2 T.C. 607 (1943), 110521, Order of Railway Employees v. C.I.R.

Docket Nº:110521.
Citation:2 T.C. 607
Opinion Judge:MELLOTT, Judge:
Attorney:Hartley F. Peart, Esq., Howard Hassard, Esq., and Homer H. Tooley, C.P.A., for the petitioner. Samuel Taylor, Esq., for the respondent.
Case Date:August 24, 1943
Court:United States Tax Court

Page 607

2 T.C. 607 (1943)




No. 110521.

United States Tax Court.

August 24, 1943

A mutual insurance company does not lose its right to be taxes as such under sec. 207(a), I.R.C., merely because its directors, in the exercise of their discretion, accumulated and held, in an account designated ‘ surplus,‘ the excess of premiums over cost for eight years of its existence. The test of determining mutuality is the ownership of the company, its earnings and accumulations, by its policyholders. Mutuality not lost merely because holders of lapsed policies forfeit their right share in the distribution of accumulated surplus.

Hartley F. Peart, Esq., Howard Hassard, Esq., and Homer H. Tooley, C.P.A., for the petitioner.

Samuel Taylor, Esq., for the respondent.

Page 608

Petitioner challenges the correctness of the following deficiencies in income tax:

1936 $693.69

1937 4,497.44

1938 9,325.93

1939 8,868.39

1940 4,045.87

Total 27,431.32

The facts are found to be as stipulated. Other facts appearing in our findings are based upon evidence adduced at the hearing. The sole issue is whether the respondent erred in holding that petitioner is to be taxes as an insurance company other than life or mutual. Petitioner contends that it is taxable either as a mutual life insurance company or as a mutual insurance company other than life. FINDINGS OF FACT. Petitioner is a California corporation, incorporated in August 1906. Under its original articles of incorporation petitioner was a fraternal beneficiary society. In March 1919 its articles of incorporation were amended to provide for the issuance to its members of health and accident insurance contracts on the assessment plan. The fraternal and lodge features were eliminated by this amendment. In May 1926 petitioner's articles were again amended to provide for the issuance to its members of life insurance and annuity or endowment insurance contracts in addition to health and accident insurance. Between 1926 and 1934 petitioner operated as a mutual life, health, and accident insurance company on the assessment plan. During this period its policies contained the following provision: Mutual Provision: The Order of Railway Employees is a mutual insurance corporation organized and operating under the laws of California. The power is reserved, in the event of and during an emergency, to collect from the members necessary additional amounts to protect this and other like certificates. On October 18, 1934, petitioner's articles were again amended. The following are excerpts from the articles which were in force during the taxable years:

SECOND: The purposes for which this corporation is formed are: To carry on and transact in the State of California and elsewhere the business of a mutual legal reserve life, and accident and sickness or health insurance company, and life, and accident and sickness or health insurance as a mutual legal reserve insurer; to provide funds by mutual agreement and obligation of the members of this corporation to one another from policy fees, premiums, interest, assessments, and general income, for one or more of said kinds of insurance upon the lives of the members of the corporation and against injury, disablement or death resulting from sickness, sustained or suffered by the members of the corporation; to furnish to its members one or more of said kinds of insurance on the mutual Page 609

legal reserve plan; to issue to the members of this corporation, in consideration of the payment by them of policy fees and premiums as therein provided, policies or other contracts of insurance, for one or more of said kinds of insurance, specifying the sum or sums to be paid upon the happening of the contingencies insured against and when such payments must be made; * * * from time to time to distribute to the members any surplus of net income which in the judgment of the board of directors it is not necessary to retain for the purposes of the corporation; * * * SIXTH: This corporation shall not be authorized to issue shares of stock, but shall be composed of members, each of whom shall hold a subsisting policy, certificate of membership, or other contract of insurance issued to each thereof respectively by this corporation, and whose voting rights shall be equal. This corporation is not formed with a view to pecuniary gain or profit to its members.

On October 25, 1934, petitioner was granted a certificate of authority to transact life, accident, and health insurance as a mutual legal reserve insurance company by the Insurance Commissioner of the State of California. The phrase ‘ mutual legal reserve‘ used in petitioner's articles of incorporation as amended in 1934 and its policies thereafter issued refers to provisions of California law which at that time permitted any domestic insurer to convert to a mutual corporation doing an insurance business with a statutory reserve fund for the protection of policyholders in lieu of a provision for special assessments on all policyholders. The California law authorized any domestic insurer having a reserve of at least $200,000 to amend its articles and to elect to operate as a ‘ mutual legal reserve company.‘ The $200,000 minimum reserve permits a mutual leg reserve insurer to engage in the business of life insurance. In order to do a health and accident insurance business, an additional $50,000 reserve is required.[1] Page 610 Petitioner's officers are elected annually by its directors and its directors are elected annually by its members. Each policyholder is a member and entitled to vote. Each policy issued by petitioner from October 1934 to 1940, inclusive, contained the following provision: The Order is a mutual legal reserve insurance corporation, and is owned wholly by its policyholders who are its members. This Policy constitutes the evidence of the Insured's membership in the Order and is the certificate thereof. Membership begins upon the taking effect of this Policy and shall end upon the death of the member, or the lapsing or other termination of this Policy. * * * Any failure to comply with the provisions of this Policy shall render invalid any claims hereunder. Since its inception petitioner has been primarily an organization of railroad employees. Its officers and directors have always been railroad men and at the time of the hearing approximately 90 percent of its members were railroad employees. On the 1st day of March 1931 petitioner distributed to its then members and policyholders a dividend aggregating $53,918.80. This distribution was made pursuant to resolutions of the board of directors of petitioner adopted on November 11, 1930, and February 11, 1931. Immediately thereafter, and for a period of several years, petitioner's losses and expenses exceeded its current income. This resulted from the nationwide economic depression. As a result of this experience the directors decided it would be inadvisable to pay any dividends ‘ for the time being.‘ Their ambition and desire, as expressed at the hearing by their president, was ‘ to make the financial condition of the Order absolutely solid and impervious to any kind of condition that might arise in the way of strikes, epidemics or those other conditions that cut so heavily into our income as a result of claims and decreased premium receipts.‘ It was expected that this policy would ‘ insure the prompt and equitable payment of claims.‘ During 1934 and thereafter petitioner issued policies providing for payments during the lifetime of the insured, if accidentally injured, whereas the earlier policies had provided for payments during not to exceed 24 months. It also increased its payments for illness from 6 months to 16 months. The directors were desirous of building the surplus up to a point where Page 611 these additional contingencies would be taken care of. In recent years they were also conscious of the uncertainties created by war. While the declaration of a dividend was discussed, none was made or paid by petitioner after 1931. During the years 1931 to 1940, inclusive, the reserve funds held by petitioner, and the purposes for which they were held, were as follows:

Life reserve Statutory reserve Emergency reserve Surplus in

(based on fund (held for all fund (held for addition

American classes of insurance contingencies, e.g.; to reserves

Year Experience outstanding, unusual losses (also held for

Table as required and expenses) contingencies)

at 3 1/2%) by Cal. law)

1931 $37,012 $250,000 $150,000 $15,392.16

1932 40,282 250,000 100,000 20,310.77

1933 44,199 250,000 50,000 57,199.54

1934 46,321 250,000 50,000 43,636.32

1935 52,159 250,000 50,000 55,363.10

1936 55,219 250,000 50,000 72,184.23

1937 60,726 250,000 50,000 117,220.54

1938 64,705 250,000 50,000 188,515.84

1939 68,478 250,000 50,000 258,847.10

1940 71,500 250,000 50,000 302,300.44

During each of the taxable years petitioner issued policies of insurance providing for the payment of accident and illness benefits as well as for the payment of a specified principal sum if loss of life resulted from injuries sustained by accidental means. Straight life insurance policies were not issued after 1931. The following table shows the number of...

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