UNITED STATES TAX COURT

T.C. Memo. 1996-152

UNITED STATES TAX COURT

TOWER LOAN OF MISSISSIPPI, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 570-93.

Filed March 26, 1996.

Leonard D. Van Slyke, Jr., and Denise F. Schreiber

(specially recognized), for petitioner.

Thomas R. Ascher and Kim A. Palmerino, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, Judge:

Respondent determined deficiencies in

petitioner’s Federal income tax for 1988 and 1989 of $370,317 and

$490,267, respectively.

The issues for decision are: (1) Whether certain commission

income should be reallocated to petitioner from petitioner’s

- 2 wholly owned subsidiary pursuant to section 482.1

We hold that

it should not. (2) Whether petitioner can take a bad debt

deduction pursuant to section 166 for the 1989 tax year.

We hold

that it cannot.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts filed by the parties and its

accompanying exhibits are incorporated herein by this reference.

At the time the petition was filed herein, petitioner, Tower Loan

of Mississippi, Inc., had its principal place of business in

Jackson, Mississippi.

Petitioner is engaged in the business of making small

consumer loans, ranging from $100 to $5,000.

bank or a savings and loan association.

Petitioner is not a

Petitioner was

incorporated in 1972 as a business corporation under the

Mississippi Business Corporation Act.

Petitioner used the

accrual method of accounting during the years in issue.

In February 1983, petitioner organized two wholly owned

subsidiary insurance companies, the American Federated Life

Insurance Co. (AFLIC) and the American Federated Insurance Co.

(AFIC).

In addition to providing financing to its customers,

petitioner makes available credit life insurance to its

1

All section references are to the Internal Revenue Code in

effect for the taxable years in issue, and all Rule references

are to the Tax Court Rules of Practice and Procedure, unless

otherwise stated.

- 3 customers.

Prior to its organization of AFLIC and AFIC in 1983,

petitioner had received and retained a portion of the premium

payments from the sale of the credit life insurance.

However,

petitioner was sued by several customers who claimed that because

petitioner received insurance commissions, effectively, the loans

were usurious and unenforceable.

being sued on this theory as well.

Other finance companies were

The primary purpose for the

formation of the insurance companies was to avoid the legal

problems associated with petitioner’s charging and receiving

premiums from the sale of credit life insurance.

AFIC is in the

business of providing property and casualty insurance.

AFIC

files consolidated returns with petitioner.

AFLIC is primarily in the business of providing credit life

and disability insurance.

from petitioner.2

AFLIC files its returns separately

AFIC and AFLIC continued to exist as wholly

owned subsidiaries of petitioner during the years in issue.

Petitioner gives its customers the option of purchasing credit

insurance for their loans.3

Credit insurance policies offer

protection to the creditor and debtor by providing for payment of

the loan in the event of certain occurrences such as death or

2

Pursuant to sec. 1504(b)(2), AFLIC is not an includable

corporation and therefore is not eligible to file in the

consolidated returns.

3

Petitioner also offers property insurance. We will not

discuss property insurance policies, as they are not relevant to

the issues in this case.

- 4 disability of the debtor, depending on the type of policy.

Prior

to the formation of AFLIC, petitioner employed licensed insurance

agents who sold insurance policies underwritten by outside

insurance companies.

Petitioner was not and never has been

licensed under Mississippi law as an insurance agent; it has

always employed licensed agents who sold the insurance.

Some

portion of the premiums from these sales was remitted to

petitioner as commissions.

After the formation of AFLIC, petitioner offered only AFLIC

credit insurance to its customers.

Petitioner required all of

its branch managers to acquire a license to sell the insurance.

If a customer chose to purchase insurance, then the premiums were

added to the amount of the loan.

Petitioner would then remit the

entire premium amount to AFLIC.

AFLIC would not pay the licensed

branch managers or petitioner commissions or other compensation

for selling AFLIC insurance.

Petitioner, however, would pay

bonuses to its licensed branch managers based on the amount of

insurance each manager sold.

AFLIC sells credit insurance to debtors of other creditors

besides petitioner through agents who are not employees of

petitioner.

AFLIC pays these other agents sales commissions,

usually between 45 and 65 percent of the premium.

AFLIC has no employees or offices.

It does not advertise.

It pays another company to do its tax returns, compute its

reserves, and do its actuarial work.

- 5 On its amended 1988 and 1989 U.S. Life Insurance Company

Income Tax Returns, Forms 1120L, AFLIC respectively reported

$3,000,498 and $2,958,091 in gross premiums and respectively took

deductions for commissions paid in the amounts of $1,366,543 and

$1,360,371.4

Respondent sent petitioner a notice of deficiency dated

October 28, 1992, which included increases to petitioner’s gross

income in the amounts of $1,083,197 and $1,140,414, for the years

1988 and 1989, respectively, to clearly reflect commission income

from the sale of credit insurance during 1988 and 1989.

On or about September 23, 1985, Matheney Ford, Inc.

(Matheney Ford), executed a loan agreement and promissory note

(the loan agreement) whereby AFLIC and AFIC agreed to and did

lend Matheney Ford $225,000.

The president of Matheney Ford was

George O. Cooper, Jr. (Cooper).

AFIC and AFLIC were granted a

security interest in Matheney Ford’s used cars and certain

accounts.

Cooper executed a guaranty for Matheney Ford’s debt.

As security for his guaranty, Cooper and his wife executed a deed

of trust on their residence in favor of AFLIC and AFIC.

The deed

of trust was subordinate to a first deed of trust held by

Trustmark National Bank (Trustmark) as security for promissory

4

AFLIC’s commission deductions include the commission

income allocated to petitioner under sec. 482. The commission

deductions were claimed on the amended return to preserve the

deduction in the event respondent prevailed on the proposed sec.

482 adjustment.

- 6 notes that Cooper executed to Trustmark (the Trustmark notes).

The loan agreement further provided for the assignment to AFIC

and AFLIC of life insurance policies issued by Lamar Life

Insurance Co. (the Lamar policies) on Cooper’s life.

In January

1986, Mrs. Cooper, the owner of the Lamar policies, so assigned

the Lamar policies.

Matheney Ford defaulted on the loan, leaving Cooper indebted

to AFLIC in the amount of $140,000 (hereinafter sometimes

referred to as the Cooper debt).

On May 24, 1988, the Coopers

and AFLIC executed a second loan agreement (the second loan

agreement).

Under the second loan agreement, AFLIC agreed to

purchase the outstanding Trustmark notes and the Trustmark deed

of trust for $210,000 and to renew Cooper’s $140,000 indebtedness

in exchange for new promissory notes from the Coopers.

In

accordance with the second loan agreement, the Coopers executed

the following, with AFLIC as payee:

(1) A promissory note in the

amount of $328,500 and (2) a nonrecourse promissory note in the

amount of $21,500.

The second loan agreement provided that the

Lamar policies remained assigned to AFLIC.

AFLIC foreclosed on the deed of trust, purchased the Cooper

residence, and subsequently sold it, applying the proceeds to

reduce the Coopers’ debt.

On or about June 22, 1989, Cooper and

AFLIC entered into a third loan agreement (the third loan

agreement), whereby they agreed to refinance the Coopers’

indebtedness by having Cooper execute a new promissory note to

- 7 AFLIC for the balance of the debt, $93,595, payable in

installments beginning January 15, 1990.

The third loan

agreement further provided that Mrs. Cooper would be released

from liability, but that the Lamar policies would remain assigned

to AFLIC.

On or about July 21, 1989, AFLIC assigned all its

interest in the third loan agreement to AFIC.

Cooper was sent to prison sometime in 1989.

As of December

1989, the Lamar policies had a total cash value of $853.

On its

1989 Federal income tax return petitioner claimed a bad debt

deduction in the amount of $118,356 relating to the debts of

AFIC.5

OPINION

Issue 1. Section 482 Issue

Petitioner sold credit insurance policies written by AFLIC,

its wholly owned subsidiary, to its customers.

Petitioner

remitted all the premiums to AFLIC and, in turn, received no

commissions or payments for selling the insurance.

Respondent,

pursuant to section 482, reallocated 45 percent of the premiums

as commission income to petitioner.

Section 482 provides, in pertinent part, as follows:

5

Of the disallowed $118,356, $104,641 stems from the

Cooper debt. Respondent disallowed the balance, $13,715, because

petitioner failed to establish that a debt existed or became

worthless during 1989. Petitioner fails to address the $13,715.

We therefore assume that petitioner concedes that amount, and we

so find. Rule 151(e)(4) and (5); Petzoldt v. Commissioner, 92

T.C. 661, 683 (1989); Money v. Commissioner, 89 T.C. 46, 48

(1987).

- 8 In any case of two or more organizations, trades,

or businesses * * * owned or controlled directly or

indirectly by the same interests, the Secretary may

distribute, apportion, or allocate gross income,

deductions, credits, or allowances between or among

such organizations, trades, or businesses, if he

determines that such distribution, apportionment, or

allocation is necessary in order to prevent evasion of

taxes or clearly to reflect the income of any of such

organizations, trades, or businesses. * * *

Section 1.482-1(b)(1), Income Tax Regs., explains the purpose of

section 482 as follows:

The purpose of section 482 is to place a controlled

taxpayer on a tax parity with an uncontrolled taxpayer,

by determining, according to the standard of an

uncontrolled taxpayer, the true taxable income from the

property and business of a controlled taxpayer. * * *

Generally put, section 482 is designed to prevent artificial

distorting of the true net incomes of commonly controlled

entities.

The Commissioner has broad discretionary power to

allocate income, and a heavier than normal burden is placed on

the taxpayer to prove that the allocation is arbitrary or

unreasonable.

Procter & Gamble Co. v. Commissioner, 95 T.C. 323,

331 (1990), affd. 961 F.2d 1255 (6th Cir. 1992).

In meeting its

burden, petitioner must show that it did not improperly utilize

its control to shift income.

Id.

Petitioner concedes that it and AFLIC are under common

control.

Petitioner, however, argues that it did not improperly

utilize its control over itself and AFLIC to shift commission

income from itself to AFLIC, because under Mississippi law it

would have been illegal for petitioner, during the years in

- 9 issue, to receive the commission income.

Petitioner, in this

regard, relies primarily on the Supreme Court’s decision in

Commissioner v. First Security Bank, 405 U.S. 394 (1972), a case

whose facts are strikingly similar to those now before us.

In

First Security, two banks, wholly owned subsidiaries of a holding

company, offered credit insurance to their borrowers.

The

premiums would be forwarded to an independent insurer, which

would then reinsure the policies with an insurance company which

was also wholly owned by the holding company.

The subsidiary

insurance company would receive 85 percent of the premiums, and

the outside insurance company, which furnished actuarial and

accounting services, kept the remaining 15 percent.

The banks

received no commissions or payments for selling the insurance.

The Commissioner, pursuant to section 482, determined that a

percentage of the premiums was allocable to the banks to properly

reflect commission income.

The Supreme Court set aside the Commissioner’s allocation.

The Court emphasized that, under Federal law, the banks were

prohibited from receiving commissions.

Id. at 401.

Since the

banks could not have legally received that income, the Court

determined that the holding company did not improperly utilize

its control over its subsidiaries to distort income.

404.

Id. at 403-

In its analysis, the Court found no decision of the Supreme

Court wherein a person had been found to have taxable income that

he did not receive and that he was prohibited from receiving.

- 10 Id. at 403.

Moreover, in cases dealing with the concept of

income, it has been assumed that the person to whom the income

was attributed could have received it.

Id.

The underlying

assumption always has been that in order to be taxed for income,

a taxpayer must have complete dominion over it.

Id. (citing

Corliss v. Bowers, 281 U.S. 376, 378 (1930)).

We understand the Supreme Court’s opinion to forbid

allocation of income to a taxpayer when restrictions imposed by

law prohibit the taxpayer from receiving such income.

See

Procter & Gamble Co. v. Commissioner, supra at 336; see also

Salyersville Natl. Bank v. United States, 613 F.2d 650 (6th Cir.

1980); Bank of Winnfield & Trust Co. v. United States, 540 F.

Supp. 219 (W.D. La. 1982).

Thus, if we find that Mississippi law

made it illegal for petitioner to receive commissions during the

years in issue, we must hold for petitioner.

See Procter &

Gamble Co. v. Commissioner, supra at 336.

Petitioner argues that Miss. Code Ann. secs. 83-17-105 and

83-17-7 (1973) prohibited it from receiving commissions during

the years in issue.

For those years, Miss. Code Ann. sec. 83-17-

105 states in pertinent part:

No insurer or agent doing business in this state

shall pay, directly or indirectly, any commission or

any other valuable consideration to any person for

services as an agent within this state unless such

person shall hold a currently valid license and

certificate of authority to act as an agent, as

required by the laws of such state. Nor shall any

person other than a duly licensed agent accept any such

commission or other valuable consideration. * * *

- 11 Miss. Code Ann. sec. 83-17-7 likewise states:

It shall be unlawful for any insurance company or

any insurance agent to pay, directly or indirectly, any

commission, brokerage or other valuable consideration

on account of any policy or policies written on risks

in this state to any person, agent, firm or corporation

not duly licensed as an insurance agent in this state,

* * *.

These statutes seem to forbid commission payments to petitioner,

as petitioner is not a “duly licensed agent”.

Respondent,

however, cites Miss. Code Ann. sec. 83-53-25(1)(1973), which

states as follows:

No one shall pay, accrue, credit or otherwise

allow, either directly or indirectly, any compensation

to any creditor, person, partnership, corporation,

association or other entity in connection with any

policy, certificate or other contract of credit life

insurance or credit disability insurance which exceeds

forty-five percent (45%) of the premium rates approved

for such policy, certificate or contract.

A similar regulation, limiting the amount allowable as

compensation to any “creditor or agent” for the sale of credit

life insurance, was in place during the years in issue.

Mississippi Insurance Department Reg. No. LA & H 82-102.6

The

Supreme Court of Mississippi addressed this apparent conflict

6

Miss. Ins. Dept. Reg. No. LA & H 82-102, sec. VII

provides:

No insurance company shall pay, credit or otherwise allow

any compensation or other valuable consideration, either

directly or indirectly to any creditor or agent for the sale

of any policy, certificate or other contract of credit

insurance which exceeds fifty percent of the premium rates

specified for such policy, certificate or contract.

- 12 among the statutes in Tew v. Dixieland Finance, Inc., 527 So. 2d

665 (Miss. 1988).

Tew involved a small loan company which, like petitioner,

sold credit life insurance through licensed employees.

Like

petitioner, the loan company itself was not licensed to sell

insurance.

The loan company brought suit against a borrower who

had defaulted on his loan.

The borrower counterclaimed,

asserting that the loan company’s receipt of commissions on his

purchase of credit life insurance from the loan company was in

violation of Miss. Code Ann. sec. 83-17-105--as the loan company

was not a licensed agent--and in violation of Miss. Code Ann.

sec. 75-67-121.

In Tew, before deciding the issue of whether the loan

company violated section 83-17-105, the court noted that it was

common practice in the industry for unlicensed creditors to

receive commissions for the sale of credit insurance.

670.

Id. at

Furthermore, the court cited Miss. Code Ann. sec. 83-53-25

and Ins. Dept. Reg. 82-102 as evidence that the Mississippi

Legislature and Department of Insurance have recognized that

unlicensed creditors may receive commissions.

Id. at 670-671.

However, the court emphasized that these “regulations ignore the

inconsistency of these provisions with Miss. Code Ann. §83-17-105

(Supp. 1987) which prohibits the payment of any commission to any

person who is not a licensed agent”.

Id. at 671.

Accordingly,

the court held “that the receiving of * * * [the] commission by

- 13 Dixieland [i.e., the loan company] from its sale of insurance is

in violation of the Miss. Code Ann. section 83-17-105”.

Id.

Because of the reliance placed on the Department of Insurance

regulations, the court made its ruling prohibiting an unlicensed

agent from collecting commissions prospective to cases arising on

and after July 1, 1989.

Id. at 673.

The court chose a

prospective date to allow the Legislature and Executive

Departments to deal with the inconsistencies noted.

Id.7

Petitioner argues that the prospective language in Tew

relates only to the private cause of action asserted by the

defendant against the loan company, not to the legality of the

loan company’s actions.

Thus, petitioner argues, it would have

been illegal for it to receive commissions even prior to July 1,

1989.

We agree.

The Mississippi Supreme Court clearly held that

the receiving of commissions by the loan company from the sale of

credit insurance was in violation of Miss. Code Ann. sec 83-17105, which required it to be a licensed agent to receive

commissions.

Id.

Neither party disputes the rule of Commissioner v. First

Security Bank, 405 U.S. 394 (1972), wherein the Supreme Court

held that the Commissioner’s allocation of income to a taxpayer

7

The statutes in question were not amended after Tew v.

Dixieland Finance, Inc., 527 So. 2d 665 (Miss. 1988). However,

on July 1, 1989, the Department of Insurance promulgated Ins.

Dept. Reg. 89-102 to specifically allow an unlicensed creditor

which sells credit insurance through its licensed employees to

receive commissions.

- 14 pursuant to section 482 was inappropriate when the taxpayer’s

receipt of such income was prohibited by local law.

The Court

concluded that section 1.482-1(b)(1), Income Tax Regs.,

contemplated that the controlling interest, i.e., the holding

company, must have “complete power” to shift income among its

subsidiaries.

Id. at 404.

Section 1.482-1(b)(1), Income Tax

Regs., provides, in pertinent part, as follows:

The interests controlling a group of controlled taxpayers

are assumed to have complete power to cause each controlled

taxpayer so to conduct its affairs that its transactions and

accounting records truly reflect the taxable income from the

property and business of each of the controlled taxpayers.

* * *

Thus, the Court continued, it is only when this power

exists, and has been used to understate the controlled taxpayer’s

true income, that the Commissioner is authorized to reallocate

income under section 482.

Id.

The Court concluded that the

holding company did not have the “complete power” to shift income

between its controlled interests unless it violated the Federal

banking laws.

Moreover, the Court concluded that the “complete

power” referred to in the regulations hardly includes the power

to force a subsidiary to violate the law.

Id. at 405.

Applying the same type of analysis, we hold that petitioner

could not have received commission income from AFLIC without

violating Mississippi State law as provided in Miss. Code Ann.

secs. 83-17-105 and 83-17-7 (1973) and as construed by the

Mississippi Supreme Court in Tew v. Dixieland Finance, Inc.,

- 15 supra.

See Estate of Bosch v. Commissioner, 387 U.S. 456 (1967).

Petitioner has not utilized its control over AFLIC so as to

improperly shift income.

Rather, there has been a deflection of

income by operation of Mississippi State law.

See Procter &

Gamble Co. v. Commissioner, 95 T.C. at 341.

Accordingly, we hold that an allocation under section 482 is

unwarranted and an abuse of the respondent’s discretion.

Issue 2. Bad Debt Deduction

Petitioner took a deduction under section 166(a) for the

Cooper debt which AFLIC assigned to AFIC in July 1989.8

Section 166(a) provides a deduction for any debt which

becomes worthless during the taxable year.

The amount of the

deduction for a bad debt is limited to the taxpayer’s adjusted

basis in the debt as provided in section 1011.

Sec. 166(b);

Perry v. Commissioner, 92 T.C. 470, 477-478 (1989), affd. without

published opinion 912 F.2d 1466 (5th Cir. 1990).

Whether, and

when, a debt becomes worthless is determined by looking at all

the facts and circumstances including the value of the

collateral, if any, securing the debt and the financial condition

of the debtor.

8

Sec. 1.166-2(a), Income Tax Regs.

Generally, a

Since AFIC was a member of the affiliated group with

petitioner, AFIC’s operations were included in the consolidated

filing. Sec. 1.1502-76(b)(1), Income Tax Regs. The common

parent shall be the sole agent for each subsidiary in the group.

Sec. 1.1502-77(a), Income Tax Regs. As common parent, petitioner

is authorized to petition and conduct proceedings before the

Court on behalf of all members of the group. Id.

- 16 debt will be considered worthless only when it can be reasonably

expected that the debt is without possibility of future payment

and legal action to enforce the debt would not result in

satisfaction.

Hawkins v. Commissioner, 20 T.C. 1069 (1953).

Petitioner bears the burden of proof, Rule 142(a), and must show

that the debt had value at the beginning of the taxable year in

question--in this case 1989--and that it became worthless during

and prior to the end of that year, Millsap v. Commissioner, 46

T.C. 751, 762 (1966), affd. 387 F.2d 420 (8th Cir. 1968).

We have found the amount of the debt, as assigned to AFIC in

1989, to be $93,595.

Of that amount, petitioner concedes that

$853, the cash value of the Lamar policies, is not deductible as

a bad debt.

Petitioner proposes no findings of fact and makes no

arguments supporting its position that the debt became worthless

in 1989 other than that Cooper began serving a prison sentence

during 1989.

The only evidence submitted by petitioner

pertaining to the worthlessness of the debt is Jack Lee’s

subjective testimony on the matter.9

Lee testified as follows:

Q.

Well, prior to his going to prison, what effort

did you make -- after the business went defunct, what

efforts did you make to collect on the loan?

A.

We went through a long history of George trying to

collect. He went from -- after the thing -- after

Cooper Ford went broke, then he bought the restaurant

9

Lee is chairman, chief executive officer, and part

owner of petitioner.

- 17 on Highway 80; I forget the name of it.

make it with the restaurant.

And he didn’t

[Trustmark] had a lien on his house, and I had a

buyer for the house, so I went up there and got

[Trustmark] to sell me their position. And we

subsequently foreclosed on that house, and I did make

some money, which reduced the debt some on the

settlement of that house. * * *

Q.

And after that occurred, what happened to make you

finally conclude that the loan was uncollectible?

A.

Well since that time -- since he lost -- it was

Fisherman’s Wharf was the restaurant -- since he lost

that restaurant, and he went to prison in my knowledge

George has never worked since then.

We assume that the loan that Lee was referring to was the

original loan in 1985, which was refinanced in 1988 and again in

1989.

The parties have treated the 1989 note as merely a

continuation of the debt which was refinanced in 1988 by AFLIC,

and we see no difference in result by doing the same.

Assuming the 1989 note was a continuation of the earlier

debt, without anything more than Lee’s testimony, we are not

persuaded that the debt was worthless.

The only evidence that

petitioner (or AFLIC) attempted to collect on the debt was the

purchase of the Coopers’ home in the 1988 foreclosure sale.

Petitioner has not shown that Cooper was without any other assets

which could have provided payment in an action to collect on the

debt.

Moreover, even if the debt was worthless, the record does

not establish that it became worthless in 1989.

became insolvent no later than 1988.

Matheney Ford

AFLIC foreclosed on the

- 18 Coopers’ house and sold it in 1988.

Accordingly, petitioner has

failed to meet its burden of proof.

We add that if the 1989 note is viewed as a separate debt

from the earlier debt, petitioner has failed to show that such

debt had value when created, or when acquired by AFLIC.

that showing, a deduction is not permitted.

Without

See, e.g., Garrett

v. Commissioner, 39 T.C. 316, 317 (1962).

Finally, petitioner has failed to prove AFIC’s basis in the

note, which is required in order to take a section 166 deduction.

Sec. 166(b).

Normally, for section 166(b) purposes, a taxpayer’s

basis in property is the cost of such property.

1012.

Secs. 1011 and

The assignment agreement stated that the assignment was

“For a valuable consideration, the receipt and sufficiency of

which is hereby acknowledged”.

Lee testified that AFIC

reimbursed AFLIC for the amount of the debt; i.e., that AFLIC

furnished consideration for the debt.

However, we have found no

evidence of any such payments and would not, therefore, be able

to determine the amount allowable as a deduction under section

166.

Accordingly, we sustain respondent’s disallowance of

petitioner’s bad debt deduction.

Decision will be entered

under Rule 155.