Great Commonwealth Life Insurance Co. v. United States, 73-1504.

• Decision Date: 18 March 1974
• Docket Number: No. 73-1504.,73-1504.
• Parties: GREAT COMMONWEALTH LIFE INSURANCE CO., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

491 F.2d 109 (1974)

GREAT COMMONWEALTH LIFE INSURANCE CO., Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 73-1504.

United States Court of Appeals, Fifth Circuit.

March 18, 1974.

O. Jan Tyler, Robert K. Sands, Dallas, Tex., for plaintiff-appellant.

Scott P. Crampton, Gary R. Allen, Asst. Attys. Gen., Meyer Rothwacks, Atty., Tax Div., Dept. of Justice, Lee H. Henkel, Jr., Acting Chief Counsel, IRS, Washington, D. C., Frank D. McCown, U. S. Atty., Martha Joe Stroud, Asst. U. S. Atty., Dallas, Tex., for defendant-appellee.

Before THORNBERRY, GODBOLD and CLARK, Circuit Judges.

THORNBERRY, Circuit Judge:

In computing its taxable gain from operations for 1966, Great Commonwealth took account of only the net valuation portion of deferred and uncollected premiums. On examination of the return, the Commissioner increased the taxable income by requiring inclusion of the gross amount of those premiums and assessed a deficiency of $62,260.15 plus interest. Great Commonwealth paid the deficiency and subsequently filed this suit for a refund, which the district court denied. The company contends that it should not have been required to report the gross amount, or, at least, that it should have been allowed a deduction either for additions to a reserve for unearned premiums or for the agents' commissions attributable to the deferred and uncollected premiums. We hold that the district court was correct in requiring accrual of the gross amounts but that it should have allowed a deduction for the associated commissions.

The proper tax treatment of deferred and uncollected premiums is one of the most difficult and often litigated questions under the Life Insurance Company Income Tax Act of 1959, 26 U.S.C. §§ 801-820.¹See Franklin Life Insurance Co. v. United States, 7 Cir. 1968, 399 F. 2d 757; Jefferson Standard Life Insurance Co. v. United States, 4 Cir. 1969, 408 F.2d 842; Western National Life Insurance Co. v. Commissioner of Internal Revenue, 5 Cir. 1970, 432 F.2d 298; Western and Southern Life Insurance Co. v. Commissioner of Internal Revenue, 6 Cir. 1972, 460 F.2d 8; United Life and Accident Insurance Co. v. United States, D.N.H.1971, 329 F.Supp. 765; Western National Life Insurance Co., 1968, 50 T.C. 285, modified on rehearing, 1969, 51 T.C. 824, rev'd, Western National Life Insurance Co. v. Commissioner of Internal Revenue, supra; Western and Southern Life Insurance Co., 1971, 55 T.C. 1036, rev'd, Western and Southern Life Insurance Co. v. Commissioner of Internal Revenue, supra. Without duplicating the detailed explanations of the problem set out in those cases any more than is necessary, we will define the key concepts for purposes of this opinion.

Definitions

The gross annual premium under a life insurance policy is the consideration paid by the insured for coverage for a policy year, which is a twelve-month period from the date of issuance of the policy (the "anniversary date"). The gross annual premium is composed of two elements. The net valuation portion, referred to as the net valuation premium, is the amount, computed under legally required interest and mortality assumptions, that is added to life insurance reserves for payment of policy claims. The difference between the gross annual premium and the net valuation premium is the loading, which is the portion used to pay agents' commissions, administrative costs, and other expenses of the company, and to provide the company a profit.

Although some life insurance policies provide for the payment of the gross annual premium in one lump sum on the policy anniversary date, it is not unusual for it to be paid in semi-annual, quarterly, or monthly installments over the policy year. As a result, portions of gross annual premiums may remain outstanding and not as yet received by the company at the end of the taxable year. Deferred premiums are those portions of gross annual premiums which are due to be paid after December 31 but before the next policy anniversary date. Uncollected premiums are annual or installment premiums which, as of December 31, have fallen due but have not as yet been paid. The company is required to continue its life insurance contracts in force for a 31-day grace period after a premium due date, and it customarily carries such policies for up to 60 days. The policyholders are not legally required to pay either deferred premiums or uncollected premiums. If they do not, the policies will lapse, but the company cannot compel payment.

History of the Case

Great Commonwealth filed an annual statement for 1966 with the Texas State Board of Insurance and the appropriate authorities of the other states where it is licensed to do business, using standard forms approved by the National Association of Insurance Commissioners (N.A.I.C.). As required by state law, the company computed its reserves on the assumption that all premiums for all policies in force at the close of the year had been paid in full on the policy anniversary date. Since deferred and uncollected premiums as of December 31 had not in fact been paid, the reserves were overstated in the amount of the net valuation portion of the deferred and uncollected premiums. To offset this overstated reserve liability, the company listed an asset of equal amount. This is the standard industry practice.

In calculating its taxable income,² Great Commonwealth used the same accrual assumptions regarding deferred and uncollected premiums as it did for its annual statement. As a result its gross premium income³ included an amount equal to the net valuation portion of the deferred and uncollected premiums. This was exactly offset by a corresponding increase in the deduction for net increases in life insurance reserves.⁴ Therefore, the accrual of the net valuation portion of the deferred and uncollected premiums had no net effect on the company's taxable income.⁵

The Commissioner required the company to accrue gross deferred and uncollected premiums rather than merely the net valuation portion, holding that, once the company had accrued a portion of those premiums for some purposes, it was bound to accrue the whole of the premiums for all purposes. This approach has been approved by all circuit courts which have considered the question, including our own. Franklin Life Insurance Co. v. United States, supra; Jefferson Standard Life Insurance Co. v. United States, supra; Western National Life Insurance Co. v. Commissioner, supra; Western and Southern Life Insurance Co. v. Commissioner of Internal Revenue, supra. This had the effect of increasing the company's gain from operations in the amount of the loading on the deferred and uncollected premiums, resulting in the increased tax liability at issue here.

I. Accrual of the Gross Amount

The company first contends that it should not have been required to accrue the gross amount of deferred and uncollected premiums, despite our apparent holding to the contrary in Western National Life. In distinguishing that case, the company asserts that it involved "only the question of whether gross deferred and uncollected premiums were assets under the Phase I⁶ computation. The Western National Life case did not involve, and, therefore, this Court did not have before it, the question of whether gross deferred and uncollected premiums are includable in premium income under the Phase II⁷ computation."

It is true that the only contested issue in Western National Life was the accrual of gross deferred and uncollected premiums for purposes of the Phase I calculation. Nevertheless, the case is strongly suggestive that gross deferred and uncollected premiums should be accrued for all tax purposes. Although not strictly bound by that suggestion, we find it persuasive and adopt it.

Western National Life was a Phase I taxpayer, in the sense that its taxable investment income was taken into account in determining its taxable income under § 802(b). By the terms of that section, the taxable investment income is taken into account only if it is less than or equal to the gain from operations. § 802(b)(1). In such a case, the company's taxable income includes the Phase I taxable investment income and one-half of the excess of the Phase II gain from operations over the Phase I taxable investment income. In Western National Life, the Commissioner chose to attack the handling of deferred and uncollected premiums only under the Phase I computation. No doubt he did so because Western National had already accrued the gross amount for the Phase II calculation. Western National Life Insurance Co. v. Commissioner of Internal Revenue, supra, 432 F.2d at 302. In upholding the Commissioner's approach, the court explicitly approved the reasoning of the Seventh Circuit in Franklin Life and the Fourth Circuit in Jefferson Standard Life, both of which involved the Phase II computations.

It would be highly inconsistent to require accrual of the gross deferred and uncollected premiums under Phase I but only the net under Phase II. This inconsistency would be particularly glaring in cases in which the company's gain from operations exceeds its taxable investment income, since overall taxable income in those cases includes both Phase I and Phase II elements. This would add unnecessary complexity to an already complex tax formula. Great Commonwealth offers no justification for this procedure, and we certainly perceive none. Therefore, the district court was correct in requiring the accrual of the gross deferred and uncollected premiums.

II. Reserve for Unearned Premiums

Great Commonwealth next argues that, if required to accrue the gross deferred and uncollected premiums, it should be allowed to set up a reserve for unearned premiums under § 801(c)(2) in the amount of that portion of the loading attributable to life insurance coverage to be provided in the succeeding taxable year. This would generate a deduction for increases in reserves under § 809(d)(2).

There...