The opinion of the court was delivered by: HANNUM
Before the Court are cross-motions for summary judgment filed on behalf of the United States of America (hereinafter "Claimant") and the Trustee in bankruptcy of I. J. Knight Corporation (hereinafter "Trustee" and " Realty", respectively). This litigation arises out of the Government's assessment of federal income taxes and penalties against the Trustee for the fiscal years ended November 30, 1964 through and including November 30, 1970. Both parties have submitted a stipulation setting forth the pertinent facts. The initial question presented is whether the provisions of the Internal Revenue Code of 1954 require the Trustee to report and pay federal taxes on income generated during the liquidation and distribution of the bankrupt's estate. If the Trustee is obligated to pay federal taxes on income thus generated, there exist several questions concerning the nature and amount of the deductions to which he is entitled, if any, and the penalty provisions to which he and the estate may be subjected. In order properly to understand the legal questions raised, a full statement of the facts is necessary.
I. J. Knight Realty Corporation is a Pennsylvania corporation which owned as its principal asset the fire torn and now destroyed Fretz Building located at 1001-15 West Diamond Street, Philadelphia, Pennsylvania. Realty's sole business was to lease space and maintain the building for the benefit of its tenants.
On November 16, 1962, the corporation filed a petition for an arrangement under Chapter XI of the Bankruptcy Act, 11 U.S.C. §§ 701-799. On the same day, Francis Shunk Brown, III, Esquire, was appointed receiver and was authorized to continue the operation of Realty's business. Approximately six weeks later, on January 1, 1963, the Fretz Building was totally destroyed by a fire of unusual intensity. The conflagration spread to adjoining premises, damaging or destroying the real and personal property of others, and destroying all of Realty's corporate and financial records. Because both Realty's principal asset and its corporate records were destroyed, no business remained for the receiver to operate.
On April 18, 1963, Samuel Marx, Esquire, counsel for the receiver, filed a petition with the Bankruptcy Court for leave to retain the law firm of Dechert, Price & Rhoads as co-counsel due to its skill in defending negligence cases. On April 23, 1963, this petition was granted.
On May 14, 1963, pursuant to a voluntary consent filed on its behalf, Realty was adjudicated a bankrupt. In the superseding bankruptcy proceedings the receiver, Francis Shunk Brown, was elected trustee in bankruptcy. On August 23, 1963, he, as trustee, was authorized to retain Samuel Marx, Esquire and Dechert, Price & Rhoads as counsel.
From the time they were filed to the present all the fire damage claims have been contested. In resulting litigation the fire damage claimants' position that their claims were entitled to a priority over general creditor's claims as administrative expenses of the Chapter XI arrangement proceedings was upheld by the Supreme Court. See Reading Company v. Brown, 391 U.S. 471, 88 S. Ct. 1759, 20 L. Ed. 2d 751 (1968). To date approximately 190 claimants have filed proofs of claim totalling nearly $4,400,000. The total assets marshalled by the trustee have a present value of approximately $650,000.
When Realty was adjudicated a bankrupt on May 14, 1963, its assets consisted of: (1) insurance claims against Lloyd's, London, Southwest Casualty Company, and Annapolis Fire and Marine Insurance Company in the gross amount of $1,440,000, (2) the land on which the Fretz Building once stood, and (3) cash amounting to $2,030.11. On September 26, 1963 the City of Philadelphia instituted condemnation proceedings against all the land owned by Realty. The Trustee was subsequently awarded $130,000 plus interest for this land. On November 7, 1963, the Referee in Bankruptcy approved a settlement of Realty's claim against Lloyd's, London for $800,000. Later, in fiscal year 1966, the Trustee compromised Realty's claims against the remaining two fire insurance companies for $56,250. Consequently, the fair market value of Realty's assets on May 14, 1963 was $988,280.11, i.e., $856,250.00 in insurance claims, $130,000.00 in land, and $2,030.11 in cash.
On March 3, 1964 the Trustee was authorized to pay $162,789.45 out of the insurance proceeds to satisfy an outstanding mortgage on the Fretz Building that was held by the Presbyterian Ministers Fund. On March 25, 1964 he was authorized to deposit at least $500,000.00 of the insurance proceeds in interest-bearing accounts and to increase those deposits without further court order. Pursuant to this authorization, he deposited $500,000 in such accounts in fiscal year 1964, and $65,000 in fiscal year 1966.
On February 15, 1967 counsel for the Trustee first filed with the District Director the Trustee's federal income tax returns for the fiscal years 1963, 1964, 1965 and 1966. Each return was filed on a corporate income tax return Form 1120. Each return specified each item of income and each deduction for the fiscal year in question. Except for the gain or loss on the involuntary conversion of the Fretz Building, all of these items were computed to indicate the Trustee's taxable income or loss for the particular fiscal year. Based on the figures available to the Trustee, each return showed no taxable income after net operating loss carry-overs and, hence, no federal income tax due.
"The Corporation is in a pending bankruptcy proceeding (Docket 27540) in the United States District Court for the Eastern District of Pennsylvania. Proofs of Claims have been filed on behalf of the Internal Revenue Service and numerous items making up prior returns are in dispute. Since correct figures have not been agreed upon and await resolution of these claims it is impossible to furnish the balance sheet, net operating loss deduction, etc. Upon resolution of the claims, more complete returns will be filed."
The covering letter from the Trustee's counsel, dated February 15, 1967 and filed with these returns, also pointed out that Realty's returns for fiscal years 1958-1962 were under audit before the Internal Revenue Service Appellate Division in Philadelphia. The covering letter requested that the enclosed returns be forwarded to the Appellate Division for disposition along with the prior years' returns.
The Trustee's return for fiscal year 1963 showed rental income of $7,628.85, miscellaneous income of $370.89 and various expenses aggregating $20,396.07, producing a loss from operations of $12,396.83. In addition, the return claimed a Section 461(f) deduction of $3,000,000 for "Damage Claims Asserted," producing a total net operating loss of $3,012,396.83.
In his return for fiscal year 1964 the Trustee reported the interest income of $6,815.79 earned on the deposits, as well as various deductions aggregating $78,575.64. The receipt of $800,000.00 in insurance proceeds was noted as follows in Part I of Schedule D, entitled ...