Waldheim Realty & Inv. Co. v. Commissioner of Int. Rev.

• Decision Date: 04 June 1957
• Docket Number: No. 15651.,15651.
• Citation: 245 F.2d 823
• Parties: WALDHEIM REALTY AND INVESTMENT COMPANY, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Eighth Circuit

245 F.2d 823 (1957)

WALDHEIM REALTY AND INVESTMENT COMPANY, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 15651.

United States Court of Appeals Eighth Circuit.

June 4, 1957.

Ray Eder, St. Louis, Mo. (H. M. Stolar and Robert C. Johnson, St. Louis, Mo., were with him on the brief), for petitioner.

Sheldon I. Fink, Atty., Dept. of Justice, Washington, D. C. (Charles K. Rice, Asst. Atty. Gen., and Lee A. Jackson and Hilbert P. Zarky, Attys., Dept. of Justice, Washington, D. C., were with him on the brief), for respondent.

Before WOODROUGH, VOGEL, and VAN OOSTERHOUT, Circuit Judges.

VAN OOSTERHOUT, Circuit Judge.

Taxpayer petitions this court to review the decision of the Tax Court determining taxpayer owes additional income taxes for the years 1950, 1951, and 1952. The facts are stipulated. Taxpayer is a Missouri corporation engaged in the business of ownership and management of real estate. During the period involved it kept its records and made its income tax returns on a cash basis. Taxpayer protected its property with insurance coverage. In many instances the premiums paid purchased insurance coverage for a number of years. On its records and for all purposes, including federal income tax purposes, taxpayer, at all times since its incorporation in 1905, has consistently deducted from gross income as a business expense the entire amount of insurance premiums paid in the respective years in which the premiums were paid. Taxpayer's returns have been frequently examined, and no previous objection has been made to the manner in which it treated its insurance payments.

The primary issue upon this appeal is whether a cash basis taxpayer, who has uniformly treated insurance premiums as a business expense in the year the premiums were paid, may deduct such premiums as a business expense in the year paid when part of such premiums was for insurance coverage for subsequent years, or whether the taxpayer must prorate the premiums paid over the years of coverage.

An alternate issue, in event of a finding adverse to the taxpayer upon the primary issue, is whether taxpayer may deduct in the years 1950 to 1952 that portion of insurance premiums paid in the 1947-1949 period which is for insurance coverage in the 1950-1952 period, it being conceded that the taxpayer had deducted the full amount of premiums paid in computing its income tax for the years 1947 to 1949.

The Tax Court held against the taxpayer upon both the primary issue and the alternate issue. The opinion of the Tax Court is reported at 25 T.C. 1216.

The Commissioner takes the position that prepaid insurance is a capital asset, the cost of which must be prorated or amortized over the life of the policy. He asserts that the amortized deduction must be claimed under section 23(l) of the Internal Revenue Code of 1939, 26 U.S.C.A. § 23(l).¹ The Commissioner relies largely upon Commissioner of Internal Revenue v. Boylston Market Ass'n, 1 Cir., 131 F.2d 966. There the court recognized that the line to be drawn between capital expenditures and business expenses often presents a close question, but concluded that prepaid insurance should be treated as a capital asset. The court relied upon cases which it cited treating prepayment of rent, bonus for acquisition of leases, bonus for cancellation of leases, and commissions for acquisition of leases, as capital expenditures subject to amortization. The court overruled Welch v. DeBlois, 1 Cir., 94 F.2d 842. It should be noted that none of the First Circuit judges participating in the DeBlois case participated in the Boylston Market opinion. In the DeBlois case the court calls attention to the fact that insurance policies are frequently taken out for a number of years to obtain the benefit of lower rates. The court, in a well considered opinion, mentions that in many businesses more supplies are acquired than can be consumed during the accounting period, and then states at page 844:

"* * * If the cost of insurance is apportioned between different years, the cost of many other kinds of materials and supplies and equally ordinary requirements, must also be apportioned, and great difficulties in accounting will be introduced which are foreign to the principle which the statute contemplates and will serve no useful purpose. Expenditures for such things are in no true sense capital expenditures. * * *"

The section 23(l) depreciation deduction is allowed for exhaustion of property used in a trade or business or for the production of income.

Regulations 118, section 39.41-3(b) provides:

"(b) Expenditures made during the year shall be properly classified as between capital and expense; that is to say, expenditures for items of plant, equipment, etc., which have a useful life extending substantially beyond the year should be charged to a capital account and not to an expense account".

Insurance premiums certainly are not expenditures for items of plant, equipment, etc.

Insurance doubtless serves a useful business function in protecting the taxpayer's investment from casualty loss. The Government, in the event of loss, also receives some benefit from insurance as casualty losses are not deductible to the extent that they are compensated for by insurance. Section 23(e), Internal Revenue Code of 1939. The payment of the insurance premium adds nothing to the taxpayer's plant or equipment or his ability to produce income. In this respect the insurance premiums differ from prepaid rent, lease bonuses, and commissions, as such expenditures are for the purpose of providing the taxpayer the place in which to carry on his business. Merten's Law of Federal Income Taxation, Vol. 2, section 12.25, p. 78, impliedly recognizes that insurance is not a typical capital asset, stating:

"There are, however, cases in which the expenditure cannot be said truly to result in the acquisition of a capital asset, but where the effect and benefit of the payment or obligation will extend over future periods. In such cases proration has been required of a taxpayer using the cash method, e. g., in situations involving prepaid insurance premiums. * * *"

The amortization statutes apply to capital assets and should not be stretched to items which do not fall in the capital asset classification.

The Tax Court has uniformly held that insurance for a one year period is a deductible expense even though it carries protection for part of a subsequent year. Kauai Terminal, Ltd. v. Commissioner, 36 B.T.A. 893, 898; Bell v. Commissioner, 13 T.C. 344, 348. The Tax Court has likewise held that the cost of insurance running more than one year should be prorated. Higginbotham-Bailey-Logan Co. v. Commissioner, 8 B.T.A. 566, 577; Jephson v. Commisssioner, 37 B.T.A. 1117, 1120; Martha R. Peters v. Commissioner, 4 T.C. 1236, 1242.

In our present case the Tax Court upheld the disallowance of the deduction of that part of the insurance premiums applicable to the years subsequent to 1952. The taxpayer had claimed a business expense deduction for all insurance premiums paid in each year here involved. In effect, the business expense deduction was allowed to the extent of the prorata cost thereof for the period ending in 1952. Such treatment was inconsistent with considering prepaid insurance as a capital asset. It would appear that, logically, prepaid insurance should in its entirety be treated either as a capital asset or a business expense.

The main reason assigned in Boylston Market and the Tax Court decisions why insurance should be treated as a capital asset is that the unexpired insurance has a surrender value. The same argument would be applicable to insurance running for a one year period, extending into a subsequent taxable year. It is common knowledge that the surrender value of a policy cancelled by the insured is upon a short term rate basis, and considerably less than the prorata return of the premium for the unexpired term. We do not believe that the fact that some salvage value could be realized at the end of the taxable year out of prepaid insurance is sufficient to make the prepaid insurance a capital asset. Some salvage value could also be realized out of miscellaneous supplies unused and on hand at the end of the taxable year, but this fact alone would be insufficient to warrant the classification of such items as capital assets.

We are of the opinion that prepaid insurance under the circumstances of this case is not a capital asset. Under the revenue statutes the depreciation deduction is only applicable to capital assets.

We now consider whether the entire premiums paid for insurance running more than one year are properly deductible as a business expense for the year of payment. Deductions of business expenses are authorized by section 23(a). Regulations 118, section 39.23(a) lists deductible business expenses, and included in the listed deductions is "insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business." The regulation contains no express limitation as to the period of insurance coverage.

The Commissioner, relying upon sections 41 and 43 of the Internal Revenue Code, 26 U.S.C.A. §§ 41, 43, asserts that the method of accounting employed by the taxpayer with respect to the insurance premium payments does not properly reflect income, and that the Commissioner is authorized to determine income by such method as will, in his opinion, clearly reflect income.

Section 41 provides in substance that net income shall be computed in accordance with the method of accounting regularly employed in keeping the books of the taxpayer, but that, if the method employed does not clearly reflect income, the computation shall be made in accordance with such method as, in the opinion of the Commissioner, clearly reflects the income. Section 43 provides that in the case of a taxpayer on a cash basis deductions shall be taken as paid or incurred, unless, in order to clearly reflect the income,...