Western Casualty & Surety Co. v. Commissioner

WILLIAM E. DOYLE, Circuit Judge. We here review a decision of the Tax Court which upheld in part the Commissioner’s determination of deficiencies in the Western Casualty and Surety Company’s income tax for the taxable years 1967, 1968 and 1969. The basic issue is one of income tax law as it pertains to a fire and casualty insurance company. We must determine whether the petitioner was entitled to include as deductions commissions on deferred premium installments, in the computation of “expenses incurred,” as defined in § 832(b)(6). The second issue must be considered only if it is ruled that the Commissioner was correct in denying deductions on deferred premium installments. That is concerned with how the taxpayer’s income is to be adjusted so as to reflect the change of accounting method required by the Tax Court’s determination on the first issue. There is little or no dispute as to the facts. Western is a stock fire and casualty company organized under the laws of Kansas. It is petitioner’s custom to issue insurance policies covering a period of more than 12 months from the effective date of the policy. The duration of these is generally three years or five years. The insured has an option to pay only the premium for the first year of coverage, and he may pay the premium installment for each succeeding year of coverage on the anniversary date of the insurance or he may allow the policy to lapse by not paying the premium. Western also has one year policies under which the premium may be paid in installments within the policy year. This policy lapses also if there is a failure to pay an installment. The portion of the premium which is not paid at the outset is called “deferred premium installments.” In its annual statement an insurance company is required to report its annual premiums on policies in force and its gross and net premiums. The company may include deferred premium installments either as they become due or as if they were in fact prepaid. Western has chosen the latter method, that is has included its deferred premium installments as if they had been — 516 — prepaid. Each year it establishes a reserve for unearned premiums and the deferred premium installments are included. Commissions are paid to salesmen both currently and in ensuing years only if actual payment is made of the premium by the insured. However, the total amount of commissions for the entire term which are anticipated to be payable are charged to reserves for commissions at the time a policy is written. These reserves are reduced as the commissions are actually paid. As noted above, Western pays commissions to its agents according to the premiums actually paid by the policyholder. Under the policies with respect to which there are deferred premium installments, the total of the agent’s commission which will be payable if the policy is continued in force for its entire life is added to its reserve for commissions at the time of writing. This reserve is reduced as the commissions are paid. In the years in question Western added the amounts of the reserves for commissions to the commissions actually paid and deducted the entire sum. The Commissioner determined that since Western had not been obligated to pay the commissions until premiums were actually paid and inasmuch as the policyholders were not obligated to pay premiums, the deduction of the whole amount, that actually paid and that which was treated as reserve, constituted an overstatement of deductions to the extent that it included unpaid commissions on deferred premium installments. It is this action of the Commissioner, which was affirmed by the Tax Court, which is the first issue on this appeal. The Tax Court pointed out that § 1.446-l(c)(l)(ii) of the regulations provides that a deduction under the accrual method of accounting is not allowable for a taxable year unless all events have occurred which establish the fact of liability giving rise to such deduction. The Tax Court rejected the contention of Western that its receipt of deferred premium installments was to be regarded as merely a matter of collection since the obligation to pay the premium had not arisen. It reasoned that since the policyholders are not obligated to pay premiums and since there is no legal right on the part of Western to collect its payment of related commission, it is not to be considered merely contingent on collection. The Tax Court relied on the last sentence of § 832(b)(6), which provides that the deductions are to be reduced by expenses incurred which are not allowable as deductions by subsection (c). I. DID THE TAX COURT ERR IN RULING THAT TAXPAYER WAS NOT ENTITLED TO INCLUDE AS DEDUCTIONS SALES COMMISSIONS ON DEFERRED PREMIUM INSTALLMENTS AND THAT SUCH COMMISSIONS CAN BE DEDUCTED ONLY IN THE YEAR PAID? The applicable taxing statute is I.R.C. § 832. Part (b) deals with income, and subsection (b)(6) defines “expenses incurred.” The deductions are provided for in § 832(c). The part of that section which is relevant is § 832(c)(1), allowing deduction of “all ordinary and necessary expenses incurred, as provided in section 162 (relating to trade or business expenses).” Section 832(b)(6) defines the term “expenses incurred” as meaning all expenses shown on the annual statement approved by the National Association of Insurance Commissioners. It goes on to say that these are to be computed as follows: “To all expenses paid during the taxable year, add expenses unpaid at the end of the taxable year and deduct expenses unpaid at the end of the preceding taxable year.” It goes on to provide that “there shall be deducted from expenses incurred all expenses incurred (as defined in this paragraph) which are not allowed as deductions by subsection (c).” The taxpayer contends that the commissions shown on the statement of the NAIC are deductible because of the fact that they are shown on the annual statement ap — 517 — proved by the NAIC in the initial year of the policy. However, the Tax Court rejected this argument, relying on the last sentence of § 832(b)(6), just referred to, which prohibits deduction of all expenses incurred which are not allowed as deductions by subsection (c). The position that the Tax Court thus took was that the obligation of the taxpayer to pay commissions is not fixed until the premium installment is paid. Because of this, under normal § 162 standards the commission could not be considered an accrued expense and deducted immediately even by an accrual method taxpayer. Since § 832(c) incorporates expressly § 162, including its standards, the Commissioner’s position and that of the Tax Court are in accordance with the applicable provisions of the Code. The taxpayer’s contention is that the reference to § 162 is to the type of commissions and not to the timing of the deduction. Thus, there is a conflict. On the one hand, the item of deduction does appear on the statement just as § 832(b)(6) requires. One question is whether this of itself gives it the character of a deduction. In addition, the Tax Court reasoned that since deferred premiums were not included in income in the year that the policy was sold, under § 832(b)(3)-(4), the result is that the deductions fail to match up with the related income, the premiums. Consequently, the taxpayer’s method of accounting fails to reflect income from which the commission can be deducted. We are in full agreement with the Tax Court’s conclusions and reasons. Finally, we must reject Western’s position that the “expenses incurred,” which term appears in § 832(b)(6), are deductible if shown in the annual statement in accordance with NAIC regulation. The consequence of this, according to Western’s further argument, is that the presence of unpaid commissions on the annual statement form is itself enough to render them exempt from the requirements or standards of § 162, so that they can be deducted without more. The further consequence of this argument is that in the case of a conflict between the NAIC statement form and a provision of the Code, § 162, the latter is to be ignored or construed as meaning only those expenses that are not shown on the annual statement and are to be tested against subsection (c). The effect of this latter approach is subversion of § 162. Also, this would lead (as was pointed out in the Tax Court’s opinion) to an anomalous result. It would mean that anything appearing in the report would be free of being disallowed under § 162 whether it is in agreement with the relevant Act of Congress or not. This we cannot accept. In 8 J. Mertens, The Law of Federal Income Taxation § 44.55 (1970), it is stated that § 832(b)(6) is to be read in connection with § 832(c) “which further defines the deductions which insurance companies of this class may take.” Id. at 221. The latter provision lists the deductions allowable to an insurance company. The Mertens analysis, which construes § 832(b)(6) with § 832(c) for the present purposes, is followed by the Tax Court in this case. In this connection it is to be concluded from the last sentence of § 832(b)(6) and § 832(c)(1), that the NAIC forms are not absolute and that where they conflict with the ordinary requirements of § 162, the latter prevails. The position of the Commissioner and of the Tax Court is supported by Commissioner v. General Reinsurance Corp., 190 F.2d 148 (2d Cir.), cert. dismissed, 342 U.S. 863, 72 S.Ct. 111, 96 L.Ed. 649 (1951). In that case the court was construing § 204(b)(1) of the 1939 Internal Revenue Code, which was identical in pertinent part to the present § 832(b)(1) and which required gross income to be “computed on the basis of the underwriting and investment exhibit of the annual statement of proof by the National Convention [now Association] of Insurance Commissioners.” The court there said in pertinent part as follows: This is what we think Congress intended, that is, to require the taxpayers to report their true net income for taxation, allowing them to take the “Convention Form” as their “basis” for computation. But in so far as that computation excluded fac — 518 — tors, like the unauthorized unearned premium and loss reserves here involved, which the statutory methods of reporting income in subdivisions (5) and (6) did not exclude, we think that the specific provisions of the statute are controlling. 190 F.2d at 151. Thus, the case holds that where there is a conflict between the National Convention of Insurance Commissioners, now National Association, and the revenue statute, the latter controls. To the same effect is Commissioner v. United States Guarantee Co., 190 F.2d 152 (2d Cir. 1951). The decision of the Tax Court is also in general accord with the requirement of symmetry of income and expenditure entries, which is prescribed in Commissioner v. Standard Life & Accident Insurance Co., 433 U.S. 148, 97 S.Ct. 2523, 53 L.Ed.2d 653 (1977). We must conclude that the Commissioner and the Tax Court were correct in holding that the relevant statutes prevail and were in conflict with the NAIC. Deference to the NAIC would allow the deduction of commissions which had not been actually paid or incurred and were mere accounting entries. II. WHETHER THE COMMISSIONER AND TAX COURT ERRED IN HOLDING THAT IMPROPER DEDUCTIONS TAKEN BY THE TAXPAYER PRIOR TO 1967 COULD BE CORRECTED BY MAKING AN ADJUSTMENT IN TAXPAYER’S 1967 INCOME PURSUANT TO I.R.C. § 481(a). In Part I of this opinion we have upheld the determination that petitioner-appellant is allowed to deduct sales commissions applicable to deferred premium installments only in the year in which such commissions are actually paid. We must now consider the extent to which the Commissioner is authorized to correct the improper deductions which were made by taxpayer prior to 1967. The Commissioner included in taxpayer’s 1967 income an adjustment amounting to $6,404,442. He did so pursuant to § 481(a) of the I.R.C., which provides that if the taxpayer computes his income under a method of accounting different from the method under which the taxable income for the preceding taxable year was computed there shall be taken into account, in the year of the change, those adjustments necessary to prevent the duplication or omission of amounts of gross income or deductions.1 The amount of the adjustment found by the Commissioner was $6,527,381. This was the amount of the reserve for unpaid commissions as of December 31, 1966. The net figure, $6,404,442, reflected a deduction of $122,939 for policies sold prior to 1954, the date of the enactment of the adjustment statute. The taxpayer also deducts this figure in compliance with the “except” clause of § 481(a). Taxpayer does not dispute the fact that an adjustment is necessary to comply with § 481(a). The difference between it and the Commissioner is a sizable amount. The taxpayer argues that it should be $5,059,297 rather than the Commissioner’s amount, $6,404,442. Thus, the dispute involves a $1,345,145 difference. The controversy turns on the interpretation of § 481(a). — 519 — The taxpayer’s first argument is that since it was not yet known in 1967 (the taxable year for which § 481 requires an adjustment) how much of the remainder of the reserves would ultimately have to be paid out as commissions, it was unknown whether any duplication of deductions would occur. Taxpayer acknowledges that some adjustment must be made; that it is required by § 481(a) due to the change of accounting method.2 There can be no dispute as to the need for adjustment for commissions previously deducted which were actually paid in 1967, because under the modified system of accounting such expenditures are deductible in 1967. Therefore, adjustment is essential in order to prevent duplication of the deduction. By the same token, the balance of the taxpayer’s December 31, 1966 reserves will result in duplicated deductions in later years if they are actually paid (i.e. if the premium installments are paid by the policyholders). If, of course, the premium installments are not paid, no duplication will occur since no future deduction will be allowable under the new method of accounting. The commissions which have been deducted previously (in the year the policies have been sold), but which will never be paid, will result in an omission from the taxpayer’s income. Under taxpayer’s former method of accounting these commissions were deducted from reserves for unpaid commissions in the year when it was determined that they would not have to be paid. This constituted a correction of taxable income in that year. Under the new method of accounting the reserve is not taken into account in computing the deduction for commissions. The result is that commission expenses that have been improperly deducted in prior years, which would have been corrected under the old method of accounting, will not be corrected under the new method. These result in an omission from income “solely by reason of the change” in accounting method within § 481, whereby an adjustment under that provision must be made. Taxpayer contends that under any method of accounting the commissions previously deducted would have to be added to income in the year that it is determined that they will not have to be paid. This is the so-called “tax benefit rule.” See, e.g., Commissioner v. Anders, 414 F.2d 1283 (10th Cir.), cert. denied, 396 U.S. 958, 90 S.Ct. 431, 24 L.Ed.2d 423 (1969); Southwestern Illinois Coal Corp. v. United States, 491 F.2d 1337, 1339 (7th Cir. 1974); 1 J. Mertens, The Law of Federal Income Taxation § 7.34, at 111 (1974). However, the Commissioner need not wait for this eventuality. Inasmuch as the omission results solely from the change in accounting method, § 481 requires that the adjustment be made in 1967, the year of the change. Moreover, the taxpayer’s first argument would prevent a § 481 adjustment from being made in any case in which the Commissioner disallows the accrual of an item of deduction under the “all events” test;3 the application of that test always implies a possibility that the deduction in a future year will never occur. This would severely limit the applicability of § 481 and would defeat its basic purpose of preventing a distortion 'of taxable income and a windfall to the taxpayer as a result of change in accounting method at a time when the statute of limitations is a bar to a reopening of the taxpayer’s early returns. See Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 572 (5th Cir. 1965). Thus, § 481 has been invoked where deductions for accrued expenses have been allowed under the “all events” test. See Shepherd Construction Co., 51 T.C. 890, 898-99 (1969). — 520 — Taxpayer’s second argument is that § 481 requires an adjustment only for items that would be omitted or duplicated during the year of the change of accounting method. This would give the taxpayer a double deduction for commissions paid in 1968 or later on policies sold before 1967. This would eventuate simply because the second deduction of the item would occur after the year of the change. Section 481 does provide any adjustment to be made to the taxpayer’s income for the year of the change; except as otherwise permitted by § 481(b), it states no limitation on the “amounts being duplicated or omitted” for which adjustment is required. To impose such a limitation would be at odds with the intent of Congress to prevent items of income and expense from being reported more than once or omitted entirely. See H.R. Rep. No. 1337, 83d Cong., 2d Sess., reprinted in [1954] U.S. Code Corig. & Admin. News pp. 4017, 4076, 4303; S. Rep. No. 1622, 83d Cong., 2d Sess., reprinted in [1954] U.S. Code Cong. & Admin. News pp. 4621, 4696, 4947. Both the Senate and House Reports have examples which reflect the intent that § 481 adjustments are to be used to prevent duplication or omissions in taxable years after the year of the change. See H.R. Rep. No. 1337, 83d Cong., 2d Sess., reprinted in [1954] U.S. Code Cong. & Admin. News pp. 4017, 4303-04; S. Rep. No. 1622, 83d Cong., 2d Sess., reprinted in [1954] U.S. Code Cong. & Admin. News pp. 4621, 4948-49. See also Treas. Reg. § 1.481 — 2(d), example (1) (1974). There are no cases which expressly consider the taxpayer’s contention. There are authorities, however, which give approval to the Commissioner’s making § 481 adjustments despite the fact that the duplication or omission might not occur for many years after the year of the change in the accounting method. Such a case is Adolph Coors Co. v. Commissioner, 519 F.2d 1280, 1284 (10th Cir. 1975), cert. denied, 423 U.S. 1087, 96 S.Ct. 878, 47 L.Ed.2d 97 (1976). Certain costs relative to construction were deducted as incurred. We held that the items had to be capitalized. To prevent double deduction, a § 481 adjustment was necessary, notwithstanding that the duplication would spread out over a long period. Accord, Electric & Neon, Inc., 56 T.C. 1324 (1971), aff’d without opinion, 496 F.2d 876 (5th Cir. 1974). The position of the Commissioner has been consistent that when a change of accounting method postpones the deductibility of an expense item, the § 481 adjustment is in the amount of the full balance of whatever account on the taxpayer’s books represents the amount of deductions already taken that will be duplicated at any time in the future less any pre-1954 adjustment. See, e.g, Rev.Rul. 71-137, 1971-1 C.B. 104; Rev.Rul. 67-379, 1967-2 C.B. 127. See generally Treas. Reg. § 1.481 — 1(c)(1) (1960). The § 481 adjustment procedure is capable of imposing a substantial burden on the taxpayer in that it may involve the necessity of paying in the year of the change in accounting method expenses covering many taxable years. It is to be emphasized, however, that the large sum represents improper deductions which would otherwise result in omission from income. Section 481 has the effect of accelerating the ultimate taxation of omitted income from an unascertainable date in the future to the year of the change. See Note, Problems Arising From Changes in Tax-Accounting Methods, 73 Harv.L.Rev. 1564, 1576-77 (1960). Congress was cognizant of the probable burdens resulting from liquidating the amount of the adjustment in one year. This is apparent from provisions made for alleviating this burden in certain cases. See I.R.C. § 481(b)(1) — (2). The taxpayer here has not sought to use any such method. * * * * * * The third issue which was before the Tax Court involved the deduction of losses under § 832. On this the ruling was for the taxpayer. The Commissioner has not appealed this ruling. The judgment of the Tax Court is affirmed. Footnotes [1] The text of § 481(a) is as follows: SEC. 481. ADJUSTMENTS REQUIRED BY CHANGES IN METHOD OF ACCOUNTING. (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. [2] Were it not for § 481(a) making provision for this, the statute of limitations (§ 6501(a)) would be an impediment to correcting deductions taken during taxable years before 1967, the year of the change. [3] Treas. Reg. § 1.446-l(c)(l)(ii) (1973). Under accrual method, income is to be included for the taxable year when all of the events have occurred which fix the right to receive such income and the amount can be determined with reasonable accuracy.