Left with no business and crippling damage claims, I. J. Knight filed for bankruptcy, and on May 14, 1963, was adjudicated a bankrupt. Francis Shunk Brown, Esquire, the former receiver, was elected trustee in bankruptcy. Besides its land and a small amount of cash, at this point, I. J. Knight's value lay in insurance claims against Lloyds, London, Southwest Casualty Co., and Annapolis Fire & Marine Insurance Co., in a gross amount of $1,440,000. The trustee settled the claim against Lloyds for $800,000., received in fiscal 1964, and later, in fiscal 1966, settled the claims against the other two companies for $56,250. A portion of these funds was placed in interest bearing accounts while awaiting distribution in liquidation.
On February 15, 1967, counsel for the Trustee filed federal income tax returns for fiscal years 1963-1966.
These returns showed miscellaneous income including interest on the deposited money, and for years in which insurance settlements had been received, these amounts in full were listed as "Gain from disposition of Depreciable Property under Section 1245." It was noted, however, that actual gain on the involuntary conversion caused by the fire could not then be computed. Because I. J. Knight's corporate records had been lost in the fire, its adjusted basis in the Fretz Building was unknown. Based on the figures then available to the Trustee, each return showed no taxable income after deductions and net operating loss carry-overs and, hence, no federal income tax due. Returns for subsequent years were filed on or before their due dates and followed basically the same format.
In 1971, the I.R.S. conducted an audit of the Trustee's returns for fiscal years 1963 through 1970. As a result of this audit, certain deductions and net operating loss carry-overs were disallowed. In addition, the auditing agent determined the adjusted basis of the Fretz Building to be $237,036.78, thus making the gain on its involuntary conversion $619,213.22. This gain in its entirety was allocated to fiscal year 1964 by the auditor. The above changes resulted in deficiencies which were assessed against the Trustee. The I.R.S. also claimed that I. J. Knight owed Personal Holding Company Tax under Section 541 of the Internal Revenue Code.
In September and October 1972, the Trustee and the Government each filed motions for summary judgment based on the facts as stipulated. It was the Trustee's contention at that time that a "non-operating" trustee for a bankrupt corporation is not liable for the payment of federal taxes on income generated during the liquidation and distribution of the bankrupt estate. On August 14, 1973, this Court so held in a Memorandum and Order granting the Trustee's motion for summary judgment and denying the government's motion for summary judgment. In Re I. J. Knight Realty Corp., 366 F. Supp. 450 (E.D.Pa.1973). Since that ground alone was dispositive of both motions, the Court did not consider the other contentions of the parties.
On July 31, 1974, the Third Circuit Court of Appeals reversed the judgment of this Court and remanded the case for further proceedings. In Re I. J. Knight Realty Corp., 501 F.2d 62 (3d Cir. 1974). Between that time and the present, the parties have tried diligently to settle the claims to no avail. The issues have, however, been considerably simplified and refined in two respects. First, taxes for post-1966 fiscal years have been eliminated from consideration. The Trustee has conceded that the federal income tax claims for these years are administrative expenses of the bankruptcy proceeding and that interest accrues on these claims as provided by law. The parties have agreed upon the amounts due for these years and by order of this Court dated August 21, 1975, the Trustee was authorized to pay these amounts. Second, the United States has abandoned its claim for personal holding company taxes.
Accordingly, there are four questions left for resolution by the Court with respect to fiscal years 1964, 1965 and 1966. These are:
1. Whether the tax claims of the United States for these years are barred by the applicable statute of limitations.
2. Whether the Trustee was entitled to a deduction under Section 461(f) of the Internal Revenue Code and, if so, the amount of that deduction.
3. Whether the claim of the United States for fiscal 1964 is an expense of the administration of the Chapter XI proceeding which gives it a priority only as high as the fire damage claims, or an expense of the succeeding bankruptcy which would give the claim priority over the fire loss claims.
4. Whether the Trustee is subject to additions to tax imposed by Section 6651(a) of the Internal Revenue Code for fiscal years 1964 and 1965.
In connection with issue 3, the Court has granted the motion of the Reading Company (the principal fire loss claimant) and other fire loss claimants represented by the same counsel to intervene in this proceeding.
I. The Statute of Limitations.
Section 6501(a) of the Internal Revenue Code provides that assessments of tax allegedly due must be made by the Internal Revenue Service within three years after the return was filed. Failure to meet this deadline bars collection of the tax. The Trustee filed what are alleged to be I. J. Knight's tax returns for fiscal 1963, 1964, 1965 and 1966 on February 15, 1967; the I.R.S. assessed the alleged income tax deficiencies here in issue by letter dated November 12, 1971 and proofs of claim filed with the Trustee on March 2 and 24, 1972, all more than three years after the returns were filed. The specific issue for the Court thus becomes whether the papers filed as returns in 1967 were sufficiently complete to constitute "returns" within the meaning of the Internal Revenue Code. If they were, then the assessments are barred.
Each return was filed on a corporate income tax return form 1120 and specified each item of income and each deduction for the fiscal year in question. On the returns for fiscal 1964 and 1966, the Trustee reported the receipt of the proceeds of the settlements with the fire insurance companies, however, no gain or loss as a result of the involuntary conversion of the Fretz Building was computed. Such computation was impossible since the corporate records showing adjusted basis of the building were destroyed in the fire. As previously stated, each return showed no taxable income after net operating loss carry-overs.
Each return also carried the following notation to the I.R.S. explaining why certain figures could not be shown on the return:
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.
As yet no further returns have been filed.
The covering letter from Trustee's counsel, dated February 15, 1967 and filed with these returns, also pointed out that I. J. Knight'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 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 deduction under Section 461(f) of the Internal Revenue Code (the subject of issue III, infra) of $3,000,000.00 for "Damage Claims Asserted," producing a total net operating loss of $3,012,396.83.
In his return for fiscal 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 of insurance settlement proceeds was noted as follows in Part I of Schedule D, entitled "Gain from Disposition of Depreciable Property under Section 1245:"
"Fire insurance proceeds during year amounted to $800,000.00. Gain or loss on fire cannot be computed at this time. This return is under examination by the I.R.S."
The fiscal 1966 return carried the same notation, except that the figure was changed to show the receipt of $56,250. in insurance settlement proceeds in that year.
In the returns for fiscal 1965 and 1966, the Trustee again reported the interest income earned in each year from the deposits and took various deductions. In each return the difference between the gross income and deductions as reported was offset by a net operating loss carry-over.
At the audit in 1971, the Section 461(f) deduction in fiscal year 1963 was disallowed by I.R.S., as were various unpaid expense deductions and most net operating loss deductions. The I.R.S. verified the receipt of the $856,250. of insurance proceeds; determined that the Trustee's adjusted costs basis for the Fretz Building was $273,036.78; and determined that, as a result of the involuntary conversion of the Fretz Building, a taxable gain of $619,213.22 ($856,250. less $237,036.78) was realized on the collection of the fire insurance proceeds. The auditing agent also determined that all of this gain was taxable to the Trustee in fiscal 1964. These changes, which produced the alleged deficiencies asserted here, will be discussed in more detail later.
The above facts convince the Court that the returns filed were clearly as complete as could reasonably be expected in view of the ongoing audit of prior years' returns and the loss of corporate records caused by the fire. No allegation is made that there was any misrepresentation or attempt to evade taxes. The Trustee endeavored in the utmost good faith to meet his obligations to file tax returns. However, in order to start the statute of limitations running, returns must be sufficiently complete to enable the I.R.S. to determine the correct tax liability. Myles Salt Co., Ltd. v. Commissioner, 49 F.2d 232 (5th Cir. 1931); Valentine-Clark Co. v. Commissioner, 52 F.2d 346 (8th Cir. 1931). Our tax system is based on self-assessment and the burden is on the taxpayer to supply adequate information. Florsheim Bros. Dry Goods Co. v. United States, 280 U.S. 453, 50 S. Ct. 215, 74 L. Ed. 542 (1930); Alkire Inv. Co., Inc. v. Nicholas, 114 F.2d 607 (10th Cir. 1940); National Contracting Co. v. Commissioner, 105 F.2d 488 (8th Cir. 1939). It would be unfair to afford the benefit of the statute of limitations to a taxpayer whose return was so incomplete and sketchy that his proper tax liability could not be determined.
On the other hand, not every incomplete return will fail to trigger the running of the statute of limitations. The Supreme Court has held that,
. . . Perfect accuracy or completeness is not necessary to rescue a return from nullity, if it purports to be a return, is sworn to as such . . . and evinces an honest and genuine endeavor to satisfy the law. This is so though at the time of filing the omissions or inaccuracies are such as to make amendment necessary. Zellerbach Paper Co. v. Helvering, 293 U.S. 172, 180, 55 S. Ct. 127, 131, 79 L. Ed. 264 (1934).