Interstate Fire Insurance Company v. United States

• Decision Date: 06 March 1963
• Docket Number: Civ. A. No. 3604,3639.
• Citation: 215 F. Supp. 586
• Parties: INTERSTATE FIRE INSURANCE COMPANY v. UNITED STATES of America (two cases).
• Court: U.S. District Court — Eastern District of Tennessee

215 F. Supp. 586

INTERSTATE FIRE INSURANCE COMPANY v. UNITED STATES of America (two cases).

Civ. A. Nos. 3604, 3639.

United States District Court E. D. Tennessee, S. D.

March 6, 1963.

COPYRIGHT MATERIAL OMITTED

COPYRIGHT MATERIAL OMITTED

Swafford, Jahn & Taylor, Chattanooga, Tenn., for plaintiff.

George Hrdlicka, Tax Division, Washington, D. C., for defendant.

FRANK W. WILSON, District Judge.

These two lawsuits are actions by a taxpayer to recover the sum of $313,996.30, plus interest, claimed to have been over paid as federal income taxes and excess profit taxes for the calendar years 1952 through 1957 inclusive. There are two lawsuits by reason of the fact that two separate claims for refund were filed and acted upon at different times, Case No. 3604 involving a claim for a refund relating to the years 1952 through 1955, and Case No. 3639 involving a claim for a refund relating to the years 1956 and 1957. The same issues are involved in each case and the cases were therefore consolidated for trial.

The facts in these lawsuits are largely undisputed, either by reason of having been stipulated or by reason of the testimony being undisputed. The Interstate Fire Insurance Company was organized in 1951 as a wholly owned subsidiary of Interstate Life and Accident Insurance Company, the latter company having been in the life and casualty insurance business since 1929. For brevity and clarity these two companies will be referred to in this opinion as the "Fire Company" and the "Life Company." The Fire Company is the only party plaintiff in these suits, with the Life Company not being involved as a party. Since the organization of the Fire Company not only has it at all times remained a wholly owned subsidiary of the Life Company, but the officers, directors, executive committees and finance committees of both companies have at all times been the same with the same individuals holding corresponding positions in each company, and the two companies have shared offices and other facilities. At the time of the organization of the Fire Company it entered into an agency contract with the Life Company whereby in consideration of payment to the Life Company of 90% of the Fire Company's premium income, the Life Company would perform all work through its employees and pay all expenses involved in producing business and settling claims, leaving the Fire Company with 10% of the gross premium income, out of which it was to pay officers' salaries and possibly other items. This contract was modified from time to time as will be more fully noted hereinafter. Proper records were kept of all income and disbursements of the two companies and the accuracy of these records is not in any way in dispute.

Both the Life Company and the Fire Company sold insurance policies that are referred to as "industrial policies," meaning that they were written specifically with the needs of industrial workers in mind, having a smaller than usual face value and being normally paid for on a weekly premium basis. Almost all of the insurance sold by the Fire Company was of the industrial or weekly premium type.

Income tax returns were duly filed by the Fire Company upon a calendar year basis for each of the years 1951 through 1957 and income taxes were paid accordingly. In each of the returns a deduction was made for a reserve entitled "Unearned Premium Reserve." Likewise, in making the original return for each of the years 1951 through 1956, the allocation of deductible expenses by the Fire Company and the Life Company was based upon the agency contract currently in effect between the two companies. The original 1957 return allocated expenses between the two companies, not in accordance with the agency contract then existing between the companies, but rather on a cost accounting basis, which will be more fully discussed in a later portion of this Opinion. The development and application of the cost accounting system grew out of an Internal Revenue Service review and investigation during 1957 of the plaintiff's prior returns, and the details of this will likewise be more fully discussed later. Suffice it to say for the present that about 1957 the taxpayer deemed that an error to its disadvantage had been made in calculating the amount of the unearned premium reserve for each of the previous years and further that it was entitled to apply a cost accounting method of allocating expenses between the parent company and itself with respect to each of the previous years as well as to the year 1957. Consequently, amended returns were filed by the taxpayer for each of the years 1951 through 1956. The Internal Revenue Service declined to accept any adjustment of the unearned premium reserve and declined to permit application of a cost accounting system for allocating expenses between the Life Company and the Fire Company for previous years, insisting that the unearned premium reserve was correctly stated in the original returns and that the correct method of allocating expenses was in accordance with the agency contracts between the two companies. Assessments of taxes were made by the government accordingly and these assessments were paid by the taxpayer and claims for refunds were duly and timely filed by the taxpayer.¹

It is conceded that the statute of limitations has run against both the plaintiff and the defendant with respect to the allowance of refund claims for the years 1951 and 1952, except to the extent that the plaintiff received a tentative carry back allowance from the year 1954 to the year 1952, which matter has however been adjusted between the parties and is not in issue here.

Two major issues remain for decision. The first issue is as to the correct method, under applicable tax laws and regulations, of establishing the plaintiff insurance company's unearned premium reserve for purposes of deduction and in the light of a resolution of this issue, determining whether any amendment of prior tax returns in this regard would be lawful and proper.

The second major issue for determination is whether the cost accounting method of allocating expenses between the Life Company and the Fire Company, as proposed by the Fire Company, is correct, lawful, and proper, and if so, whether any amendment of a prior tax return for any year or years in this regard would be lawful and proper.

Turning first then to the unearned premium reserve problem, as stated above the Fire Company sold an industrial fire policy upon which the premiums were payable weekly. The Fire Company was in fact a pioneer in the sale of an industrial type fire insurance policy and has grown to be one of the leading insurance companies in this field in the United States. Although the weekly premium policy was not the total business of the company, it did constitute approximately 99% of the business, and the only premium reserve here involved is with respect to the weekly premium policies. In the original tax returns filed by the taxpayer, the unearned premium reserve was established by setting up one-half of the debits, or premiums paid, for the last weekly premium period in the calendar year. The increase in the premium reserve thus established over the premium reserve for the previous year was then taken as a deductible item in determining taxable income. In the course of the study and review of its previous returns, the taxpayer concluded that it had overlooked the grace period provided in the policy and that in establishing the unearned premium reserve it should have included the four weeks grace period provided in the policy in determining the unearned premium reserve.

Under 26 U.S.C.A. § 832 "taxable income" of insurance companies for the payment of income tax is defined as including "premiums earned" which in turn is to be computed as follows:

"(4) Premiums earned. — The term `premiums earned on insurance contracts during the taxable year' means an amount computed as follows:

"(A) From the amount of gross premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance.

"(B) To the result so obtained add unearned premiums on outstanding business at the end of the preceding taxable year and deduct unearned premiums on outstanding business at the end of the taxable year."²

No further statutory definition of "premiums earned" or "unearned premiums" is contained in the Internal Revenue Code. Reference is made in Section 832 to gross income being "computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners."

As a matter of mutual assistance and to achieve greater uniformity in the regulation of insurance companies, the various state insurance commissioners have organized the National Convention of Insurance Commissioners. This group publishes standard detailed forms for each type of insurance company to report its annual financial condition upon, the form being commonly referred to as the "Convention Form" or "Annual Statement." The Insurance Department of the State of Tennessee, as well as all other states in which the Fire Company was doing business, have adopted the Convention Form as the official form for annual reports by insurance companies in the said states.

It has been stated that the Convention Form, having been specifically referred to in Section 832, becomes not merely a guide, but in fact the statutory standard for arriving at the taxable income of insurance companies. Commissioner of Internal Revenue v. New Hampshire Fire Insurance Company, 1 Cir., 146 F.2d 697. Closer scrutiny of the Convention Form reveals, however, that no fixed formula is stated therein for calculating the unearned premium reserve. In view of the fact that Congress has made no attempt to prescribe a formula for determining unearned premiums or otherwise to define the words, the Court can only conclude that the term "unearned premiums" should...