Maloof v. Comm'r of Internal Revenue , Docket No. 4615-72.
| Decision Date | 10 November 1975 |
| Docket Number | Docket No. 4615-72. |
| Citation | 65 T.C. 263 |
| Parties | FRED MALOOF, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Richard Z. Steinhaus and Stephen Hochhauser, for the petitioner.
Michael A. Menillo, for the respondent.
Prior to Dec. 7, 1941, petitioner conducted a business in China of importing, exporting, and contracting for the manufacture of linens and other goods. He sustained a war loss of assets of this business, consisting largely of inventory. In 1966,he recovered an amount with respect to the lost inventory and realized a gain under sec. 1333(3), I.R.C. 1954. A replacement fund was established under sec. 1033(a)(2) and, within the required time, petitioner used the fund to establish a manufacturing business dealing with the same sort of goods as before. The assets of the new business included a complete manufacturing plant as well as inventory. Held, on the facts of this case, the proceeds of the involuntary conversion of inventory were reinvested in property similar or related in service or use only to the extent they were reinvested in inventory.
Respondent determined a deficiency of $33,406.45 in petitioner's 1966 Federal income tax. Petitioner has conceded some of the issues raised in the notice of deficiency, leaving for our decision the question whether his taxable income included $83,456 recovered during the taxable year with respect to a war loss.
Virtually all of the material facts have been stipulated and are found accordingly.
Petitioner's address at the time the petition was filed herein was in case of Charles Hecht & Co., 595 Madison Avenue, New York, N.Y.1 His 1966 calendar year income tax return was filed with the District Director of Internal Revenue, Manhattan, N.Y.
From sometime in 1938 until December 7, 1941, when hostilities commenced between the United States and Japan, petitioner operated a sole proprietorship engaged in the general import and export business in China. His head office was at 98 Kialat Road, Swatow, China, which city was the center of the drawnwork business in China. Petitioner had an office and warehouse located at 150 Kialat Road, Swatow, China, and two branches— one in Shanghai, China, and the other in Hong Kong, China.
The business was conducted along traditional lines. Raw materials known in the trade as ‘piece goods,‘ mostly Irish linens, were purchased in Belfast and other foreign markets and were shipped to China for manufacturing and processing. Some materials were purchased in the United States; others, principally silks, in China and Japan.
The processing and manufacture of the piece goods were preceded by the selection of the designs and colors were subject to frequent change as dictated by changing fashions and by competition. The designs were created by or under the direction of petitioner, at considerable cost, in some cases, and sent by him to his Swatow offices. By far the larger part of the business was the linen drawnwork business, such as handkerchiefs and tableware.
The piece goods, together with the designs, thread, yarn for embroidery, etc., were placed in the hands of Chinese ‘contractors' in the Swatow area who did the ‘manufacturing.’ The procedure was generally as follows:
(a) The designs were made and selected.
(b) The materials were measured on a frame and a thread was drawn to mark each dozen. Then more threads were drawn to square and mark each piece of handkerchief2 before cutting.
(c) After the handkerchiefs were cut, each one was stamped with a design and style number.
(d) After bargaining, the Chinese contractor or contractors who had submitted the lowest bid was given the contract to do the work. He then proceeded to his village with the cargo; he distributed as many dozens as his village workers could handle, and subcontracted the balance to others.
The petitioner's head office at 98 Kialat Road, Swatow, China, performed the following services: (a) Receiving and storing all piece goods, yarn for embroidery, etc., (b) supervising designs, (c) marking and preparing all materials for processing, (d) distributing and receiving work in process, (e) laundering, finishing, and shipping, (f) local buying, and (g) bookkeeping and general office work.
The petitioner's office at 150 Kialat Road performed the following services: (a) tailoring and finishing all wearing apparel, (b) receiving and storing piece goods, mostly silks, and (c) packing and preparing goods for shipment.
Petitioner's Shanghai office attended to: (a) purchasing Chinese-made silk piece goods, yarn, etc., for embroidery and sewing, (b) purchasing merchandise available in the Shanghai market for export, and (c) transshipment of cargo from Swatow to foreign ports, and from foreign ports to Swatow— ‘in transit’ cargo.
Petitioner's Hong Kong office attended to the ‘in transit’ cargo which went through Kong Kong.
On or about December 7, 1941, petitioner's business was confiscated by the Japanese, and he sustained a war loss under section 127, I.R.C. 1939. Petitioner's net investment in the business as of the date of the seizure consisted of:
He deducted $254,971 as a war loss on his income tax return for the fiscal year ended July 31, 1942.
In 1945, petitioner recovered a portion of the seized assets, consisting of merchandise valued at $81,388 which had cost $71,981. He also obtained cancellation of bank loans of $41,825, resulting in a total recovery of $123,213. He elected, pursuant to subparagraphs (3) and (5) of section 127(c), I.R.C. 1939, to report his war loss recovery by reducing the war loss deduction to $131.758. The amount of the net war loss was subsequently fixed at $94,000 by agreement between petitioner and respondent's agents.
On July 2, 1964, pursuant to the War Claims Act of 1948, 50 U.S.C. app. sec. 2001 et seq. (1970), petitioner claimed that he sustained losses as follows:
(a) Swatow losses.— On December 8, 1941, the properties of the petitioner in Swatow, China, were taken over by the Japanese military forces. From time to time thereafter during the period of the war, the petitioner's large inventory was taken by the Japanese military authorities. Also confiscated were the contents of a five-room apartment located at 98 Kialat Road which was the personal residence of petitioner.
(b) Shanghai losses.— The losses in Shanghai consisted of an inventory of merchandise in stocks; 22 cases of drawnwork and embroidered articles which had been received at the Shanghai office a few days prior to Pearl Harbor day and which were awaiting transshipment to the United States; and some Chinese antiques which were the personal possessions of the petitioner.
(c) Hong Kong losses.— The losses in Hong Kong consisted of merchandise in transit stored in Holts Wharf and in the godown of the Hong Kong and Kowloon Wharf and Godown Co., Ltd., and some of petitioner's personal effects which were in the custody of petitioner's Hong Kong manager.
(d) Ship cargo losses.— In November of 1941, petitioner shipped 35 cases of linen goods from his Swatow offices to his Shanghai offices for transshipment to the United States. This cargo was loaded in Shanghai on the S.S. Bernadin de St. Pierre for transshipment via Manila to the United States and a bill of lading was issued therefor to petitioner. This cargo never reached its destination in the United States.
On June 1, 1966, the Foreign Claims Settlement Commission found that petitioner sustained war losses and awarded him $331,912.37 with respect to lost business property (consisting entirely of inventory items) and $22,090 with respect to his personal property. Petitioner determined that $83,456 of this amount should be treated as gain from an involuntary conversion of property by virtue of section 1333(3)3 and reported it accordingly on his 1966 return. Since the involuntary conversion involved herein occurred prior to January 1, 1951, he applied for and received the consent of the Internal Revenue Service to establish a fund to replace his business which was destroyed during the war.4 Including extensions of time, petitioner was allowed until July 1, 1969, to expend the fund in reestablishing his business.
On January 9, 1969, petitioner registered the Frederick Trading Co. in Hong Kong as a sole proprietorship engaged in general import-export and manufacturing. Petitioner had invested HK$728,087.74 in that business by April 30, 1969. The company's balance sheet as of that date showed the following assets at cost:5
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