North Cent. Life Ins. Co. v. Comm'r of Internal Revenue
| Citation | 92 T.C. No. 15,92 T.C. 254 |
| Decision Date | 06 February 1989 |
| Docket Number | Docket No. 22761-81. |
| Parties | NORTH CENTRAL LIFE INSURANCE COMPANY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | United States Tax Court |
OPINION TEXT STARTS HERE
Petitioner, a stock life insurance company, contracted with various financial institutions and automobile dealerships to pay them commissions and retroactive rate credits for placing credit insurance. HELD: Petitioner may deduct retroactive rate credits as compensation under section 809(d)(11). HELD FURTHER: Petitioner's reserve for retroactive rate credits may not be taken into consideration in computing the amount of the deduction for retroactive rate credits. HELD FURTHER: The disallowance of the reserve for retroactive rate credits constitutes a change in method of accounting under section 481. Bruce J. Shnider, Leslie J. Anderson, and Phillip H. Martin, for the petitioner.
Judy Jacobs and Ross A. Rowley, for the respondent.
This matter was assigned to Special Trial Judge Pate, for consideration and ruling pursuant to the provisions of section 7456(d) () and Rules 180, 181, and 183.1 The Court agrees with and adopts her opinion which is set forth below.
Respondent determined deficiencies in petitioner's Federal income taxes for the years 1972 through 1976 in the following amounts:2
Petitioner timely filed a petition alleging error in respondent's determination regarding certain ‘retroactive rate credits.‘4 Specifically, we must decide:5 (1) whether petitioner's ‘retroactive rate credits‘ are deductible as ‘dividends to policyholders,‘ ‘return premiums,‘ or ‘commissions;‘ (2) whether petitioner may take into account change in its reserve for retroactive rate credits in computing the amount of the deduction; and (3) if not, whether disallowance of petitioner's reserve for retroactive rate credits constitutes a change in method of accounting.
North Central Life Insurance Company (hereinafter ‘petitioner‘) is a stock life insurance company organized under the laws of the State of Minnesota, with its principal office and place of business in St. Paul, Minnesota. Petitioner was a life insurance company as defined in section 801 et seq. For each of the calendar years 1972 through 1976, it filed Federal income tax returns on Form 1120L (U.S. Life Insurance Company Income Tax Return) together with required schedules and attachments.
Insurance companies are regulated by the states in which they do business. As part of that process, they are required to file each calendar year a detailed ‘Annual Statement‘ prescribed by the National Association of Insurance Commissioners (hereinafter ‘NAIC‘) with the state or jurisdiction of domicile and each state or jurisdiction in which they engage in the insurance business. Pursuant to section 1.6012-2(c)(1), Income Tax Regs., petitioner filed a copy of its Annual Statement with its Federal income tax return for each of the years in issue.
During the years in issue, petitioner's principal business consisted of the sale of credit life insurance and credit accident and health insurance (hereinafter collectively referred to as ‘credit insurance‘) which it sold in connection with specific credit transactions. Credit life insurance provided coverage on the life of the person taking out a loan or financing a purchase (hereinafter ‘borrower‘ or ‘insured‘) and provided for the repayment of the remaining indebtedness if the borrower died during the term of the insurance contract. Credit accident and health insurance provided that periodic payments due on the borrower's installment indebtedness would be made if, and while, he was disabled during the term of the insurance contract. Accident and health coverage could be obtained only if credit life was also purchased. In both types of insurance, the amount of the coverage decreased as the borrower made periodic or installment payments on the debt.
Petitioner issued credit insurance principally under a single premium plan. In most cases, the amount of the premium was relatively small. For example, in 1975, the average initial coverage was $2,660 and the average single premium was $65 for credit life, $71 for credit accident and health, and $110 for combined coverage.
Because the individual premiums were so small, petitioner used a procedure whereby group insurance policies were issued to ‘Accounts‘ consisting primarily of financial institutions and automobile dealerships.7 The Accounts made loans or financed automobiles only for persons who the Accounts had determined were creditworthy. Those borrowers who chose to purchase insurance8 provided the Accounts with an extra level of protection in that collection measures might not be necessary in the event of the borrowers' death or disability. Under the group policies, the Accounts were authorized to issue a certificate of insurance (within agreed policy limits and without further approval) to borrowers who purchased coverage. The Account was primary beneficiary of the policy to facilitate direct repayment of the loan in the event of the borrower's death or disability. The borrower had the right to designate a second beneficiary to which petitioner paid any benefits in excess of those needed to discharge his obligation to the Account.
The Account calculated the premium charged on the certificates of insurance it issued using rates provided by petitioner,9 collected the premium from the borrower (either in cash or by adding the premium to the borrower's initial indebtedness), and then forwarded the premium, less any commissions due the Account, to petitioner. The entire cost of the insurance was borne by the borrower; no contribution toward its cost was made by the Account. The Account also collected claim information, facilitated the payment of claims by completing forms provided by petitioner, and maintained records of certificate holders under the group policy. This arrangement made credit insurance more profitable to petitioner because, under the contract, the Account was required to complete much of the paperwork (e.g., form completion, insurability screening).
Petitioner recruited new and provided service to existing Accounts through sales representatives. The recruitment of Accounts was competitive because, as a practical matter, credit insurance is a homogenous product. Accounts generally selected or remained with a particular insurance company based on the level of income and service offered to the Account by competing companies. Consequently, the solicitation of new Accounts by petitioner's representatives usually included a discussion of commissions and retroactive rate credits to be realized by the Account.
Petitioner and the Accounts generally executed three documents to effectuate this arrangement: a group policy,10 a commission agreement, and a retroactive rate credit agreement. However, where the amount of compensation for the sale of credit insurance was limited by law, the commission agreement provided for the maximum allowable amount of compensation and the retroactive rate credit agreement was omitted.11 The Account had to agree to handle only petitioner's insurance during the term of their agreement.
Petitioner's group policy named the Account as ‘policyholder‘12 and provided specifically that it was ‘non-participating;‘ that is, the holder of the policy was not entitled to share in petitioner's surplus earnings. The Account did not pay any premium for the group policy. Petitioner retained the power to terminate the policy upon notice if the number of insureds dropped below a specified percentage of all borrowers eligible for insurance. The Account was able to cancel the policy for any reason upon 30 days' notice. In the event of cancellation, however, each borrower's coverage continued throughout the period for which he had paid premiums. The borrower could not cancel his coverage during its term except by discharging the underlying indebtedness.13 If the borrower did cancel the insurance by prepaying his loan, petitioner then refunded a portion of the premium to the Account who was required by the group policy to remit the refunded amount to the borrower.14
Under the group policy, the Account was required to deliver a certificate of insurance to each borrower describing the coverage he had purchased.15 The Account submitted a list of certificate holders (borrowers) and remitted the premiums collected thereon to petitioner at stated intervals.16
Petitioner's commission agreement also listed the Account as ‘policyholder.‘ However, because states commonly require that persons selling life insurance be licensed, the commission agreement often was executed by an employee of the Account who was a licensed insurance agent. Concurrently, the right to commissions was assigned to the Account or a designee of the Account. Commission rates were set in advance and usually amounted to 40 to 50 percent of the net premiums collected. These rates seldom varied, although petitioner's sales representatives were allowed to ‘bid‘ on certain large Accounts in order to obtain their business. The bidding sometimes included petitioner's promise to deposit compensating balances in specified financial institutions.
Petitioner incurred the following amounts under its commission agreements:
+----------------+
¦Year¦Amount ¦
+----+-----------¦
¦1974¦$4,987,103 ¦
+----+-----------¦
¦1975¦5,550,559 ¦
+----+-----------¦
¦1976¦9,932,495 ¦
+----------------+
Petitioner included these amounts in its deduction of commission...
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