
    RKO THEATRES, INC., SUCCESSOR BY MERGER OF KEITH MEMORIAL THEATRE CORPORATION v. THE UNITED STATES
    [No. 333-56.
    Decided July 16, 1958]
    
      
      Mr. Harry Levine for the plaintiff.
    
      Mr. Sheldon J. Gitelman, with whom was Mr. Assistant Attorney General Charles K. Bice, for the defendant. Mr. Lyle M. Turner, Mr. Charles H. Magnuson, and Miss Jv/ne Murray were on the briefs.
   Need, Justice (Bet.),

sitting by designation, delivered the opinion of the court:

Following .a tragic fire that happened in 1942 at a night club, the Cocoanut Grove, in Boston, the Commonwealth of Massachusetts enacted, in 1943, a statute providing for inspection and licensing of buildings of public assembly. Prior to that time the City of Boston granted such licenses under its safety code. Thereafter, by section 4 of Chapter 544 of the Acts and Eesolves of the General Court of Massachusetts, licensing authority was given to the State Commissioner of Public Safety.

After the passage of the State legislation, the petitioner’s predecessor, Keith Memorial Theatre Corporation, was advised by the Commissioner that no future license would be granted unless the seating capacity of the theatre was reduced or new exit facilities and fire escapes were installed. The latter alternative was chosen and the necessary changes were made in the theatre at an aggregate cost of more than $60,000 in 1944 and 1945.

Petitioner’s return asserted a deduction for the construction expenses. The Commissioner of Internal Eevenue disallowed it upon a determination that it was a capital expenditure. The deficiency was duly paid and this suit filed.

Petitioner claims, first, the cost of these changes as a trade or business expense under Section 23 (a) (1) (A) of the Internal Eevenue Code of 1939, and, second, “that the property demolished and made useless by the work done exceeded in value tbe expenditures ordered capitalized by defendant.” Therefore the property values necessarily demolished by the required changes should be set off as an uncompensated loss.

The first claim as to business expense is based on the fact that $59,511.09 was spent in 1944 and $5,062 in 1945 upon the theatre property to provide proper exits required by the Commissioner of Safety. The details appear in Findings of Fact 8. These changes did not contribute to the efficient operation or attractiveness of the theatre or extend its useful life. See Finding 12.

First. Petitioner supports its argument that these expenditures were deductible business expenses under section 28 (a) (1) (A) of the 1939 Code by reference to cases that, while bearing on the application of the Trade or Business Expenses Section, do not touch upon the classification problem, as between business or capital expenses, section 24 (a) (2), see note 6, infra, for structural changes to meet governmental safety requirements. The language of the cases relied upon must be read in the light of the problem presented. For example, in Union Pacific R. Co. v. United States, 99 U. S. 402, an excerpt of which is quoted by plaintiff to support its argument that the present structural changes were not capital, the question was whether net earnings, five percent of which was to be paid on the indebtedness to the United States, were to be determined before or after deducting from gross earnings of “expenditures for station buildings, shops, &c.” They were held deductible, as a matter of good business practice in such a case, not as a legal conclusion such as is required under section 23. See pages 420-422. Actually the words quoted by petitioner seem to limit expenses to maintenance of “good condition and repair,” although the Supreme Court did consider in that case large improvements could be charged to income.

Plaintiff cites Illinois Merchants Trust Co., 4 B. T. A. 103, as a leading case in the capital versus ordinary expense controversy. There piles under a building rotted when exposed by recession of a water level. They were treated or replaced. The cost of repair was held to be an expense deduction for income taxation.

Plaintiff also relies on American Bemberg Corporation, 10 T. C. 361, affirmed without opinion, 177 F. 2d 200. There expensive foundation reconstruction was necessitated by previously unknown subsurface weakness. The expenditures caused no improvement of efficiency or extension of life for the plant. The cost was held an ordinary and necessary expense. The same result was reached in Kansas City Southern Railway Co. v. United States, 125 Ct. Cl. 287, also cited by plaintiff, where piles were necessary to shore up the railway tracks along a river bank when it was softened by water pockets and mudheaves.

Midland Empire Racking Co., 14 T. C. 635, apparently comes nearer to supporting plaintiff’s position than any other cited. There the court approved a business expense deduction when the taxpayer was compelled to line its concrete walled cellar storage room for meats with additional concrete to exclude damaging oil seepage from a nearby refinery under threat from Federal meat inspectors to oilproof the cellar or shut down the plant. The life or value of the building was not increased by the lining. Page 641. It was held the repairs were made in order that the taxpayer might continue to operate the plant. Since no new construction or equipment was added, the court held the facts called for the application of the holding in the Illinois Merchants Trust Co. case.

Since the decision of the Midland case, a case much closer on its facts to this case has been decided. In order to operate, tbe taxpayer was required by Trenton’s Building Inspector to construct a fire passageway to tbe street. It eliminated certain theatre conveniences.

It was held:

Tbe petitioner first contends that the cost of tbe construction and installation of the fireproof fire passageway was a charge against income for 1947 because unless the expenditure had been made the Capitol Theatre would have had to close in that year, and also, that the expenditure was made for the purpose of keeping the theatre property in good and ordinarily efficient operating condition. It contends further that the new passageway decreased the value of the theatre and the possibilities for its profitable operation rather than improving and bettering the theatre.
We do not agree with the petitioner. The fire passageway represented a permanent addition to the theatre property to give it an additional safety facility for the safe exit of its patrons from the balcony to an open area or a street. It was ordered by the city of Trenton. It was an improvement or betterment having a useful life of more than the year in which it was constructed and which depreciates over a period of years. 13 TCM at 551.

The Government and the cases admit the difficulty of differentiating in many instances between “ordinary and necessary expenses” on one hand, and, on the other, amounts “paid out for new buildings or for permanent improvements or bet-terments made to increase the value of any property or estate.” The finding against the taxpayer by the Commissioner is presumptively correct. Besides the New Brum-wick Theatre case, there has been Hotel Sulgrave, Inc. v. Commissioner, 21 T. C. 619. There the City of New York required a sprinkler system to be installed in an apartment house. No additional income or other advantage was realized from the installation. The court said:

We do not agree that the installation of the sprinkler system constituted a repair made “for the purpose of keeping the property in an ordinarily efficient operating condition.” Cf. Illinois Merchants Trust Co., 4 B. T. A. 103, 106, cited by petitioner. It was a permanent addition to the property ordered by the city of New York to give the property additional protection from the hazard of fire. It was an improvement or betterment having a life extending beyond the year in which it was made and which depreciates over a period of years. While it may not have increased the value of the hotel property or prolonged its useful life, the property became more valuable for use in the petitioner’s business by reason of compliance with the city’s order. The respondent did not err in determining that the cost of this improvement or betterment should be added to petitioner’s capital investment in the building, and recovered through depreciation deductions in the years of its useful life. International Building Co., 21 B. T. A. 617, 621, and cases cited therein; Difco Laboratories, Inc., 10 T. C. 660, 669.

Accord: George Haiss Mfg. Co., ¶ 57,241 P-H Memo TC. See also Mt. Morris Drive-in Theatre, 25 T. C. 272.

In the present case, the taxpayer decided to comply with the construction necessary to meet the requirements for safety. The additions and changes were not in any sense a repair or replacement of existing facilities. They were permanent changes designed to make it possible to carry on a business for profit. They were ordinary and necessary expenditures in the sense of a normal reaction of an owner to a governmental safety requirement for the operation of a profitable businesss. Cf. Defuty v. DuPont, 308 U. S. 488, 494-497. But putting in fireproof doors in masonry walls, reconstructing fire escapes, and closing an underground passageway are not the “ordinary and necessary expenses” of carrying on a business that allows a deduction from income for tax purposes under § 23 of the 1939 Code. This was not a repair, “a substitution of new parts or restoration of certain parts of a given whole,” but a capital improvement made to increase the value of the property for use in the taxpayer’s theatre business. Cf., Hotel Sulgrave, sufra.

Second. Petitioner argues also for a set-off against any disallowed expenditures of the depreciated cost, $47,000, of the portion of the theatre property demolished or made useless by the required improvements. See Commissioner’s Report, ¶ 11. There is an allegation in the petition referring to this destruction of values but apparently no claim was made to tbe Commissioner of Internal Revenue. See section 3772, IRC 1939; section 7422, IRC 1954. The brief of the Government dismisses this claim, summarily, thus:

The amounts alleged as property demolished or destroyed cannot be deducted pursuant to Section 23 (f) of the Internal Revenue Code of 1939. * * * Those amounts constitute the cost of making the structural changes pursuant to state authority. Therefore they are includible as part of the capital investment and cannot be set off against such expenditures.

Where realty is bought for the purpose of building a new plant or enlarging the old, the value of any buildings demolished to erect others is not a deductible loss. The same is true as to a lessor, when a lessee removes existing structures to erect a new building. The value of the existing property continues as a part of the cost of the new construction. It is to be capitalized and amortized. The same rule has been applied when the demolition is determined upon after acquisition.

If a building is demolished because unsuitable for further use, the transaction with respect to the building is closed and the taxpayer may take his loss; but if the purpose of demolition is to make way for the erection of a new structure, the result is merely to substitute a more valuable asset for the less valuable and the loss from demolition may reasonably be considered as part of the cost of the new asset and to be depreciated during its life, as is a broker’s commission for negotiating a lease.

We think the same rule should be applied here. The ownership of the theatre by petitioner is not a completed transaction. The depreciated value before the additions, plus the cost of the additions, when depreciated will restore the entire cost to the owner. It is not a repair of a fixture or wall, damaged by accident or natural forces. There is an addition of facilities to meet safety requirements made for the purpose of increasing the value of the property for use as a theatre. This we hold is a capital improvement.

Judgment shall be entered for the United States.

Laeamoee, Judge; Maddeh, Judge; LittletoN, Judge; and JoNes, Ohief Judge, concur.

EINDINGS OE EACT

The court, having considered the evidence, the report of Commissioner Mastin G. White, and the briefs and argument of counsel, makes findings of fact as follows:

1. The plaintiff is the successor-by-merger of the Keith Memorial Theatre Corporation. The Keith Memorial Theatre Corporation was organized under the laws of the State of Massachusetts on October 81, 1928, and it existed under that name and authority until October 26,1945, when it was merged into the B. F. Keith Corporation, a New York corporation. The name of the corporation was changed to KKO Theatres, Inc., on January 5, 1946, then to KKO Keith-Orpheum Theatres, Inc., on December 29, 1950, and then back again to KKO Theatres, Inc., on May 17, 1956.

2. For a number of years, including the tax years 1944 and 1945 that are involved in this action, the Keith Memorial Theatre Corporation owned and operated the Memorial Theatre in Boston, Massachusetts.

3. The Memorial Theatre was built in 1928 as a memorial to the recognized leader of the vaudeville form of entertainment, Mr. B. F. Keith, a Bostonian. It was the finest theatre in Boston, and one of the finest in the country.

4. At all times after its construction, the Memorial Theatre was a thoroughly fireproof building, and it enjoyed one of the lowest insurance rates available for that type of structure.

5. Until 1938, the Memorial Theatre was devoted to the exhibition of motion pictures and the presentation of vaudeville and stage shows. Since 1938, vaudeville and stage shows have not been presented, and the Memorial Theatre has been engaged only in the exhibition of motion pictures.

6. (a) As an aftermath of a disastrous fire which occurred in November 1942 at a Boston night club called the Cocoanut Grove, and which resulted in a large loss of life, the Legislature of the State of Massachusetts on June 12, 1943 enacted a cods of safety (Chapter 544, Acts of 1943), to which all theatres and others places of amusement and of public assembly were made subject.

(b) Before the enactment of the legislation mentioned in paragraph (a) of this finding, the City of Boston had exercised sole jurisdiction over places of amusement and of public assembly in Boston under its own safety code. Annual licenses to operate the Memorial Theatre and to exhibit motion pictures and present vaudeville and stage shows at the theatre had been granted by the City of Boston under its safety code from the time when the Memorial Theatre was first opened in 1928 to and including the year 1943.

7. When the newly enacted safety code of the State of Massachusetts became effective, State officials informed the Keith Memorial Theatre Corporation that no license for the operation of the Memorial Theatre during the year 1944 would be granted upon the termination of the 1943 license from the City of Boston on December 31, 1943, unless the corporation would either (a) reduce drastically the seating capacity of its theatre or (b) install new exit facilities and replace the existing fire escapes with new ones prescribed by State law. A failure by the Keith Memorial Theatre Corporation to adopt one of these alternative courses of action would have resulted in the closing of the Memorial Theatre. As the first alternative would have made it impossible to operate the theatre economically, the Keith Memorial Theatre Corporation chose the second alternative.

8. In order to comply with the State law, the following reconstruction work at the Memorial Theatre was necessary and was accomplished :

(a) Openings were cut in the existing masonry walls and fireproof doors were installed in the orchestra section, in the balcony, and on the stage at points leading to passageways, fire escapes, and stairways.

(b) Fire escapes and stairways were reconstructed, widened, and extended.

(c) The Tremont Street entrance to the theatre was abandoned. This involved placing a floor over and abandoning an underground passageway beneath Mason Street that led from Tremont Street to the theatre lobby.

9. In accomplishing the work mentioned in finding 8, the Keith Memorial Theatre Corporation expended $59,511.09 in 1944 and $5,062 in 1945. These figures together represent the total cost of all the work, including the necessary incidental demolition work, done on the Memorial Theatre in order to comply with the applicable State safety code.

10. As a result of the work referred to in finding 8:

(a) Stage facilities to the right and left of the stage, totaling more than 32,000 cubic feet of space and consisting of elaborately equipped and furnished dressing rooms, a property room, and a scenery room, were demolished and abandoned.

(b) Additional facilities aggregating approximately 26,-000 cubic feet of space were made useless for lack of access.

(c) The means of delivering scenery directly to the stage area from the street were destroyed.

(d) A store at Mason Street, from which an income of $1,500 per annum had been received by the Keith Memorial Theatre Corporation, was permanently destroyed.

(e) Space that had been reserved for elevators to serve four additional stories of the theatre building, if and when added, was blocked off.

11. The depreciated cost of the property demolished or otherwise made useless as a result of the work mentioned in finding 8 amounted to approximately $47,000 as of 1944.

12. The work done and the changes effected did not contribute to the more efficient operation of the Memorial Theatre, or enhance its attractiveness to potential patrons, or extend its useful life. However, all the changes were permanent in nature, and they made possible the continued operation of the Memorial Theatre, without any reduction in seating capacity, as a place of public amusement in the same manner that it had been operated since 1938, except for the loss of the underground passageway leading from Tre-mont Street to the theatre lobby and the loss of the yearly rental of $1,500 through the demolition of the store on Mason Street.

13. Policies regarding the presentation of motion pictures, vaudeville, and stage shows, separately or in combination, change with the public demand and taste. If vaudeville or stage shows were to become popular again, it would not be possible to present at the Memorial Theatre shows as elaborate as those presented prior to 1938, due to the demolition of a portion of the stage facilities.

14. In its income tax return for 1944, the Keith Memorial Theatre Corporation took as a deduction the amount of $59,-511.09 representing the cost of the reconstruction work done on the Memorial Theatre during that year. In its 1945 income tax return, the amount deducted by the Keith Memorial Theatre Corporation as the cost of the reconstruction work done in 1945 was $5,062.

15. (a) Upon auditing the income tax returns of the Keith Memorial Theatre Corporation for 1944 and 1945, the Commissioner of Internal Revenue disallowed the respective deductions of $59,511.09 and $5,062 referred to in finding 14. The Commissioner of Internal Revenue regarded these amounts as constituting capital expenditures, and he allowed the Keith Memorial Theatre Corporation a total deduction of $2,387.03 as depreciation for the two years in connection with such expenditures.

(b) The tax deficiencies resulting from the disallowances and allowances referred to in paragraph (a) of this finding amounted to a total of $52,114.79, which sum was duly paid.

16. On or about March 21,1952, the plaintiff filed in the office of the Collector of Internal Revenue, Third District of New York, three claims for refund in the respective amounts of $9,272.44, $30,321.15, and $12,521.20. They represented the principal amounts of the deficiencies referred to in finding 15. The ground for each claim was stated in the following language:

In J"une 1943, the Legislature of Massachusetts passed an act, as an aftermath of the disaster in Boston resulting from the Cocoanut Grove fire, establishing certain standards of safety for places of public assembly. In pursuance of this act, inspectors of the State Department of Safety, in November and December of 1943, informed deponent that its license to operate the Memorial Theatre in Boston would not be renewed upon its expiration date which was December 31, 1943. The renewal of the theatre license for 1944 was conditioned on the making of extensive changes in exit facilities of the said theatre. The changes were effected at very great cost and without the enhancement of the value of the theatre, its seating capacity, its earning power or the length of its life. The large expenditures made in 194417 to permit deponent to operate its theatre in the same manner as it had for many years prior to the new State legislation were ordinary and necessary expenses and were deducted by it in 1944. The Bureau compelled deponent to capitalize these expenditures. This was error.

17. By a registered letter dated August 4,1954, the District Director of Internal Revenue, Upper Manhattan District of New York, successor in office to the Collector of Internal Revenue, Third District of New York, rejected the claims mentioned in finding 16.

18. The plaintiff filed the present suit on July 31, 1956.

CONCLUSION OR LAW

Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that the plaintiff is not entitled to recover, and the petition is therefore dismissed. 
      
      
        Keith Massachusetts Corporation v. United States, No. 332-56, also a claim by a Massachusetts theatre to treat costs for required changes in structure as a deductible expense, is ruled by this opinion and a similar order ■will be entered. The only legal difference from the facts in the two cases is that in the Keith case improvements were put upon a leasehold with more than a year to run instead of a fee, as in the present case. We do not see that this difference in title affects the problem of whether the cost was a capital investment or an allowable expense. [Pursuant to the foregoing an order dismissing plaintiff’s petition in No. 332-56 was entered July 16, 1958].
     
      
       Sec. 23. Deductions from Gross Income.
      “In computing net income there shall be allowed as deductions:
      “(a) Expenses.
      “(1) Trade or Business.
      “(A) In General. All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity. * *
     
      
       See. 23. Deductions from Gross Income.
      “In computing net income there shall be allowed as deductions:
      “(f) Losses by Corporations. In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise.”
     
      
       Theoretically, the expenses chargeable to earnings include the general expenses of keeping up the organization of the company, and all expenses incurred in operating the works and keeping them in good condition and repair; whilst expenses chargeable to capital include those which are incurred in the original construction of the works, and in the subsequent enlargement and improvement thereof. 99 U. S. at 420.
     
      
       Pointing a wall to preserve a building for its useful life was held, citing the Midland Empire case, a business expense. City Nat’l Bank v. Commissioner, 11 T. C. M. 411; likewise as to cushioning or resurfacing a racetrack, Delaware Steeplechase and Race Assn., ¶ 50, 245 P-H TC Memo; likewise J. H. Collingwood v. Commissioner, 20 T. C. 937, terracing land in cultivation. “Nothing was added to the soil. No new farming areas were developed; and no clearing of the land or work to prepare land for cultivation was done. The terracing work did not change the fertility of the soil, or make farming operations easier. The terracing did not increase the value of the land or its products.” Id., at 942.
     
      
      
        Trenton-New Brunswick Theatres Co. v. Commissioner, 13 TCM 550.
     
      
       Internal Revenue Code of 1939, see. 24 (a) (2) ; cf. Hotel Kingkade v. O. I. R., 180 F. 2d 310, 312.
     
      
      
        Welch v. Helvering, 290 U. S. 111, 115.
     
      
      
         Red Star Yeast & Products Co., 25 T. C. 321, 349.
     
      
      
        Liberty Baking Co. v. Heiner, 37 F. 2d 703; Providence Journal Co. v. Broderick, 104 F. 2d 614.
     
      
      
        Anahma Realty Corp. v. C. I. R., 42 F. 2d 128; Young v. C. I. R., 59 F. 2d 691; Spinks Realty Co. v. Burnet, 62 F. 2d 860.
     
      
      
         Commissioner v. Appleby’s Estate, 123 F. 2d 700, 702. See also CCH Standard Federal Tax Reporter (1955), p. 18, 146; Biscow v. United States, 139 F. Supp. 775.
     
      
       The demolition work proper cost $14,905, and the cost of flooring1 over the underground passageway from Tremont Street amounted to $1,750.
     
      
       During 1944 and the early part of 1945, the seating capacity of the theatre was reduced by approximately one-fourth pending the completion of the structural changes in the theatre.
     
      
      
         The plaintiff's name was then RKO Keith, Orpheum Theatres, Inc.
     
      
       The phrase “and 1945” was added at this point In the claim for $12,521.20, which related to the deficiency for 1945.
     
      
       The word “large” was omitted from the claim for $12,521.20.
     
      
       The claim for $12,521.20 substituted “1945” for “1944”.
     