Local Finance Corporation v. CIR

• Decision Date: 09 April 1969
• Docket Number: No. 16840-16850.,16840-16850.
• Citation: 407 F.2d 629
• Parties: LOCAL FINANCE CORPORATION, Local Finance Corporation of South Marion, Local Finance Corporation of Elkhart, Local Finance Corporation of Gas City, Local Finance Corporation of Rushville, Local Finance Corporation of Danville, Local Finance, Inc., Local Finance Co., Inc. of Gary, Local Finance Company, Inc., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant, v. GUARDIAN AGENCY, INC., Beneficial Insurance Agency, Inc., Petitioners-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

407 F.2d 629 (1969)

LOCAL FINANCE CORPORATION, Local Finance Corporation of South Marion, Local Finance Corporation of Elkhart, Local Finance Corporation of Gas City, Local Finance Corporation of Rushville, Local Finance Corporation of Danville, Local Finance, Inc., Local Finance Co., Inc. of Gary, Local Finance Company, Inc., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant, v. GUARDIAN AGENCY, INC., Beneficial Insurance Agency, Inc., Petitioners-Appellees.

Nos. 16840-16850.

United States Court of Appeals Seventh Circuit.

February 28, 1969.

Rehearing Denied April 9, 1969.

Stephen A. Milwid, John K. O'Connor, Max E. Meyer, Wilbur S. Legg, Chicago, Ill., Lord, Bissell & Brook, Chicago, Ill., of counsel, for Local Finance Corp.

Mitchell Rogovin, Asst. Atty. Gen., Stuart A. Smith, Attorney, Department of Justice, Tax Division, Washington, D. C., Lee A. Jackson, J. Edward Shillingburg, Attorneys, Department of Justice, Washington, D. C., for C.I.R.

Before SWYGERT, FAIRCHILD and KERNER, Circuit Judges.

SWYGERT, Circuit Judge.

We are asked to review a decision of the Tax Court upholding the assessment of income tax deficiencies by the Commissioner of Internal Revenue.¹ This case presents the question whether the Tax Court was correct in holding that the Commissioner's allocation to the petitioners, Local Finance Corporation and its subsidiaries pursuant to his authority under Int.Rev.Code of 1954, § 482,² of one-half of the credit life insurance net premiums paid by borrowers from these corporations was not arbitrary or unreasonable. Federal income taxes for the years 1958 through 1962 in the amount of $418,977.31 are in question.

The facts are largely undisputed and have been set forth in the Tax Court's opinion reported at 48 T.C. No. 76 (Aug. 31, 1967). We will only recite the facts which are necessary for a basic understanding of the financial interrelationships which existed between the various corporate taxpayers involved in this appeal. Taxpayers are Indiana corporations which, during the years in question, engaged in the business of making small and industrial loans. Local Finance Corporation is the parent corporation and all the other named finance company taxpayers are wholly owned subsidiaries of Local Finance.

Taxpayers, Guardian Agency, Inc. and Beneficial Insurance Agency, Inc., are respectively parent and wholly owned subsidiary. They were organized as general insurance brokers to provide fire and casualty insurance coverage on property given as security to Local Finance by its borrowers. The finance companies were virtually the entire source of their fire and casualty business. During the years in question, stockholders who owned in excess of seventy per cent of Local Finance's stock also owned all the stock of Guardian and its subsidiary beneficial.

In connection with the loans made by the finance companies, credit life insurance was offered to their borrowers for a term which was coextensive with the contractual term of the related indebtedness. Although not required to do so, about ninety per cent of the borrowers took out credit life insurance. This insurance was written by Old Republic Life Insurance Company, an unrelated concern, at a rate of one dollar per year per $100 of coverage. Such rate was commonly charged in the credit life insurance industry in Indiana and its reasonableness is not at issue. Since it was customary for insurance companies to pay a commission for the sales of such insurance, the rate of premium charged by Republic was fixed in an amount sufficient to provide for such commission.

During the period January 1 through June 30, 1958, the commissions on the credit life insurance sold to borrowers from the finance companies were not paid directly to the finance companies. Rather, such commissions were paid pursuant to an agreement entered into between Republic and Don H. Miller, who was an officer of each of the finance companies. The agreement provided that Miller should act as agent for Republic and receive a fixed commission of forty per cent of the net premiums paid by the borrowers from the finance companies, that Republic should retain nine and a half per cent of such net premiums to cover its overhead and profit, and that Miller should receive an additional contingent commission measured by the remainder of the net premiums after payment of all claims. Miller simultaneously executed an assignment of such commissions to Guardian. The commissions so assigned to Guardian over the period ending June 30, 1958 amounted to about fifty-six per cent of total net premiums.

After June 30, 1958, Republic continued to write the insurance on the lives of the borrowers from the finance companies, but no commissions, as such, were paid to Miller. Instead, Republic entered into an agreement with Grand National Life Insurance Company, an Arizona corporation, which was controlled by the finance companies and Guardian, whereby Grand National agreed to reinsure the risks and receive ninety and a half per cent of the net premiums, Republic retaining nine and a half per cent of the net premiums. Over the period July 1, 1958 through December 31, 1962, the proceeds which Grand National received, after provision for payment of the claims, amounted to about fifty-eight per cent of the total net premiums. Grand National also had some operating expenses, but in relatively small amounts.

It was the contention of the Commissioner before the Tax Court that a portion of the commission income received by Guardian and Beneficial during the period January 1 to June 30, 1958 and a portion of the reinsurance premiums received by Grand National during the period July 1, 1958 to December 31, 1962 constituted compensation actually earned by the finance companies for selling and processing the credit life insurance, and therefore should be allocated to them in proportion to the amount of insurance which each finance company sold. The amounts allocated by the Commissioner equaled fifty per cent of the total net premiums received by the finance companies throughout the taxable years in question. The Tax Court upheld the Commissioner's allocation and deficiency assessment and found that fifty per cent of the net premiums were taxable to the finance companies under sections 61 and 482 of the Internal Revenue Code.

The taxpayers make two principal contentions: that the finance companies did not earn or have sufficient control over the premium income from the insurance to be taxed thereon and that the Tax Court's decision conflicts with prior cases holding that a taxpayer is not taxable on income he does not receive and is prohibited by law from receiving. In reviewing the Commissioner's allocation and the Tax Court's determination, our inquiry is a limited one. Ballentine Motor Co. v. Commissioner of Internal Revenue, 321 F.2d 796 (4th Cir. 1963). When evaluating section 482 situations, the Commissioner is empowered to examine closely the transactions between controlled taxable entities in order to determine whether they are such as would have been consummated in an arm's length negotiation between strangers and to make an allocation when they fail to meet that standard. Eli Lilly & Co. v. United States, 178 Ct.Cl. 666, 372 F.2d 990, 1000 (1967); Oil Base, Inc. v. Commissioner of Internal Revenue, 362 F.2d 212, 214 (9th Cir. 1966). Because of the Commissioner's broad discretion to appraise the factual situation, his determination under section 482 "is essentially one of fact and * * * must be affirmed if supported by substantial evidence." Advance Machinery Exchange v. Commissioner of Internal Revenue, 196 F.2d 1006, 1007-1008 (2d Cir. 1952).

The two primary elements which must exist to sustain a section 482 allocation are the existence of commonly controlled companies and the earning of income by certain of these companies which in the absence of the Commissioner's reallocation would not adequately be reflected in the income they would otherwise report for federal income tax purposes.

The goal of the statutory allocation procedure is to insure that controlled taxpayers are placed on a parity with uncontrolled taxpayers. Turning first to the question of common control, there is no doubt that during the years at issue Local Finance, Guardian, Beneficial, and Grand National were controlled by the same interests within the meaning of section 482. The common shareholder interests previously described make it clear that the "control" requirements have been met.³

The more difficult inquiry is whether the finance companies and insurance companies would have entered into the same arrangements had they been uncontrolled corporations and bargained at arm's length. This question can be resolved only by determining who actually earned the commission premiums. The undisputed evidence in the record shows that during the entire period employees of the finance companies performed most of the services incident to the sale and servicing of the insurance. It is well known that insurers pay policy solicitors a portion of the premium as a commission for generating and processing the insurance. The touchstone of our analysis is who expended the effort which caused the policies to be issued. The record demonstrates that it was the finance companies who advised the borrowers of the opportunity to obtain life insurance and encouraged them to subscribe.⁴ The finance companies wrote the policies, collected the premiums and deposited them in the bank accounts of Guardian and Beneficial, made refunds, prepared the necessary papers in the event of the death of an insured borrower, and made weekly reports to Guardian and Beneficial. The sole function of the latter companies was to collate and transmit information and premiums to Old Republic.⁵ The Commissioner's allocation had the effect of compensating the finance companies for their...