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April 11, 1977

In the Matter of I. J. KNIGHT REALTY CORP., Bankrupt

The opinion of the court was delivered by: HANNUM


 HANNUM, District Judge.

 Before the Court for resolution are cross motions for summary judgment filed by the Trustee in Bankruptcy of I. J. Knight Realty Corp. ("Trustee") and the United States regarding the government's claim for certain federal income taxes. Disposition by summary judgment is appropriate since the parties have submitted a joint stipulation of facts.

 To provide the context for the legal questions raised, a brief summary of the facts and prior proceedings is appropriate. I. J. Knight Realty Corp. ("I. J. Knight") is a Pennsylvania corporation which formerly owned as its principal asset the Fretz Building located at 10th and Diamond Streets in Philadelphia. I. J. Knight's business consisted of leasing space in this building and maintaining it 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. Francis Shunk Brown, Esquire, was appointed receiver and authorized to continue operation of the business. Approximately six weeks later, on January 1, 1963, the Fretz Building was totally destroyed by fire in one of the largest conflagrations in Philadelphia history. The fire destroyed all of I. J. Knight's corporate records and damaged adjoining properties severely. Because of the destruction of the corporation's principal asset, no business remained for the receiver to operate. There were, however, numerous claims filed with the receiver for damage resulting from the fire. The dollar amount of these claims was considerably in excess of I. J. Knight's total assets. It was alleged (and ultimately held by the Supreme Court in Reading Co. v. Brown, 391 U.S. 471, 88 S. Ct. 1759, 20 L. Ed. 2d 751 (1968)) that these claims constituted administrative expenses of the Chapter XI proceeding and therefore took priority over the claims of general creditors.

  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. *fn1" 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. *fn2"

 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).

 The major alleged deficiency in I. J. Knight's returns is the failure to compute the gain on the involuntary conversion of the Fretz Building. The total of the insurance proceeds was known, but the adjusted basis to be subtracted from this total to determine gain was not. Although it was impossible to compute gain, the occurrence of the involuntary conversion and the full amount of the insurance proceeds were disclosed on the return. Standing alone, this degree of completeness would probably be sufficient to start the statute of limitations. In C. T. McDaniel, 44 B.T.A. at 570 (1941), the Board of Tax Appeals held that a corporate tax return which failed to compute gain on a sale of assets, but fully disclosed the fact of the sale was sufficiently complete to trigger the statute of limitations.

 The fundamental difference which points toward a contrary conclusion here is that the taxpayer attached a note to the return stating that "upon resolution of the claims, more complete returns will be filed." This notation would reasonably indicate to the I.R.S. that the returns were not the Trustee's final word and that more would follow. It would thus be reasonable to wait until the final returns were in before examining them critically to determine their correctness. The case law seems to allow the I.R.S. this privilege.

 It is already established that returns labeled "Tentative" do not start the statutory period running. In Florsheim Bros. Dry Goods Co. v. United States, supra, the Court held that a tentative return form specifically provided for by I.R.S. procedure did not start the statute of limitations. The problem there faced was caused when the Revenue Act of 1918 was not approved until February 24, 1919, with returns due March 15, 1919. Because of the short interval available to prepare returns, the I.R.S. promulgated a "tentative" return form which was to be filed by the due date with the final return to follow later. Even though this form may technically have been a return, the Court found it insufficient for statute of limitations purposes where a final return was also anticipated. See also, Lucas v. Pilliod Lumber Co., 281 U.S. 245, 50 S. Ct. 297, 74 L. Ed. 829 (1930). In J. L. Foutz, 24 T.C. 1109 (1955), the taxpayers filed a return on the ordinary form which they labeled "Tentative" by typing this word at the top. They later attempted to claim that this return started the statute of limitations. In rejecting this claim on the grounds of estoppel, the Tax Court stated,


By making their return "Tentative" petitioners clearly indicated that they did not intend it as a final return, and that something more was to follow. 24 T.C. at 1112.

 Although the word "Tentative" was not used, much the same idea was conveyed by the Trustee in this case when he informed the I.R.S. that ". . . more complete returns will be filed." The promise of something more to follow reasonably permitted the I.R.S. to treat the returns as non-final. It would be unfair to allow the Trustee to consider them final now for statute of limitations purposes. The Court therefore concludes that the statute of limitations does not bar the assessments made by the Commissioner. *fn3"

 II. The Section 461(f) Deduction.

 After the disastrous fire of January 1, 1963, Francis Shunk Brown, III, Esquire, the receiver and subsequently Trustee of I. J. Knight, received more than $3,000,000.00 in fire damage claims from third parties which contended that the fire was caused by the negligence of the receiver or his employees. Although Brown, as Trustee, diligently contested liability for these claims, on I. J. Knight's tax return for fiscal 1963, he took a deduction of $3,000,000.00 in respect of them, relying on § 461(f). The Trustee now concedes that the maximum amount of any deductions would be $988,280.11, the total value of I.J. Knight's assets as of the date of bankruptcy. There is also agreement that at some point a deduction for fire loss liability was or will be proper. The disagreement centers around whether Section 461 allows the Trustee to take that deduction in fiscal 1963.

 Section 461 of the Internal Revenue Code establishes rules for determining the year in which a deduction may be taken. Section 461(f) contains a special rule which allows a deduction for a contested liability to be taken in the year in which it is provided for by the taxpayer rather than the year in which the contest is finally settled. The section was added by Congress in 1964 to overrule by legislation the rule of United States v. Consolidated Edison Co., Inc., 366 U.S. 380, 81 S. Ct. 1326, 6 L. Ed. 2d 356 (1961). In that case, the Supreme Court held that even though a contested tax had been paid, no deduction could be taken for it until the year in which the contest was ended.

 To qualify a deduction under Section 461(f), four criteria must be met. The section provides:


If --


(1) the taxpayer contests an asserted liability,


(2) the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability,


(3) the contest with respect to the asserted liability exists after the time of the transfer, and


(4) but for the fact that the asserted liability is contested, a deduction would be allowed for the taxable year of the transfer (or for an earlier taxable year), then the deduction shall be allowed for the taxable year of the transfer. * * *

 The parties agree that the deduction taken by the Trustee meets criteria (1), (3) and (4). The only issue is whether the second criterion, that the taxpayer transfer money or other property to provide for the satisfaction of the asserted liability, has been met.

 The Trustee contends that the transfer of all assets of I. J. Knight from the receiver under Chapter XI to the Court pursuant to the adjudication of bankruptcy on May 14, 1963, constitutes the transfer required by Section 461(f)(2). He reasons that since Reading Co. v. Brown, 391 U.S. 471, 88 S. Ct. 1759, 20 L. Ed. 2d 751 (1968), establishes that all fire damage claims are first priority administrative claims and since these claims far exceed the value of the assets, the transfer to the Court constitutes provision for contingent liability on the fire damage claims. In support of his position, the Trustee relies on excerpts from the Treasury Regulation specifying how criterion (2) may be met. Regulation Section 1.461-2(c)(1) provides in part: *fn4"


A taxpayer may provide for the satisfaction of an asserted liability by transferring money or other property beyond his control . . . (iii) to a trustee pursuant to an order of . . . a court that the money or other property be delivered in accordance with the settlement of the contest. A taxpayer may also provide for the satisfaction of an asserted liability by transferring money or other property beyond his control to a court with jurisdiction over the contest.

 Specifically, the Trustee maintains that the bankruptcy adjudication constituted an order that the money and property of I. J. Knight be delivered in accordance with the settlement of the fire damage claims and/or that it constituted a transfer to a court with jurisdiction over the contest since the Bankruptcy Court has jurisdiction over contested administrative claims.

 On the other hand, it is the government's position that there was no transfer qualifying under Section 461(f)(2). The regulations stress that a qualifying transfer must put the property beyond the taxpayer's control and must be specifically earmarked for the payment of the contested liability. The transfer to the Bankruptcy Court, the government contends, satisfies neither condition.

 Although the arguments on each side of the question are well taken, the Court is persuaded that the government's position has greater weight. Initially, it must be noted that tax deductions are matters of legislative grace to be strictly construed. Only if there is clear provision for a deduction may it be allowed. Commissioner v. National Alfalfa Dehydrating, 417 U.S. 134, 148-49, 94 S. Ct. 2129, 40 L. Ed. 2d 717 (1974); New Colony Ice Co. v. Helvering, 292 U.S. 435, 440, 54 S. Ct. 788, 78 L. Ed. 1348 (1934). Such clear provision is lacking in the circumstances of this case. The transfer alleged to satisfy Section 461(f)(2) fails to constitute a transfer "to provide for the satisfaction of the asserted liability." The Court agrees with the government that Congress intended that a qualifying transfer must be specifically earmarked for payment of the particular liability. The Senate's report on the Tax Reform Act of 1964, *fn5" of which Section 461(f) is a part, stresses this aspect by using the term, "payment" in its description of the operation of the section. *fn6" Although a strict construction of this term is not indicated, it is clear that Congress intended a qualifying transfer to be directly linked to the contingent liability.

 The Trustee's argument provides only an indirect, attenuated link. Although it may well have appeared at the time of filing the returns in question that the entire bankrupt's estate would be required to satisfy the fire damage claimants if they were successful, the transfer of assets to the Bankruptcy Court was for the purpose of disposition in accordance with bankruptcy law, not specifically for the payment of fire damage claims. In fact, even though no fire damage claims have yet been paid, already certain unrelated secured claims *fn7" and incidental expenses have been paid out of the estate. The type of transfer contemplated by Section 461(f)(2) is wholly incompatible with the consequences of a transfer of property pursuant to a bankruptcy decree. The former must limit the transferred property's use to payment of specific liabilities; the latter must leave the assets available to satisfy all claimants in accordance with bankruptcy law. The fortuitous circumstance that bankruptcy law could mandate the application of the entire estate in satisfaction of the contested liability does not alter this basic dichotomy. Accordingly, the Court is constrained to hold that the transfer of assets to the Bankruptcy Court cannot satisfy the requirements of Section 461(f)(2).

 The Trustee contends alternatively that if I. J. Knight is not entitled to a deduction for the entire value of the estate pursuant to Section 461(f), then such a deduction should be allowed for $825,490.66, the amount of the net insurance recovery realized as of the date of bankruptcy plus the value of the other property transferred to the Bankruptcy Court. In the further alternative, the Trustee believes he should be entitled at the least to a deduction for the $565,000. deposited in interest bearing accounts in 1964 and 1965. Under the Court's analysis above, however, these contentions require no discussion. The first alternative presents no reasons why that particular property should be subject to deduction when the entire estate is not. As for the second alternative, the transfer of funds to interest bearing accounts was merely for preservation of the estate in accordance with the trustee's fiduciary duty, not specifically for the payment of fire damage claims. Thus, it can no more validate the deduction than the transfers to the Court pursuant to the bankruptcy decree. Since the Court has decided that the I.R.S.'s assessment of tax is not barred by the statute of limitations and that the Trustee was not entitled to a deduction under Section 461(f) in any amount, in accordance with the stipulation of the parties, the claim of the United States is as follows: (a) for fiscal 1964 $154,803.30 (b) for fiscal 1965 4,709.32 (c) for fiscal 1966 5,829.71


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