DocketNumber： Docket No. 22761-81
Judges： Cohen,Pate
Filed Date： 2/6/1989
Status： Precedential
Modified Date： 11/14/2024
*20
Petitioner, a stock life insurance company, contracted with various financial institutions and automobile dealerships to pay them commissions and retroactive rate credits for placing credit insurance.
*254 OPINION
This matter was assigned to Special Trial Judge Pate, for consideration and ruling pursuant to the provisions of section 7456(d) (redesignated as section 7443A(b) by the Tax Reform Act of 1986, Pub. L. 99-514, *255 100 Stat. 2755) and Rules 180, 181, and 183. *21 adopts her opinion which is set forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
Pate, Insurance companies are regulated by the States in which they do business. As part of that process, they are required to file each calendar year a detailed "annual statement" prescribed by the National Association of Insurance Commissioners (hereinafter NAIC) with the State or jurisdiction of domicile and each State or jurisdiction in which they engage in the insurance business. Pursuant to During the years in issue, petitioner's principal business consisted of the sale of credit life insurance and credit accident and health insurance*24 (hereinafter collectively referred to as credit insurance) which it sold in connection with specific credit transactions. Credit life insurance provided coverage on the life of the person taking out aloan or financing a purchase (hereinafter borrower or insured) and provided for the repayment of the remaining indebtedness if the borrower died during the term of the insurance contract. Credit accident and health insurance provided that periodic payments due on the borrower's installment indebtedness would be made if, and while, he was disabled during the term of the insurance contract. Accident and health coverage could be obtained only if credit life was also purchased. In both types of insurance, the amount of the coverage decreased as the borrower made periodic or installment payments on the debt. Petitioner issued credit insurance principally under a single premium plan. In most cases, the amount of the premium was relatively small. For example, in 1975, the average initial coverage was $ 2,660, and the average single premium was $ 65 for credit life, $ 71 for credit accident and health, and $ 110 for combined coverage. Because the individual premiums were so small, petitioner*25 used a procedure whereby group insurance policies were issued to "accounts" consisting primarily of financial institutions *257 and automobile dealerships. *26 The accounts made loans or financed automobiles only for persons who the accounts had determined were creditworthy. Those borrowers who chose to purchase insurance *27 Petitioner recruited new and provided service to existing accounts through sales representatives. The recruitment of accounts was competitive because, as a practical matter, credit insurance is a homogenous product. Accounts generally selected or remained with a particular insurance company based on the level of income and service offered to the account by competing companies. Consequently, the solicitation *258 of new accounts by petitioner's representatives usually included a discussion of commissions and retroactive rate credits to be realized by the account. Petitioner and the accounts generally executed three documents to effectuate this arrangement: a group policy, *28 a commission agreement, and a retroactive rate credit agreement. However, where the amount of compensation for the sale of credit insurance was limited by law, the commission agreement provided for the maximum allowable amount of compensation and the retroactive rate credit agreement was omitted. *259 the group*29 policy to remit the refunded amount to the borrower. *30 Under the group policy, the account was required to deliver a certificate of insurance to each borrower describing the coverage he had purchased. *31 The account submitted a list of certificate holders (borrowers) and remitted the premiums collected thereon to petitioner at stated intervals. *260 Petitioner incurred the following amounts under its*32 commission agreements: Petitioner included these amounts in its deduction of commission expense on its 1974, 1975, and 1976 income tax returns. Respondent allowed the deduction of these commissions, and they are not in issue in this case. The third document involved was a retroactive rate credit agreement. *33 made a part hereof. *261 Thereafter, from the amount remaining there shall be deducted all earned commissions previously paid or advanced, losses incurred, and claim and/or contingency reserves chargeable to insurance written pursuant to agreement(s) between the Company and the Policyholder. Any balance then remaining following the preceding calculation *35 In late 1976, the language on the agreement was changed from "may be paid" to "shall be paid" in conjunction with raising the minimum account size eligible to receive a retroactive rate credit. The revision did not affect existing agreements and the new forms were introduced to new accounts on a State-by-State basis. Thus, both the "old" and "new" forms were in use concurrently. This change did not modify the manner or method petitioner employed to calculate or pay retroactive rate credits. The accounts did not completely understand the manner in which the retroactive rate credits were calculated, especially the deduction for the various reserves. However, they did have enough information to estimate roughly the amount due them, and they expected those amounts to be paid. In fact, at least one account changed to an insurance company other than petitioner for a time because the account was not receiving as large a retroactive rate credit as it had expected. By requiring the subtraction of claims in determining the amount of retroactive rate credits it paid the account, petitioner sought to encourage accounts to sign up only those borrowers who represented good insurance risks, *36 *262 thereby reducing the likelihood of claims on petitioner. *37 Petitioner calculated retroactive rate credits for each account pursuant to the formula contained in its retroactive rate credit agreement based on the "contract year." However, petitioner paid these credits only to accounts which had produced a minimum net written premium of $ 5,000 or more. Petitioner made no material changes either in the formula or the method of calculation during the years in issue. *38 its retention. Petitioner determined its retention by multiplying net premium earned by the applicable retention percentage prescribed in the account's retroactive rate credit agreement. Since the retention percentage provided petitioner with an up-front "profit," it necessarily varied because of the differing premium rates chargeable under applicable State law. From the remainder, petitioner subtracted the following items: (a) Earned commissions paid or advanced *263 pursuant to the commission agreement; (b) losses incurred, including an amount for claim reserves; (c) increases in contingency reserves; and (d) for credit life insurance accounts only, a negative unearned reserve. Losses incurred equaled claims paid plus the amount of the current period's claim reserve, less the amount of the previous period's claim reserve. Claims paid were the actual claims petitioner paid during the calculation period with respect to the credit insurance which the account wrote. The claim reserve was petitioner's estimate of the amounts which it would ultimately pay because of claims incurred but not yet reported, claims incurred and reported but not yet paid, and a portion of resisted*39 claims, as determined at the end of the period. The factors petitioner used in determining claim reserves were the size of the account, claims paid to the account's certificate holders in the current and prior periods, and earned premium. The contingency reserve was essentially a method to calculate the amount of net premium earned and unearned during a particular contract year. Petitioner determined the contingency reserve by multiplying "true earned premium" for the period (computed on the basis of the Rule of 78's for decreasing term credit life insurance and pro rata for level credit life insurance and credit accident and health insurance) by a percentage in accordance with a constant schedule established by petitioner. Petitioner added the product of the multiplication to the preliminary "true unearned premium." In effect, this "slowed" the payment of retroactive rate credits to the accounts. Upon termination, the amount of the account's contingency reserve eventually became zero as petitioner allocated all premiums to net premium earned. Petitioner computed the unearned reserve for each account by deducting from "true unearned premium" for credit life insurance and the account's*40 contingency reserve for all credit insurance: (a) The amount of retention; (b) the amount of commissions which would be applicable pursuant to the commission agreement and retroactive rate credit agreement; and (c) the account's portion of mortality reserves. If an account's unearned reserve was negative, *264 petitioner subtracted it from net premium earned for the particular period. After petitioner deducted all the above-described amounts from "net premium earned," the resulting balance was the retroactive rate credit for the period. If the resulting balance was negative, petitioner carried it forward to the next period. If it was positive, petitioner paid it to the account. Petitioner did not pay any retroactive rate credits to the insureds. When an account terminated or was canceled and the retroactive rate credit calculation resulted in a negative balance, petitioner absorbed that balance. If there was a positive balance, petitioner paid it to the account except that, under these circumstances, petitioner increased its retention percentage by 10 percent as authorized by the retroactive rate credit agreement. *41 and paid all losses and expenses arising from the insurance written by the account. Petitioner paid retroactive rate credits to its accounts of $ 940,799 in 1974, $ 1,049,692 in 1975, and $ 1,032,486 in 1976 pursuant to the calculations described above. Petitioner also established a reserve for retroactive rate credits (hereinafter reserve). Petitioner computed this reserve using the same formula for all years in issue. The reserve consisted of both earned and unearned portions. The "earned" portion was the major component, and it represented the aggregate amount payable under the retroactive rate credit agreements from the end of each contract year to December 31, except that the reductions for contingency reserves and negative unearned reserves were ignored. The "unearned" portion of the reserve was the aggregate of the unearned credit life insurance*42 premium and contingency reserve for all credit insurance which petitioner estimated would become payable in the future as a retroactive rate credit assuming future life insurance claims equaled petitioner's mortality reserve for the account. The unearned portion of the reserve was negative on December 31, 1975, and December 31, 1976, indicating that, if future credit life claims were equal to the amount of petitioner's mortality *265 reserve, petitioner would not have to pay any retroactive rate credits in the future with respect to its existing credit life insurance. Petitioner did not establish any reserve for credit accident and health insurance because of the unearned premium reserve required for the latter. The balances in the reserve on December 31 of each of the years specified were: These balances reflect an increase in petitioner's reserve in 1974 of $ 75,442 and in 1976 of $ 187,363 and a decrease in 1975 of $ 338,224. Therefore, after petitioner adjusted the retroactive rate credits for changes in the reserve, they equaled: *43 Petitioner took into account adjustments to the reserve in computing the amount of the deduction it claimed for commissions for Federal income tax purposes. Consequently, the use of the reserve in 1974, 1975, and 1976 actually decreased the commission deduction (thereby increasing underwriting income) by $ 75,519 over the 3-year period. Petitioner also included the reserve on its annual statement as part of "commissions to agents due or accrued" and as part of the "commission" data in petitioner's credit accident and health exhibits. The reserve is also referred to in the "triennial reports" in connection with the examination of commissions. In his notice of deficiency, respondent determined that retroactive rate credits paid by petitioner were dividends to policyholders and were subject to the limitations on deductibility applicable thereto. Respondent further determined *266 that no deduction was allowable with respect to petitioner's reserve for retroactive rate credits. In addition, respondent added $ 1,477,475 (the difference between the reserve balance on December 31, 1973, of $ 1,579,825 less the reserve balance on December 31, 1957, of $ 102,350) to petitioner's *44 1974 underwriting income because he determined that the disallowance of petitioner's reserve constituted a change in method of accounting. OPINION The first issue for our decision is whether petitioner may deduct retroactive rate credits it incurred as "return premiums,' "commissions," or "dividends to policyholders." This issue is significant because the amount of dividends to policyholders that may be deducted by a life insurance company is strictly limited by subchapter L of the Internal Revenue Code. 73 Stat. 112 (the 1959 Act), sets out a relatively complicated scheme for the income taxation of life insurance companies. *45 Basically, these provisions establish a three-phase approach for determining a life insurance company's taxable income. Sec. 802(b); see The major component of underwriting income is insurance premiums. Insurance premiums consist of the gross amount of premiums less "return premiums" and certain payments in connection with reinsurance. Lastly, The definitions of "return premiums" and "dividends to policyholders" are mirror images of one another. Return premiums are amounts paid to policyholders which In contrast, what return premiums and dividends to policyholders have in common is that each must be amounts paid to Consequently, before petitioner's retroactive rate credits are deductible either as dividends or return premiums, we must determine whether the accounts (to whom petitioner paid the retroactive rate credits) were "policyholders" as The group policy, commission*54 agreement, and retroactive rate credit agreement, all designate the account as "policyholder." We look, however, to the economic realities of a transaction not to the form employed by the parties, to determine tax consequences. *55 Using this approach, we find that the insureds, not the accounts, were the real "policyholders." The insureds decided whether to purchase petitioner's insurance based on their personal considerations. The accounts could not and did not require their insureds to purchase insurance from petitioner. Moreover, the insureds chose the particular *271 insurance policy they purchased. If they were not satisfied with the rights provided in petitioner's policy, they could buy insurance from an independent source. Therefore, the accounts did not determine whether there would be any coverage, the type of coverage, or whether the coverage would be purchased from petitioner. This situation stands in sharp contrast to the usual group policy (i.e., employer-provided insurance) where the named policyholder determines whether there will be any coverage, the persons covered, the amount of coverage, and from whom coverage will be obtained. Further, although the account was the primary beneficiary, petitioner relieved the insured or the insured's estate of the credit obligation in the event of the insured's death or disability. For example, if the insured purchased insurance covering an installment*56 obligation arising from his purchase of an automobile, then, in the event of the insured's death during the term of the insurance, his estate could distribute the automobile free of any debt without reducing his estate's other assets. Consequently, in handling his estate, the insured determined the real beneficiary of the policy. From the account's viewpoint, it based the decision whether to make the loan (which created the need for the insurance) on the general creditworthiness of the insured, not on the availability of insurance coverage. The account had to be satisfied that the insured would repay the loan because the more likely event was that the insured would outlive the term of the loan. Therefore, while the account's collection task was simplified in the event of the insured's untimely death, creditworthiness was the primary consideration in granting the loan. Additionally, the insured paid the premium. The account invested none of its own funds; it acted merely as a conduit between the insured and petitioner. The statute describes return premiums as "amounts returned" to the policyholder and the legislative history makes clear that the amounts returned must be in the*57 nature of redundant premiums. *58 Finally, the legislative history examined by the Court of Claims in Respondent argues, however, that the account was the policyholder, not only because the policy named him as such but because he enjoyed certain rights traditionally accorded a policyholder. Respondent identifies the "right" of cancellation, the "right" to demand the use of certain mortality tables in calculating reserves and the right to receive the retroactive rate credits. However, because the insured prepaid the premium on each policy, the account's "right" to cancel the coverage was illusory. The insured purchased and paid for coverage which petitioner had to provide. In fact, even if the account terminated his relationship with petitioner, petitioner continued all coverage which the account had written for the entire term. Consequently, as*60 a practical matter, only the insured could effectively cancel the policy and then only by prepaying his credit obligation. With regard to the "right" to demand the use of certain mortality tables, the record does not provide us with an evaluation of such right nor any evidence that any of the accounts ever exercised this right. Therefore, we have no basis on which to accord that factor much weight. Finally, the reason petitioner entitled the account to retroactive rate credits is the very question before this Court. Therefore, such right does not, in and of itself, support respondent's argument. Most importantly, we are convinced that petitioner paid retroactive rate credits as compensation to accounts for services they performed in conjunction with selling and servicing petitioner's insurance and, therefore, they qualify as a deduction under In generating the obligations which gave rise to the insurance, the accounts were already doing business with the persons having a need for petitioner's product, at the time when such need arose. Therefore, it was logical for petitioner to seek their services to sell its product. Moreover, in obtaining and processing the borrower's loan applications, the accounts possessed much of the information they needed to evaluate the borrower as an insurance risk. Therefore, the accounts were positioned naturally to solicit a prime group of prospects at little cost and with little effort. In fact, petitioner sought these relationships with the accounts for this purpose. Under their arrangement, *62 petitioner could not incur any liability for retroactive rate credits without first paying commissions to the account. The accounts also performed much of the paperwork traditionally performed by an insurance company providing insurance coverage. They were obligated to, and did, approve or deny applications by their borrowers for insurance (within certain policy limits) without further approval by petitioner. In addition, they calculated the premium, collected that premium from the borrower, computed the commissions due thereon, and forwarded the balance thereof to petitioner. They maintained records of certificate holders and collected claim information on forms provided by the petitioner. These additional services reinforce our conclusion that the retroactive rate credits were, in substance, compensation. Finally, the regulations expressly state that the form or method of fixing compensation is not decisive of deductibility and that contingent compensation is acceptable when it, in fact, constitutes compensation and is not a disguised distribution of earnings. Petitioner's accounting treatment of its retroactive rate credits is consistent with our finding. Petitioner represented its retroactive rate credits as "commissions to agents due or accrued" on its annual statement and as "commissions" in other reports. Petitioner included them in its deduction for commissions on its Federal income tax returns. Respondent argues, however, that the commissions petitioner incurred under the commission agreements fully compensated the accounts for the services they rendered. He maintains that the retroactive rate credits were not commissions because State law in some States prohibited direct payment of "commissions" or "other compensation" to the accounts. See, e.g., Respondent relies on Respondent also cites Texas Attorney General Opinion No. 297A (1961) for the proposition that the account was a credit insurance policyholder, that it did not "sell" insurance and, therefore, that it is not required to be a licensed insurance agent. However, in this case, we have already found that the accounts sold petitioner's insurance to their borrowers and realized sizable commissions therefrom. Moreover, since respondent has*66 allowed petitioner to deduct the amounts it paid to the accounts under the commission agreement as "commissions," it strikes us that he already has admitted that the accounts "sell" insurance. Respondent correctly observes that in Moreover, in To summarize, we find that the accounts were not "policyholders" within the contemplation of The total amount of the retroactive rate credits petitioner deducted as "commissions" on its Federal income tax returns consisted of amounts it paid the accounts under the retroactive rate credit agreements and adjustments for changes in its retroactive rate credit reserve (hereinafter sometimes referred to as the reserve). In other words, the amount of the commission deduction attributable to retroactive rate credits equaled the total retroactive rate credits actually paid through the end of each account's contract year, less the reserve balance at the beginning of the year, plus the reserve balance at the end of the year. *278 In the notice of deficiency, respondent determined that petitioner could deduct amounts actually paid under the retroactive rate credit agreements*69 but not the retroactive rate credit reserve. Accordingly, he eliminated changes in the reserve from the computation of petitioner's deduction for retroactive rate credits. Petitioner contends that inclusion of the reserve is a proper method of accounting and, therefore, that respondent's adjustment is unwarranted. Section 818 provides, in general, that life insurance companies must report their income and deductions using the accrual method of accounting. In addition, and to the extent possible, such accounting method should be consistent with that required by the NAIC. In The nature of * * * insurance requires accounting rules substantially different from the accounting rules applicable to general commerce. In commerce generally, expenses come first and income follows. The manufacturer must incur the cost of manufacturing his product before he gets paid for it. The merchant must purchase his inventory before he can resell it. In the insurance industry, however, the reverse is true. The policyholder pays the insurance company in advance and the insurance company's costs, which are primarily the payment of claims, come afterwards. If the premiums were to be taxed as received and the deductions allowed only as they later became fixed, the result would be to tax very large sums of money *73 as income when in fact those amounts will never really become income because they will have to be paid out to policyholders and other claimants. * * * * The Annual Statement method of accounting relies extensively on the use of estimated amounts which would be improper under general tax accounting. Thus, for example, instead of taking into income all of the premiums received or accrued, * * * insurance companies take into account only the portion of those premiums which are estimated to be "earned." Similarly, the major deductions from income are "losses" and "loss adjustment expenses," which are again estimated amounts. The deduction of these loss and loss adjustment expense items is fundamentally at odds with the "all events" test: The items include amounts for liabilities which are not established, but, on the contrary, vigorously *280 contested; they include, in the case of the loss adjustment items, expenses which will not only be paid in the future, but which are attributable to events which will not even occur until the future * * * . Petitioners herein do not contend that the Annual Statement method of accounting is controlling in every respect for tax purposes. However, *74 the Internal Revenue Code clearly adopts the basic approach of the Annual Statement method in computing underwriting income and that basic approach, *76 *281 Accrual accounting seeks to match income earned with expenses attributable to earning that income in the same accounting period. Under an accrual method of accounting, an expense Thus, there are two requirements an item of expense must satisfy to be properly accruable: (1) That all events necessary to "fix" liability for the expense have occurred, and (2) that the amount of the expense is ascertainable with reasonable accuracy (hereinafter all-events test). After consideration of the record in this case, we find that petitioner's retroactive rate credit reserve does not meet the all-events test for deduction of an expense. We have no quarrel with the deduction of retroactive rate credits which petitioner calculated at the end of each account's contract year whether paid or unpaid. The reserve, however, reflects retroactive rate credits both "earned" for a period which begins with the end of the various contract years of*80 each account and ends with December 31, and "unearned" on January 1 (the day after the end of the taxable year) and ending on those various dates on which the individual certificates would expire. We can dispose of the "unearned" portion of the reserve rather quickly. It is composed of estimated retroactive rate credits which petitioner might owe in the future, based on premiums petitioner had not yet taken into income. *283 Petitioner calculated this portion of the reserve by taking into consideration an estimated amount of claims for which the underlying events had not yet occurred. Because the unearned portion of the reserve provided for commissions on premiums not yet taken into income, petitioner failed to match income with expenses. Rather, petitioner deferred its recognition of premium income which it had already received and deducted commissions which might become payable thereon. Clearly, this procedure did not properly reflect income. Therefore, respondent's disallowance was warranted. *81 With regard to the "earned" portion of the reserve, however, petitioner's contention is not so easily dismissed. Petitioner correctly points out that premiums earned through December 31 of each year were included in its income as of the end of its taxable year. Consequently, to match income earned with expenses, all properly accruable expenses relating to such income should be taken into account. However, the earned portion of petitioner's reserve does not pass the all-events test. First, an account had to produce a minimum net written premium (usually $ 5,000) during a contract year *284 Second, claims for which the underlying events had not yet occurred at December 31 (the death or disability of an insured after December 31 but before the forthcoming end of each contract year) affected petitioner's liability for retroactive rate credits to any particular account. Because many claims were substantial when compared with the account's potential retroactive rate credit, these claims could easily prevent petitioner's contingent liability to that account from maturing into a liability in fact. Third, petitioner failed the first prong of the all-events test because the amount of *84 petitioner's total liability for retroactive rate credits depended on the distribution of claims among accounts. All other variables being equal, petitioner would be liable for a smaller aggregate amount of retroactive rate credits if a disproportionately large number of claims were made by insureds of an account with a positive balance rather than by insureds of an account with a negative balance. This disparity was caused by the fact that claims made by the insureds of an account with a positive balance currently reduced petitioner's overall liability for retroactive rate credits dollar-for-dollar, whereas claims made by insureds of an account with a negative position would not reduce petitioner's current liability at all. Therefore, not only the number and size of claims but the distribution of such claims among the various accounts would, after December 31, affect the amount of the liability actually incurred. Since the distribution of claims was not *285 established until after petitioner's taxable year, liability was not "fixed" at December 31. Fourth, petitioner's failure to take contingency reserves and negative unearned reserves into consideration when it calculated*85 the "earned" portion of the reserve was inconsistent with the liability it incurred under the retroactive rate credit agreement, resulting in consistently overstating the amount of the commission deduction. Petitioner's overstatement of the reserve precludes our finding that the amount of the reserve was reasonable. Petitioner's provision for a contingency reserve in the retroactive rate credit agreement operated to slow payment of the retroactive rate credits to the account. Therefore, the amount in the reserve at December 31 was greater than the liability under the agreement at that date. Moreover, use of a contingency reserve exposed the deferred credits to further dissipation by claims on insurance written after December 31, thereby actually reducing petitioner's ultimate liability for retroactive rate credits. The amount of the reserve could not be determined with reasonable accuracy in one other respect. Until petitioner knew what a particular account's total annual net premium earned was, it could not ascertain the proper retention percentage, which varied with the volume of premium the account produced in each contract year. Without being able to ascertain the retention*86 percentage, petitioner could not determine with reasonable accuracy the amount of its liability for future retroactive rate credits applicable to the period starting with the account's contract year and ending on December 31. Petitioner argues, however, that reserves similar to its retroactive rate credit reserve consistently have been allowed as deductions by various Courts. It cites in support thereof In In Similarly, in *287 The general rules of accrual accounting and the applicable sections of the Code and regulations are silent with regard to the question*89 of the method for determining the reserves under consideration in this case. However, the NAIC form and its accompanying instructions contain detailed specifications as to how the reserves are to be calculated. [ Petitioner's retroactive rate credit reserve, however, is not comprised of dividends to policyholders, deductible under Petitioner also cites The North American Life issue was later considered by the Supreme Court in Beyond the basic premise that expenses should be matched with related income, these cases simply do not apply to the case at hand. We are not here concerned with a fictitious assumption as to deferred and uncollected premium*92 income. The credit insurance premiums at issue here were all bona fide, collected premiums. Moreover, the allocation between the earned and unearned portions of that premium income is not in issue here. We assume that petitioner has properly reported the portion of the premium it collected that is includable in its gross income, as respondent has not questioned petitioner's method for determining the recognized portion of the premium. Rather, the issue here is whether at the end of each calendar year petitioner properly accrued commissions for which it was in fact liable in an amount that could be reasonably determined. We find that petitioner's reserve does not meet those criteria. Accordingly, we hold that petitioner may not take into account changes in its retroactive rate credit reserve for purposes of computing its commission deduction. The final issue for our decision is whether respondent's determination -- that petitioner may not take into consideration changes in its retroactive rate credit reserve in computing its commission deduction -- constitutes a change in method of accounting within the meaning of section 481. If it does, section*93 481 requires certain adjustments to *289 petitioner's income to prevent amounts from being either duplicated or omitted from the computation of taxable income as a result of the change. *94 Section 481 applies to not only a change in the taxpayer's overall method of accounting, but also to a change in the treatment of a "material item." Essentially, *95 this is the same argument made by the taxpayer in The court rejected the taxpayer's argument, reasoning that: The reserve method determines when income will be taxed. When deductions are taken early (at the time [additions are made] to the reserve), an equal amount of income is obviously not taxed. That income is taxed, however, at the later time when deductions would have been taken under a different system (i.e., at the time rebates *96 are paid, the absence of deductions means that an equal amount of income is taxed). Most important, at the time the company ceases to use the reserve (e.g., when the company closes out its business), any remaining balance in the reserve must be included in taxable income. * * * Thus, no income is avoided altogether. Any excess deductions in earlier years are offset by an equal amount of taxable income in the final day. The question becomes one of timing, whether income is taxed when the amounts are added to the reserve or when the reserve is abandoned at the Day of Armageddon * * * [ Here too, petitioner reduced its income earlier than was proper by accruing retroactive rate credits which had not matured sufficiently to meet the all-events test. This method of accounting allowed a deduction for retroactive rate credits in the year they were added to the reserve, and in effect, eliminated that deduction in the year in which they were properly accruable. We have already decided that petitioner's retroactive rate credits are fully deductible as commissions; the reserve does not change that. The reserve affected only the year in which *97 the deduction was claimed. Consequently, we find that respondent's disallowance of petitioner's reserve for retroactive rate credits constitutes a change in method of accounting. Accordingly, we hold that respondent's section 481 adjustment with regard to petitioner's reserve for retroactive rate credits is proper. 1. Unless otherwise specified, all section references are to the Internal Revenue Code of 1954 as amended and in effect during the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩ 2. The deficiencies for 1972 and 1973 resulted from the disallowance of net operating loss carrybacks from the latter years in issue.↩ 3. Respondent also determined deficiencies in petitioner's Federal income taxes for the years 1977, 1978, and 1979 in the amounts of $ 349,858, $ 156,858, and $ 1,002,931, respectively. A petition was filed (docket no. 7739-86) raising the same issues litigated here. The parties have stipulated that they will be bound for those subsequent years by the final decision in this case.↩ 4. The notice of deficiency includes other determinations not raised in the petition.↩ 5. Prior to trial, petitioner filed a motion for summary judgment pursuant to Rule 121, which was denied on Sept. 2, 1986, because there were factual issues to be resolved. Trial was held on those issues May 26 to 29, 1987, in St. Paul, Minnesota.↩ 6. Many of the facts have buen stipulated. The stipulation of facts, the two supplemental stipulations of facts, and the attached exhibits are incorporated herein by this reference.↩ 7. In addition to its group policies, petitioner wrote a minor amount of individual credit life and credit accident and health insurance policies. These policies are not at issue in this case.↩ 8. Most States prohibited an account from requiring a borrower to purchase insurance from it.↩ 9. Premiums charged for credit insurance are limited by State laws and regulations. Petitioner almost always charged the maximum amount permitted by law.↩ 10. Several different credit life policies were used by petitioner on a State-by-State basis during the years in issue. However, for purposes of our decision the differences between these various policies are not material.↩ 11. These laws generally limited total compensation to a stated maximum percentage of the premium. "Compensation" generally included commissions, dividends, and rate credits.↩ 12. Because of various State laws restricting insurance sales, sometimes an insurance agency related to the account was the named "policyholder."↩ 13. In contrast, life insurance typically is sold by an agent who sells the insured (or designated owner) a life insurance policy which, if participating, guarantees the policyholder the right to participate in the distribution of divisible surplus of the company (dividends). Although the company normally does not guarantee that there will be any divisible surplus earnings to be divided, to convince the customer to purchase the insurance, the agent usually shows him a nonbinding dividend illustration based on past dividends paid by the company and projected economic performance during the term of the contract. Generally, the customer pays the premium directly to the insurance company. He is usually the named "policyholder" and has the right to cancel the policy. The agent usually is paid a commission based on the amount of the premium.↩ 14. The group policy "premiums" clause provided in part that: "In the event of termination of the indebtedness of a Debtor to the Creditor through prepayment, refinancing, or otherwise, the insurance on said Debtor shall be cancelled. Upon receipt of notification from the Creditor of the cancellation of insurance on any Debtor prior to the Expiration Date stated in the Certificate issued to said Debtor, the Company will refund to the Creditor any unearned portion of the premium paid to the Company by the Creditor on account of said Debtor's insurance in excess of any cancellation charges, all in accordance with refund tables on file with the Insurance Department of the state where this policy is issued, and the Creditor shall pay to the Debtor all or such part of said refund to which the Debtor is entitled."↩ 15. Petitioner supplied the certificates of insurance. Specifically, they provided in part that: "In consideration of the payment in advance of the above Term Premium(s), the Company [petitioner] hereby insures the above named Debtor under a Creditor's Group Policy (herein called the 'Policy') issued to the Creditor [Account] named above, but only with respect to the coverage or coverages completed above * * *. The limit of the Company's liability against each such coverage shall be as stated herein, subject to all the terms, limitations and provisions of the Policy. Insurance under the Policy is for the above Term * * *. The limit of the Company's liability against such coverage shall be as stated herein, subject to all the terms, limitations and provisions of the Policy. Insurance under the Policy is for the above term."↩ 16. The group policy provided that: "Premiums under this policy are payable as stated in the application herefor and shall be paid to the Company by the Creditor [the account] at the same time the Creditor shall furnish the Company with reports and information required pursuant hereto."↩ 17. In 1980, this agreement was revised and the nomenclature changed. The revised agreement was entitled "Retrospective Commission Agreement" rather than "Retroactive Rate Credit Agreement." At trial, petitioner's witnesses sometimes referred to payments made pursuant to these agreements as "retrospective commissions."↩ 18. The group policy referred to the retroactive rate credit as follows: "In addition to or in lieu of a reduction in the premium rate, at the beginning of any policy year the Company may make a retroactive rate reduction for theprevious policy year. Such retroactive rate reduction, herein called 'retroactive rate credit' shall be applied in such manner as may be mutually agreed upon between the Company and the Creditor [Account]. Payment of a retroactive rate credit or its equivalent application shall completely discharge the liability of the Company with respect to the retroactive rate credit so paid or applied. No increase in premium rate shall be retroactive."↩ 19. For example, the retention schedule attached to one of the Retroactive Rate Credit Agreements provided in part: 20. It is obvious that at least three factors influenced an account's decision to try to sell insurance to a particular borrower: (1) The amount of commission on the sale; (2) the probability that a claim would be filed; and, (3) whether the account's retroactive rate credit balance was positive or negative. Because the amount of commission was so large relative to the amount of the average retroactive rate credit, the accounts may not have been strongly motivated to screen out borrowers with health problems. Moreover, if an account's retroactive rate credit balance with petitioner was already negative, it would be to the account's short term advantage to sell insurance to all risks in order to maximize the amount of its commissions. This was a viable alternative because, upon termination of the relationship, negative balances were absorbed by petitioner.↩ 21. In 1975, petitioner changed the computation of its mortality reserves (from the "1958 CSO 3%" to the "1958 CET 3%") but, this change was not taken into account for purposes of computing the retroactive rate credit reserve.↩ 22. The retroactive rate credit agreements provided that petitioner could waive the addition of 10 percent to its retention percentage. However, petitioner never did so.↩ 23. Subch. L of the Code (secs. 801 through 844) governs the income taxation of insurance companies, generally.↩ 24. The Deficit Reduction Act of 1984 substantially changed the Federal income taxation of life insurance companies for tax years beginning after Dec. 31, 1983. See sec. 211 et seq., Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 494, 720. These changes generally do not apply to the years at issue in this case.↩ 25. In computing underwriting income, (1) Premiums. -- The gross amount of premiums and other consideration, including -- (A) advance premiums, (B) deposits, (C) fees, (D) assessments, (E) consideration in respect of assuming liabilities under contracts not issued by the taxpayer, and (F) the amount of dividends to policyholders reimbursed to the taxpayer by a reinsurer in respect of reinsured policies, on insurance and annuity contracts (including contracts supplementary thereto); less return premiums, and premiums and other consideration arising out of reinsurance ceded. Except in the case of amounts of premiums or other consideration returned to another life insurance company in respect of reinsurance ceded, amounts returned where the amount is not fixed in the contract but depends on the experience of the company or the discretion of the management shall not be included in return premiums.↩ 26. During the calendar years 1974 through 1976, the provision concerning "other deductions" was found in 27. Sec. 162(a) provides: SEC. 162(a). In General. -- There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including -- (1) a reasonable allowance for salaries or other compensation for personal services actually rendered * * *↩ 28. The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. * * * If contingent compensation is paid pursuant to a free bargain * * * made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on a fair and advantageous terms the services * * * it should be allowed as a deduction * * *↩ 29. The amounts deducted by petitioner as "dividends to policyholders" consist solely of amounts attributable to ordinary life insurance policies which expressly provided for participating dividends and which were paid in accordance with a formula approved from time-to-time by resolutions of petitioner's board of directors. They are not at issue in this case.↩ 30. In general, any payment not fixed in the contract which is made with respect to a participating contract (that is, a contract which during the taxable year, contains a right to participate in the divisible surplus of the company) shall be treated as a dividend to policyholders. Similarly, any amount refunded or allowed as a rate credit with respect to either a participating or a nonparticipating contract shall be treated as a dividend to policyholders if such amount depends on the experience of the company * * *↩ 31. Respondent maintains that we should consider only the written contracts, and he objects to our use of parol evidence in determining the character of the retroactive rate credits. However, in determining the economic realities of a transaction, we cannot confine ourselves to consideration of just written materials. 32. See 33. This design was summarized by the Court of Claims as follows: "The legislative history indicates that Congress distinguished between the deductibility of policyholder dividends and of return premiums because it believed that unlimited deductibility against phase I income of policyholder dividends would enable mutual insurance companies to avoid taxation on investment income and thereby to obtain a competitive advantage over stock companies. Congress did not perceive the same inherent danger in allowing other amounts returned to policyholders to be deducted without limitation against phase I income. There is no indication that Congress understood, or intended to create, any other relevant distinction between the two deductions. [ 34. SEC. 818. ACCOUNTING PROVISIONS. (a) Method of Accounting. -- All computations entering into the determination of the taxes imposed by this part shall be made -- (1) under an accrual method of accounting, or (2) to the extent permitted under regulations prescribed by the Secretary, under a combination of an accrual method of accounting with any other method permitted by this chapter [i.e., chapter 1, relating to normal taxes and surtaxes] (other than the cash receipts and disbursements method).↩ 35. See also 36. In 37. We applied this principle in 38. This "matching" principle has been recognized with regard to life insurance companies. See 39. The Commissioner espoused these modifications pursuant to his power to disallow methods of accounting which do not clearly reflect income. 40. SEC. 461. GENERAL RULE FOR TAXABLE YEAR OF DEDUCTION. (a) General Rule. -- The amount of any deduction or credit allowed by this subtitle [i.e., subtitle A, relating to income taxes] shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.↩ 41. Although the premium for the entire term of the policy is collected from the borrower at the time the insurance is sold, petitioner does not recognize the entire premium as income when it is received. As explained in petitioner's accountant's report (Joint Exhibit 33AD): "Credit life insurance premiums are recognized as earned revenues ratably over the coverage period of each policy, averaging approximately 30 months. Substantially all of the unearned premiums * * * are calculated on the sum of the months method and represent the unexpired portion of premiums. "Credit accident and health insurance premiums and policy reserves: "Insurance premiums are recognized as earned revenues ratably over the terms of the policies. Unearned premiums * * * are calculated on the monthly pro-rata basis and represent the unexpired portion of premiums."↩ 42. Based on an average coverage of $ 2,660, an average combined premium of $ 110 and an average retroactive rate credit of 4 percent of premium, one loss of $ 2,660 would wipe out the retroactive rate credits attributable to approximately 600 insureds ($ 2,660 / ($ 110 X 4 percent)).↩ 43. These circumstances are analogous to those in 44. 45. Sec. 481 provides: SEC. 481(a). General Rule. -- In computing the taxpayer's taxable income for any taxable year (referred to in this section as the "year of the change") -- (1) if such computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then (2) there shall be taken into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted, except there shall not be taken into account any adjustment in respect of any taxable year to which this section does not apply unless the adjustment is attributable to a change in the method of accounting initiated by the taxpayer.↩ 46. United States v. Anderson ( 1926 ) Commissioner v. Court Holding Co. ( 1945 ) Peoples Bank and Trust Company v. Commissioner of Internal ... ( 1969 ) Lawyers' Title Guaranty Fund v. United States ( 1975 ) James v. United States ( 1961 ) United States v. Hughes Properties, Inc. ( 1986 ) Estate of James E. Craft, Thomas J. Craft v. Commissioner ... ( 1979 ) Comdisco, Inc. v. United States ( 1985 ) Bennett Paper Corporation and Subsidiaries v. Commissioner ... ( 1983 ) North American Life and Casualty Co. v. Commissioner of ... ( 1976 ) Trinity Construction Co., Inc. v. United States ( 1970 ) Prairie States Life Insurance Co. v. United States ( 1987 ) Graphic Press, Inc. v. Commissioner of Internal Revenue ( 1975 ) Knight-Ridder Newspapers, Inc. v. United States ( 1984 ) the-western-casualty-and-surety-company-v-commissioner-of-internal ( 1978 ) Republic National Life Insurance Company, Plaintiff-... ( 1979 )Year Deficiency 1972 $ 39,195.91 1973 4,473.56 1974 538,531.96 1975 189,476.68 1976 319,320.94 Total *22 Petitioner timely filed a petition alleging error in respondent's determination regarding certain "retroactive rate credits." Year Amount 1974 $ 4,987,103 1975 5,550,559 1976 9,932,495 Year Balance 1957 $ 102,350 1973 1,579,825 1974 1,655,267 1975 1,316,943 1976 1,504,306 Change Total Year Amount paid in reserve deduction 1974 $ 940,799 $ 75,442 $ 1,016,241 1975 1,049,692 -338,224 711,368 1976 1,032,486 187,363 1,219,849
Having found that the taxpayer's reserve conformed to NAIC requirements, the Court upheld the deduction.Footnotes
Equivalent company Annual net written premium Company retention retention (in terms of during the year preceding (in terms of percentage $ per $ 100 of decreasing the date of calculation of premium) life insurance $ 5,000 - $ 9,999 25% 0.1875 10,000 - 24,999 20 0.1500 25,000 - 29,999 18 0.1350 30,000 - 39,999 17 0.1275 40,000 - 49,999 16 0.1200 50,000 - 99,999 15 0.1125 100,000 - 199,999 14 0.1050 over - 200,000 13.5 0.10125 Authorities (18)