Rev. Rul. 68-104

Advice has been requested concerning the proper income tax treatment of the sale of rental diapers in the situation described below.

The taxpayer was engaged in the operation of a commercial laundry that included a diaper rental service. In the current taxable year, taxpayer sold its diaper service business. Among the assets sold was the supply of used rental diapers. The cost of the diapers had been deducted as an ordinary and necessary business expense at the time they were initially placed in service, since taxpayer's experience had established that the average useful life of diapers for rental purposes was less than one year. Hence these diapers are not subject to depreciation and do not qualify as `property used in the trade or business' as defined in section 1231(b)(1) of the Internal Revenue Code of 1954.

Section 111 of the Code excludes from gross income recoveries of bad debts, prior taxes, and delinquency amounts to the extent of the absence of a related tax benefit. Section 1.111-1(a) of the Income Tax Regulations states that `The rule of exclusion so prescribed by statute applies equally with respect to all other losses, expenditures, and accruals made the basis of deductions from gross income for prior taxable years * * * but not including deductions with respect to depreciation, depletion, amortization, or amortizable bond premiums.' (Emphasis added.) See John V. Dobson et al . v. Commissioner , 320 U.S. 489 (1943), Ct. D. 1597, C.B. 1944, 56. The converse of this rule is that where amounts previously deducted from gross income (which thereby effected a tax benefit) are recovered in subsequent years, such recoveries are includible in gross income for the year of recovery. These rules are applicable in the present case, since the proceeds from the sale of diapers represent a recovery of amounts previously deducted for Federal income tax purposes.

Accordingly, the proceeds from the sale of the diapers in the instant case represent a recovery of amounts previously deducted for Federal income Tax purposes and are taxable as ordinary income to the extent of any prior tax benefit.