Modern Home Life Ins. Co. v. Commissioner

Modern Home Life Insurance Company, Petitioner 1 v. Commissioner of Internal Revenue, Respondent Modern Home Life Ins. Co. v. Commissioner Docket No. 1380-68 United States Tax Court 54 T.C. 935; 1970 U.S. Tax Ct. LEXIS 146; May 7, 1970, Filed *146 Decision will be entered under Rule 50. Held, an insurance company, which undertakes to pay the monthly sum due on the insured's mortgage while the insured is absent from work on account of illness or other disability, may treat as "unpaid losses" within the meaning of sec. 832(b)(5), the estimated liability in a subsequent year on account of a disabling illness or accidental injury in the taxable year (sec. 832(b)(5); Regs. sec. 1.832-1). Paul Johnston, for the petitioner. Robert D. Hoffman, for the respondent. Quealy, Judge. QUEALY *935 Respondent determined the following deficiencies in petitioner's income tax: Calendar year Deficiency 1961 2 $ 7,184.21 — 1962 — 3 11,594.61 — 1963 — 11,777.70 — 1964 — 1,804.40 Total 32,360.92 Due to *147 a concession by the petitioner, the only issue remaining for decision is the amount allowable to petitioner in taxable years 1962 through 1964 as deductions for losses incurred during those years on insurance contracts. A final computation of the petitioner's tax liability depends on the availability of net operating loss carrybacks in the years in issue. The parties agree on brief that the amount of any net operating loss and carryback thereof depends solely on our determination of the amount allowable as deductions for losses incurred on insurance contracts, and that the amount of the losses and available carrybacks can be automatically adjusted in a Rule 50 computation. FINDINGS OF FACT Some of the facts have been stipulated, and these facts are so found. The stipulations and exhibits attached thereto are incorporated herein by this reference. Petitioner Modern Home Life Insurance Co. was incorporated June 14, 1960, under the laws of the State of Alabama, with an authorized capital of 1,000 shares of common stock of the par value of *936 $ 100 per share. The petitioner commenced business with paid-up capital of $ 100,000 and paid-in surplus of the same amount, derived from the sale of *148 1,000 shares for $ 200 per share. The petitioner's home office, located in Montgomery, Alabama, served as the principal office until November 1965. Since that time the petitioner's operations have been directed from its offices in Valdosta, Ga., which was petitioner's principal office on March 25, 1968, the date on which the petition was filed in this case. For the calendar years 1961 through 1964, petitioner filed its income tax returns with the district director of internal revenue, Birmingham, Ala. For the fiscal period ended September 30, 1965, petitioner filed its income tax return with the district director of internal revenue, Atlanta, Ga. At the date of incorporation all of petitioner's capital stock was owned equally by Ralph S. DeLoach and members of his family, and J. W. Wells and members of his family. In 1961 the stockholders exchanged all of their stock in petitioner for stock of Modern Homes Construction Co. In 1964 all of the capital stock of petitioner was acquired by Modern Homes Finance Co., a wholly owned subsidiary of Modern Homes Construction Co. Petitioner has been licensed each year by the State of Alabama to carry on an insurance business and has been licensed *149 in no other State. During the taxable year 1961 through 1964 Modern Homes Construction Co. was engaged in selling, constructing, and financing shell homes, principally in the Southern and Southwestern States. Petitioner wrote a single master policy of group disability insurance for Modern Homes Finance Co. which insured payments on the indebtedness to the finance company in the event of the debtor's injury or sickness. Individual statements or contracts were issued pursuant to the master policy to the mortgagors purchasing shell homes from Modern Homes Construction Co. With respect to the liability of the petitioner to make payments on account of the insurable event, the master policy provided: LOSS OF TIME INDEMNITY If injury or sickness shall wholly and continuously disable an Insured Mortgagor and prevent him from performing each and every duty pertaining to his occupation, the Company, commencing with the fifteenth day of such disability and retroactive to the first day, periodically, will pay to the Policyholder for credit to the Insured Mortgagor's indebtedness to the Policyholder, monthly indemnity at the rate of the Insured Mortgagor's monthly installment payments due to the *150 Policyholder for the period of time the Insured Mortgagor is so disabled and under the regular care of a legally qualified physician or surgeon (other than himself) but not beyond the Maximum Period of Any One Disability shown in the Schedule nor beyond the expiration date of the Insured Mortgagor's indebtedness, whichever is the earlier. *937 The statement of insurance received by a debtor, the purchaser of a shell home, stated in part: MODERN HOME LIFE INSURANCE COMPANY, MONTGOMERY, ALABAMA, has insured the payments on the indebtedness to the CREDITOR, master policyholder, in the event of injury or sickness which has wholly and continuously disabled the Insured Debtor and prevented him from performing each and every duty pertaining to his occupation for a period of at least fifteen days, periodically, will pay, retroactive to the first day, to the Creditor the amount of the Insured Debtor's payment each month so long as the insured Debtor is so disabled and remains under the care of a legally qualified physician or surgeon (other than himself) but not to exceed 72 consecutive months as a result of any one illness or injury or beyond the expiration date of the indebtedness, whichever is *151 earlier. All indemnity payments are subject to the terms and limitations of the Master Policy. Petitioner deducted as losses incurred in each year the sum of the monthly mortgage payments due and owing in that year from sick or disabled mortgagors who had filed claims plus the estimated liability for the mortgage payments that would become due and owing in the next year from those claimants who were still sick or disabled on December 31 of the prior year. This estimated liability was computed by examining each claim file, which contained a physician's report and at times the physician's estimate of length of disability, and determining the number of months that the illness or disability would continue. The estimates were not in excess of the actual liability of the petitioner for such claims. The amounts deducted by petitioner as losses incurred, the monthly mortgage payments due at December 31, and the estimated additional liability which would become due after December 31 were as follows: Amounts Mortgage Estimated deducted by payments due liability for Year petitioner 4*152 at Dec. 31 payments after Dec. 31 — 1962 — $ 78,935.04 $ 56,735.13 $ 22,199.91 — 1963 — 161,154.51 101,423.42 59,731.09 — 1964 — 173,166.15 151,210.73 21,955.42 The respondent has disallowed the deduction of all amounts in excess of the mortgage payments due at December 31 of each year. OPINION The petitioner claims, and the respondent concedes, that the petitioner is taxable as an insurance company (other than life or mutual) under part III (secs. 831 and 832) 5 of subchapter L. Section 832(c)(4) permits an insurance company to deduct losses incurred (as defined *938 in subsection (b)(5) of section 832) during the taxable year. Section 832(b)(5) provides as follows: (b) Definitions. -- In the case of an insurance company subject to the tax imposed by section 831 -- * * * * (5) Losses incurred. -- The term "losses incurred" means losses incurred during the taxable year on insurance contracts, computed as follows: (A) To losses paid during the taxable year, add salvage and reinsurance recoverable outstanding at the end of the preceding taxable year and deduct salvage and reinsurance recoverable outstanding at the end of the taxable year. (B) *153 To the result so obtained, add all unpaid losses outstanding at the end of the taxable year and deduct unpaid losses outstanding at the end of the preceding taxable year. In determining the applicability of the statute to the facts in this case, both parties rely on the regulations. The respondent's regulations 6 provide that: In computing "losses incurred" the determination of unpaid losses at the close of each year must represent actual unpaid losses as nearly as it is possible to ascertain them. The respondent's regulations 7 also provide that: Every insurance company to which this section applies must be prepared to establish to the satisfaction of the district director that the part of the deduction for "losses incurred" which represents unpaid losses at the close of the taxable year comprises only actual unpaid losses stated in amounts which, based upon the facts in each case and the company's experience with similar *154 cases, can be said to represent a fair and reasonable estimate of the amount the company will be required to pay. Amounts included in, or added to, the estimates of such losses which, in the opinion of the district director are in excess of the actual liability determined as provided in the preceding sentence will be disallowed as a deduction. The district director may require any such insurance company to submit such detailed information with respect to its actual experience as is deemed necessary to establish the reasonableness of the deduction for "losses incurred." In respondent's view, the reserves did not represent "unpaid losses" because such losses did not, in fact, occur in the taxable year of the deduction. Respondent argues that the losses were contingent on the continuing nonpayment of mortgages as the result of the continuing illness or disability of the mortgagors. Respondent further argues that by claiming a deduction for the reserves the petitioner attempted to establish a reserve for future losses and that there is *155 no Code provision which permits such a reserve to be established. In support of his position, respondent relies on the principles of Brown v. Helvering, 291 U.S. 193, as applied by this Court in Simplified *939 ., 41 T.C. 5 (1963), and Peoples Bank & Trust Co., 50 T.C. 750 (1968), affd. 415 F. 2d 1341 (C.A. 7, 1969). The latter cases both deal with the accruability of a reserve for future expenses, in the one case a reserve for services to be rendered in subsequent years and in the other for interest to be paid. Petitioner takes the position that the facts show that the sickness or disability occurred within the year in which the reserve was deducted, and that the petitioner incurred a loss at that time which was, however, not paid at the close of that year. The petitioner then goes on to state, as its sole argument, that it has carried its burden of proving that its deductions for "unpaid losses" constituted a fair and reasonable estimate of the amount that it would be required to pay on such "unpaid losses." The petitioner does not cite any authority other than the regulations. At the outset, we must recognize that if the regulations are to be given any meaning, the terms *156 "losses incurred" and "unpaid losses" must be construed to include the estimated liability for losses which could not otherwise be accrued as a deduction in the year in which the insurable event occurred. No special statute or regulations would be required to permit the deduction of losses which were deductible as accrued liabilities as of the close of the taxable year. Therefore, the regulations must be construed to mean that a deduction will be allowed for a loss resulting from the occurrence of an event which fixed liability prior to the close of the taxable year notwithstanding that the amount of the liability cannot then be ascertained with certainty. The terms "losses incurred" and "unpaid losses" are predicated on insurance concepts of long standing. The same formula for determining the deduction for losses by other than life or mutual insurance companies may be found in the Revenue Act of 1928. In the application of that formula the accepted procedure was described by this Court in Pacific Employers Insurance Co., 33 B.T.A. 501 (1935), affd. 89 F. 2d 186 (C.A. 9, 1937), as follows: The amount claimed in the return filed by the petitioner and allowed by the respondent was *157 the result of a careful calculation based on the claims filed with it. An examiner investigated each claim, took into consideration a number of factors, listed in the stipulation, which might affect the amount of petitioner's liability and arrived at a sum that in his opinion the petitioner would be required to pay. These sums were totaled and the totals were listed by petitioner as the "unpaid losses" and approved by the respondent. In a case analogous on the facts, but arising under the different statutory provisions of the Revenue Act of 1918, deductions for losses calculated as in this case were allowed as "accrued but unpaid losses." Ocean Accident & Guarantee Corporation, Ltd. v. Commissioner, 47 Fed. (2d) 582. We conclude that the method used by petitioner in reporting unpaid losses in its return was proper and that the method now advanced by it is not in accordance with the statute. The respondent's determination is affirmed. *940 The procedure even antedates the 1928 Act. Similar procedures were promulgated under the Revenue Act of 1918 and affirmed in Ocean Accident & G. Corp. v. Commissioner, 47 F. 2d 582 (C.A. 2, 1931). In thus arguing that the allowance of the deduction in *158 this case should be measured by the strict terms of accrual, the respondent would ignore a long history of insurance law. Admittedly, all of the elements required for the accrual of a liability may not have been present. The respondent's regulations do not require that the liability meet the test of accrual. The insurance provided by the petitioner is closely akin to, if not within the category of, casualty insurance. The risk insured against was the risk that the policyholder would become sick or disabled and that his employment would thereby be interrupted. The petitioner was obligated to pay the insured's liability monthly under the terms of the mortgage during the period that the insured was prevented by this disability or sickness from performing his work. Thus, if we regard the initial sickness or illness or disability as the occurrence of the event insured against, the petitioner's liability to pay "something" became fixed on or before December 31 of the year in which the insured first became sick or disabled. The amount which the petitioner would be called upon to pay was dependent on the duration of that illness or disability but that condition went to a determination *159 of the amount of the liability, if any, rather than to the fact of liability. The petitioner has computed its liability for "unpaid losses" in accordance with respondent's regulations. The petitioner followed recognized procedures in estimating the amount of that liability on a case-by-case basis. The respondent does not challenge those estimates. In fact, subsequent events show that the estimates may have been on the low side. It clearly appears, therefore, that the petitioner's estimates were not "in excess of the actual liability" and that the deduction could not be disallowed on that account. The liability thus determined constituted "unpaid losses" within the meaning of section 832(b)(5) and the net amount was properly deducted by the petitioner under section 832(c)(4). Decision will be entered under Rule 50. Footnotes 1. This case was consolidated for trial only with that of Modern Home Fire & Casualty Insurance Co., docket No. 1379-68.↩ 2. Year 1961 is in issue only because of a claimed net operating loss carryback from a subsequent year.↩ 3. Petitioner acknowledges that in the final computation of its 1962 tax liability an adjustment in favor of the respondent is required under sec. 6213(b), I.R.C. 1954↩. 4. In each year petitioner computed its losses under sec. 832(b)(5), I.R.C. 1954↩, by adding the reserve for that year to the losses paid in that year, and by then subtracting from this sum the reserve for the prior year. 5. Unless otherwise indicated all subchapter and section references are to the Internal Revenue Code of 1954, as amended.↩ 6. Sec. 1.832-4(a)(5) applicable to taxable years beginning after Dec. 31, 1962; sec. 1.832-1↩ applicable to taxable years beginning before Jan. 1, 1963. 7. Sec. 1.832-4(b) applicable to taxable years beginning after Dec. 31, 1962; sec. 1.832-1(b)↩ applicable to taxable years beginning before Jan. 1, 1963.