28 T.C. 1017 (1957), 51781, Citizens Fund Mut. Fire Ins. Co. v. C.I.R.

Docket Nº:51781.
Citation:28 T.C. 1017
Opinion Judge:OPPER, Judge:
Attorney:Charles R. Johnston, Esq., and Nicholas S. Kiefer, Esq., for the petitioner. George E. Van Roekel, Esq., for the respondent.
Case Date:August 23, 1957
Court:United States Tax Court

Page 1017

28 T.C. 1017 (1957)




No. 51781.

United States Tax Court.

August 23, 1957

Charles R. Johnston, Esq., and Nicholas S. Kiefer, Esq., for the petitioner.

George E. Van Roekel, Esq., for the respondent.

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.

Page 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).


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 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 incomes 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 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

Page 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. 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 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 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 initially paid 5 per cent to R.F.C., it later paid 4 per cent and 3 1/2 per cent for some periods.

Page 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:


Amount year Year paid

$1,750 1944 1945

$1,750 1944 1948

$3,500 1945 1946

$3,500 1946 1947

$3,500 1947 1948

$3,500 1948 1949

$1,750 1949 1950

$1,750 1949 1951

$1,750 [1] 1951

$3,500 [1] 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 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 of 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, 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 * * *

Page 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...

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