Western Nat'l Life Ins. Co. of Texas v. Comm'r of Internal Revenue, Docket No 1621-64

• Decision Date: 13 May 1968
• Docket Number: Docket No 1621-64
• Citation: 50 T.C. 285
• Parties: WESTERN NATIONAL LIFE INSURANCE COMPANY OF TEXAS, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

50 T.C. 285

WESTERN NATIONAL LIFE INSURANCE COMPANY OF TEXAS, PETITIONER
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No 1621-64

Tax Court of the United States.

Filed May 13, 1968

[50 T.C. 285]

J. W. Bullion and Buford P. Berry, for the petitioner.

Harold L. Cook, for the respondent.

Under sec. 805(b)(4) of the 1954 Code, as amended by the Life Insurance Company Income Tax Act of 1959, the following items are includable or not includable in ‘assets' used in computing a life insurance company's taxable investment income (phase I):

1. That portion of the company's home office building, owned by it subject to a mortgage, not used by it for the conduct of its insurance business, is includable in ‘assets' at its fair market value unreduced by the mortgage indebtedness.

2. ‘Deferred and uncollected premiums,’ ‘due and unpaid premiums,‘ and ‘loading’ related thereto, are not includable in assets.

3. ‘Agents' debit balances' and ‘accounts receivable from reinsurance assumed’ are includable in ‘assets.’

DRENNEN, Judge:

Respondent determined deficiencies in income tax against petitioner as follows:

+--------------------+
                ¦Year ¦Deficiency ¦
                +------+-------------¦
                ¦ ¦ ¦
                +------+-------------¦
                ¦1958 ¦$49,960.98 ¦
                +------+-------------¦
                ¦1959 ¦47,856.21 ¦
                +------+-------------¦
                ¦1960 ¦7,256.03 ¦
                +------+-------------¦
                ¦1961 ¦22,216.23 ¦
                +--------------------+
                

Respondent has conceded an issue relating to interest on policy and contract funds. Petitioner has conceded that it is not entitled to deduct from gross investment income in determining investment yield during the years in question, 80 percent of the interest paid on the mortgage,

[50 T.C. 286]

and that the respondent did not err in determining earnings rates pursuant to the provisions of section 805(b), I.R.C. 1954, by increasing investment yield by 80 percent of the interest paid by petitioner on the indebtedness to which its real estate was subject during the years 1956-61.

The remaining issues, all to be determined under section 805(b)(4), are (1) whether petitioner in establishing the ‘fair market value’ of its home office property as an asset may exclude the mortgage encumbrances on the improved real estate which was acquired ‘subject to the mortgage’; whether petitioner, in determining the mean of its assets under section 805(b)(4), must include (2) ‘net premiums deferred and uncollected’; (3) ‘premiums due and unpaid’; (4) ‘loading’ applicable to gross premiums deferred and uncollected; (5) agents' debit balances; and (6) accounts receivable from reinsurance assumed.

FINDINGS OF FACT

Substantially all of the facts have been stipulated. Those facts which have been stipulated are hereby found and are recited in pertinent parts. From the testimony of the only witness and the exhibits received in evidence we make such findings of fact as might hereinafter appear which are not stipulated facts.

Petitioner is a life insurance company duly organized under the insurance laws of the State of Texas and, at all times material, was engaged in business as a life insurance company as defined in section 801(a), I.R.C. 1954. Petitioner's principal place of business is now and was at the date of filing of its petition in its home office building at 205 East 10th Street, Amarillo, Tex. It is the wholly owned subsidiary of the Southwestern Investment Co.

As a life insurance company petitioner writes life and other types of insurance permitted to be written by life companies and carries on an investment business. It conducts two broad categories of business, i.e., underwriting and investments.

Petitioner keeps a cash receipts and disbursements ledger, as required by the insurance laws, and an accrual ledger. It has prepared all of its Federal income tax returns and all of its National association of Insurance Commissioners (NAIC) convention forms¹ on the basis of an accrual method of accounting and a year ending December 31 of each year.

Petitioner filed its Federal income tax returns for the taxable years ending December 31, 1958, to December 31, 1961, inclusive, wit, the district director of internal revenue at Dallas, Tex. Each year petitioner was required to and did file a duplicate of its NAIC annual

[50 T.C. 287]

statement for that year with its Federal income tax return. This statement is prepared on a hybrid system on which petitioner must report its cash receipts and disbursements which are then converted to an accrual basis, and is for use for examination and audit by State insurance departments and has nothing to do directly with income tax.

Petitioner owns its home office building subject to a mortgage indebtedness. It acquired such real estate by deed on January 6, 1956, subject to an outstanding mortgage indebtedness of $700,000. The principal amount outstanding of the mortgage indebtedness to which the property was subject at the end of the respective years was as follows:

+-----------------------+
                ¦ ¦Principal ¦
                +------+----------------¦
                ¦ ¦mortgage ¦
                +------+----------------¦
                ¦ ¦indebtedness, ¦
                +------+----------------¦
                ¦Year ¦Dec. 31 ¦
                +------+----------------¦
                ¦ ¦ ¦
                +------+----------------¦
                ¦1956 ¦$661,000 ¦
                +------+----------------¦
                ¦1957 ¦625,000 ¦
                +------+----------------¦
                ¦1958 ¦589,000 ¦
                +------+----------------¦
                ¦1959 ¦553,000 ¦
                +------+----------------¦
                ¦1960 ¦517,000 ¦
                +------+----------------¦
                ¦1961 ¦481,000 ¦
                +-----------------------+
                

At all times material the fair market value of petitioner's home office real estate, free and clear of any mortgage indebtedness, was $912,500.

Petitioner leases the entire building to the Southwestern Investment Co., its parent company, which operates the building, paying for all repairs, utilities, and janitorial services. Southwestern Investment Co. sublease 20 percent of it to petitioner. At all times material 80 percent of the entire rental value of petitioner's home office real estate was held and used by petitioner as an investment and the remaining 20 percent was used by petitioner in its insurance business.

There is a practice in the life insurance industry that life companies generally attempt to avoid liability for any indebtedness on their real estate. They acquire their real estate subject to indebtedness. They do not borrow money to invest; they invest their assets. Pursuant to this practice petitioner bought its home office property subject to the mortgage and was not liable on the note secured by the mortgage.

Standard Improvement Co. is liable for the note secured by the mortgage. It is a dormant corporation created and used for this purpose. It was set up with small capital, borrowing the money to build the building, and then conveying the property to petitioner subject to the indebtedness. The life insurance company which made the mortgage loan was aware of the character of Standard Improvement Co. and required a lease on the entire building by Southwestern Investment Co. to make its loan safe. Petitioner was required to and did make all payments of principal and interest on the indebtedness when due. By making the principal payments on the mortgage petitioner's equity in the building was increased.

[50 T.C. 288]

Petitioner, on its income tax returns for the years in issue, valued its real estate (home office) for purposes of section 805(b)(4) as of the end of the respective years, as follows (cost less the outstanding encumbrance and depreciation allowances):

+-------------------+
                ¦Year ¦Amount ¦
                +------+------------¦
                ¦ ¦ ¦
                +------+------------¦
                ¦1958 ¦$243,606.07 ¦
                +------+------------¦
                ¦1959 ¦260,147.11 ¦
                +------+------------¦
                ¦1960 ¦276,688.15 ¦
                +------+------------¦
                ¦1961 ¦293,229.19 ¦
                +-------------------+
                

In its NAIC annual statements petitioner shows its real estate as an asset. It is required in these statements to reduce the book value of its real estate (determined in the accepted sense) by the principal balance of the mortgage indebtedness to which it is subject because petitioner does not owe the debt.

Petitioner regards the fair market value of its home office real estate, less the encumbrance, as the value of that property for its investment purposes because, in order to pay off the mortgage indebtedness in full, petitioner would be required to pay off his indebtedness with funds obtained from liquidating other investment assets.

In life insurance, premiums are the agreed price for assuming and carrying the risk. The part of the premium intended to meet the cost of insurance, both current and future, and carry it from period to period, is called the net premium. In addition to this amount, policyholders also pay what is known as loading, which is a sum added to the net premium for estimated administration, management and operating expenses, as well as for contingencies, and, in some cases, profits. Loading when added to the net premium constitutes what is known as the gross premium. ‘Premiums deferred and uncollected’ are premiums not yet due to be paid under the terms of the policies, and will not become due prior to the end of the year. No premium collected but not recorded would be shown in the deferred and uncollected accounts. ‘Premiums due and unpaid’ are premiums which relate only to accident and health insurance and are due to be paid before the end of the year under the terms of the policies but which have not been paid. There is no obligation, legal or otherwise, on insured to pay to the insurer either premiums deferred and uncollected or premiums due and unpaid. If the policyholder does not pay the premium in conformity with the provisions of the policy, the policy is canceled after the grace period and appropriate adjustments are made to reserves.

The net premiums deferred and uncollected, the premiums due and unpaid, the loading, and the total thereof with reference to petitioner's outstanding policies as of the end of the various years indicated were:

+----------------------------------------------------------------+
                ¦ ¦Net deferred¦Due and ¦ ¦ ¦

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