under the second issue is whether insurance proceeds received by petitioner for the loss of the use and occupancy of its manufacturing plant are excludible as capital gains from petitioner's *85 excess*138 profits net income under section 711 (a) (2) (D), or whether the proceeds are taxable as ordinary income and therefore includible in petitioner's excess profits net income. Petitioner contends that the recovery was received as the result of an involuntary conversion of property destroyed by fire, and that any gain therefrom is taxable as capital gain under section 117 (j). However, it is well settled that proceeds received under a use and occupancy insurance contract as compensation for the loss of net profits resulting from the partial or total suspension of a business because of a fire are taxable as ordinary income. Oppenheim's Inc. v. Kavanagh, 90 Fed. Supp. 107; Miller v. Hocking Glass Co., 80 Fed. (2d) 436, reversing 5 Fed. Supp. 355, certiorari denied, 298 U.S. 659; International Boiler Works Co., 3 B. T. A. 283; Regulations 111, section 29.112 (f)-1; cf. Williams Furniture Corporation, 45 B. T. A. 928. Reference to the contract between petitioner and the Hartford Fire Insurance Company*139 clearly shows that the insurance proceeds in question were received as compensation for the loss of net profits. They were not received as indemnification for property destroyed. The recovery was measured by the estimated loss in net income, to which was added continuing expense. Under the insurance contract, the insurer agreed to be liable for "the actual loss sustained," to wit: I. Net profit which is thereby prevented from being earned and such charges and other expenses * * * as must necessarily continue during a total or partial suspension of business, to the extent only that such charges and expenses would have been earned had no fire occurred. * * * * The amount of net profit and/or charges and expenses covered hereunder shall be determined * * * by giving due consideration to the experience of the business before the fire and the probable experience thereafter. As was said by the Court of Appeals in Miller v. Hocking Glass Co., supra: The insurers agreed to be liable for the actual loss sustained "consisting of net profits" measured by the profits of the preceding year. The purpose expressly stated was to insure anticipated earnings which*140 might be interrupted by the destruction of the plant, earnings to arise out of "the business which is thereby prevented." So regarded, the sum received was taxable income within the broad provisions of section 213 (a) of the Revenue Act of 1924. [Now section 22 (a), I. R. C.] Since the net profits themselves would have been taxable as ordinary income under section 22 (a), the insurance proceeds in lieu thereof are equally taxable as ordinary income. The proceeds, therefore, are not excludible as capital gains from petitioner's excess profits net income under section 711 (a) (2) (D). Respondent's determination on this issue is sustained. Decisions will be entered under Rule 50. Footnotes 1. SEC. 112. RECOGNITION OF GAIN OR LOSS. * * * * (f) Involuntary Conversions. -- If property (as a result of its destruction in whole or in part, theft or seizure, or an exercise of the power of requisition or condemnation, or the threat or imminence thereof) is compulsorily or involuntarily converted into property similar or related in service or use to the property so converted, or into money which is forthwith in good faith, under regulations prescribed by the Commissioner with the approval of the Secretary, expended in the acquisition of other property similar or related in service or use to the property so converted, or in the acquisition of control of a corporation owning such other property, or in the establishment of a replacement fund, no gain shall be recognized, but loss shall be recognized. If any part of the money is not so expended, the gain, if any, shall be recognized to the extent of the money which is not so expended (regardless of whether such money is received in one or more taxable years and regardless of whether or not the money which is not so expended constitutes gain).↩