Security Ben. Life Ins. Co. v. United States

• Decision Date: 04 August 1980
• Docket Number: No. 77-4201.,77-4201.
• Parties: SECURITY BENEFIT LIFE INSURANCE COMPANY, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of Kansas

517 F. Supp. 740

SECURITY BENEFIT LIFE INSURANCE COMPANY, Plaintiff, v. UNITED STATES of America, Defendant.

No. 77-4201.

United States District Court, D. Kansas.

August 4, 1980.

E. P. Baker, Washington, D.C., Ross Freeman, Topeka, Kan., for plaintiff.

Bruce I. Crocker, Dept. of Justice, Tax Division, Washington, D.C., James P. Buchele, U.S. Atty., Topeka, Kan., for defendant.

MEMORANDUM AND ORDER

INTRODUCTION

ROGERS, District Judge.

This is an action pursuant to Section 7422 of the Internal Revenue Code of 1954 (26 U.S.C.), for the recovery of federal income taxes, plus interest, paid by the plaintiff for its taxable year 1968. Over one-half million dollars are in controversy. Jurisdiction is conferred upon the Court by 28 U.S.C. § 1346(a)(1).

The plaintiff is a life insurance company whose claim is based upon the carryback to 1968 of a loss from operations for its taxable year 1971. Thus, while this is an action for refund of taxes and interest paid for 1968, the issues presented involve items on the plaintiff's 1971 income tax return.

The rather complicated issues presented in this case arise from two unrelated events â (1) plaintiff's acquisition in 1971 of all the insurance business of a fraternal benefit society, the Ladies' Society of the Brotherhood of Locomotive Firemen and Enginemen ("Society"), and (2) the plaintiff's change in 1971 of its method of accounting for loading on deferred and uncollected premiums as a consequence of the Supreme Court's decision in Commissioner v. Standard Life & Accident Ins. Co., 433 U.S. 148, 97 S.Ct. 2523, 53 L.Ed.2d 653 (1977).

Although these two events will be discussed in detail in the Court's findings of fact infra, a brief description of their factual backgrounds may be helpful to an understanding of the issues presented.

Assumption Reinsurance Transaction

The first event arises from plaintiff's acquisition of the insurance business of the Ladies Society of the Brotherhood of Locomotive Firemen and Enginemen. Organized in 1884, the Society provided insurance benefits to its members, including funeral and life insurance benefits. Due to declining membership and the advanced age of its members, the Society began to face an "assessment spiral." The Society solicited offers and ultimately concluded an arrangement with plaintiff whereby the premiums charged members were raised from $12 to $15 per thousand, the plaintiff assumed all liabilities under the policies, and the Society transferred to the plaintiff all of its assets which were set aside to pay benefits due under the policies. Plaintiff obtained the permission of the State Insurance Commissioner to carry securities transferred from the Society at the par value for Annual Statement purposes, though the market value of the securities had declined substantially. The par value was approximately $7,569,000; the market value was approximately $5,543,110. Plaintiff assumed liabilities which required it to establish reserves of about $7,554,519.

In filing its 1971 tax return, which showed a $2,679,881 loss from operations, the plaintiff took the tangible assets into account at the $5,943,814 value, and the reserves at the claimed $7,554,519. In rejecting this tax treatment, the I.R.S. stated in a Notice of Deficiency:

It is determined that you paid the Ladies' Society of the Brotherhood of Locomotive Firemen and Enginemen $1,769,111.00 for the purchase of the insurance contracts you acquired in connection with the assumption reinsurance transaction, which amount is equal to the excess of the amount of the increase in the reserves over the net amount of assets you received from that Society. Accordingly, $1,769,111.00 is includible in your premium income in 1971 and is amortizable over the estimated life of the contracts, 10 years from July 1, 1971.

The transaction between plaintiff and the Society is termed, in insurance parlance, an "assumption reinsurance transaction." SBL is the reinsurer and the Society the reinsured. This transaction raises questions regarding how great a sum plaintiff should be deemed to have paid for the insurance business of the Society, and how plaintiff should have established reserves to cover the liabilities assumed.

§ 481 Adjustment â Standard Life Case

For many years, life insurance companies and the I.R.S. disagreed as to the proper manner of treating unpaid deferred and uncollected premiums for income tax purposes. In Commissioner v. Standard Life & Accident Ins. Co., supra, 433 U.S. at 150-151, 97 S.Ct. at 2525, the Supreme Court pointed out:

Under normal accounting rules, unpaid premiums would simply be ignored. They would not be properly accruable since the company has no legal right to collect them. Nevertheless, for the past century, insurance companies have added an amount equal to the net valuation portion of unpaid premiums to their reserves, with an offsetting addition to assets. State law uniformaly requires this treatment of unpaid premiums, as does the accounting form issued by the National Association of Insurance Commissioners (NAIC).

. . . . .

... In his the Commissioner's view, if reserves are calculated on the fictional assumption that these premiums have been paid, the same assumption should apply to the calculation of assets and gross premium income.

After viewing the arguments of the parties, the Supreme Court "split the baby", holding that

... the net valuation portion of unpaid premiums, but not the loading, must be included in assets and gross premium income, as well as in reserves. (emphasis added) (433 U.S. at 151, 97 S.Ct. at 2526

Between 1958 and 1970, plaintiff was required by the Internal Revenue Service to include the loading portion of unpaid premiums in its assets and gross premium income. Because of the erroneous position taken by the I.R.S., plaintiff overpaid its taxes for this time period. The parties agree that due to the Supreme Court's decision in Standard Life, plaintiff is entitled to an adjustment in its income taxes pursuant to 26 U.S.C. § 481(a) in order to prevent duplicate reporting of income. However, the parties disagree as to the amount of the adjustment and whether plaintiff may take advantage of said adjustment in a single year, 1971, or whether the adjustment must be spread over a period of years.

ISSUES PRESENTED

According to the pretrial order, this case presents the following issues of law:

1. What amount is includible in plaintiff's 1971 income as consideration received from the Society in exchange for plaintiff's obligation to pay death benefits to the members of the Society.

2. If the amount so includible in plaintiff's 1971 income is greater than that reported on its 1971 return, whether plaintiff is entitled to a deduction in 1971 of the excess, or whether such amount must be amortized.

3. If the amount so includible in plaintiff's 1971 income is not greater than that reported on its 1971 return, whether a portion of plaintiff's 1971 year-end reserve of $7,554,519 attributable to its obligations to the Society members constituted a deficiency reserve within the meaning of section 801(b)(4) of the Internal Revenue Code.

4. Whether plaintiff is entitled in 1971 to an adjustment under section 481 of the Internal Revenue Code as a result of the 1971 change in the tax treatment of its loading on deferred and uncollected premiums, and if so, in what amount.

In their briefs, the parties have effectively merged issues one and two, and have discussed the legal issues presented within the context of three major questions, the first two of which relate to the transaction regarding the Society and the final of which relates to the results of the Standard Life case: (1) Did plaintiff properly file its 1971 income tax return in reporting the consideration it received for providing benefits to members of a fraternal society? (2) Is any part of SBL's 1971 year-end reserve for benefits provided to Society members a "deficiency reserve" within the meaning of 26 U.S.C. § 801(b)(4)? (3) How should plaintiff's 26 U.S.C. § 481 adjustment in response to the Standard Life case be calculated?

After overruling cross motions for summary judgment, the Court heard evidence on the merits of this action on May 27-29, 1980. The Court is now prepared to rule.

INTRODUCTORY FINDINGS OF FACT

1. This is an action pursuant to 26 U.S.C. § 7422 for the recovery of federal income taxes of $528,017, plus interest, paid by the plaintiff, Security Benefit Life Insurance Co. for its taxable year 1968.

2. Jurisdiction is conferred upon this Court by 28 U.S.C. § 1346(a)(1).

3. Plaintiff's claim is based upon the carryback to 1968 of a loss of operations from its taxable year 1971. Thus, while this is an action for refund of taxes and interest paid for the year 1968, the issues presented involve items on plaintiff's 1971 income tax return.

4. Plaintiff Security Benefit is, and at all times relevant was, a corporation organized and existing under the laws of the State of Kansas as a mutual life insurance company, engaged in the business of writing various forms of life insurance, annuities and accident and health insurance.

5. The plaintiff is, and at all times relevant was, a life insurance company as defined by 26 U.S.C. § 801(a), and was therefore subject to the Internal Revenue Code's provisions regarding taxation of life insurance companies, 26 U.S.C. §§ 801-820.

6. Plaintiff is also, and was at all times relevant, subject to regulation by the Kansas Insurance Department.

7. Plaintiff timely filed its 1968 Federal income tax return, reporting a liability thereon of $718,450. Plaintiff paid this amount, but upon audit the Internal Revenue Service determined the correct tax to be $697,509, and refunded to plaintiff the $20,941 overpayment.

8. Plaintiff timely filed its 1971 Federal income tax return, reporting taxable investment income of $1,937,096, and a loss from operations of $2,679,881.

9. In July, 1972, plaintiff timely filed a...