General Counsel Memorandum 35266
Internal Revenue Service (I.R.S.)
General Counsel Memorandum (G.C.M.)
March 14, 1973
Section 1033 — Involuntary Conversion
PETER P. WEIDENBRUCH, JR.
Assistant Commissioner (Technical)
Attention: Director, Income Tax Division
This is in response to your memorandum (T:I:C:P) dated November 27, 1972 that referred the above-captioned proposed revenue ruling to this Office for our concurrence or comment.
Whether actuarial and underwriting criteria as well as the terms of a policy of insurance should be examined in determining if a policy insures against a loss of net profits plus fixed charges as distinguished from a loss of the right to use and occupy a particular premises.
The Income Tax Division takes the position in the proposed revenue ruling that the terms of a policy are not of themselves determinative of the manner in which the proceeds from such a policy should be treated for Federal income tax purposes, i.e., as a substitute for lost profits or as proceeds from the involuntary conversion of the right to use and occupy a particular premises. We agree with the position taken in the proposed revenue ruling, but believe that in order to more clearly state Service position the proposed revenue ruling should be amended to state that the Service will not follow Shakertown Corp. v. Commissioner, 277 F.2d 625 (6th Cir. 1960).
Treas. Reg. Section 1.1033(a)-2(c)(8) provides:
The proceeds of a use and occupancy insurance contract, which by its terms insured against actual loss sustained of net profits in the business, are not proceeds of an involuntary conversion but are income in the same manner that the profits for which they are substituted would have been. [Emphasis added.]
The proposed revenue ruling holds that the phrase 'insurance contract, which by its terms' used in the regulation set forth above does not limit the Service to an analysis of the terms of a policy. It holds that underwriting and actuarial criteria also may be analyzed in determining the character of the policy and, consequently, the treatment of the proceeds for Federal income tax purposes.
In International Boiler Works Co., 3 B.T.A. 283 (1926), acq. V-2 C.B. 2 (1926), the taxpayer was insured under a policy characterized as a policy of use and occupancy insurance. The policy provided that the insurer would be liable * * * for the actual loss sustained of net profits on the business which is thereby prevented, and for such fixed charges and expenses as must necessarily continue during a total or partial suspension of business * * * [Emphasis added.] International Boiler Works Co., supra at 287.
After a fire had destroyed the taxpayer's property, taxpayer contended that the insurance proceeds replaced a lost property right, i.e., the right to earn income and that the proceeds were, in effect, a return of capital. The Commissioner, however, contended that the proceeds were merely a substitute for profits that would have been earned during the period of suspended operations and therefore constituted ordinary income. The Board of Tax Appeals looked to the terms of the policy and determined that the proceeds of the policy were received in lieu of gross income.
In Piedmont-Mt. Airy Guano Co., 3 B.T.A. 1009 (1926) acq. V-2 C.B. 3 (1926), acq. withdrawn, nonacq. substituted, X-1 C.B. 89 (1931), nonacq. withdrawn, acq. substituted, 1942-2 C.B. 15, the taxpayer's plant, with the exception of one small building that was of no productive value, was destroyed by fire. The policy of insurance covering the property was a fire policy with a rider covering the use and occupancy of the buildings and machinery.
The rider provided:
The conditions of this contract of insurance applying to use and occupancy are--that if the buildings herein described or any part thereof or machinery or equipment or any part thereof shall be destroyed or entirely disabled by fire and/or lightning during the term of this policy so as to entirely prevent operating or carrying on of the business at the above described location or if the said buildings or machinery or equipment, or any part thereof shall be so damaged or disabled as to prevent the full use and occupancy of said premises, then this Company shall be liable for its pro rata part of the loss sustained by reason of such total or partial prevention not exceeding its pro rata share of $200 per day in the case of total prevention * * * [Emphasis added.] Piedmont-Mt. Airy Guano Co., supra at 1010.
In addition, the policy contained 'Lightning and Dynamo Clauses for Use and Occupancy Insurance'. The dynamo clause provided:
This policy does not cover loss of earnings due to stoppage of dynamos, motors, or any other apparatus for generating, utilizing regulating or distributing electricity, caused by any defect or break in the insulation or machine or by excess current, whether artificial or natural, or by lightning.
Piedmont-Mt. Airy Guano Co., supra at 1011.
All of the proceeds received, i.e., from both the fire insurance and the use and occupancy insurance were expended in rebuilding the plant.
Just as in International Boiler Works Co., supra, the Commissioner argued that the proceeds of the use and occupancy insurance were received in lieu of lost profits. The taxpayers contended that the use and occupancy rider amounted to nothing more than additional fire insurance. The Board recognized that the right to use and occupy a particular premises had been held to be a separate property right by several state courts and at least one Federal court. See e.g., Jacksonville Oil Mills v. Stuyvesant Insurance Co., 3 F.2d 1006 (W.D. Tenn. 1925), rev'd 10 F.2d 54 (6th Cir. 1926) cert. denied, 276 U.S. 634 (1928); Chicago & W.E.R. Co. v. Englewood Connecting Ry. Co., 115 Ill. 375, 4 N.E. 246 (1886); Michael v. Prussian Nat'l Ins. Co., 171 N.Y. 25, 63 N.E. 810 (1902) . The right to use and occupancy was furtheremore analogized to an easement granted on property. Thus, the court reasoned that if the right to use and occupy the premises was involuntarily converted (as it could be by fire) the gain generated by the insurance proceeds received as compensation for such loss could be deferred if all of such proceeds were reinvested in property similar or related in service or use to that converted under section 234(a)(14) of the Revenue Act of 1921 (now Code Sectino 1033(a)(3)(A)). Consequently, since all of the proceeds of both the fire insurance policy and the use and occupancy policy were expended on the rebuilding of the plant, the Board held that the taxpayer recognized no gain in the year the proceeds were received.
The Board distinguished International Boiler Works Co., supra, on the ground that the language of the policy involved in that case left no doubt as to the fact that it protected against lost profits. It was stated merely that there was no such provision in the instant case except for the reference to lost earnings in the 'dynamo clause,' and that the per diem indemnity fixed by the policy was set at an agreed upon rate of $200. The effect on the entire policy of the reference to 'earnings' in the dynamo clause was not discussed by the Board.
In Flaxlinum Insulating Co., 5 B.T.A. 676 (1926), acq. VI-1 C.B. 2 (1927), acq. withdrawn, nonacq. substituted, X-1 C.B. 79 (1931), nonacq. withdrawn, acq. substituted, 1942-2 C.B. 7, the Board again considered a case in which a taxpayer had received the proceeds of a policy of 'use and occupancy insurance' after a fire. The policy provided that * * * if the buildings or any part thereof, their equipment or any part thereof, or the contents or any part thereof, shall be so destroyed or disabled by fire occurring during the term of this policy as to entirely prevent the assured from operating or carrying on business, then the liability of this company shall for each day of such enforced idleness be at the rate of one three-hundredth (1/300th) part of the sum insured for each working day during the period of such idleness, and proportionately for partial prevention for each day thereof. Flaxlinum Insulating Co., supra at 682. The dynamo clause merely denied any liability for stoppage of dynamos, motors or other electrical apparatus. However, the policy provided that the insured must, as soon as possible after any loss, resume partial or complete operation, and, * * * in the event of the insured continuing business (in whole or in part) at some other location, or using other property during the time occupied in repairing or reconstructing the building named herein, the net profits earned at the new location shall be deducted from the amount that under the terms of this policy would be recoverable by the insured. [Emphasis added.] Flaxlinum Insulating Co., supra at 683.
The Commissioner contended that the insurance proceeds under the use and occupancy policies were received in lieu of profits. The taxpayer contended that the proceeds were a per diem compensation for each day of enforced idleness and, as such, would qualify as proceeds from the involuntary conversion of the property. The Board merely relieu on the decision in Piedmont-Mt. Airy Guano Co., supra, in holding for the taxpayer.
These cases were followed by a series of cases that were decided on the facts, the court looking to the language of the particular policy. See Maryland Shipbuilding & Drydock Co., v. United States, 409 F.2d 1363 (Ct. Cl. 1969); Miller v. Hocking Glass Co., 80 F.2d 436 (6th Cir. 1935), cert. denied, 298 U.S. 659 (1936); Mellinger v. United States, 45 A.F.T.R. 885 (S.D. Tex. 1953), rev'd 228 F.2d 688 (5th Cir. 1956); Oppenhiem's Inc. v. Kavanagh, 90 F. Supp. 107 (E.D. Mich. 1950); Marcalus Manuf. Co., 30 T.C. 1345 (1958) acq. 1959-1 C.B. 4, aff'd per curiam, 268 F.2d 739 (3rd Cir.) cert. denied, 361 U.S. 924 (1959); Massillon-Cleveland-Akron Sign Co., 15 T.C. 79 (1950); Williams Furniture Corp., 45 B.T.A. 938 (1941) acq. 1942- 1 C.B. 17; Zerweck Jewlery Co., 31 P-H Tax Ct. Mem. 492 (1962); Darlington Veneer Co., 11 P-H B.T.A. Mem. 125 (1942).
Based on these cases, the law developed that if a policy, by its terms, measured loss in terms of net profits plus fixed charges the proceeds would be deemed to have been paid in lieu of net profit plus fixed charges or gross profits. Alternatively, if a policy by its terms insured against a lost property right and measured loss by reference to a per diem or per week value agreed upon by the insured and the insurer (i.e., was a valued policy), nonrecognition treatment would be available under Code Sectin 1033(a) (if the requirements of Code Section 1033 were otherwise met). Thus, the characterization of a policy developed, in essence, as a question of fact that would depend upon the provisions of a particular policy.
In Shakertown Corp., 28 P-H Tax Ct. Mem. 94 (1959), rev'd 277 F.2d 625 (6th Cir. 1960), the Tax Court considered two policies that purportedly insured against a lost property right. Under the policies, the insurer was liable at a fixed rate per week for a total suspension of operations and at a lesser rate (based on the ratio of reduced output to total output applied to the weekly rate) for a partial suspension of operations. The taxpayer was also required to make a report to the insurer every six months (beginning six months from the inception of the policy) setting forth the total net profit plus fixed charges for the preceding twelve months. If the weekly rate shown on the report was less that the policy's weekly rate, the policy rate would be automatically reduced to the amount shown on the report. In addition, the policy provided:
* * * Should the Assured fail to make such report the Underwriters in the event of claim hereunder shall be permitted to inspect all records of the Assured's operations at the premises covered hereunder to determine if the amounts insured exceed the Assured's net profit plus fixed charges. Should the amounts insured hereunder exceed the Assured's net profit plus fixed charges then the weekly amounts payable will be reduced to 1/52 of the amount of the Assured's actual net profit plus fixed charges during the twelve months period preceding [sic] the occurrence of the loss and the total amount of the insurance hereunder shall be reduced in the same proportion, it being understood and agreed that the maximum period of insurance for which loss may be claimed shall not exceed that previously stated in the conditions of this certificate. Shakertown Corp., 28 P-H Tax Ct. Mem. 94, 95 (1959). Consequently, although there was a fixed value, such fixed value existed only as a maximum limitation on any recovery under the policies.
The Tax Court held that the policies of insurance reimbursed the petitioner for its loss of net profit plus fixed charges to the extent that total amount thereof did not exceed its net profit plus fixed charges for the proceding twelve months.
In Shakertown Corp. v. Commissioner, 277 F.2d 625 (6th Cir. 1960), the Sixth Circuit reversed the decision of the Tax Court after examining the terms of the policies. The Sixth Circuit held that the Commissioner's position, i.e., that the policies insured against a loss of profits, was in conflict with the insuring clause of each of the policies. It was held that the insuring clause merely set forth a weekly amount to be paid in the event of suspension of business without a reference to lost profits. The court took the position that the limitation placed on the weekly rate, i.e., that liability will be reduced based on semi-annual reports to the extent that the liability exceeds weekly net profits plus fixed charges, was merely a contingent provision. Consequently, the provision did not fix liability but merely limited it. The court concluded that the determination of the amount of recovery and the limitation thereon are distinct computations based on different factors, and, therefore, the limitation clause does not alter the valued nature of the policy.
It is our opinion, contrary to that of the Sixth Circuit in Shakertown, that the limitation that gears a policy in a specified contingency to a measure of damages based on net earnings plus fixed charges is directly related to the object that the policy insures and cannot be disregarded merely because it appears in a limitation clause rather than in the insuring clause. See, G.C.M. 35193, ***, I-4990 (Jan. 15, 1973).
In reaching its conclusion, the Sixth Circuit distinguished between the limiting clause and the insuring clause in finding that the policy was of a 'valued' type. It cited as authority the District Court opinion in Jacksonville Oil Mills v. Stuyvesant Ins. Co., 3 F.2d 1006 (W.D. Tenn. 1925), rev'd 10 F.2d 54 (6th Cir. 1926), cert. denied, 276 U.S. 634 (1928). The policy considered therein provided:
It is a condition of this contract that, if the above described buildings and machinery, or either of them, or any part thereof, shall be destroyed or damaged by fire or lightning occurring during the term of this policy, so that the assured is entirely prevented from operating, this company shall be liable for not exceeding one hundred fifty dollars ($150) for each and every working day * * *. [Emphasis added.] Stuyvesant Ins. Co. v. Jacksonville Oil Mill, 10 F.2d 54, 55 (6th Cir. 1926). The Sixth Circuit, however, reversed the District Court and held that although the right to use and ouccupancy was a property right there was a maximum limitation on recovery for the loss of this right of $150 per day and the fact that the policy could vary beneath this maximum was characteristic of an open policy that insured against a loss of earnings.
Thus, the ultimate holding in Jacksonville is contrary to that in Shakertown because in the latter case the court disregarded the limitation in construing the policy. Although, Shakertown could thus be construed to overrule the holding in Jacksonville we are puzzled by the fact that in citing the District Court opinion, the Sixth Circuit ignored its own reversal of such opinion.
We are inclined to believe that the holding in Jacksonville as opposed to the one in Sakertown is the proper result because by establishing a maximum per diem amount and permitting a reduction by the insurer based upon actual loss the amount received under the policy may vary up or down with earnings and profits to the extent of the maximum.
In Shakertown Corp. v. Commissioner, supra, in the event of a partial suspension of operations, there was a limitation on the daily indemnity based upon the ratio of the reduction in output to total output. The Sixth Circuit noted that the formula contained no reference to profits. The court specifically stated that:
* * * The 'output' or production of a plant is entirely different from its operating profit. If a plant is operating at a loss, a fire can cause a large reduction in output or production without causing any loss in profits. If the insurance is intended to cover loss of use and occupancy, the insured is entitled to a recovery even though there is no loss of profits. If there is only a partial suspension of business, the normal way to measure what proportion of the full amount of the policy is to be recovered, would be to base it upon the proportionate amount of loss of output or production, as was provided in the present case, instead of upon loss of profits. Clearly, there is no insurance of lost profits under the insuring clauses of the policies in this case. Shakertown Corp. v. Commissioner, supra, at 629.
In drawing the distinction between the use of a formula based on 'production' and one based on 'profits' the court, in the passage set forth above, made reference to a situation in which a company was operating at a loss. It commented that if a disaster occurred and production was curtailed there would be no reduction in profits. This is true of a corporation operating at a loss. But the court's statement is inherently falacious because although profits will not decrease (because they do not exist) profitability will be affected and increased losses may be generated. Thus, the use of a ratio based on production is not materially different from one based on earnings because earnings, are, in essence, merely a function of production. It is our opinion that a reference to earnings in the partial indemnity formula either directly or indirectly, is a factor that must be considered in characterizing a policy of use and occupancy insurance, because such reference indicates that the loss generated by the cessation in operations is measured by a reduction in earnings.
Furthermore, in Shakertown Corp. v. Commissioner, supra, the Commissioner argued that in negotiating a settlement with the taxpayer the insurance adjuster based his computation on information concerning the operation of the business, including sales, selling and administrative expenses and net profits. The court, however, believed that the percentages applied to the weekly allowance in determining the partial amount to be paid were derived from anticipated total lost output, but not profits.
We agree with the Commissioner's characterization. In G.C.M. 35193, ***., I-4990 (Jan. 15, 1973) we have taken the position that even when such data is not requested immediately after the loss by the adjuster, but when such data was provided to the insurer by means of periodic statements and there is a right to reduce coverage based on these statements, the policy is one that insures against a loss of net profits plus fixed charges.
Thus, in Shakertown Corp. v. Commissioner, supra, and the cases decided prior thereto only the terms of the policies and other documents filed by the insured with the insurer were examined in characterizing the proceeds received. The proposed revenue ruling extends the analysis even further and looks to the underlying underwriting criteria in characterizing the policy. Based on this approach, notwithstanding that a policy contains none of the terms that have been considered important in characterizing a policy as insuring against lost profits (e.g., a reference to net profits and fixed charges or gross profits in the policy, or a right to receive a previously agreed upon per week or per diem indemnity) the proceeds of a policy will be deemed received in lieu of net earnings plus fixed charges if the previously agreed upon indemnity was derived from an analysis of past and projected earnings plus fixed charges.
The administrative file reveals that a representative of your Division discussed with a representative of the National Underwriter Company the manner by which the amount of coverage was determined under both a valued policy, that purportedly insures against the loss of a property right, and a policy that specifically insures against a loss in net earnings plus fixed charges. It is stated that your representative was informed that lost net profits are a principal factor utilized in determining awards in both valued use and occupancy policies and in policies that specifically insure against a lost net earnings and fixed charges. We have received similar information from a representative of the Travelers Insurance Companies. The representative stated, however, that fixed charges incurred during the cessation of operations are also considered.
Since net profits and fixed charges are apparently utilized in determining the amount of an award under both a valued use and occupancy policy and a policy that specifically insures against a loss in net profits plus fixed charges, the question arises whether the terms of a policy, i.e., its form, should dictate the Federal income tax consequences of the receipt of the proceeds. Assume that a policy contains a provision for a fixed per diem or per week indemnity (with no provision for variation of the indemnity with net profits), is written for a one year term, is intended to be renewed annually, and, bases the fixed per diem or per week value on an annual evaluation of net earnings plus fixed charges of the previous year and projections of such items for the forthcoming year. The hypothetical policy will be, in form, a valued use and occupancy policy. It does not, however, differ substantially from the policies considered in Shakertown Corp. v. Commissioner, supra, that we have concluded insured against a loss in net profits and fixed charges. The Shakertown Corporation policies were drawn for more than a one year term and contained stated per week indemnities that would be varied downward based on semi-annual earnings statements (covering the prior twelve month period) which were required to be submitted to the insurer. We do not believe that this distinction in form justifies different Federal income tax consequences.
Consequently, we agree with the position taken in the proposed revenue ruling. Furthermore, we believe that Service position will be clarified if the proposed revenue ruling is expanded to state that the Service will not follow the decision in Shakertown Corp. v. Commissioner, supra. In order to effectively accomplish this result a reorganization of the proposed revenue ruling is necessary.
We have amended the proposed revenue ruling in conformity with the opinion stated herein and attach a copy.
LEE H. HENKEL, JR.
Internal Revenue Service
Revised proposed revenue ruling
Control No. 68-6-17153
The Internal Revenue Service has been asked about the application of section 1.1033(a)-2(c)(8) of the Income Tax Regulations to the following situations.
(1) An insurance contract provides for per diem payments of 35x dollars whenever specified causes suspend business operations. The contract also provides that the insurer can reduce the per diem coverage whenever the insured's per diem net profits plus fixed charges for the preceding twelve months fall below 35x dollars.
(2) An insurance contract provides for per diem payments of 20x dollars whenever specified causes suspend business operations. Although not stated in the terms of the contract itself, the 20x dollar coverage was determined from an analysis of the insured's net profits plus fixed charges experience.
Section 1033 of the Internal Revenue Code of 1954 provides, in general, for the nonrecognition of gain when all of the proceeds of an involuntary conversion of property are used to purchase qualified replacement property.
Section 1.1033(a)-2(c)(8) of the regulations provides as follows:
The proceeds of a use and occupancy insurance contract, which by its terms insured against actual loss sustained of net profits in the business, are not proceeds of an involuntary conversion but are income in the same manner that the profits for which they are substituted would have been.
If an insurance contract insures against a lost property right (i .e., the right to use property), nonrecognition treatment under section 1033 of the Code is available with respect to the proceeds if the requirements of section 1033 are otherwise satisfied. Flaxlinum Insulating Co., 5 B.T.A. 676 (1926), acq., 1942-2 C.B. 7, Piedmont-Mt. Airy Guano Co., 3 B.T.A. 1009 (1926), acq., 1942-2 C.B. 15. But, if the insurance contract insures against lost profits and fixed charges, the proceeds are ordinary income, and nonrecognition treatment under section 1033 is not available. Maryland Shipbuilding and Drydock Co. v. U.S., 409 F.2d 1363 (Ct. Cl. 1969); International Boiler Works Co., 3 B.T.A. 283 (1926), acq., V-2 C.B. 2 (1926).
The terms on the face of an insurance policy are not of themselves determinative of how the proceeds should be treated for Federal income tax purposes. Although no indication that the proceeds are a substitute for lost net profits and fixed charges is contained on the face of the policy, the underwriting and actuarial criteria used in writing the insurance, as well as other factors deemed pertinent, must be examined to determine if the insurance is designed to reimburse the taxpayer for a loss of net profits and fixed charges.
In situation (1), the terms on the face of the insurance contract indicate that it insures against lost profits and fixed charges because it permits a reduction of the coverage based on recent profits and fixed charges experience. In situatiion (2), although the terms on the face of the contract do not mention profits and fixed charges, the profits and fixed charges experience of the insured was a significant factor in setting these terms. In both situations, the insurance is designed to reimburse the taxpayer for a loss of net profits and fixed charges.
Accordingly, insurance proceeds in both situations will be ordinary income, and nonrecognition treatment under section 1033 of the Code will not be available.
The Service does not follow the decision of the United States Court of Appeals for the Sixth Circuit in the case of Shakertown Corp. v. Commissioner, 277 F.2d 625 (6th Cir. 1960), reversing 28 P-H Tax Ct. Mem. 94 (1959), which held that the nonrecognition provisions of section 1033 of the Code were available with respect to the proceeds of an insurance contract similar to the one described in situation (1) of this revenue ruling.
This document is not to be relied upon or otherwise cited as precedent by taxpayers.
END OF DOCUMENT
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