Citizens Fund Mut. Fire Ins. Co. v. Commissioner

Citizens Fund Mutual Fire Insurance Company, a Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent Citizens Fund Mut. Fire Ins. Co. v. Commissioner Docket No. 51781 United States Tax Court 28 T.C. 1017; 1957 U.S. Tax Ct. LEXIS 113; August 23, 1957, Filed *113 Decision will be entered for the petitioner. Petitioner, licensed and doing business as a mutual fire insurance company, held taxable as a mutual company under section 207, Internal Revenue Code of 1939, notwithstanding existence of guaranty fund certificates bearing interest, with principal payable from accumulated surplus, and which entitled the holders to elect one-half of the directors. Holyoke Mutual Fire Insurance Co., 28 T. C. 112, followed. Charles R.*114 Johnston, Esq., and Nicholas S. Kiefer, Esq., for the petitioner. George E. Van Roekel, Esq., for the respondent. Opper, Judge. OPPER *1018 Respondent determined a deficiency in petitioner's income tax for the calendar year 1948 of $ 24,347.41. The primary issue to be decided is whether petitioner was a mutual insurance company within the meaning of section 207 of the Internal Revenue Code of 1939. An alternative issue raised by amended petition and to be decided only if it is found that petitioner was not such a mutual insurance company, is whether, under section 204 of the Internal Revenue Code of 1939, petitioner may compute its reserve for unearned premiums on the full reserve basis (sometimes called the New York standard basis). FINDINGS OF FACT. Certain facts were stipulated and are so found. Petitioner, incorporated as a mutual fire insurance company under the laws of Minnesota on March 20, 1914, maintained its principal office in Red Wing, Minnesota. Since 1914 it has been licensed by the State of Minnesota as a mutual fire insurance company and has operated under the provisions of Minnesota law applicable to mutual fire insurance companies. In each *115 foreign State in which licensed to do business, it operated under the provisions of law applicable to foreign mutual fire insurance companies. Petitioner filed a timely Federal income tax return for 1948 with the collector of internal revenue for the district of Minnesota on Form 1120M, entitled "Mutual Insurance Company Income Tax Return." Petitioner filed its returns on similar forms for 1942 through 1947 with that collector and paid income taxes computed under section 207 for these years. Petitioner filed a copy of its annual statement with its returns for each year and the statement for each of the years 1944-1947 indicated the existence and the amount of the guaranty fund. Petitioner had no guaranty fund certificates outstanding prior to 1935. In 1935, petitioner (through a wholly owned subsidiary) issued to the Reconstruction Finance Corporation, hereafter referred to as R. F. C., a guaranty fund certificate bearing interest at the rate of 5 per cent per annum in return for a loan of $ 100,000, to be repaid in 5 annual installments. Petitioner paid the final balance on this loan in 1942, the guaranty fund certificate being retired at that time. R. F. C. never exercised nor*116 attempted to exercise any voting right in petitioner. R. F. C. originally declined to lend money to petitioner on guaranty fund certificates for lack of authority. It did so after the enactment on June 19, 1934, of Public Law No. 417, 73d Cong., 2d Sess., authorizing loans to mutual insurance companies. As petitioner retired the guaranty fund certificate issued to R. F. C., its surplus decreased and the directors informally in 1941 discussed *1019 the creation of a new fund. After receiving a letter from the Board of Insurance Commissioners, Austin, Texas, the directors discussed the necessity for taking some action with respect to the issuance of guaranty fund certificates. No director offered to buy the guaranty fund certificates. Hjalmar Hjermstad, petitioner's president, discussed the question with an investment banker who refused to handle that type of security. Hjermstad also discussed the question with the bank with which he did his banking business. The bank agreed to let Hjermstad and his wife borrow the money to buy the guaranty fund certificates. The two Hjermstads agreed to lend $ 35,000 to petitioner in exchange for its guaranty fund certificate in that amount. *117 Thereafter the bank loaned the money on the security of the certificate and Hjermstad's life insurance policy, both of which were deposited with the bank. The Hjermstads in turn paid the money to petitioner. Petitioner purchased United States Government Series G bonds with the money received, and held these bonds throughout the period 1944-1952. Petitioner received interest on the bonds at the rate of 2 1/2 per cent per annum. The pertinent parts of the certificate issued to Hjermstad and his wife on February 16, 1944, provided as follows: That * * * HJERMSTAD AND * * * [wife], have advanced to * * * [petitioner] for the creation of a Guaranty Fund, * * * ($ 35,000.00) to be repaid, together with interest thereon * * * of * * * (10%) per annum * * *; and that there is vested in said * * * HJERMSTAD and * * * [wife], or registered assigns, in consideration of said advance, all rights of a holder of record of a Guaranty Fund Certificate under the laws of * * * Minnesota * * *; and that, pursuant to agreement of the Company and vote of the * * * Directors * * *, the holder hereof shall be entitled to demand and receive at the principal office of the Company * * *, but only out *118 of funds available therefor in accordance with provisions of law applicable thereto * * *, payments until retirement of this Certificate, as follows: A. On December 31, 1944, interest from the date hereof at * * * (10%) * * *, and on each succeeding December 31, interest at said rate for the calendar year ending on that date; providing that, if funds available for such payments on account of interest in any year are insufficient to pay in full interest at such rate, the difference shall be paid in any subsequent year or years from funds available therefor under the provisions of law applicable thereto in such subsequent year or years; B. Such Guaranty Fund may be reduced or retired by vote of the * * * Directors * * * if the net assets of the Company, above its legal reserves, if any, and all other claims and obligations, are sufficient therefor. * * * * This Certificate shall be transferable only on presentation at the office of the Company, properly endorsed. This Certificate is fully paid and nonassessable. The return rate shown on the certificates did not indicate the actual amount of interest paid on the certificates issued to R. F. C. or to the Hjermstads. Although petitioner*119 initially paid 5 per cent to R. F. C., it later paid 4 per cent and 3 1/2 per cent for some periods. *1020 The Hjermstads were entitled by the terms of the certificate to receive a return of 10 per cent, the maximum rate allowable under Minnesota law, because it was not secured. They received the following amounts on the certificate while outstanding: Applicable Amount year Year paid $ 1,750 [1945] $ 1,750 [1948] $ 3,500 [1946] $ 3,500 [1947] $ 3,500 [1948] $ 3,500 [1949] $ 1,750 [1950] $ 1,750 [1951] $ 1,750 [1951] $ 3,500 [1952] An entry made in petitioner's journal in September 1952 transferred the 1952 payment of $ 3,500 to its bonus account from its dividend 1 account. The certificate remained outstanding approximately 8 years and 4 months. A 10 per*120 cent return on the certificate for 8 years and 4 months amounts to approximately $ 29,166. The amount designated by petitioner as "dividends" received by the Hjermstads was $ 22,750. Neither the bank nor the Hjermstads ever voted the certificate. The guaranty fund represented by this certificate was established and maintained in accordance with the laws of Minnesota. The Hjermstads were policyholders in petitioner while the certificate was outstanding. Upon payment of the principal to the Hjermstads on June 23, 1952, petitioner retired the certificate. The two guaranty fund certificates previously described were the only guaranty fund certificates which petitioner issued. The reasons for issuance of these certificates were: (1) The need to provide additional protection to policyholders during periods in which petitioner's surplus for policyholders (exclusive of guaranty funds) was at unduly low levels, both in absolute terms and in ratio to net premiums written; and (2) the need to insure that petitioner's surplus for policyholders (including its guaranty fund) would be sufficient to allow petitioner to continue to qualify to do business in the various States. Petitioner's surplus, *121 after providing for unearned premiums on the full reserve basis and exclusive of guaranty fund, increased from $ 56,823.49 in 1936 to $ 103,023.94 in 1948, and to $ 229,133.81 in 1952. Its articles of incorporation in effect throughout 1948 authorized petitioner to write fire and allied lines of insurance for its members. The material parts of article 6 provide as follows: 6. The management * * * shall be vested in a Board of not fewer than five nor more than nine directors, who shall be policyholders or holders of guaranty fund certificates, and shall be elected by ballot * * * *1021 Each holder * * * of any guaranty fund certificate * * * issued by this corporation shall be entitled to one vote in person or by proxy at any meeting of the members of the company for each $ 10 investment by him in its guaranty fund certificates and the certificate holders shall be entitled to choose and elect from among their own members or from among the policyholders at least one-half of the total number of Directors, and notice of the time, place and purpose of * * * all meetings of the members of the corporation, whether regular or special, shall be sent * * * to all the holders of record*122 of guaranty fund certificates * * * In 1948 petitioner's bylaws provided that an annual membership meeting be held and that notice of the time and place of this meeting should be printed on the back of every policy, receipt, and certificate of renewal, and that special membership meetings should be held only after at least 10 days' written notice to each member. Members were entitled to vote by written proxy, but no officer, director, or employee was permitted to vote any policyholder's proxy. Policyholders were not permitted to give proxies to any person except a member resident in the county where the proxy was given. With respect to the qualification of directors, petitioner's bylaws provided: No person shall be elected, nor be eligible to act as a Director of this Company, unless he is at the time of the election the holder of record of at least one policy of insurance of this Company. If any Director shall cease to be a policy holder of record his office shall * * * cease. These bylaws also provided that premiums on insurance policies issued should be determined at rating bureau rates or rates established by petitioner, and that the cash deposit collected on each policy was*123 the primary fund from which all losses and expenses were to be paid. Since petitioner's organization, its articles of incorporation or its bylaws have contained provisions requiring that it shall have no capital stock, that every policyholder shall be a member, that every policyholder shall be entitled to one vote for each policy of insurance in force, that every policyholder shall be entitled to a pro rata share of the dividends, that every policyholder shall be subject to a contingent liability for the payment of losses and expenses, that no funds shall be diverted to any purpose other than to indemnify members against losses and expenses, that all funds above the reserve for unearned premiums, liabilities, and such undivided surplus as the directors may designate for safety purposes shall be returned to the members as dividends to policyholders, and that on dissolution the reserve fund remaining after payment of losses, debts, and liabilities shall be distributed pro rata to the persons holding policies at the time of such dissolution. Petitioner operated in accordance with these provisions. During 1948, 11 States licensed petitioner to write fire and allied lines of insurance*124 for its members. *1022 Petitioner made its annual statement for 1948 and each prior year in which a guaranty fund was outstanding to Minnesota and to all other States in which it was licensed and doing business on a form approved by the National Association of Insurance Commissioners, and entitled "Mutual Fire Companies -- Association (Convention) Edition," and each statement showed petitioner's guaranty fund outstanding at the close of the year. Each insurance policy issued by petitioner during 1948, or in force at any time during 1948, contained the following provision: Mutual Policy Conditions The Company being a Mutual Insurance Company, organized under the laws of the State of Minnesota, every policyholder becomes a member of said Company during the period of their insurance, and the extent of the contingent liability of said members shall in no event exceed a sum equal to one annual premium. The insured hereunder is hereby notified that he is a member of the Company and that its annual meeting will be held on * * * The collector of internal revenue ruled petitioner to be exempt from Federal income tax as a mutual insurance company under subsection Tenth of section 11 (a) *125 of the Revenue Act of 1916 on May 7, 1919. The Commissioner of Internal Revenue ruled petitioner to be exempt from Federal income tax as a mutual fire insurance company under section 231 (11) of the Revenue Act of 1926 on April 7, 1926. The Commissioner reaffirmed petitioner's continued exemption from Federal income tax on October 10, 1935, by ruling that petitioner was exempt from the capital stock tax under section 701 (c) (1) of the Revenue Act of 1934 by reason of petitioner's exemption from Federal income tax under section 101 of the Revenue Act of 1934. In reliance on the foregoing rulings, petitioner made no return of Federal income tax for any year prior to 1942. During 1948 and prior thereto, petitioner belonged to the Minnesota Association of Mutual Insurance Companies and the National Association of Mutual Insurance Companies. The Minnesota Association limited its membership to mutual or cooperative insurance companies, associations, or corporations, incorporated under the Minnesota laws, or legally admitted to transact business in Minnesota. The National Association limited its membership to: Any mutual insurance company other than life which has been in continuous*126 successful operation for a period of at least five (5) years and which has the endorsement of at least two (2) active members of this Association * * * From January 1, 1944, to December 31, 1948, petitioner subscribed to or was a member of the predominant fire insurance rating bureau in each of the States in which it was licensed and wrote fire insurance. Insurance rating bureaus are regulated by State statutes and are under the supervision of a State officer. These bureaus promulgate rates for various types of insurance including fire and extended coverage. *1023 Insurance companies may qualify in the various States to write insurance at rates which deviate from the rates promulgated by the rating bureaus. Petitioner wrote fire and extended coverage insurance at rates below the rates promulgated by the insurance rating bureaus in the States in which it was licensed to do business. Throughout the years prior to 1944, petitioner operated substantially at cost. During 1948, petitioner had approximately 45,000 policies in the hands of members, each policy entitling the policyholder to one vote in person or by proxy at all meetings of the members of petitioner. The holders of*127 the guaranty fund certificate outstanding during 1948 were entitled to 3,500 votes. In its annual statements filed with the Minnesota commissioner of insurance and with its Federal income tax returns, petitioner computed its unearned premium reserves on the basis permitted to Minnesota mutual fire insurance companies having assessment liability in their policies. Petitioner endeavored to compute its reserves on statements submitted to foreign States in accordance with their requirements. Some States accepted the same reserves that petitioner used in its Minnesota statement. Iowa required mutual companies to have reserves of 40 per cent of the net premiums in force. Montana accepted petitioner's Minnesota statement with the same reserve as Minnesota. In North Dakota petitioner used a reserve based on 40 per cent of the premiums in force. In Texas petitioner used the full reserve basis after filing its 1940 statement and having its attention called to the fact that it had to have its reserves on the full reserve basis. In Nebraska petitioner filed under a mutual assessment section which allowed it to use the same reserve as the Minnesota basis. Texas was the only State in 1948*128 which required petitioner to file its statement on a full reserve basis. Petitioner conducted approximately 10 per cent of its 1948 business in Texas. Petitioner's unearned premium reserve, computed on the basis permitted to Minnesota mutual fire insurance companies having assessment liability in their policies, as of December 31, 1947, totaled $ 204,811.62, and as of December 31, 1948, totaled $ 235,323.31. These figures were used by respondent in computing the deficiency. Petitioner's unearned premiums reserve computed on a full reserve basis as of December 31, 1947, totaled $ 409,623.24, and as of December 31, 1948, totaled $ 470,646.62. In insurance company accounting, the term "unearned premiums" or "unearned premium reserve" reflects the liability of the company for premiums collected but not yet earned. The unearned premium reserve of stock companies under the laws of all of the States, and that *1024 of mutual companies under the laws of many States, must be computed on the full reserve basis. In computing the reserve on that basis, there must be allocated to it so much of the net premiums written on each policy in force at the end of the year as the length of the*129 term which the policy will continue after the end of the year bears to the total term of the policy. For the purpose of this computation it is generally assumed that the term of each policy begins on July 1 of the year in which it actually begins. The following schedule reflects unearned premium reserves on the full reserve basis: Unearned premium Policies reserve -- fraction in force of net premiums December 31 written 1 year or less 1/2 2-year policies: First year 3/4 Second year 1/4 3-year policies: First year 5/6 Second year 3/6 Third year 1/6 4-year policies: First year 7/8 Second year 5/8 Third year 3/8 Fourth year 1/8 5-year policies: First year 9/10 Second year 7/10 Third year 5/10 Fourth year 3/10 Fifth year 1/10 Over 5 years Pro rata Premiums paid in advance 100% The laws of Minnesota permit mutual fire insurance companies issuing policies with contingent assessment liability to compute the unearned premium reserve as an amount equal to one-half of that computed on the full reserve basis. In its annual statements filed with the Minnesota commissioner of insurance and with its Federal income tax returns, *130 petitioner always computed its unearned premium reserves on the basis of one-half of the full reserve. Minnesota law required periodic examinations of petitioner. The insurance examiners for Minnesota observe the rules set out in the Manual of Association Examination, prepared and published by the National Association of Insurance Commissioners, which direct the examiners to: Ascertain if provisions of charter and by-laws are complied with, and determine if all changes made during the period of examination were properly authorized and approved. Read the policyholders', stockholders', directors' and Executive, Finance, etc., Committee minutes for period under examination and report any act inconsistent with the charter or by-laws. Minnesota and Wyoming examined petitioner as of September 30, 1947. In their report to the commissioners of insurance of Minnesota and Wyoming, respectively, dated December 8, 1947, the examiners stated: *1025 The Company is operating on the mutual or assessment plan under and pursuant to the Laws of Minnesota governing fire insurance companies. * * * * The management is vested in a board of directors composed of five members who are elected by the*131 policyholders. * * * * A guaranty fund of $ 35,000 was established in 1944 pursuant to Section 3548, Mason's Minnesota Statutes. * * * * * * * In some of the states where the Company is licensed to transact business, the unearned premium reserve is required to be computed in accordance with the New York Standard Basis, [50%] and in some states the unearned premium reserve must be reported on the basis of 40% of the premiums in force. For the purpose of showing what the surplus would be if determined on the basis required by the respective states in which the Company is licensed, the following summary was prepared: Surplus, including States guaranty fund Minnesota, Nebraska, Oklahoma, Wyoming, Colorado and Montana $ 256,790.31 North Dakota, South Dakota and Iowa 177,920.63 Texas 74,349.80 The Minnesota Commissioner of Insurance approved and adopted this report. Minnesota next examined petitioner as of September 30, 1950. In this report dated February 19, 1951, the examiner stated: The Company * * * is operating on the mutual assessment plan under and pursuant to the laws of Minnesota governing fire insurance companies of this kind. * * * * The government of the*132 Company and the management of its affairs are vested in a board of directors consisting of five members, all of whom are policyholders. * * * * * * * A guaranty fund of $ 35,000.00 was established in 1944, pursuant to Section 3548, Mason's Minnesota Statutes. * * * The Minnesota commissioner of insurance approved and accepted this report. Fire and marine companies are generally classified under the following headings: (a) Stock companies; (b) mutual companies; (c) Lloyd's organizations; and (d) reciprocal or inter-insurance exchanges. The insurance industry classifies as mutual companies those companies which have paid-in guaranty funds including those companies, such as petitioner, incorporated in the jurisdictions the statutory law of which expressly authorizes the holders of guaranty fund certificates to exercise voting rights. Petitioner's insurance in force on December 31, 1948, totaled approximately $ 107,496,000. From its organization until the close of *1026 1948, petitioner wrote total net premiums of $ 10,490,181.07 and paid a total of $ 1,116,533.37 of dividends to policyholders. Petitioner was during the year in issue a mutual insurance company. OPINION. It cannot*133 now be doubted that the mere existence of a "guaranty fund," 2 with participating-certificate holders who are allowed to vote, will not alone classify an insurance company, other than life, as a "stock" company under section 204, I. R. C. 1939, rather than a "mutual" company under section 207. Holyoke Mutual Fire Insurance Co., 28 T. C. 112. In many respects that case resembles this one on its facts and, in principle, we find it indistinguishable. The differences relate only to details. Petitioner here was organized under the laws of Minnesota, while the Holyoke company operated in Massachusetts. 3 The guaranty fund there carried cumulative interest at *134 7 per cent, where here the rate is 10 per cent. 4 Certain provisions relating to the retirement of guaranty funds out of accumulated surplus, see Order of Railway Employees, 2 T. C. 607, may be slightly different in Minnesota from the Massachusetts law. But in no significant respect do we find any distinction in the law or facts governing the two cases. There is a further possible factual (or legal) distinction, the scope of which, however, as the case is presented by respondent, is not entirely*135 clear. In the Holyoke case, the directors elected by the certificate holders were required to be policyholders, whereas under Minnesota statutes certificate holders could elect directors "from their own number." But the condition of petitioner's bylaws here is that certificate holders may be directors 5 only if they are policyholders as well. The burden of respondent's argument throughout both cases seems to be that in practice the certificate holders could, if they wished, control *1027 or at least deadlock the company. This would be equally true in the Holyoke situation through the selection by the certificate holders, as directors, of friendly and controllable policyholders, including themselves and relatives and friends, if necessary even by having these become policyholders. Here, as we have said, all of petitioner's directors were in fact policyholders, and on their face the bylaws required them to be such. The possibility of control was hence no less present in the Holyoke case than here, and its practical exercise here as absent as it was there. We do not regard this as a valid distinction between the two organizations. Other considerations, if not*136 contentions, of respondent are similar to those advanced in Property Owners Mutual Insurance Co., 28 T. C. 1007, and are there disposed of. The Holyoke opinion, to be sure, was filed after the briefs in this proceeding were submitted. But we have had no application from either party to give us the benefit, by way of supplemental briefs, *137 of any contentions that the cases are distinguishable. One other aspect of the problem of "control" may warrant a short additional discussion. The conclusion in the Holyoke case was that, on the facts there present, there was no violation of those powers vested democratically in the policyholders which are presumably prerequisite to the designation of an insurance company as a mutual. See Mutual Fire, Marine & Inland Insurance Co., 8 T. C. 1212, 1217. Respondent contends here that, in fact, votes at the annual meeting could have been or were cast in a preponderant degree by the holders of guaranty fund certificates. 6 We think this contention adequately disposed of by the following quotation from the Holyoke case (p. 117): The respondent says that this company is dominated by the shareholders, since the voters at the annual meeting represent but a few policyholders while more than half the shares of guaranty capital are voted. It is also contended that one shareholder at such a meeting could elect half the board of directors while 100,000 policyholders elected the other half. If this is true it may be pointed out that the converse is also*138 true, one policyholder present could elect half the board while 1,000 shares of guaranty capital chose the other half. There appears to be some question whether the shareholders and policyholders vote separately or as a single group, but we consider it unnecessary to resolve the point. All policyholders have the right to attend and vote and the taxable *1028 status of the petitioner does not depend upon the number who exercise this right. *139 We find it impossible to distinguish in principle Holyoke Mutual Fire Insurance Co., supra, and Property Owners Mutual Insurance Co., supra, and on the authority thereof, Decision will be entered for the petitioner. Footnotes 1. No evidence to indicate the applicable year.↩ 1. Petitioner entered the amounts paid on the certificate in its books as dividends even though the certificate refers to these amounts as interest.↩ 2. A "paid-in guaranty fund" is a fund created by advances to a company of sums of money in consideration of the company's assumption of an obligation to pay an agreed rate of return until the principal is repaid, all payments by the company, both of the annual return and of the principal sum advanced, to be made from surplus only.↩ 3. Demonstrating further this similarity, respondent's brief in a related case ( Property Owners Mutual Insurance Co., 28 T. C. 1007↩) comments: "In two states there are provisions which expressly permit the guaranty certificate holders to elect half or at least half of the directors of the petitioner. These two states are Minnesota and Massachusetts." 4. We have found as a fact that the actual amounts received were less than a total of 10 per cent per annum.↩ 5. We have found as a fact that under the bylaws all of petitioner's directors were actually required to be policyholders. But respondent says as to this: "In regard to the power of the guaranty certificate holders over the operations of the petitioner, the Court's attention should be invited to provision in petitioner's by-laws * * * which states in effect that no person shall be elegible [sic↩] to act as a director unless he is a policyholder. Respondent submits that this provision is invalid because it is in conflict with the articles of incorporation of the petitioner * * * and also with sections 66.08 and 66.12 of Minnesota Statutes Annotated." 6. The following statements in petitioner's brief (p. 73) are disputed only collaterally by respondent: The record reveals that the guaranty fund certificate holders never in fact exercised their right to vote or their right to elect directors. All the policyholders had the right to vote and shared in the right to control the company and only policyholders voted at policyholder meetings. If the right to vote, as distinct from the exercise of that right, is important, then the voting power of the guaranty fund certificate holders was not sufficient to effect control. There were 3,500 guaranty fund certificate votes and over 45,000 policyholder votes.↩