Rev. Rul. 72-528

Advice has been requested concerning the proper Federal income tax treatment of insurance proceeds received by the taxpayer from his insurance carrier following the destruction of a certain asset under the circumstances described below.

The taxpayer is a publicly held corporation engaged in the manufacture of various types of machinery. It has conducted research and experimental activities in connection with development of new machinery and equipment. As part of these research and development activities the taxpayer constructed, in 1970, a "pilot model" of a machine for use in its product development program. The taxpayer claimed and was allowed, in 1970, a current deduction under section 174(a) of the Internal Revenue Code of 1954 for the entire amount of the costs incurred on the "pilot model." The entire deduction effected a reduction of the taxpayer's 1970 Federal income tax liability.

In September 1971, more than six months after the "pilot model" was placed in service, an explosion and fire occurred at the taxpayer's facility that resulted in the total destruction of the "pilot model." Subsequently, in 1972, the taxpayer was reimbursed by its insurance carrier for the loss suffered.

Section 174 of the Code provides two methods for treating research and experimental expenditures paid or incurred by a taxpayer in connection with his trade or business. Section 174(a) of the Code provides that the expenditures may be treated as expenses, not chargeable to a capital account, that are deductible in the year in which they are paid or incurred. Section 174(b) of the Code provides that such expenditures may be deferred and amortized over period of not less than 60 months (but only if they were not incurred in the acquisition of property subject to the allowance for depreciation provided by section 167 of the Code, or the allowance for depletion under section 611 of the Code). However, research and experimental expenditures that are neither treated as expenses under section 174(a) of the Code nor deferred and amortized under section 174(b) of the Code must be charged to a capital account. See section 1.174-1 of the Income Tax Regulations.

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 regulations states that "[t]he 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." See also 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 when amounts previously deducted from gross income (that thereby effected a tax benefit) are recovered in subsequent years, such recoveries are includible in gross income as ordinary income for the year of recovery. Rev. Rul. 68-104, C.B. 1968-1, 361. Together these rules are known as the "tax benefit rule." See generally Spitalny v. United States, 430 F.2d 195 (1970); and Commissioner v. Anders, 414 F.2d 1283, as corrected by order denying rehearing 414 F.2d 1289 (1969), certiorari denied, 396 U.S. 958 (1969), in which the courts held, in the context of a corporate liquidation to which section 337 of the Code applied that the "tax benefit rule" was applicable to restore to income amounts previously deducted properly under section 162 of the Code.

The "tax benefit rule" is applicable in the present case because the insurance proceeds received from the taxpayer's insurance carrier for the destruction of the "pilot model" represents a recovery of an amount previously deducted for Federal income tax purposes other than as depreciation, depletion, amortization, or amortizable bond premiums. Accordingly, the insurance proceeds are taxable as ordinary income in 1972 to the extent that they do not exceed the previous deduction.