Petition — Home Mutual Insurance v. Commissioner
Supreme Court brief1981
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Office-Supreme Court, U.S
80-1599 FILED
__MAR_ 90 198
No. ALEXAN ce STEVAS,
IN THE —
SUPREME COURT OF THE UNITED STATES
October Term, 1980
HOME MUTUAL INSURANCE COMPANY,
Petitioner,
US.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.
PETITION FOR WRIT OF CERTIORARI TO
THE UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT
PAUL A. PAKALSKI
2100 Marine Plaza
Milwaukee, Wisconsin 53202
(414)271-&210
Counsel for Petitioner
Of Counsel:
MICHAEL T. HART
JOHN F. EMANUEL
WHYTE & HIRSCHBOECK S.C.
2100 Marine Plaza
Milwaukee, Wisconsin 53202
March 29, 1981
QUESTIONS PRESENTED
1. Whether the exclusionary “tax benefit rule”
may be invoked, in the context of Section 832(b) of the
Internal Revenue Code, to exclude certain items from a
taxpayer’s taxable income.
2. Whether the Respondent’s construction and
application of Section 832(b) of the Internal Revenue
Code under the circumstances of the present case
constitutes a violation of the constitutional limitations
on the taxing power of the Congress, by imposing a
tax on that which is not “income” within the meaning
of the 16th Amendment.
PARTIES
All of the parties to this proceeding are listed in
the caption of the case as set forth on the cover of this
Petition. The only parent, subsidiary, or affiliate of the
Petitioner is a subsidiary known as Homeco Life
Insurance Co., Inc., 93.2% of whose outstanding stock
is owned by Petitioner.
&;
TABLE OF CONTENTS
Page
eB . PPPPPRe Te eer rr 1
Pe oon sco 0's cv eucpézees ne eeseneen eee 1
Constitutional Provisions &
Dtatwhen TVG o.oo sciences csunstacasaneeeeee 2
Statement of the COG0.... cscs ccscusasececeseaavaeuee 2
Reasons for Granting the Writ...................... 9
I. The Issue Presented By The
Decision Of The Court Of
Appeals Is Of Continuing
Significance In The Ad-
ministration And _ Interpreta-
tion Of The Income Tax Law ....... 9
A. The doctrine with which
the case is concerned, the
“tax benefit rule,” is a
well-established doctrine of
income tax jurisprudence,
applicable in a wide array
of contexts throughout the
Cet BO oi ccsankeeessuveant eee 9
B. The decision of the Court of
Appeals constitutes a
significant, and conceptual-
ly unsound, departure from
previously well-established
“tax benefit rule”’ doctrine. ....13
II. The Decision Of The Court Of
Appeals Is In Conflict With This
Court’s Decision In Dobson uv.
Commissioner, 320 U.S. 489
(1O6GB) 2... cccdcucessducbasaees 17
ITI.
IV.
ili
Page
The Decision Of The Court Of
Appeals Is In Conflict With The
Decisions Of Other Circuit
Courts And The Court Of
Claims Regarding The Scope Of
The Tax Benefit Rule .............. 18
The Statute In Question As
Interpreted And Applied By
The Court Of Appeals Violates
Cases
Constitutional Limitations On
Congress’ Taxing Powers ......... 20
Appendix A
(Opinions of the
Se ee I ond cgh ca ae ewadae cas ans A-l
Appendix B
(Opinion of the U.S. Tax Court)............. A-39
Appendix C
(Judgments of the
Ot OO ss anc us neh tes saabnc ke A-61
Appendix D
(Statutory Provisions) .................eee0e- A-65
TABLE OF AUTHORITIES
American Financial Corp.,
Tee ee, Me IS 6 ce saws icilencacakessscac 12,16
Anders uv. U.S., |
Gin. ae Be Ce, Ge ETO ok ko vikcecasevcvecses 19
Barnett v. Commissioner,
SD BEA, G6, GET-GS C1GGD) .... cscs ccccveccoces 15
iv
Page
Birmingham Terminal Co.,
17 T.C. 1011 (1951)
een. 1GGB-1 C.B. 1 onc ccc cc edececcecsceseses 12,16
Bromley v. McCaughn,
Bee EC TR TTC CTT Tee TTT LETT 23
California & Hawaiian Sugar
Refin. Corp. v. U.S.,
ioe Bo 8 Re | ee 12
Commissioner v. Anders, |
414 F.2d 1283 (10th Cir. 1969)...........s.000.. 19
Connery v. U.S.,
460 F.2d 11380 (Srd Cir. 1972) ........cceeceees 19
Continental Insurance Co. v. U.S.,
474 F.2d 661, 665 (Ct. Cl. 1973) ...........-50eee 8
Dallas Title & Guaranty Co.
v. Commissioner, 40 B.T.A. 1022 (1939),
rev'd on other grounds, 119 F.2d 211
(Sth Cir. 1941) .......cccciccceeccccvcccvcccccees 12
Dobson v. Commissioner,
RAR Re Ps re 10,11,17,22
Eisner v. Macomber,
ET BD CUO IG ooo ada li chic cg csc rad easiews 20
Estate of Block v. Commissioner,
39 B.T.A. 338 (1939)
aff’d., sub. nom. Union Trust Co.
of Indianapolis v. Commissioner,
111 F.2d 60 (7th Cir. 1940)
cert. den. 311 US.
8: I ee eer Tee re ree re 15
Evans, S.E. v. U.S.,
317 F. Supp. 423 (W.D. Ark. 1970) ..........-.. 19
Fernandez v. Wiener,
Tee ec aceuweeeseeccens 23
Home Savings and Loan Co.,
39 T.C. 368 (1962) acq.
1963-2 C.B. 4, 1965-2
FE sve ccceccsecveceene 12,16,17
Knowlton v. Moore,
es a cc awccnescescccesceseses 23
M & E Corp.,
MRED On ow ccc cece cccnesccccceses 12
Mager v. U.S.,
499 F. Supp. 37 (M.D. Pa. 1980)................ 19
Munter’s Estate,
SEEM CRUOUD ow concen cccccccccscccccccccess 19
McCamant,
nn ec eweeevecccccncvecsesecses 19
New York ex. rel. Cohn v. Graves,
BOO US. SOB (19387)... ccc ccc cc cc cc cece cccces 21
Penn Mutual Indemnity Co. v.
Commissioner, 277 F.2d 16
ce bececccecceccccccsecece 24
Pollock v. Farmer’s Loan &
Trust Co., 157 U.S. 429
(initial decision) 158 U.S. 601
(on rehearing) (1895) ............. 0.00. e ee eee 21,23
Scholey v. Rew,
90 U.S. (23 Wall.) 331 (1875) ................... 23
Simmons uv. U.S.,
308 F.2d 160 (4th Cir. 1962)................. 22,23
Page
South Lake Farms, Inc. v.
Commissioner, 324 F.2d 837 (9th
Nee saw seeeaecsees 19
Spitalny v. U.S.,
me ee bee Cems Cie, 1870)... 2.2... cccccceees 19
Tennessee Carolina Transportation,
Inc. v. Commissioner, 19
eo
Constitutional Provisions:
ET ee 2,21
EE ES ES ee 21
CE Ee ek ccc ce cc ccecscees 3 3i
DS 2,20,21
Statutory Authority, Regulations and
Revenue Rulings:
ES eee 1
Nese e cde ecsseccesccssescccces 18
ee eck desc edesenececcsopes 12,16,19
Ne cues vecevccceeessesccccsss 3
sce see decesccercccccccess 3,4
re ccc css ceceeseccccpececs 3,4
sec cececpecscceseseesvcces 3
Te tts tec esesserrcesecescocces 3
Ua lhbhycewacseesseccocsecvcoress 3
vl
Page
Re A Ns ii oko 3d Ou ORS s PEARS ONAN CARERS OOeEe 3
De, MM ca wa kk WERE Dak bo bede oN wen ee cenbiewe es 3,6
De, A I ge OU EL Slat a wh beer keees 1,7,21
Fe | Ore ere rer ree oe 5,6,24
te GN 0k dan koa kae > aca be een ee abea ees 8
Rens En abd asad Vee es ehh eee nes edendeed 8
Se eh ek ck hd aus cess een bee h bao EOE OO 9
I.R.C. §§ 821-26, as amended by
Revenue Act of 1942, ch. 619,
2. 8 ge Re, errr yess errr r ee ye Te 11
Int. Rev. Code of 1939
I eS clic rs hes cau bas ee KROES 11,12
Int. Rev. Code of 1954, ch. 736,
§ 821, § 822, 68A Stat. 260
CE ats dh a b's 5's Seow sie ee we 4
Revenue Act of 1942, ch. 619,
Bs ¢ Ff & Bee yr rrr err 11
Revenue Act of 1962, Pub. L. No. 87-834,
Ue Se aah ola an hee 4
Treas. Reg. 118, § 39.22(b)(12)-1
Se ae ol GL rate ee as 11
ee Ee oe a ae ee hee hb ee brenes ee 12
Treas. Reg. § 1.832-l(c), § 1832-4(c) ...........cceeeee 8
ey. Tek. DE-Te, TH) Cu. UB va ciccccccccsccsewes 12
Rev. Rul. 58-546,
NE kL ie Ce is wek bean ab oeeen eek reas 16
Vili
Rev. Rul. 67-200,
ee Els eo a 16
Other Authorities:
Bittker and Kanner,
The Tax Benefit Rule, 26 U.C.L.A.
iL. Rev. 366, 369, 271, 274 (1978) .... 0... ccccss 15
O’Hare, Statutory Nonrecognition of
Income and the Overriding Principle of
Tax Benefit Rule in the Taxation
of Corporations and Shareholders,
27 Tax L. Rev. 216, 222-26,
| Pg RR CR oe a 19
1 Mertens, The Law of Federal Income
Taxation § 7.34 (Rev. ed. 1974).............. 10,17
OPINIONS BELOW
The opinions of the Court of Appeals herein are
not yet reported officially. They are reported unofficial-
ly at 80-1 U.S.T.C. para. 9392, 45 A.F.T.R. 2d 80-1608
(original opinion) and 81-1 U.S.T.C. para. 9127, 47
A.F.T.R. 2d 81-503 (opinion on rehearing, en banc), and
are printed in Appendix A hereto, infra, pages A-l, et.
seq. The opinion of the United States Tax Court herein
is reported at 70 T.C. 944 (1978), and is printed in
Appendix B hereto, pages A-39, et seq.
JURISDICTION
The judgement of the Court of Appeals herein was
originally entered on April 29, 1980. A copy of such
judgment is set forth in Appendix C hereto, infra, at
page A-61. Ey order dated July 22, 1980, this judgment
was vacated and a rehearing, en banc, was granted
with respect to the issues here presented. This order is
reproduced in Appendix C hereto, at page A-62. The
final judgment of the Court of Appeals, on rehearing,
was entered on December 23, 1980. Such judgment is
reproduced in Appendix C, infra, at page A-63.
Jurisdiction of this Court to review such judgment is
invoked under 28 U.S.C. Section 1254(1).
CONSTITUTIONAL AND STATUTORY
PROVISIONS INVOLVED
United States Constitution:
Article I, Section 2, Clause 3: “Representatives
and direct Taxes shall be apportioned among
the several States which may be included
within this Union, according to their respec-
tive Numbers ... .”
Article I, Section 9, Clause 4: No Capitation, or
other direct, Tax shall be laid, unless in
proportion to the Census or Enumeration
herein before directed to be taken.”
Amendnient Sixteen: The Congress shall have
power to lay and collect taxes on incomes,
fron: whatever source derived, without appor-
tionment among the several States, and
without regard to any census or enumeration.”
Internai Revenue Code of 1954 (26 U.S.C.):
Section 111
Section 821
Section 823
Section 832
The foregoing Internal Revenue Code provisions are
lengthy, and the pertinent portions of their texts are
set out in full in Appendix D hereto, infra, page A-65,
et seq.
STATEMENT OF THE CASE
Petitioner is a mutual casualty insurance com-
pany, with its principal offices located in Appleton,
Wisconsin. As a mutual insurance company, Petitioner
is subject to the federal income tax under Chapter 1,
ot.
Subchapter L, Parts II and III of the Internal Revenue
Code, Sections 821 through 832.! The present case
involves the construction and application of certain
provisions of Section 832 of the Code, in the context of
what are known as an insurance company’s “unpaid
losses.”
Briefly stated, the controversy arises from a
change, enacted in 1962, in the method of computing
the taxable income of mutual casualty insurance
companies, such as Petitioner. With this change, such
companies first became taxable on their “underwriting
income” beginning with the year 1963. As a result of
the application of a prescribed statutory formula for
computing such underwriting income, however, a
company whose “unpaid losses” as of December 31,
1962 later are proven to have been overestimated or
“overaccrued” is required, at least by the literal terms
of the pertinent statutory provisions, to increase its
post-1962 taxable income by the amount of this
overestimate, as it is later recovered. This is true
regardless of the fact that the company enjoys no
economic gain from its recovery of this overaccrual,
and the fact that the overaccrual did not give rise to
any corresponding reduction in its taxable income in
any preceding year. It is Petitioner’s position that
under such circumstances the applicable statutory
provisions should be construed, in light of other
provisions of the Code as well as established non-
statutory doctrines of income taxation, to exclude such
recoveries of overaccrued unpaid losses from post-1962
taxable income, and that any application of the statute
which fails to do so is violative of the constitutional
limitations on the taxing power of Congress.
' LR.C. §821-32. All reference in the text to the “Code”, the
“Internal Revenue Code,” or to Section numbers refer, unless
otherwise stated, to the Internal Revenue Code of 1954, as
amended.
For years prior to 1963, the federal income tax was
not imposed on the underwriting income of mutual
casualty insurance companies. Rather, the tax was
imposed on the basis of such companies’ gross
premiums and/or investment income.? With the enact-
ment of the Revenue Act of 1962° however, such
taxpayers became subject to a federal income tax
based on both their investment income and their
“statutory underwriting income.”* The present con-
troversy involves certain elements of the computation
of a mutual casualty insurance company’s “statutory
underwriting income” which, together with its “tax-
able investment income,” forms the basis for its
“mutual insurance company taxable income” upon
which the income tax is imposed.°®
“Statutory underwriting income” is to be deter-
mined, with certain modifications and adjustments not
here pertinent, under the provisions of Sections 831
and 832, which govern the taxation of nonmutual
casualty insurance companies. Sections 831 and 832
had been included in the Internal Revenue Code for
some time prior to the 1962 Act; thus Congress merely
adopted the preexisting statutory formula and applied
it to mutual insurance companies.
Under Section 832 “statutory underwriting in-
come” cons‘sts, essentially, of “premiums earned”
during the year, less expenses and “losses incurred.”
The computation of this “losses incurred” deduction is
the basis of the present controversy.
2 See, Int. Rev. Code of 1954, ch. 736 §§ 821, 822, 68A Stat. 260
(amended 1962).
3 Pub. L. No. 87-834, 76 Stat. 960 (Effective with respect to taxable
years beginning after December 31, 1962).
4 I.R.C. §§ 821-26, as amended by Revenue Act of 1962, Pub. L.
No. 87-834, § 8(a), (b), (c), 76 Stat. 960, 989-93 (Effective with respect
to taxable years beginning after December 31, 1962).
5 I.R.C. § 821(a), (b).
5
Under the formula prescribed by Section 832(b)(5)
for the computation of “losses incurred,’® the tax-
payer’s “losses incurred” deduction for any particular
taxable year consists of all losses actually paid during
the year plus any increase (or minus any decrease)
during the year in its accrued unpaid losses. “Unpaid
losses” as of the end of a year consists, for these
purposes, of the taxpayer’s estimate of the amount
which it will be required to pay on account of losses
which have occurred prior to the end of the year. Thus,
when the company receives notice of a claim having
been made against one of its policies, it establishes an
accrued liability on its books, and recognizes an
expense, chargeable against current income, for the
amount estimated to be necessary to discharge the
claim. When each such claim, for which an unpaid loss
accrual had been established, is ultimately paid, the
accrued liability is removed from the company’s books,
to reflect the fact that it has been discharged.
However, if the amount ultimately paid to settle a
particular claim is less than the estimated liability
therefor previously accrued in the unpaid _ losses
6 L.R.C. § 832(b)5) provides, in pertinent part, as follows:
‘(5) LOSSES INCURRED. The term “losses
incurred” means losses incurred during the taxable
year on insurance contracts, computed as follows:
(A) To losses paid during the taxable year
(B) ... add all unpaid losses outstanding
at the end of the taxable year and
deduct unpaid losses outstanding at
the end of the preceding taxable
year.”
The portion of the statute omitted in the above quotation concerns
the adjustment which is prescribed for so-called “salvage and
reinsurance recoverable,” not directly at issue herein.
account (i.e., the unpaid loss was “overaccrued’’), the
excess amount of the accrual is proven to have been
unnecessary, and accordingly is restored to the
company’s earned surplus.’
On its face, therefore, this formula for computing
statutory underwriting income, as prescribed by
Section 832, requires these recoveries of overaccrued
unpaid losses to be included in, and increase the
taxpayer’s income for the years in which the losses are
paid. Thus, to the extent that unpaid losses are
overstated as of the end of any taxable year, the
taxpayer’s losses incurred deduction for subsequent
years will be understated, and its taxable income for
such subsequent years will be correspondingly in-
creased. Under ordinary circumstances, however, any
such overstatement of unpaid losses as of the end of a
taxable year will result in an understatement of
taxable income for that year (by virtue of the fact that
the balance in the unpaid loss account at the end of a
year is added to the losses paid in computing the
losses incurred deduction for that year), and hence the
only effect of such an overstatement of unpaid losses
will be to shift taxable income from one year to the
next. However, in the case of mutual casualty
insurance companies, an overaccrual of unpaid losses
7 In financial accounting terms, the entries made to record the
unpaid loss accrual and the subsequent payment of the claim are
as follows: When notice of a claim is received, an entry is made
charging “losses incurred” (an expense account) and crediting
“unpaid losses” (a liability account). When the claim is paid, a
credit entry is made to “cash” (reflecting the cash outlay) and a
charge is made to “unpaid losses” (eliminating the liability from
the books). If the amount paid is less then the accrued unpaid loss,
the difference is credited to earned surplus.
8 This is due to the fact that, under the prescribed formula, the
entire “unpaid losses” balance at the beginning of a year is
subtracted from losses paid during the year, while only the amount
actually paid in settlement of those unpaid losses is taken into
account in determining “losses paid’’. See, I.R.C. § 832(b)(5).
at December 31, 1962 has no such effect, because
mutual casualty insurance companies were not subject
to the income tax on their underwriting income for
years prior to 1963. In such a case, therefore, the effect
of an overaccrual of unpaid losses at December 31,
1962 is to increase a taxpayer’s taxable income for
1963 and later years without any corresponding
decrease in taxable income for vre-1963 periods.
As of December 31, 1962, the total of Petitioner’s
unpaid losses, as accrued on its books, was $2,729,-
746.00. During the years 1963 through 1975, Petitioner
ultimately paid and disposed of all of the claims which
comprised this December 31, 1962 balance, for a total
net amount of $2,327,431.41.9 Thus, Petitioner ultimate-
ly recovered and restored to its earned surplus a total
of $402,314.59 of the losses which it had incurred and
accrued prior to December 31, 1962. Under the literal
terms of Section 832(b) of the Code, Petitioner was
required to include this recovery in its post-1962
taxable income.
It is Petitioner’s position herein that its recoveries
of these overaccrued unpaid losses from pre-1963 years
should not be included in its post-1962 taxable income,
since the overaccrual of its December 31, 1962 balance
produced no correlative reduction in Petitioner’s
taxable income for any prior period. Petitioner thus
invokes the so-called “tax benefit rule,”'® a_ well-
established judicial doctrine of income taxation, now
partially codified in Section 111 of the Code.!!
® This figure represents the total amount actually paid by
Petitioner in full settlement of all of the claims comprising its
unpaid losses balance as of December 31, 1962. The figure is stated
net of salvage and subrogation recoveries received which were
attributable to such claims.
19 See, Reasons for Granting Writ, Section I.A. infra.
In its decision (Appendix B, page A-39, et seq.), the
Tax Court found in favor of the Petitioner with respect
to the unpaid losses issue. Accordingly, it found it
unnecssary to reach the alternative salvage
and subrogation issue.!2 On appeal to the Seventh
Circuit,!° the Court of Appeals reversed the Tax Court
with respect to the unpaid losses issue and remanded
the case to the Tax Court for a determination of the
salvage and subrogation issue. Three members of the
Seventh Circuit dissented from this opinion, holding
that if applied in the manner proposed by Respondent,
so as to tax pre-1962 unpaid loss recoveries, the statute
in question would be unconstitutional. Before this
Court, Petitioner seeks a reversal of the Court of
Appeals’ decision with respect to the unpaid losses
issue. If the Court of Appeals is reversed with respect
to this issue, no remand to the Tax Court will be
necessary.
11 The deficiency in income taxes for the years at issue which was
asserted by Respondent (and which therefore conferred Tax Court
jurisdiction) (See, I.R.C. §§ 6213(a), 7442) did not involve the
“unpaid losses” issue. Rather, it was based on Respondent’s
inclusion in Petitioner’s post-1962 taxable income of certain cash
recoveries of “salvage and subrogation” relating to pre-1963 losses
paid. The Respondent’s Regulations purport to require such
recoveries to be taken into account as a reduction of “losses paid”
in the year of recovery (and to therefore increase taxable income),
regardless of whether or not the earlier payment of the loss to
which they relate conferred any “tax benefit” on the taxpayer in
the year of payment. See Continental Insurance Co. v. U.S., 474
F.2d 661, 665 (Ct. Cl. 1973); Treas. Reg. §1.832-1(c), §1.832-4(c) (final
sentences.) Petitioner had excluded such recoveries from its taxable
income, in its returns as originally filed, on the ground that such
recoveries related to earlier losses the payment of which resulted in
no reduction in Petitioner’s taxable income, due to the fact that
when such losses were paid, prior to 1963, Petitioner was not taxed
on its underwriting income. Thus Petitioner relied on the same “tax
benefit rule” doctrine which it invokes in support of its position
regarding the unpaid losses issue.
(footnote continued on following page)
REASONS FOR GRANTING THE WRIT
I. The Issue Presented By The
Decision Of The Court Of
Appeals Is Of Continuing
Significance In The Ad-
ministration And _ Interpreta-
tion Of The Income Tax Law.
A. The doctrine with which
the case is concerned, the
“tax benefit rule,” is a
well-established doctrine of
income tax jurisprudence,
applicable in a wide array
of contexts throughout the
tax laws.
As described in the Statement of the Case, supra,
when an insurance company, such as Petitioner,
Respondent’s statutory notice of deficiency, asserting the
additional tax due on account of the salvage and subrogation issue,
was issued on April 14, 1975. On or about July 11, 1975, Petitioner
filed its timely Petition to the United States Tax Court. Before the
Tax Court, Petitioner not only contested Respondent’s inclusion of
these salvage and subrogation recoveries in taxable income, but
also maintained, as its principal argument, that it should be
entitled to a refund of taxes paid for the periods in issue on the
ground that its overaccrued unpaid losses as of December 31, 1962
should be excluded from post-i962 taxable income. Because the
amount by which the unpaid losses were ovéraccrued ($402,314.59)
is computed net of any salvage and subrogation recoveries relating
to such claims, the salvage and subrogation issue is raised only as
an alternative position and need not be addressed if a finding is
made in Petitioner’s favor on the unpaid losses issue. Because of
this fact, neither Court below addressed the salvage and
subrogation issue on the merits, and it is not before this Court on
the merits.
12 See note 11, supra.
‘3 Jurisdiction of the Court of Appeals to review decisions of the
Tax Court is conferred by I.R.C. §7482.
—“—
10
settles a claim against its policies for an amount less
than the amount which had been accrued therefor as
an “unpaid loss,” the company in effect “recovers”
(and restores to its earned surplus) an amount which
had previously been charged against its earnings as
an expense or loss. By the operation of Section 832 of
the Code, at least as literally worded, such “recoveries”
are included in and serve to increase the company’s
taxable income for the year in which the claims are
settled, even though the recoveries relate to losses
incurred in years prior to 1963 when the occurrence of
the losses did not reduce the taxable income of the
company. In asserting that such recoveries of pre-1962
unpaid losses should not be includible in its post-1962
taxable income, Petitioner relies upon a_ well-
established doctrine of income taxation known as the
“tax benefit rule.”
The “tax benefit rule” is a doctrine which evolved
to prevent the imposition of the income tax upon
amounts received by a taxpayer which do not repre-
sent any real economic gain to him. Now partially
codified in Section 111 of the Code, the rule stands for
the proposition that a taxpayer is not required to
recognize as taxable income mere recoveries of a prior
year’s costs, expenses, losses or accruals unless the
prior year’s cost, expense, loss vr accrual resulted in
some “tax benefit” to the taxpayer. Dobson ov.
Commissioner, 320 U.S. 489 (1943). See, generally, 1
Mertens, The Law of Federal Income Taxation, § 7.34
(Rev. ed. 1974). A brief review of the history of this
rule, its theoretical underpinnings, and its judicial
application, will demonstrate its broad applicability in
various contexts throughout the income tax law.
Prior to 1942 the tax benefit rule existed only in
judicial decisions. In that year a portion of the rule
was codified in Section 22(b)(12) of the Internal
11
Revenue Code of 1939.'4 Since then, the United States
Supreme Court has led the way in a series of judicial
decisions firmly establishing that the tax benefit rule
is far broader in its application than the limited
codification of Section 22(b)(12) (now Section 111).
Even though prior judicial decisions had establish-
ed a far broader rule, Section 22(b)(12) of the 1939
Code, as adopted in 1942, and its supporting
regulations,'® referred only to the recovery of bad
debts, taxes, and “delinquency amounts.” This Court,
however, basing its decision on pre-statutory judicial
precedents, quickly established that the coverage of the
tax benefit rule went far beyond these three items. In
the landmark case of Dobson v. Commissioner, 320
U.S. 489 (1943), the Court excluded from taxable
income amounts received by the taxpayer as a
recovery of losses previously sustained on a sale of
securities. Under the facts of Dobson, the taxpayer had
sold certain securities, at a loss, in prior years. The
facts of the case established that, even if these losses
had not been sustained, the taxpayer’s tax returns for
the years in which the sales occurred would still have
shown net losses, and therefore he had obtained no “tax
benefit” from the losses when incurred. The taxpayer
therefore contended that his later recovery of a portion
of these losses was in the nature of a return of capital,
representing no economic gain overall, and that since
he had received no tax benefit from the loss deductions
previously claimed this later recovery should not be
included in income when received. In holding the
recovery not includable in income this Court emphasiz-
ed that the significant factor in determining in-
cludibility is whether the taxpayer received either an
economic gain or a tax benefit from the “transaction”
14 Revenue Act of 1942, ch. 619, § 116, 56 Stat. 798 (Effective for
taxable years beginning after December 31, 1938).
‘5 Treas. Reg. 118, § 39.22(b)(12)-1 (1939 Code).
12
as a whole. In so holding, this Court made it clear that
the tax benefit rule was to be given broad application
and was not to be limited to those items specified in
the statute, viewing the three items specifically
mentioned in Section 22(b)(12) merely as examples of
areas in which the tax benefit rule should apply,
rather than as a definitive list. The Court rejected the
Commissioner’s contention that such recoveries are
taxable income in the absence of a specific statutory
exemption.
Numerous decisions subsequent to Dobson have
followed this Court’s directive in that case by expand-
ing the coverage of the tax benefit rule to include
various items not specified in Section 111. See, e.g.,
California & Hawaiian Sugar Refin. Corp. v. U.S., 311
F.2d 235 (Ct. Cl. 1962) (recovery of previously-paid
taxes); American Financial Corp. v. Commissioner, 72
T.C. 506 (1979) (mutual insurance company’s recovery
of salvage and subrogation); Home Savings & Loan
Co. v. Commissioner, 39 T.C. 368 (1962), acg. 1963-2
C.B. 4, 1965-2 C.B. 5 (recovery of previously paid
taxes); Birmingham Terminal Co. v. Commissioner, 17
T.C. 1011 (1951), acg. 1952-1 C.B. 1 (recovery of prior
operating losses, even though receipts denominated
“rent’); M & E Corp. v. Commissioner, 7 T.C. 1276
(1946), acqg. 1947-1 C.B. 3 (recovery of prior accrued
reserves for losses on mortgage loans); Dallas Title &
Guaranty Co. v. Commissioner, 40 B.T.A. 1022 (1939),
reu'd on other grounds, 119 F.2d 211 (8th Cir. 1941)
(recovery of overaccrued estimated losses on title
insurance policies). See also, Rev. Rul. 58-126, 1958-1
C.B. 13 (transfer to earned surplus of overestimated
reserves for losses); Treas. Reg. § 1.111-l(a).
As the litany of cases discussed above makes clear,
the courts, as well as the Internal Revenue Service
itself, have expanded the scope and coverage of the tax
benefit rule as a judicial doctrine of income taxation
13
that has far-reaching application in many factual
contexts. Indeed, the rule is capable of being invoked,
as these decisions make clear, in any context wherein
the Code otherwise purports to tax a receipt which
consists of only a recovery of a prior loss, expense, or
accrual, rather than an item of “income” or gain in the
economic sense. In light of the broad scope of the
doctrine, any decision, such as that of the Seventh
Circuit herein, which would affect a_ significant
modification of that doctrine is deserving of review by
this Court.
B. The decision of the Court of
Appeals constitutes a
sig..ificant, and conceptual-
ly unsound, departure from
previously well-established
“tax benefit rule” doctrine.
As discussed above, the tax benefit rule requires
for its application that the taxpayer demonstrate the
existence of two elements: first, the taxpayer’s
“recovery” of a prior loss, expense, or accrual which,
absent the application of the rule, would result in an
increase in its taxable income for the year of the
recovery; second, the absence of gain or income in the
economic sense from the transaction as a whole and
the absence of a prior “tax benefit” from the earlier
loss, expense or accrual.
In its opinions herein, the Court of Appeals clearly
recognized that both of these elements were present in
the instant case. See, Court of Appeals decision, slip.
op. at 16-18, reproduced at Appendix A hereto, infra, at
A-18-19.'6 However, after recognizing that these two
'6 Indeed, there can be no serious dispute that both the “recovery”
element and “tax benefit” element of the rule are satisfied here. As
recognized by the Court of Appeals, the mere fact that the
(Footnote continued on following page)
14
historic elements of the rule had been satisified by
Petitioner, the Court of Appeals announced a third
element of the tax benefit rule which, Petitioner
submits, was heretofore unheard of in _ the
jurisprudence of income tax law.'?7 This new third
element, as described by the Court below, would limit
the application of the so-called “exclusionary” tax
benefit rule to cases where the item in question is
sought to be taxed solely and exclusively by virtue of
the so-called “inclusionary” tax benefit rule, and
preclude the application of the “exclusionary” rule
where the item in question is assertedly taxable by
virtue of the literal language of some particular
provision of the Code.'®
In referring to the “exclusionary” and “in-
clusionary” tax benefit rules, the Court below
recognizes that there exist two separate but related
“recovery” is in the form of bookkeeping entries rather than an
acutal cash disbursement and recei,’ does not preclude the rule’s
application. See, Court of Appeals decision, slip op. at 17
(reproduced in Appendix A, at A-19), and cases there cited. And, as
the Court of Appeals also recognized, the fact that the Petitioner
was exempt from tax on its underwriting income when the unpaid
losses were accrued is sufficient to establish the lack of a prior “‘tax
benefit.” See, Court of Appeals decision, slip op. at 17-18 (Appendix
A, at A-19), and cases there cited. Al! reference herein to the Court
of Appeals decision is to the original ecision, dated April 29, 1980,
unless otherwise indicated.
17 See, Court of Appeals decision, slip op. at 18-21 (Appendix A, at
A-20-22).
18 Somewhat paradoxically, the Court of Appeals announced this
as its holding in spite of its statement, earlier in its opinion, that
the tax benefit rule “remains substantially extra-statutory in
nature and affects a taxpayer’s taxable income beyond the literal
meaning of the Code itself. Thus it is not sufficient to rebut the
invocation of the tax benefit rule to argue that the statute makes
no provision for its use here ...” Court of Appeals decision, slip op.
at 14 (Appendix A, at A-16). This statement would appear directly
contradictory to the Court’s later holding.
15
rules, both of which are commonly referred to as the
“tax benefit rule.” Under the exclusionary rule (in-
voked by Petitioner herein), a recovery of a prior loss,
expense, or accrual is to be excluded from income in
the year of the recovery where the prior expense or
accrual produced no “tax benefit” in any earlier year.
Under the inclusionary rule, a recovery of such a prior
loss, expense, or accrual, even though not otherwise
regarded as taxable income, is to be included in income
where the taxpayer received a prior tax benefit from
the earlier loss or expense which, as its subsequent
recovery demonstrates, was unwarranted.'’ These two
rules are, of course, closely related in that they both
stem from the same theoretical and conceptual
underpinnings, that is, that a mere recovery of a prior
loss or expense is not an event which produces
“income” or gain in the economic sense, and accord-
ingly the only justification for including the recovery
in income is the underlying premise that a prior tax
benefit was received from the taxpayer’s deduction of
the earlier loss or expense.?° Thus the inclusionary rule
simply requires a taxpayer to relinquish its prior
undeserved tax benefit by including its subsequent
recovery in income. But when the underlying premise
(the existence of a prior tax benefit) is shown to be
false, the exclusionary rule requires the recovery to be
excluded from income, for in the absence of a prior tax
benefit no logical or conceptual grounds exist for
taxing the recovery as “income.”
In relegating the exclusionary tax benefit rule to
the role of a limitation on the inclusionary tax benefit
19 See, Bittker and Kanner, The Tax Benefit Rule, 26 U.C.L.A. L.
Rev., 265, 269 (1978).
20 Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff'd sub
nom. Union Trust Co. of Indianapolis v. Commissioner, 111 F.2d 60
(7th Cir. 1940), cert. denied 311 U.S. 658 (1940); Barnett v.
Commissioner, 39 B.T.A. 864, 867-68 (1939); Bittker and Kanner,
supra, note 19, at 269, 271, 274.
16
rule, rather than an independent doctrine capable of
application in a far broader range of circumstances,
the Court of Appeals breaks new ground in the
development of this doctrine of income tax law. Such a
limitation has never been suggested by any prior
decision of any court throughout the long history and
development of the tax benefit rule. In announcing this
new limitation, the Court of Appeals cites no support-
ing authority, stating only that “In the cases we have
examined” the exclusionary aspect of the tax benefit
rule has become relevant “only after the Commissioner
has employed the inclusionary aspect of the rule ...’”*!
citing Home Savings & Loan Co. v. Commissioner, 39
T.C. 368 (1962), as being “in accord with this
analysis.” In fact, Home Savings does not support the
new rule laid down by the Court of Appeals; the
decision therein merely recognizes that in that case the
source of the Commissioner’s authority to include the
recoveries in income was the inclusionary tax benefit
rule.
In fact, the exclusionary tax benefit rule has
(contrary to the Court of Appeals’ conclusion) been
applied in several instances notwithstanding the fact
that the items in question were assertedly includable
in income under specific Code provisions rather than
under the inclusionary tax benefit rule. See, American
Financial Corp. v. Commissioner, 72 T.C. 506 (1979)
(salvage and subrogation recoveries under Section
832(b)(5)); Brimingham Terminal Co. v. Commissioner,
17 T.C. 1011 (1951) (“rent”); Rev. Rul. 58-546, 1958-2
C.B. 143 and Rev. Rul. 67-200, 1967-1 C.B. 15
(“forgiveness of indebtedness” income _ ordinarily
taxable under § 61(a)(12)). Just as importantly, of
course, the Court of Appeals’ holding totally ignores
Section 111 of the Code, the statutory exclusionary tax
21. See, Court of Appeals decision, slip. op. at 18-19 (Appendix A,
at A-20).
17
benefit rule, which is not, by its terms, limited in its
application to cases wherein the Commissioner relies
exclusively on the inclusionary rule.
In light of the fact that prior judicial precedents do
not support a limitation on the exclusionary tax
benefit rule such as that promulgated by the Court of
Appeals herein, but rather reject such a limitation, and
especially in view of the significance of the tax benefit
rule as a doctrine of income tax law, as evidenced by
the wide range of contexts in which it applies, it is
important that this Court review the decison and
holding of the Court of Appeals and evaluate the
merits of the change which it would affect in this
doctrine of income tax law.
Il. The Decision Of The Court Of
Appeals Is In Conflict With This
Court’s Decision In Dobson uv.
Commissioner, 320 U.S. 489
(1943).
In Dobson?? this Court held that the income tax
laws do not compel a finding of taxable income in a
receipt arising out of a transaction from which the
taxpayer in fact derived no economic gain, where the
transaction produced no prior tax benefit. Although
this Court in Dobson declined to label its holding a
“rule of tax benefits,”2® the Dobson decision has long
been viewed as a recognition by this Court of the
conceptual underpinnings of the tax-benefit rule.*‘
Thus the significance of Dobson lies in its recognition
of the fundamental principal that the income tax laws
22, Dobson v. Commissioner, 320 U.S. 489 (1943).
23 320 U.S. at 506.
24 See, Home Savings and Loan Co., 39 T.C. 368, 369-70 (1962); 1
Mertens, The Law of Federal Income Taxation, § 7.34 (Rev. 1974).
18
must be interpreted and applied to tax only that which
is “income” in the economic sense, and its recognition
of the fact that a taxpayer’s recovery of a prior loss or
expense does not constitute such income and accord-
ingly should not be taxed in the absence of some prior
tax benefit.
When the principals of the exclusionary tax benefit
rule are thus considered, it becomes apparent that the
limitation imposed by the Court of Appeals’ decision in
the present case contradicts those principles. By
refusing to permit the application of the exclusionary
rule where specific provisions of the Code purportedly
require inclusion in income of the recoveries in
question,”> the Court of Appeals sanctions the taxation
as “income,” of that which is in fact not income. This
is blatantly contrary to the principles established in
Dobson. The question of whether Dobson’s principles
should be so limited should be decided only by this
Court, and accordingly a writ of certiorari should issue
to review the decision of the Court of Appeals in this
respect.
Ill. The Decision Of The Court Of
Appeals Is In Conflict With The
Decisions Of Other Circuit
Courts And The Court Of
Claims Regarding The Scope Of
The Tax Benefit Rule.
As discussed above, the decision of the Court of
Appeals herein would preclude the application of the
exclusionary tax benefit rule in any circumstances
wherein the Commissioner can point to a specific
provision of the Code which purports to require
25 Compare the general “omnibus” inclusionary provision of the
Code, Section 61, which provides, in pertinent part, “gross income
means all income, from whatever source derived ...,” I.R.C. § 61.
—_
19
inclusion in income of the item in question. Petitioner
subinits that such a limitation, if upheld, would be
directly contrary to the principles established by many
recent decisions of several other Circuit and other
courts involving the application of the inclusionary tax
benefit rule to include a particular “recovery” in
taxable income even in the face of express Code
provisions excluding the item in question from taxable
income.26 These cases very clearly hold that the
inclusionary tax benefit rule can “override” specific,
express language of the Code which, by its terms,
accords nonrecognition treatment to the item in
question. Given the fact that both the inclusionary and
exclusionary rules rest upon the same theory and
concepts, it is a contradiction to hold that the
exclusionary rule can not override express statutory
language in an appropriate case while the inclusionary
rule can. This is especially true when one considers the
fact that the exclusionary rule has been given express
recognition by Congress in Section 111 of the Code,
whereas the inclusionary rule is entirely non-
statutory.27 It would be manifestly irrational for the
26 See, e.g. Tennessee Carolina Transportation, Inc. v.
Commissioner, 582 F.2d 378 (6th Cir. 1978) (§ 336); Connery v. U.s.,
460 F.2d 1130 (3d Cir. 1972) (§ 337); Spitalny v. U.S., 430 F.2d 195
(9th Cir. 1979) (§ 337); Commissioner v. Anders, 414 F.2d 1283 (10th
Cir. 1969) (§ 337); Mager v. U.S., 449 F.Supp. 37 (M.D. Pa. 1980) (§
1033); S.E. Evans v. U.S., 317 F.Supp. 423 (W.D. Ark. 1970) (§ 337);
Anders v. U.S., 462 F.2d 1147 (Ct. Cl. 1972) (§ 337); Munter’s Estate,
63 T.C. 663 (1975) (§ 337); McCamant, 32 T.C. 824 (1959)
(predecessor to § 10l(a)). Cf, South Lake Farms, Inc. uv.
Commissioner, 324 F.2d 837 (9th Cir. 1963) (tax benefit rules does
not override § 336). See also, O’Hare, Statutory Nonrecognition of
Income and the Overriding Principle of the Tax Benefit Rule in the
Taxation of Corporations and Shareholders, 27 Tax L. Rev. 216,
222-26, 233-36.
27 Indeed, Section 111 is just as much a part of the Internal
Revenue Code, and therefore just as applicable to the Petitioner’s
circumstances, as is Section 832(b). The Court of Appeals, however,
refused to recognize this fact, despite Petitioner’s urging.
20
decision of the Court of Appeals herein to exist side by
side with these conflicting decisions of other courts.
More importantly, it would be manifestly unjust to
permit the law to exist in a status which permits the
Commissioner of Internal Revenue to prevail on this
issue when he invokes the inclusionary rule, yet
refuses to permit taxpayers to prevail on what is in
essence the same issue when they invoke the ex-
clusionary rule. Therefore, it is submitted that it is
appropriate for this Court to resolve this conflict by
reviewing the decision of the Court of Appeals herein.
IV. The Statute In Question As
Interpreted And Applied By
The Court Of Appeals Violates
Constitutional Limitations On
Congress’ Taxing Powers.
This Court very clearly established the principle
that the taxing power of Congress under the 16th
Amendment?’ is limited to the taxation of that which
constitutes “income” in the economic sense.”? In
Eisner, this Court held that the Revenue Act of 1916,
in purporting to tax “stock dividends” paid by a
corporation to its shareholders, exceeded Congress’
taxing power, for Congress could not invoke the 16th
Amendment as a source of authority to tax, putatively
as “income,” that which is in fact not income to the
taxpayer. Of course, as this Court recognized even in
the course of its Eisner decision, it is well established
that the 16th Amendment in and of itself does not
limit Congress’ taxing authority. Rather, it actually
28 The Sixteenth Amendment provides, “The Congress shall have
power to lay and collect taxes on incomes, from whatever source
derived, without apportionment among the several States, and
without regard to any census or enumeration.”
29 Kisner v. Macomber, 252 U.S. 189 (1919).
21
expands that authority by creating an exception, for
“income” taxes, to the general requirement that no
“direct” tax may be imposed unless it is apportioned
among the several states according to population.*°
Thus the 16th Amendment’s effect is to sanction a
non-apportioned “income” tax regardless of whether it
may be determined to be a “direct” or an “indirect”
tax.3! Before any tax levied by Congress can be found
to exceed Congress’ constitutional taxing power, then,
the tax in question must be found (1) to be a “direct”
rather that an “indirect” tax, and (2) not to tax
“income” in the economic sense.°?2
Approaching these two requirements in inverse
order, it is plain that the statute in question, as applied
by the Respondent to Petitioner’s recoveries of overac-
crued unpaid losses, does not tax “income” in the
economic sense. Plainly the transaction whereby an
insurance company incurs a loss, accrues it as an
“unpaid loss” liability on its books, and later pays it,
8° U.S. Const. Art. I, § 2, cl. 3 and § 9, cl. 4. The only express
constitutional limitation on Congress’ power to impose an
“indirect” tax is contained in Art. I, § 8, cl. 1, which requires that
“... all Duties, Imports and Excises shall be uniform throughout
the United States”.
31 In its opinion on rehearing below, the majority of the Seventh
Circuit expressed its opinion that the 16th Amendment has been
effectively rendered superfluous by this Court’s decision in New
York ex. rel. Cohn v. Graves, 300 U.S. 308 (1937), which, according
to the Seventh Circuit majority, overruled this Court’s earlier
holding, in Pollock v. Farmer's Loan and Trust Co., 157 U.S. 429
(initial decision), 158 U.S. 601 (on rehearing) (1895), that an income
tax constituted a “direct” tax. In fact, however, the Graves decision
has no such effect, as is apparent from a reading of it, for the
Court in Graves expressly distinguished that case from Pollock and
pointed out that its opinion should not be read to contradict
Pollock. 300 U.S. at 315. In any event, however, the question of
whether or not an “income” tax is a “direct” tax is at most
tangentially relevant to the present case for, as will be
demonstrated, the statute in question, as applied, does not tax
“income.”
22
does not give rise to any economic gain or benefit to
the company. The company realizes no “income” from
the transaction. Rather its income, if any, is generated
through its receipt of premiums from its policyholders,
and the process of incurring and paying claims
against its policies only reduces its net underwriting
income. Thus when an insurance company, such as
Petitioner, finds that it has estimated and accrued its
unpaid losses at too high a figure, and that the
payments which it will ultimately be required to make
will be lesser in amount than originally anticipated, its
“recovery” of the resulting ‘“overaccrual” of its unpaid
losses is hardly “income” in the economic sense. It is
nothing more than a reduction in amount of the losses
which it had earlier expected to be required to pay. The
transaction is fundamentally no different than that in
Dobson,?2 where the taxpayer recovered a portion of
his loss on a sale of securities, resulting in a lesser loss
than originally anticipated. Just as this Court
recognized that such an event did not generate
“income” in Dobson, so it does not generate “income”
here. Indeed, the dissenting judges of the Seventh
Circuit herein clearly recognized this fact.*4
Having established that the statute as applied in
the circumstances of the instant case would tax that
which is not “income,” it remains to be determined
whether or not it constitutes a “direct” tax so as to
require apportionment.*°
32. See, Simmons v. U.S., 308 F.2d 160 (4th Cir. 1962).
33. 320 U.S. 489 (1943).
34 See, Court of Appeals decision on rehearing, slip op. at 5-7
(Fairchild, Pell and Bauer, dissenting) (Appendix A, at A-35-37).
35 Jt is obvious upon a review of the statute itself that the tax in
question is not in fact apportioned among the States according to
population (nor does it purport to be).
23
This Court has on only a few occasions considered
the question of what is and is not a “direct” tax within
the meaning of the Constitution.** Although the decid-
ed cases do not establish readily discernible guidelines
applicable to every case, they do focus on a distinction
between a tax on the receipt, transmittal, or use of
property and a tax on the taxpayer’s mere ownership
of that property, the former generally regarded as
“indirect,” and the latter generally classified as
“direct.”
Although none of the decided cases relating to this
issue has involved a tax on a “recovery” such as is
present in the instant case,°* the general principles
which those cases establish nonetheless imply that a
tax on such a recovery is not properly classifiable as
an “indirect” tax, and hence is subject to the ap-
portionment requirement. As stated above, those types
of taxes which have been classified as “indirect” are
36 Scholey v. Rew, 90 U.S. (23 Wall.) 331 (1875); Pollock uv.
Farmer’s Loan and Trust Co., 157 U.S. 429 (initial decision), 158
U.S. 601 (on rehearing) (1895); Knowlton v. Moore, 178 U.S. 41
(1900); Bromley v. McCaughn, 280 U.S. 124 (1929); Fernandez v.
Wiener, 326 U.S. 340 (1945).
37 Scholey v. Rew, 90 U.S. (23 Wall.) 331 (inheritance tax held
“indirect’’); Pollock v. Farmer’s Loan and Trust Co., 157 U.S. 429
(initial decision), 158 U.S. 601 (on rehearing) (1895) (income tax
held “‘direct’”’); Knowlton v. Moore, 178 U.S. 41 (1900) (inheritance
tax held “indirect”); Bromley v. McCaughn, 280 U.S. 124 (1929)
(gift tax held “indirect’’); Fernandez v. Wiener, 326 U.S. 340 (1945)
(estate tax on community property held “indirect”). For further
examples, see also cases cited in Bromley v. McCaughn, 280 U.S. at
136, 137, and Simmons v. U.S., 308 F.2d 160 (4th Cir. 1962).
38 Cf, Pollock v. Farmer’s Loan and Trust Co., 157 U.S. 429
(initial decision), 158 U.S. 601 (on rehearing) (1895) (holding that
the income tax is a “direct” tax). Whether or not a tax on “income”
is direct or indirect is immaterial to this case, however, for as
demonstrated, the “recovery” which Respondent here purports to
(Footnote continued on following page)
24
those which tax the receipt, transmittal, use, or enjoy-
ment of property, as opposed to its mere existence or
ownership. In the present case, it is clear that the
Petitioner has not received any property, nor has it
“used” any of its property. Its “recovery” of its over-
accrued unpaid losses consists of merely a reduction in
the amount of its property which it would otherwise be
forced to give up in payment of its claims. The
Petitioner’s tax burden is increased not because it has
received any property, nor because it has used its
property in a particular manner. Rather, the Petitioner
is being taxed merely because it will continue to own a
portion of its property, which it had never ceased to
own, due to the fact that its actual losses are later
proven to be less than its estimated and accrued
unpaid losses. In effect, Petitioner is being told, “you
must pay tax because you did not lose as much money
as you expected to lose.’’°? This, Petitioner submits, is
a tax on the mere ownership of Petitioner’s property,
certainly not on its receipt or use, and accordingly
tax is not “income.” In its decision in this case, the Court of
Appeals cited Penn Mutual Indemnity Co. v. Commissioner, 277
F.2d 16 (3d Cir. 1960) as sanctioning a tax on the gross receipts of
insurance companies, without any deduction for losses incurred.
The short answer to this argument is that Petitioner does not
dispute the constitutionality of a gross receipts tax; as
demonstrated earlier, however, the tax in the instant case is
imposed in the absence of a receipt of any kind.
39 Of course, had the taxpayer received a prior “tax benefit’’ (i.e.,
a reduction in its taxable income) in an earlier year as a result of
its accrual of its estimated unpaid losses, taxation of its later
recovery of this overaccrual would be authorized, not because such
recovery is “income” but rather because it constitutes a mere
restoration of a tax benefit received, but not deserved, in an earlier
year. See, note 20, supra, and accompanying text. But when the
taxpayer has obtained no tax benefit from its earlier accrual of its
estimated losses, it is hardly rational to impose a tax merely
because not all of those losses are ultimately sustained. Yet this
would be the effect of Section 832(b)(5) of the Code as applied by
the Court of Appeals.
25
must be found to be “direct” tax within the meaning of
the Constitution.
If in fact the tax in question, as applied under the
facts of the instant case, is a “direct” tax, then it is
beyond the taxing power of Congress, for it is not
apportioned among the states, as required by Article I
of the Constitution, and it does not tax “income” as
required by the 16th Amendment. Indeed, the three
dissenting judges of the Seventh Circuit herein very
clearly stated their belief that the tax as applied in the
present case was unconstitutional, and they accord-
ingly would have construed and applied the statute to
avoid such unconstitutional effect.*°
Thus this case presents a bona fide question of the
interpretation and application of the provisions of the
Constitution which impose limits on the taxing
authority of Congress, the extent to which that
authority is limited by the proscription of unappor-
tioned direct taxes, and the extent, if any, to which
Congress’ taxing authority would be exceeded under a
construction of the statute here at issue in the manner
contended for by Respondent (and the Court of
Appeals.) We submit that this is a question which it is
appropriate for this Court to consider, and accordingly
request that the Court exercise its jurisdiction to
review the decision of the Seventh Circuit in this
regard.
40 See, Court of Appeals decision on rehearing, slip op. at 6-7
(Fairchild, Pell and Bauer, dissenting) (Appendix A, at A-35, A-36-
37). Of course, Petitioner herein does not seek to have the statute
declared invalid, but rather seeks only to have it construed in light
of the tax benefit rule, according to established principles of
statutory construction, to avoid the potential constitutional
infirmity.
26
CONCLUSION
In conclusion, the instant case presents a question
of the proper scope and application of a_ long-
established doctrine of income tax jurisprudence, the
“tax benefit rule.” The decision of the Court of Appeals
would effect a drastic and heretofore unanticipated
change in that doctrine, which conflicts in principle
with the decision of this Court, in Dobson v.
Commissioner, supra, and with the decisions of
various other lower courts. Moreover, the application of
the Code Sections here at issue, according to their bare
literal terms and without the gloss of the ‘“‘tax benefit
rule’, is beyond the taxing power of the Federal
government as limited bythe Constitution. In light of
these factors, we submit that this case is an
appropriate one for consideration and review by this
Court, and respectfully request that a writ of certiorari
issue to review the decision of the Court of Appeals
herein.
Respectfully submitted,
PAUL A. PAKALSKI, Attorney
for Petitioner,
Home Mutual Insurance Co.
Of Counsel:
MICHAEL T. HART
JOHN F. EMANUEL
WHYTE & HIRSCHBOECK S.C.
2100 Marine Plaza
Milwaukee, WI 53202
APPENDIX
_
A-l
APPENDIX A
Opinions of the Court of Appeals
United States Court of Appeals
For the Seventh Circuit
Nos. 79-1602 & 79-1603
HOME MUTUAL INSURANCE COMPANY,
Petitioner-Appellee,
Cross-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Repsondent-Appellant,
Cross-Appellee.
Appeal from the United States Tax Court
ARGUED OCTOBER 24, 1979 —
DECIDED APRIL 29, 1980
Before CASTLE, Senior Circuit Judge, PELL and
TONE, Circuit Judges.
TONE, Circuit Judge. This case involves two
provisions of the Internal Revenue Code concerning
the taxation of mutual casualty insurance companies:
§ 832(b)(5), which allows a “losses incurred” deduction
from the companies’ underwriting income; and § 821(e),
which permits certain companies a “special
transitional underwriting loss” deduction from its
statutory underwriting income. The issues presented
are highly technical and can be adequately stated only
after a more detailed description of the statute. The
Tax Court ruled in favor of the taxpayer on one issue
and in favor of the Commissioner on e-other. We
reverse and remand in part and affirm in part.
A-2
Mutual casualty insurance companies, including
the taxpayer here, Home Mutual Insurance Company,
became subject to §§ 832(b)(5) and 821(d) with the
passage of the Revenue Act of 1962, Pub. L. No. 87-834,
76 Stat. 960. Before 1963 mutual casualty insurance
companies were taxed under a formula that did not
include any deduction for underwriting losses or for a
special transitional underwriting loss.! Beginning with
that year, however, these companies have been taxed
under a method established by the Revenue Act of
1962, in which a company’s taxable income is
comprised of three components—taxable investment
income, statutory underwriting income, and funds
returned from the protection-against-loss account.” The
statutory underwriting income component consists
essentially of underwriting income as it has been
computed for non-mutual casualty insurance
companies since the 1920’s, less a deduction for funds
set aside in a protection-against-loss account.’ Under
the decades-old portion of the computation scheme,
underwriting income is defined as the amount of
premiums earned during the year, less expenses and
' A mutual casualty insurance company paid a federal income tax
either at ordinary corporate rates on its investment income or at a
rate of one percent on its gross investment income plus its
premium income less policyholder dividends, whichever amount
was greater. Int. Rev. Code of 1954, ch. 736, §§ 821 & 822, 68A Stat.
260 (amended 1962).
2 I.R.C. § 821(b); Revenue Act of 1962, Pub. L. No. 87-834, § 8a),
76 Stat. 960, 989-90. Special provisions not relevant here exist with
regard to the taxation of small mutual casualty insurance
companies. I.R.C. § 82l(c) & (d).
3 TR.C. §§ 821(b), 823(a), 824(a), & 832(b); Revenue Act of 1962,
Pub. L. No. 87-834, § 8a) & (c), 76 Stat. 960, 989-90, 992-93; see
Revenue Act of 1921, ch. 136, § 246(a) & (b), 42 Stat. 227, 262-63. An
extra deduction not relevant here was also provided in I.R.C. §
823(a) for companies having gross investment plus premium
income of less than $1,100,000.
a
A-3
“losses incurred.” I.R.C. § 832(b)(3). The “losses
incurred” deduction in turn consists of losses paid
during the taxable year netted against cash salvage
and reinsurance recoveries, plus any increase (or
minus any decrease) during the year in unpaid losses
outstanding, minus any increase (or plus any decrease)
in salvage and reinsurance recoverable outstanding.
ILRC. § 832(b)(5); Treas. Reg. § 1.832-4(c).4 The 1962
Revenue Act also provided companies that had
experienced underwriting losses during each of the five
preceding taxable years with a special transitional
underwriting loss deduction to allow them to garner
some tax advantage from those recent losses, which
had been irrelevant under the prior statute.®
The issues before us arose following’ the
Commissioner’s assertion of deficiencies in Home
Mutual’s tax liability for 1966 and 1971 totaling
$48,530.71 In a petition for a redetermination of the
deficiencies, Home Mutual contended, first, ‘that the
Commissioner had erroneously failed to allow it during
the years 1963-1966 and in 1971 to lower its figure for
unpaid losses outstanding at the start of each year by
the amount by which pre-1963 claims settled during
the year had been overestimated. Such a reduction
‘ To compute the unpaid losses component of the deduction, a
taxpayer is to “add all unpaid losses outstanding at the end of the
taxable year and deduct unpaid losses outstanding at the end of
the preceding taxable year.” I.R.C. § 832(b)(5)(B). Similarly, to take
account of salvage and reinsurance recoverable, the taxpayer is to
“add salvage and reinsurance recoverable outstanding at the end
of the preceding taxable year and deduct salvage and reinsurance
recoverable outstanding at the end of the taxable year.” I.R.C. §
832(b)(5)(A).
° LR.C. § 821(e); Revenue Act of 1962, Pub. L. No. 87-834, § 8(a), 76
Stat. 960, 991.
® The years 1963, 1964, and 1965 are also relevant to the extent
that loss carryovers for those years may affect Home Mutual’s
liability in 1966 and 1971.
A-4
would have increased Home Mutual’s losses-incurred
deduction for those years, thereby decreasing its
underwriting income and thus its tax. Alternatively,
Home Mutual argued that its exclusion in its original
tax returns during 1963-1966 of cash subrogation
recoveries from pre-1963 claims was proper because the
underwriting losses incurred on those claims had not
lessened its taxes.’ Home Mutual also raised another
claim unrelated to the first two, viz., that it should
have been allowed to deduct the special transitional
underwriting loss from total underwriting gain rather
than from underwriting gain less the protection-
against-loss deduction.
In a so-called “reviewed opinion,” the Tax Court,
with one judge dissenting, ruled in favor of Home
Mutual on the proper treatment of “unpaid losses,”
which made it unnecessary to decide the cash
subrogation recoveries issue. The court unanimously
agreed with the Commissioner on the special
transitional underwriting loss issue.* The
Commissioner appeals the determination of the unpaid
loss issue; Home Mutual cross-appeals the Tax Court’s
interpretation of the special transitional underwriting
loss and asks that, if we reverse on the unpaid losses
issue, we rule in its favor on the treatment of
subrogation recoveries. We reverse the Tax Court’s
resolution of the unpaid losses dispute, remand the
subrogation recoveries issue, and affirm the court’s
ruling on the special transitional underwriting loss.
7 This treatment of subrogation recoveries was the primary basis
for the Commissioner’s assertion of deficiency.
Subrogation recoveries are included within the meaning of the
statutory language of “salvage and reinsurance recoverable” in the
computation of the losses-incurred deduction. See Continental Ins.
Co. v. United States, 474 F.2d 661, 663, 664-65 (Ct. Cl. 1973).
8 Home Mutual Ins. Co. v. Commissioner, 70 T.C. 944 (1978).
A-5
I.
Home Mutual’s contentions with respect to the
unpaid loss deduction are ultimately grounded in the
inequity it perceives in the Code’s treatment of its
overestimate of unpaid losses outstanding as of
December 31, 1962. That overestimate, totaling $402,-
314.59,° resulted in smaller “losses incurred” deduc-
tions in later years than a totally accurate estimate of
unpaid losses would have, because, in every year that
some of those claims were settled, the unpaid-losses-
outstanding account was decreased not only by the
amounts paid on those settlements, which were offset
by a corresponding increase in paid losses, but also by
the overestimates on the claims.
The similar effect in the years of settlement of
post-1962 overestimated losses is more than compen-
sated for by the increase in the unpaid losses part of
the losses-incurred deduction that the overestimates
cause in the years in which the unpaid losses were
incurred. In those years the overestimates increase the
“unpaid losses outstanding at the end of the taxable
year,” I.R.C. § 832(b)(3)(B), and thus the losses-incurred
deduction. Accordingly, for years after 1962, over-
estimating defers taxable income by allowing a
company to accelerate its unpaid losses in this
manner.
Although Home Mutual cannot obtain a similar
acceleration of losses with respect to pre-1963 claims
because those losses were then irrelevant to the
computation of taxable income, it wishes to avoid the
“erroneous” decrease of the deduction in the years it
settled overestimated pre-1963 losses. By lowering its
“unpaid losses outstanding at the end of the preceding
® This overestimate was 14.74% of the $2,729,746.00 in unpaid
losses that Home Mutual reported in its annual statement as of
December 31, 1962.
—
A-6
taxable year” by the amounts by which pre-1963
claims settled during the year had been overestimated,
Home Mutual argues, it will obtain as a deduction its
“true” amount of losses incurred since 1962.
Home Mutual’s position can be illuminated by an
example. Assume first that the company was notified
of a claim in 1963 and estimated that $10,000 would be
required to settle the claim. That $10,000 would be
added to the unpaid-losses-outstanding account. By
raising the balance of unpaid losses outstanding, this
addition would increase the losses-incurred deduction
from premiums earned to arrive at underwriting
income for 1963, thus conferring a tax benefit for that
year. The $10,000 would then be carried as an unpaid
loss outstanding until paid. Assume the claim is
settled in 1965. If the amount of the settlement is
$10,000, that amount is removed from unpaid losses
outstanding and paid out with no further tax conse-
quences.!” If, however, the claim is settled for $8000,
there are tax consequences in 1965: assuming suf-
ficient income from premiums during the year, the
$2000 overestimate is taxed as ordinary income.'! Now
assume that Home Mutual had learned of the claim in
1962, not 1963, and therefore had added the $10,000 to
its unpaid losses outstanding in the earlier year. Under
the pre-1963 tax scheme, this addition would have had
no tax consequences. See note 1 supra. If the claim is
\© In finer statutory detail, the payment of the claim would
decrease the balance of unpaid losses outstanding by $10,000, and
would increase the amount of losses paid during the year by that
amount.
'1 In these circumstances, the balance of the unpaid-losses-
outstanding account would be decreased by $10,000 while the
amount of losses paid would be augmented by only $8000. Thus,
the losses-incurred deduction would be reduced by $2000.
If there is not sufficient premium income, the $2000 would
reduce the unused loss deduction provided by § 825 eligible for
carrybacks and carryovers.
A-7
then settled for $8000 in 1965, the company, under the
literal terms of the statute, would have to pay tax on
the $2000 overestimate in 1965 as above. While in the
first instance the taxation of the $2000 occurs only
after a company has received a corresponding tax
benefit in 1963 by including that amount in the losses-
incurred deduction for that year, in the second case
taxation of the $2000 would occur despite the absence
of such a prior tax benefit. As a remedy, Home Mutual
wishes, in computing its taxes for 1965, to lower its
unpaid losses outstanding at the beginning of 1965 by
$2000 and thereby prevent its inclusion in taxable
income in that year.!?
Home Mutual’s argument is made in the context of
comprehensive, technical, and very specific provisions
of the Internal Revenue Code. Especially when dealing
with provisions of this kind, and when no support for
the theory asserted by the taxpayer can be found in
the language of the _ statute, the appurtenant
regulations, or the legislative history, the courts should
ordinarily “resist the temptation to attempt any
creative rewriting of the Internal Revenue Code.’’!®
There is nothing in the statutory provision
involved in the case at bar, its regulations, or its
legislative history revealing even a glimmer of any
intent that Home Mutual would be allowed to make the
retroactive adjustment it wishes. The statutory formula
for computing the losses-incurred deduction was first
enacted in § 246(b)(6) of the Revenue Act of 1921, ch.
136, 42 Stat. 227, 263, for use in taxing stock casualty
insurance companies and has been reenacted since
12 Thus, the net decrease in the balance of unpaid losses
outstanding during 1965 would be only $8000, offsetting exactly the
increase in the amount of losses paid.
13 United States v. Foster Lumber Co., 429 U.S. 32, 49 (1976)
(Stevens, J., concurring).
A-8
then without substantial change. As the Tax Court
pointed out, “[t]he 1962 Act was designed to tax the
mutual companies on much the same basis as the
stock companies.” 70 T.C. at 945-46. The first
regulations concerning the losses-incurred deduction,
which were adopted in 1944, expressly recognized that
the unpaid-losses-outstanding component of the deduc-
tion is an estimate of the total amount of losses
incurred but unpaid at year’s end.'4 Given the
longstanding existence of these regulations inter-
preting a statutory provision that has remained
unchanged, they are deemed to have received con-
gressional approval and have the effect of law. See
United States v. Correll, 389 U.S. 299, 305-06 (1967);
Hanover Insurance Co. v. Commissioner, 598 F.2d
1211, 1219 n.17 (1st Cir.), cert. denied, 100 S. Ct. 229
(1979). In addition, the casualty insurance industry
has adapted its own reporting forms for use under the
regulations, so that the forms now serve as the basis
on which a company’s income is determined. See
Hanover Insurance Co. v. Commissioner, 65 T. C. 715,
720-21 (1976);!5 Continental Insurance Co. v. United
States, 474 F.2d 661, 666-67 (Ct. Cl. 1973). Since the
unpaid losses component of the losses-incurred deduc-
tion is merely an estimate, the only allowable adjust-
ment by either the Commissioner or taxpayer would be
to correct a figure that was not a “fair and reasonable”
estimate given the facts at the time the estimate was
\4 Treas. Reg. 111 § 29.204-2, 1944 C.B. 336-37 (recodified as Treas.
Reg. 118, § 39.204-2(a) & (b), 26 C.F.R. § 39.204-2(a) & (b) (1953 ed.)
by Revenue Ruling 53.226, 1953-2 C.B. 500); see also Treas. Reg. §
1.832-4(a)(5) & (b).
15 In Hanover Ins. Co. v. Commissioner, 65 T.C. 715 (1976), the
Tax Court denied Hanover’s motion to dismiss. An appeal of that
decision was dismissed. The Tax Court then rendered an opinion
on the merits at 69 T.C. 260 (1977), which was affirmed by the First
Circuit in the opinion at 598 F.2d 1211, which we also cite in our
opinion.
A-9
made. See Hanover Insurance Co. v. Commissioner,
598 F.2d 1211 (1st Cir.), cert. denied, 100 S. Ct. 229
(1979); Treas. Reg. § 1.832-4(b).'° Home Mutual admits
that no legislative history of the 1962 Revenue Act
supports its attempt to go outside the language of the
statute. In light of this absence of statutory support for
the adjustment desired by Home Mutual, only the
existence of a principled extra-statutory ground for
adjustment could persuade us to go beyond the express
bounds of the statute.
We consider in turn two theories that have been
advanced to support the adjustment Home Mutual
seeks. The Tax Court majority’s theory, which Home
Mutual does not attempt to support in this court, was
that the adjustment is analogous to permissible
retroactive adjustments of inventories and also to the
adjustment of bad debt reserve permitted by Revenue
Ruling 58-126, 1958-1 C.B. 13. Home Mutual presents
an argument that the Tax Court appeared to reject,
that the tax benefit rule allows such an adjustment.
We are not persuaded by the reasoning of the Tax
Court majority or Home Mutual.
A.
In each of the cases the Tax Court majority
believed analogous, a taxpayer has been allowed to
adjust the value of opening inventory (the closing
'6 Home Mutual argues that the Commissioner’s power under
Hanover Insurance Co. to adjust a taxpayer’s unpaid losses
outstanding retroactively and his policies allowing retroactive
adjustment by his auditors are authority for allowing Home
Mutual to adjust its unpaid losses retroactively in light of what
was actually paid. However, the Commissioner’s authority is
limited to the retroactive adjustment of an original estimate that,
given the facts and circumstances at the time, was not a fair and
reasonable estimate; that authority does not permit the Com-
missioner, or Home Mutual, to adjust an estimate retroactively so
as to equal the amount later actually paid.
A-10
inventory of the preceding year) after its original
calculation. See, e.g., Elm City Nursery Co. v. Com-
missioner, 6 B.T.A. 89 (1927), acq., VI-2 C.B. 2;
Baumann Rubber Co. v. Commissioner, 4 B.T.A. 671
(1926). These adjustments have, however, served only
to correct errors in reporting facts ascertainable at the
time of the original calculation. In Baumann Rubber
Co. the taxpayer had incorrectly counted the items in
the inventory, an error that was later discovered and
that the Board of Tax Appeals allowed the taxpayer to
correct. In Elm City Nursery Co. the value of the
inventory had been ascertainable, but the taxpayer
had deliberately inflated the figures for the purpose of
borrowing funds. When the taxpayer demonstrated
that the actual inventory value had been less, the
Board of Tax Appeals allowed the taxpayer to reduce
its inventory figures accordingly and arrive at an
accurate amount for cost of goods sold.
In the case at bar, however, taxpayer is not
attempting to adjust its unpaid losses outstanding to
an amount that could have been determined from facts
existing at the time of the original estimate. Strictly
analogous to those cases in this situation would be a
showing by taxpayer that, given the facts existing at
the end of the year preceding the taxable year, its
estimate of unpaid losses was unreasonable. See
Hanover Insurance Co. v. Commissioner, 598 F.2d 1211
(1st Cir.), cert. denied, 100 S. Ct. 229 (1979). Instead,
Home Mutual here wishes to change the estimate of an
unpaid loss to the amount actually paid to settle that
particular claim. Courts have not permitted taxpayers
to make inventory adjustments because of subsequent
events. See Estate of Stauffer v. Commissioner, 48 T.C.
277 (1967), rev'd on other grounds, 403 F.2d 611 (9th
Cir. 1968).
This reasoning has the additional defect of not
being limited in principle to application to the
A-11
estimates of unpaid losses incurred prior to 1963. The
estimate of an unpaid loss incurred in 1965, for
instance, could also prove to be higher than the actual
amount of a settlement ultimately reached in a later
year. However, nothing in this theory would prevent
the taxpayer from reducing its opening unpaid-losses-
outstanding account for the year of settlement by the
amount of the overestimate and thereby change the
deferment of income contemplated by the _ con-
gressional scheme into an outright exemption.!’ Such a
rationale plainly cannot be accepted.
Likewise unpersuasive is the analogy to Revenue
Ruling 58-126, which permitted a savings and loan
association that first became subject to taxation in
1952 to transfer the amount by which its pre-1952 loss
reserve was found to be excessive from the reserve to
its undivided profits without producing gross income.!®
Although the loss reserve of a savings and loan
association is similar to a mutual casualty insurance
company’s unpaid loss account, the Code provisions
allowing the two deductions are structured differently.
A loss reserve is merely a method of utilizing the bad
debt deduction. A taxpayer may deduct worthless debts
in the year they become worthless pursuant to § 166.
Alternatively, under § 593 a taxpayer may deduct a
reasonable amount each year to be set aside to cover
'7 Exemption would result because the increase in the losses-
incurred deduction in the year that a loss is incurred is never
counterbalanced later by a decrease in the deduction in the year in
which the loss is paid. See text at notes 9-12 supra.
'8 The Revenue Ruling also decided that any such transfer that
lowered the loss reserve below the aggregate amount of post-1951
additions to the reserve deducted for federal income tax purposes,
minus charge-offs for bad debt losses after 1951, and plus
recoveries on debts charged to the reserve after 1951 would result
in gross income to the extent of the diminution.
A-12
worthless debts generally.'*° When specific debts do
become worthless, they are charged off against the
reserve with no direct tax consequences.””
In similar fashion a mutual casualty insurance
company will set aside funds it estimates are
necessary to cover pending claims.?! The Code,
however, does not treat these funds as a § 593 loss
reserve. If it did, a taxpayer would have a choice:
either it could deduct specific losses when they accrue
or are paid or it could deduct a reasonable amount
each year as an addition to a reserve and merely
charge off against the reserve all losses when actually
paid. Instead, a taxpayer has no choice; only one
statutory method exists for deducting underwriting
losses of mutual casualty insurance companies. Under
that method, when a loss is “incurred” through the
assertion of a claim but not paid during the year, the
19 Taxpayers eligible for use of reserves for losses on loans include
mutual savings banks not having capital stock represented by
shares. I.R.C. § 593(a).
The amount a taxpayer may set aside is subject to various
statutory and regulatory limitations. I.R.C. § 593(b); Treas. Reg. §
1.593.
The Tax Reform Act of 1969 enacted § 585, a provision parallel
to § 593 that is available to banks not eligible under § 593 and to
certain other financial institutions. Tax Reform Act of 1969, Pub.
L. No. 91-172, § 431(a), 83 Stat. 487, 616-18.
20 The actual charging off of a bad debt does have indirect tax
consequences. In 1958, when Revenue Ruling 58-126 was issued, the
amount of a deductible addition to a reserve was limited to the
lesser of —
(1) the amount of its taxable income for the taxable
year, computed without regard to this section, or
(2) the amount by which 12 percent of the total
deposits or withdrawable accounts of its depositors
at the close of such year exceeds the sum of its
surplus, undivided profits, and reserves at the
begining of the taxable year.
(Footnote continued on following page)
A-13
estimated amount thereof is added to the unpaid-
losses-outstanding “reserve”; in the later year in which
the claim is actually paid, the amount of the estimate
is subtracted from unpaid losses outstanding and the
amount of the payment is added to losses paid.
Another contrast with the § 593 reserve is that none of
the losses actually paid during a taxable year is
merely charged off against a reserve. All losses paid,
including those from prior years that have been
carried as part of the unpaid-losses-outstanding
“reserve,” are added into the losses-incurred deduc-
tion.*? Another difference between the two statutory
mechanisms is the different significance attached to
changes in the reserve. The only change in a § 593
reserve with direct tax consequences is the addition of
a reasonable amount during the year; the actual
payment of a loss is charged off against the reserve
but has no direct tax consequences. In contrast, all
modifications of an unpaid-losses-outstanding reserve
Int. Rev. Code of 1954, ch. 736, § 593, 68A Stat. 205. Because the
balance of the reserve at the beginning of the taxable year was
relevant to computation of the second alternative ceiling, the
charging off of a bad debt, by lowering the balance of the reserve,
increased the ceiling for permissible additions in subsequent years.
Although current provisions placing a ceiling on the amount a
taxpayer may add to a reserve ar’ much more complicated, the
effect of charging off a bad debt (or crediting recovery of an earlier
bad debt) is much the same. Section 585(b)(2) and § 585(b)(3),
relevant through § 593(b\(3) and § 593(b)(1)(A) respectively,
establish two potential ceilings on the deduction permissible for an
addition to a bad debt reserve. In both, the charging off of bad
debts (and the crediting of recoveries) during prior years and the
taxable year are relevant to computation of the ceilings. I.R.C. §
585(b)(2) & (3)(A).
*1 However, while additions are generally made to a loss reserve
without any evaluation of the likelihood that particular debts will
soon become worthless, more than 95% of Home Mutual’s unpaid
losses outstanding on December 31, 1962 consisted of estimates of
the amounts necessary to pay particular claims.
A-14
directly affect the amount of a taxpayer’s deduction for
losses incurred. Indeed, if the balance of the unpaid-
losses-outstanding reserve decreased over the course of
the taxable year, the losses-incurred deduction itself is
diminished for that year.
The differing structures of the statutory schemes
directly affect the issue under consideration here.
Under the provisions of the statute relevant in
Revenue Ruling 58-126, the loss reserves accumulated
before 1952 were irrelevant to computation of the
savings and loan association’s income beginning that
year.23 In contrast, the express terms of § 832(b)(5)
make the amount of the unpaid losses outstanding
estimated for pre-1963 claims relevant in determining
taxable income after 1962. Thus, while savings and |
loan association income set aside in a loss reserve
when that income is not taxable may not be taxed if
returned to undivided profits in a year in which
income of a like kind is taxed, that result does not
compel the conclusion that we should interpret a
different statutory scheme as allowing Home Mutual to
adjust its estimate of pre-1963 claims at the beginning
of a taxable year according to the actual amounts paid
during that year.
22. This procedure does not result in a double deduction for a loss
included in prior years as part of unpaid losses outstanding. In the
year of payment, the amount paid becomes part of “losses paid”
and thus increases the losses-incurred deduction. Yet at the same
time, the balance of “unpaid losses outstanding” is decreased by
the amount of the estimated loss included earlier in the account for
that claim, effectively reducing the deduction by that amount. If
the actual payment of a claim equals the earlier estimate, the
procedure results in a complete washout, the addition to the losses
actually paid being exactly counterbalanced by the decrease in the
unpaid losses outstanding.
23 Revenue Ruling 58-126 has thus been explained in Rev. Rul. 73-
273, 1973-1 C.B. 79.
—__
A-15
Further support for our conclusion is provided by
Pacific Mutual Life Insurance Co., 48 T.C. 118 (1967),
rev'd on other grounds, 413 F.2d 55 (9th Cir. 1969), and
Lutheran Mutual Life Insurance Co. v. United States,
602 F.2d 328 (Ct. Cl. 1979), petition for cert. filed, 48
U.S.L.W. 3570 (U.S. Feb. 23, 1980), which concerned
questions very similar to the one before us that arose
under taxing mechanisms enacted in the Life In-
surance Company Income Tax Act of 1959 that were,
unlike the bad debt mechanism discussed above, very
similar to the one here. Both cases involved efforts by
taxpayers to lower their opening reserves to reflect
actual experience during the years and thus avoid
hardship attending Congress’ imposition of a new
taxing formula. Although the courts differed somewhat
in their evaluation of legislative history common to
both cases, both agreed that the explicit language of
the statute precluded adjustment of a reserve that, in
the words of the court in the Pacific Mutual case, “‘at
the time it was established, was based upon all
available information and contained no mathematical
error.” 48 T.C. at 129.24 The same result must be
reached at bar, where there is no legislative history
that even arguably supports the taxpayer’s position.
B.
Home Mutual argues that we should affirm the
Tax Court on this issue on the basis of the tax benefit
24 The Tax Court also held that, even if the statute would allow
an adjustment, Pacific Mutual had not in fact proved the ultimate
amount of its liablities on pre-1958 claims and thus that its
opening reserves for 1958 were overestimated. Jd. at 129-31. The
Tax Court in the case at bar and Home Mutual both attempt to
distinguish Pacific Mutual on the grounds that Home Mutual has
proved that its opening reserves in 1963 were overstated. However,
“where a decision rests on two or more grounds, none can be
relegated to the category of obiter dictum.” Woods v. Interstate
Realty Co., 337 U.S. 535, 537 (1949).
—
A-16
rule and allow reduction of unpaid losses outstanding
at the beginning of each taxable year by the amount
by which amounts actually paid that year on pre-1963
claims fell below original estimates. The tax benefit
rule is a well established judge-made rule?> that despite
partial codification in § 111 remains substantially
extra-statutory in nature and affects a taxpayer’s
taxable income beyond the literal meaning of the Code
itself. Thus it is not sufficient to rebut the invocation
of the tax benefit rule to argue that the statute makes
no provision for its use here or to cite Pacific Mutual
and Lutheran Mutual, where the tax benefit rule was
not considered. Upon examining the contours of the
tax benefit rule itself, however, we conclude that it
does not apply in this case.
The tax benefit rule is “both a rule of inclusion
and exclusion: recovery of an item previously deducted
must be included in income; that portion of the
recovery not resulting in a prior tax benefit is
excluded.” Until 1929 it was unclear, in light of
Eisner v. Macomber’s definition of income as “gain
derived from capital, from labor, or from both
combined,” whether a taxpayer was required to report
recoveries of funds owed to it that had previously been
deducted.?? Although various justifications have been
25 See First Trust & Savs. Bank of Taylorville v. United States,
614 F.2d 1142, 1144 & n.2 (7th Cir. 1980).
26 Putoma Corp. v. Commissioner, 66 T.C. 652, 664 n.10 (1976),
aff'd, 601 F.2d 734 (5th Cir. 1979) (emphasis in original.) See
Bittker & Kanner, The Tax Benefit Rule, 26 U.C.L.A. L. Rev. 265,
267-72 & n.20 (1978). The tax benefit rule is not limited to the
recoveries of deductions. It also covers recoveries of items that had
earlier resulted in tax credits and of funds, such as embezzled
monies, that were never included in gross income. See California &
Hawaiian Ref. Corp. v. United States, 311 F.2d 235, 238 n.1 (Ct. Cl.
1962); 1 J. Mertens, The Law of Federal Income Taxation § 7.34, at
114 (rev. ed. 1974).
27 Eisner v. Macomber, 252 U.S. 399, 415 (1920). See Bittker &
Kanner, supra note 26, at 266.
A-17
offered for requiring taxpayers to report funds received
from what normally is not viewed as an income-
producing event, perhaps the best is that the in-
clusionary aspect of the tax benefit rule counter-
balances the annual accounting principle enunciated
in Burnet v. Sanford & Brooks, 282 U.S. 359 (1931). A
taxpayer should not be permitted to take advantage of
the tax system’s need to treat transactions as final at
the end of the accounting year so that tax conse-
quences can be calculated. The rule allows accurate
taxation of a whole transaction that may span several
accounting periods.”® In short, the inclusionary aspect
of the rule, which is based entirely on case law,29
“recognizes the ‘recovery’ in the current year of
taxable income earned in an earlier year but offset by
the item deducted.’2° Because such recoveries are
reportable due to the existence of previous deductions,
taxpayers have successfully argued that the recoveries
should be included in income only to the extent that
the earlier deduction had in fact served to reduce its
taxable income in the year in which the deduction was
taken. This exclusionary aspect of the tax benefit rule
was not conclusively accepted until 1942, when
Congress enacted the statutory predecessor to current §
111.5! Although § 111 expressly provides for such
exclusion only for the recovery of previously deducted
bad debts, taxes, and delinquency amounts, it is well
settled that this aspect of the tax benefit rule extends
*8 See Bittker & Kanner, supra note 26, at 267-70.
*9 See 1 J. Mertens, supra note 26, § 7.34, at 111.
30 Munter’s Estate v. Commissioner, 63 T.C. 663, 678 (1975)
(Tannenwald, J., concurring).
*! See Bittker & Kanner, supra note 26, at 271; 1 J. Mertens, supra
note 26, § 7.34, at 111-12 n. 40; California & Hawaiian Sugar Ref.
Corp. v. United States, 311 F.2d 235, 238 n.3 (Ct. Cl. 1962).
A-18
beyond the literal terms of the statute.°? Thus,
although the exclusionary part of the tax benefit rule
finds a statutory anchor, the entire rule remains in
essence an extra-statutory judicial rule permitting
retroactive adjustments so that some transactions
substantially altered in years subsequent to the
original accounting period may be taxed virtually as
though the entire transaction had occurred in one
accounting period.*?
Home Mutual invokes the tax benefit rule’s
exclusionary aspect in its argument that it should not
be required to reduce its losses-incurred deduction by
the amount of its overestimation of its pre-1963 claims
paid later. According to Home Mutual, when the
company receives notice of a claim against one of its
policies, its estimate of the amount necessary to cover
the claim is entered as an accrued liability and, after
1962, effectively deducted as a “loss incurred” under §
832(b)(5). If in a later year a lesser amount satisfies the
claim, the company “recovers” the amount by which it
overestimated the claim, restores the amount of this
“overaccrual” to its earned surplus, and pays tax on
32 See Bittker & Kanner, supra note 26, at 266-67, 271; 1 J.
Mertens, supra note 26, § 7.34, at 112-14 & nn. 42.1-44, & § 7.37, at
124-25; Dobson v. Commissioner, 320 U.S. 489 (1943); California &
Hawaiian Sugar Ref. Corp. v. United States, 311 F.2d 235, 238-39
(Ct. Cl. 1962); Home Savings & Loan Co., 39 T.C. 368, 370 (1962),
acq., 1963-2 C.B. 4, 1965-2 C.B. 5; Birmingham Terminal Co., 17
T.C. 1011, 1014 (1951), acq., 1952-1 C.B. 1; M & E Corp., 7 T.C. 1276
(1946), acq., 1947-1 C.B. 3. See also Treas. Reg. § 1.111-1(a).
33 Because recoveries are treated as income in the year recovered
rather than in the year originally deducted and because marginal
tax rates vary with the amount of other income, the tax benefit
rule is not likely to result in taxpayer paying precisely the same
amount of extra tax in the year of recovery as the amount of tax
saved by the earlier deduction. See Bittker & Kanner, supra note
26, at 270-71; 1 J. Mertens, supra note 26, § 7.37, at 129-30.
A-19
this amount as income, again through the workings of
§ 832(b)(5). See text at notes 10-12 supra.
The fact that the deduction occured by means of a
bookkeeping accrual and recovery by a mere reversal
of that accrual, with the money never leaving the
taxpayer’s coffers, does not preclude the application of
the tax benefit rule. 4 Tax benefit principles, if not the
rule itself, have been held to apply to the release of
funds from reserve accounts.*®
Similarly, it is not critical to the applicability of
the tax benefit rule that, because the amount of Home
Mutual’s underwriting losses was not relevant under
the statute before 1963, no deduction was ever taken
for pre-1963 unpaid losses incurred. Although the strict
language of § 111 requires that a taxpayer have taken
a deduction or credit before it may show that that
deduction or credit produced no benefit and exclude the
recovery from income, it has been held that taxpayers
completely exempt from federal income taxation at the
time the expense was taken are eligible for tax benefit
treatment.**° Thus prior expenses not taken as deduc-
tions or credits because entirely irrelevant to the
computation of taxpayer’s taxable income would seem
eligible for tax benefit treatment.
34 See Lime Cola Co., 22 T.C. 593 (1954), acq., 1955-2 C.B. 7;,Mé&
E Corp., 7 T.C. 1276 (1946), acqg., 1947-1 C.B. 3; 1 J. Mertens, supra
note 26, § 7.37, at 128 & n.82 & 130.
%° See Maryland Casualty Co. v. United States, 251 U.S. 342, 352
(1920) (dictum) (inclusionary aspect); Dallas Title & Cuaranty Co.,
40 B.T.A. 1022, 1028-32 (1939), rev’d on other grounds, 119 F.2d 211
(5th Cir. 1941) (inclusionary aspect); M & E Corp., 7 T.C. 1276
(1946), acq., 1947-1 C.B. 3 (exclusionary aspect). Dallas Title also
excluded released reserves from income to the extent they
represented prior deductions that, although benefitting taxpayer,
were improper.
*6 See Home Savings & Loan Co., 39 T.C. 368 (1962), acq., 1963-2
C.B. 4, 1965-2 C.B. 5; California & Hawaiian Ref. Corp. v. United
States, 311 F.2d 235, 237-40 (Ct. Cl. 1962).
A-20
On the basis of these principles, Home Mutual
argues that, because the funds set aside to cover the
claim provided it with no tax benefit, their transfer to
earned surplus is not subject to tax under the
exclusionary aspect of the tax benefit rule.*’
More is required, however, for application of the
tax benefit rule. Home Mutual wishes us to apply the
exclusionary aspect of the tax benefit rule even though
the rule has had no role in ensuring that the
“recoveries” are taxed. In the cases we have examined,
with the possible exception noted in the margin,** the
exclusionary aspect of the tax benefit rule becomes
relevant only after the Commissioner has employed
the inclusionary aspect of the rule to include in gross
income recoveries that according to the strict terms of
the statute are not income.*? The historical origin of
the rule noted above supports an interpretation of the
rule that requires use of the inclusionary aspect of the
‘7 Alternatively, Home Mutual argues that the funds set aside
were actually earned by the company prior to 1963 and thus should
not be subjected to taxation now. To this contention we think it a
sufficient answer to say that, absent a well established judge-made
exception, the Code itself, as amplified by its regulations,
determines what is taxable income.
** One recent Tax Court judge has applied the exclusionary aspect
of the tax benefit rule to the treatment of salvage and subrogation
recoveries under § 832(b)(5). In American Financial Corp. v.
Commissioner, 72 T.C. 506 (1979), taxpayer, a stock casualty
insurance company taxed during the entire relevant period on a
cash basis accounting method under the same provisions that have
applied to Home Mutual since 1962, claimed losses-incurred
deductions in various years prior to 1960. Because of net operating
losses subsequently incurred and the expiration of net operating
loss carryovers relating to the pre-1960 years, these deductions
ultimately resulted in no tax benefit for taxpayer. In 1966, taxpayer
received various salvage and subrogation proceeds related to these
pre-1960 claims, which it did not include in its computation of
losses incurred on the grounds that they should be excluded under
(Footnote continued on following page)
A-21
rule before a taxpayer can employ the exclusionary
aspect. The inclusionary aspect of the tax benefit rule
does not come into play in the situation at bar.
“Recoveries” of the amounts of overestimates of actual
liability on unpaid losses are taxed not by operation of
the tax benefit rule to make such recoveries items of
gross income under § 61(a), but by the specific terms of
a detailed statutory mechanism, which _ requires
downward adjustment of a taxpayer’s unpaid losses
outstanding at the end of the year during which the
claim is actually paid by the amount of the original
estimate. See text at notes 10-12 supra.‘° Thus the case
at bar does not fall within the established scope of the
tax benefit rule. In light of the principle inhibiting
creative judicial rewriting of the statutory language,
see text at notes 13-14 supra, we decline to expand the
tax benefit rule to allow Home Mutual to go beyond
the literal terms of this statute and retroactively adjust
§ 111. In the course of ruling in favor of taxpayer, Judge Dawson
rejected the Commissioner’s argument that § 111 was inapplicable
because such recoveries were not items of income in the statutory
scheme, but merely offsets to the deduction for losses incurred.
Judge Dawson concluded that accepting the Commissioner’s theory
could lead to “absurd and unintended results.” 72 T.C. at 514. Ina
year in which a cash basis taxpayer received more in salvage
recoveries than it paid in claims, the Commissioner’s theory would
prevent inclusion of this excess in taxpayer's gross income. Noting
that “[slection 832(b)(5) does not provide that salvage can be used
only as an offset,” id. (emphasis added), Judge Dawson thought it
unlikely that the Commissioner would fail to invoke the in-
clusionary aspect of the tax benefit rule in that case. Putting
technical niceties aside, Judge Dawson concluded that salvage and
subrogation recoveries were items of gross income and the tax
benefit rule applied.
For the reasons stated in the text, we believe the use of the
exclusionary aspect of the tax benefit rule to be improper in the
case at bar. We are not persuaded to the contrary by the reasoning
of American Financial Corp. While § 832(b)(5) arguably does not
(Footnote continued on following page)
A-22
its unpaid losses outstanding at the beginning of a
taxable year by the amount by which it had originally
overestimated its ultimate liability on claims paid
during the year.
Il.
In the alternative, Home Mutual argues that it
need not include any cash salvage and subrogation
recoveries made on pre-1963 claims. Home Mutual
concedes that the literal language of the statute and
regulations would require such inclusion,‘*! but argues
that the tax benefit rule allows exclusion of these
recoveries from the computation of the losses-incurred
deduction because they relate to losses from which
Home Mutual derived no tax benefit. It cites American
Financial Corp. v. Commissioner, 72 T.C. 506 (1979), in
support of its position. Although we are not persuaded
prohibit the Commissioner from including the excess of salvage
recoveries Over paid claims in gross income on the basis of the tax
benefit rule, we believe that the exclusionary aspect of the rule may
properly be invoked only to that extent. Indeed, the facts of
American Financial Corp. themselves reinforce our conclusion.
Application of the tax benefit rule’s exclusionary aspect years after
the expiration of the loss carryovers effectively allows taxpayer to
offset recoveries that by the terms of the statute and regulations,
not by application of the tax benefit rule, should increase income.
Use of the tax benefit rule would, in effect, abrogate the statutory
limitation prohibiting a taxpayer from carrying forward net
operating losses indefinitely and allow a taxpayer to revive long-
expired deductions in the year of recovery.
39 Home Savings & Loan Co., 39 T.C. 368 (1962), acq., 1963-2 C.B.
4, 1965-2 C.B. 5, is in accord with this analysis. The taxpayer,
exempt from federal income taxation until 1952, received refunds in
1956 for state property taxes improperly collected from 1947
through 1951. Although the Commissioner attempted to include the
refunds in income as an item of gross income solely by means of a
bald assertion of I.R.C. § 6l(a), the Tax Court indicated that the
recoveries could be included as income only under the inclusionary
(Footnote continued on following page)
A-23
by the relevant reasoning in that case, see note 38
supra, possible grounds exist for distinguishing
between the unpaid losses issue and the cash subroga-
tion recoveries issue. For instance, because no explicit
statutory basis exists for the regulation requiring the
subtraction of cash salvage and reinsurance recoveries
from paid losses in the computation of the losses-
incurred deduction, it is arguable that the only
authority for the regulation is the inclusionary aspect
of the tax benefit rule. If the tax benefit rule is the
ultimate authority for requiring that cash recoveries be
used to increase a taxpayer’s taxable income, it might
be appropriate to allow a taxpayer to invoke the rule’s
exclusionary aspect. At oral argument counsel for the
Commissioner admitted that the cash subrogation
recoveries issue was a closer question than the unpaid
aspect of the tax benefit rule, quoting and citing Perry v. United
States, 160 F.Supp. 270 (Ct. Cl. 1958), an inclusionary tax benefit
rule case. Because the state taxes, when paid, produced no tax
benefit, the court then concluded that the exclusionary aspect also
applied.
40 Under the statutory mechanism, some recoveries that might be
included in gross income under tax benefit principles are not taxed
at all. If salvage recoveries for a cash basis taxpayer exceed its
losses paid during the year, that excess is not taxed. See American
Financial Corp., supra note 38, 72 T.C. at 514. Similarly, under the
simplifying assumption that no other unpaid losses accrue or are
paid during the year, the amount by which the sums paid during
the year to settle overestimated pre-1963 claims exceed the sum of
paid losses (after subtracting cash salvage and reinsurance
recoveries) and the decrease in salvage and reinsurance recoverable
is not taxed even though that excess represents funds released for
general use by the taxpayer. Only if the Commissioner attempts to
include these excesses in a taxpayer’s gross income through use of
the tax benefit rule may taxpayer use the exclusionary aspect of
the rule.
A-24
losses issue.‘? Because of the absence of prior Tax
Court consideration of these complexities in the case at
bar, we remand this issue to that court for its
consideration.
ITI.
In an argument independent of its first two, Home
Mutual contends that it should have been permitted to
deduct the special transitional underwriting loss
provided by § 821(e) from the total underwriting gain
rather than from underwriting gain less the protection-
against-loss deduction allowed by § 824(a). Home
Mutual argues for this result on the grounds that the
relevant statutory provisions are in_ irreconcilable
conflict and that the legislative history of § 821(e)
shows it to be remedial legislation, which must be
broadly construed to effectuate its purpose. We find no
irreconcilable conflict but merely a statutory scheme
that does not by its terms allow Home Mutual as much
benefit from its special transitional underwriting loss
as it would like.
The special transitional underwriting loss allowed
by § 821(e) is a special reduction in the “statutory
underwriting income” of any mutual casualty in-
surance company that was taxable for the five taxable
years preceding January 1, 1962 under § 821 as it
existed before the 1962 Revenue Act and that sustained
an underwriting loss in each of those five years. In
‘1 Strictly speaking, Treasury Regulation § 1.832-4(c), and not the
statutory provisions themselves, make cash salvage and subroga-
tion recoveries relevant to the computation of the losses-incurred
deduction by requiring them to be subtracted from losses paid
during the taxable year.
42 In addition, in his main brief before this court, the Com-
missioner suggested that we remand this issue if its resolution
became necessary for decison of this case.
ut
ad
A-25
any taxable year between 1963 and 1967 inclusive, a
company can use the aggregate of these underwriting
losses, to the extent not used before under this
subsection, to offset its statutory underwriting income.
After the company’s 1967 taxable year, any unused
special transitional underwriting loss expires. For
purposes of § 821(e), “statutory underwriting income”
is defined in § 823(a)(1). Treas. Reg. § 1.821-5(a). That
section specifies that. to compute statutory un-
derwriting income, one must subtract the deduction
provided by § 824(a) for the amount added to the
protection-against-loss account. Thus under the clear
statutory language, Home Mutual is entitled to deduct
its special transitional underwriting loss only after the
protection-against-loss deduction has been taken.
Home Mutual argues, however, that § 821(b)(1)(C)
and § 824(d) create an irreconcilable conflict. The latter
section mandates that certain subtractions be made
each year from the protection-against-loss (PAL)
account. Under some circumstances the entire amount
of the PAL deduction added to the account under §
824(b) will immediately be subracted from the account
under § 824(d). Section 821(b)(1)(C) requires that the
total amount subtracted from the PAL account under §
824(d) be included in a mutual insurance company’s
taxable income. Thus the PAL deduction granted from
the company’s statutory underwriting income for a
year may effectively be taken away that same year
through the add-back requirement of § 821(b)\(1)(C).
Under the terms of the statute explained in the
preceding paragraph the company may not use the
special transitional underwriting loss to offset the
amount of the PAL deduction added back to income
but must employ the unused loss carryovers and
carrybacks provided by § 825. Because of this limita-
tion Home Mutual had to employ part of its unused
loss carryovers available through 1968 and 1969.
A-26
rather than part of its special transitional un-
derwriting loss expiring after 1967, to offset the
amount of the PAL deduction added back to income in
1965 and 1966. Home Mutual was left with unused,
expired special transitional underwriting loss of
$217,117.31 that could otherwise have offset this
income and loss carryovers for 1968 and 1969 that
were correspondingly depleted.** Citing legislative
history showing generally that § 821(e) was remedial
legislation, Home Mutual argues that the special
transitional underwriting loss should be available to
offset statutory underwriting income after a “net”? PAL
deduction computed after the implementation of §
824(d). Only in this way, according to Home Mutual,
can conflicting provisions be reconciled so as to give
Home Mutual full use of its special transitional
underwriting loss, in harmony with the remedial
purpose of § 821(e).
We perceive no irreconcilable conflict in this
statutory scheme. Home Mutual is not caught in a
maze of conflicting statutory demands with no exit.
There is an exit, just not one to Home Mutual’s liking.
The PAL deduction is added back to income, but as an
element totally separate from statutory underwriting
income. Congress established the protection-against-
loss account in recognition of mutual casualty in-
surance companies’ lack of access to the capital
market for funds with which to pay losses. Section 824
allows companies to set aside part of their un-
derwriting gain each year, which would otherwise be
taxed, in a special account for protection against
losses. The bulk of the funds is set aside for a period as
43, Home Mutual’s original special transitional underwriting loss
totaled $936,698.29. Under Home Mutual’s method, it would have
used $450,364.68 before its expiration after 1967. Under the
Commissioner’s computation method, only $233,247.37 would have
been used.
A-27
long as five years until needed to pay losses. All the
gain set aside will eventually be taxed, but the tax is
deferred until the funds are used to cover losses or
until the five-year period expires. Section 824(d) serves
as the detailed formal mechanism for withdrawal of
money from the account as losses occur during those
five years, for establishment of a ceiling on the total
amount set aside at one time, and for return of most of
the unused funds to earned surplus after the five-year
period. See S. Rep. No. 1881, 87th Cong., 2d Sess. 54-55
(1962), reprinted in [1962] U.S. Code Cong. & Ad. News
3297, 3357-58 and 1962-3 C.B. 703, 760-61; H.R. Rep.
No. 1447, 87th Cong., 2d Sess. (1962), reprinted in 1962-
3 C.B. 402, 446-47; see also 8 J. Mertens, The Law of
Federal Income Taxation § 44.58a, at 209-11 (rev. ed
1978.) Thus the amount of underwriting gain removed
to the protection-against-loss account becomes a
special category of income on which taxation is
deferred. That the financial performance of a company
in a particular taxable year may require that the
amount removed from that year’s underwriting gain be
used, in effect, to cover losses of the same year does
not transform those funds back into statutory un-
derwriting income. The statutory scheme is both clear
and comprehensible.‘
‘4 One specific argument of conflict results from a_ potential
ambiguity in the calculation of the PAL deduction created by the
language of § 821(e)(2). That subsection states that “the statutory
underwriting income of a company [eligible for the special
transitional underwriting loss] shall be the statutory underwriting
income for the taxable year ... reduced by [the special transitional
underwriting loss].”” Section 824(a)(1), which provides that a part of
the PAL deduction is a percentage of underwriting gain, defines
underwriting gain as ‘statutory underwriting income, computed
without any deduction under this subsection.” Thus, one could
argue, as Home Mutual apparently does, that its statutory
underwriting income for purposes of calculating the PAL deduction
is the amount resulting after deduction of the special transitional
(Footnote continued on following page)
A-28
Home Mutual cites legislative history to show that
enactment of § 821(e) was intended as a remedial
measure. That it was, and Home Mutual has benefitted
from its use. However, that legislative history does not
permit us to ride roughshod over the statutory
language and provide greater benefit to a taxpayer
than that provided by the terms of the statute itself.
Pursuant to Rule 39(a) and (b) of the Federal Rules
of Appellate Procedure,*® the costs of this appeal will
be taxed against Home Mutual. The decision of the
Tax Court is hereby affirmed in part, reversed in part,
and remanded in part.
PELL, Circuit Judge, dissenting in part, con-
curring in part.
At the risk of taking an overly simplified view of a
more than ordinarily complicated example of tax law,
and notwithstanding the scholarly analysis and
treatment by the majority opinion of the issues
presented, I respectfully dissent as to the matter of the
tax benefit rule.
The ultimate situation appears to me as follows:
When the losses which comprised the December 31,
1962, unpaid loss accrual were settled at less than the
amount accrued therefor, Home Mutual received, in
effect, a “recovery” of a prior expense. By means of
bookkeeping entries these excess accruals were
underwriting loss. This interpretation would seem to give deduction
of the special transitional underwriting loss priority over the PAL
deduction and thus create a conflict with the bare language of the
statute, which allows the former deduction only after subtraction of
the PAL deduction. However, Treasury Regulation § 1.824-1l(a)
resolves any ambiguity by explicitly providing that “statutory
underwiting income” for purposes of computing the PAL deduction
is “as defined in section 823(a).”
45 See also Notes of Advisory Committee on Appellate Rules, Rule
39, subdivision (b); 28 U.S.C. § 2412.
A-29
eliminated from its liabilities and restored to its earned
surplus. Under the “tax benefit rule,” as developed by
numerous court decisions (which decisions are discuss-
ed in the majority opinion), such recoveries of prior
expenses are includable in taxable income only to the
extent that some “tax benefit’? was received from their
deduction against taxable income in a prior year. In
Home Mutual’s case, no prior tax benefit was received
from the accrual of its unpaid losses as of December
31, 1962, because mutual insurance companies, such as
Home Mutual, were not taxed on their underwriting
income prior to 1963. Therefore the tax benefit rule
should preclude the inclusion of such recoveries in
Home Mutual’s taxable income for the years 1963
through 1975.
Although the Tax Court declined to label the basis
for its holding as the “tax benefit rule,” per se, it
appears to me from the Tax Court’s opinon that that
court was recognizing the principles underlying the tax
benefit rule as being applicable to the facts of the
present case.
The majority opinion, as I read it, rests in part on
the basis that applying the tax benefit rule to the
present case would be an extension beyond any
existing authority. It appears to me that the present
situation is squarely of the type that calls for the
application of the rule.
In sum, inasmuch as the taxpayer realized no real
economic gain from its payment of the claims made
against its policies, and it received no tax benefit from
the excess accruals for unpaid losses made prior to
1963, it should not be subjected to tax on its
subsequent recovery of these excess accruals. This is
the essence of the long standing “tax benefit rule.”
Dobson v. Commissioner, 320 U.S. 489 (1943).
A-30
Because of the result I would reach in this case, it
is not necessary for me to reach the cash subrogation
recoveries issue. If I were to do so I would join in the
remand provided for in Part II of the majority opinion
with the exception that I find persuasive the reasoning
in American Financial Corp v. Commissioner, 72 T.C.
506 (1979). I concur in Part III of the majority opinion.
United States Court of Appeals
For the Seventh Circuit
Nos. 79-1602 and 79-1603
HOME MUTUAL INSURANCE COMPANY,
Petitioner-Appellee,
Cross-Appellant,
VU.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant,
Cross-Appelle.
Appeal from the United States Tax Court
ARGUED EN BANC NOVEMBER 13, 1980—
DECIDED DECEMBER 23, 1980
Before FAIRCHILD, Chief Judge, SWYGERT,
CUMMINGS, PELL, SPRECHER, BAUER, WOOD
and CUDAHY, Circuit Judges.
PER CURIAM. The sole issue before the full Court
is whether a majority of the panel properly held that
A-31
the tax benefit rule! may not be invoked unless the
items sought to be excluded from taxation are asserted
to be taxable only by means of the exclusionary [sic]
aspect of the tax benefit rule. For the reasons given in
the majority panel opinion, we hold the tax benefit rule
requires use of the inclusionary aspect of the rule
before a taxpayer can employ the exclusionary aspect.
ma Lf Eee
At the en banc oral argument, in a colloquy
between bench and bar, counsel suggested that
Sections 832(b)(5) and 821(e) of the Internal Revenue
Code as interpreted and applied in this case, while
ostensibly taxing income, in fact operate to impose a
direct tax on property that is not apportioned accord-
ing to population, in violation of Article I, Section 2,
Clause 3 and Section 9, Clause 4 of the Constitution.
A tax on income, of course, need nov be apportioned in
view .f the Sixteenth Amendment.’ This argument
appears to be founded on a confusion of “taxable
! In Putoma Corp. v. Commissioner, 66 T.C. 652, 664 n. 10,
affirmed, 601 F.2d 734 (5th Cir. 1979), the Tax Court described the
tax benefit rule as follows:
“both a rule of inclusion and exclusion; recovery of an
item previously deducted must be included in income;
that portion of the recovery not resulting in a prior tax
benefit is excluded.”’
As explained in the panel majority opinion in the present case, the
tax benefit rule is not limited to the recoveries of deductions but
also includes recoveries of items that had earlier resulted in tax
credits and of funds, such as embezzled monies, that were never
included in gross income. ..... a aes n. 26.
* Section 2, Clause 3 provides in pertinent part:
“Representatives and direct Taxes shall be appor-
tioned among the several States which may be included
within this Union, according to their respective Numbers
* em 7?
(Footnote continued on following page)
A-32
income” with “income.” As then Judge Tone’s majority
opinion stated in its discussion of the tax benefit rule,
this is not a case in which the Commissioner has
added a “recovery” or recaptured loss to taxpayer’s
gross income. The bottom line effect of the relevant
provisions here has been to reduce the amount of the
“losses incurred” deduction allowable to taxpayer in
1966 and 1971, thereby increasing the amount of its
taxable income for those years. ..... Pe knee “pei :
Taxable income is simply that portion of tax-
payer’s gross income that Congress has chosen to tax.
The term “taxable” in no way connotes a con-
stitutional limitation on the extent to which or the
manner in which gross income may be taxed. To the
contrary, it is well settled that Congress has the power
to impose without apportionment an income or excise
tax measured by gross income or gross receipts, even
where an individual taxpayer has no net income after
Section 9, Clause 4 provides:
“No Capitation, or other direct, Tax shall be laid,
unless in Proportion to the Census or Enumeration
herein before directed to be taken.”
3 The Sixteenth Amendment provides:
“The Congress shall have power to lay and collect
taxes on incomes, from whatever source derived, without
apportionment among the several States, and without
regard to any census or enumeration.”
This amendment was added to the Constitution in response to
the Supreme Court’s invalidation of the Income Tax Act of 1894 in
Pollock v. Farmer’s Loan & Trust Co., 157 U.S. 601 (initial decision),
158 U.S. 601 (decision on rehearing), on the ground that a tax on
income derived from property was the equivalent of a direct tax on
the income-producing property itself and therefore must be
apportioned in accordance with the above-quoted provisions of
Article I. Prior to the decision in Pollock, it had been the general
consensus that the term “direct taxes” as used in the Constitution
(Footnote continued on following page)
A-33
expenses, Penn Mutual Indemnity Co. v. Com-
missioner of Internal Revenue, 277 F.2d 16, 20 (3d Cir.
1960), and that deductions are generally a matter of
legislative grace. Idem. Indeed, mutual insurance
companies like taxpayer here were, as has already
been noted in the panel majority opinion, prior to 1963
taxed on the basis of gross income, and that very tax
was upheld in Penn Mutual Indemnity Co., supra,
against constitutional attack similar to the one raised
here. Congress has now chosen to use a different
measure of taxation, one which allows a deduction for
“losses incurred,” but “losses incurred” only as defined
and computed under the Code. This choice was a
matter of legislative discretion and is not rendered
constitutionally infirm for lack of apportionment
because the resulting tax is not confined to or
measured by taxpayer’s actual net income.
The Tax Court’s resolution of the unpaid losses
dispute is reversed, with costs to the Commissioner.
CUDAHY, Circuit Judge, Concurring:
I agree with the majority of the full Court and of
the panel that the decided cases, with the possible
referred only to taxes on real estate and poll or capitation: taxes.
See, e.g., Hylton v. United States, 3 U.S. (3 Dall.) 171, 177: Veazie
Bank v. Fenno, 75 U.S. (8 Wall.) 533, 544; Springer v. United
States, 102 U.S. 586, 602. In 1937, the Supreme Court effectively
overruled Pollock, see New York ex rel. Cohn v. Graves, 300 US.
308, thereby making the Sixteenth Amendment superfluous.
Congress’ power to lay and collect income taxes does not, of course,
derive from the Sixteenth Amendment, but from Article I, Section
8, Clause 1 of the Constitution, which provides in pertinent part:
“The Congress shall have Power to lay and collect Taxes,
Duties, Imposts and Excises, to pay the Debts and
provide for the common Defence and General Welfare of
the United States ***.”
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exception of American Financial Corp. v. Com-
missioner, 72 T.C. 506 (1979), appear to employ the
exclusionary aspect of the tax benefit rule only when
the items sought to be excluded are asserted to be
taxable by means of the inclusionary aspect. This is
not in my view the case in which to introduce
“flexibility” in a whole new dimension into the tax
benefit rule. Cf. First Trust & Savings Bank of
Taylorville v. United States, 614 F.2d 1142, 1145 (7th
Cir. 1980). When such a case may be presented,
however, I do not believe that the existing precedents
necessarily constitute a complete bar to extension of
the rule in some fashion as an_ exclusionary
mechanism only.
FAIRCHILD, Chief Judge, with whom PELL and
BAUER, Circuit Judges, join, dissenting in part and
concurring in part. I respectfully dissent as to the
unpaid losses disputed.
In any tax year after 1962, an estimate of a loss
incurred in that year, but not settled, measures a
deduction from underwriting income. In a later year, if
that loss is settled for less than the estimate, the
statute causes the difference to augment underwriting
income. In these instances, the statute itself is
consistent with the inclusionary aspect of the tax
benefit rule. Our problem arises because the present
statutory taxing system began at the close of 1962, and
the statute makes no allowance for the fact that an
estimate of a loss incurred in 1962 or before, but not
settled, may in fact be larger than necessary. When
such a claim is settled after 1962 for less than the
estimate, the statute causes income to be increased by
the amount of the difference. The same thing happens
where a post-1962 loss is settled in a later year for less
than the estimate, but in the latter case the taxpayer
has previously been able to deduct the full amount of
the estimate in a previous year. Not so with the pre-
1963 loss.
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Clearly enough Congress has power to treat the
post-1962 loss in the manner it has.
The settlement after 1962 of the pre-1963 loss
presents a different question. Read mechanically, the
statute treats the amount by which the company
overestimated the pre-1963 claim as taxable income in
the post-1962 year in which the claim is settled; the
company’s tax is increased solely by reason of the fact
that it paid a claim against its policies. This, however,
is inappropriate, for the Sixteenth Amendment permits
only the taxation of income, yet here the settlement
produced none. When an unliquidated debt is discharg-
ed by an amount less than anticipated there is no gain
or profit to the debtor, it receives nothing of value and
is released from satisfying no obligation it was
otherwise bound to perform. !
It seems to me that faced with a constitutional
question, we are to look for constructions of the statute
which might save it.?
A possible argument is that by taxing a mutual
casualty insurance company’s “recovery” of the
amount by which it overestimated a pre-1963 claim,
Congress is merely attempting to levy a tax on part of
the company’s previous income which under pre-1963
' Of course the taxpayer is better off than it would have been had
the claim been settled for a higher amount. The point, however, is
that because it was never obliged to pay a higher figure, no benefit
derived from the fact that the settlement cost less than estimated.
The situation here is unlike the partial cancellation of liquidated
debt, which usually results in a taxable income, for in the latter
case the debtor is released from paying an amount he otherwise
would be bound to pay. See generally, 3 Rabkin & Johnson, § 36.01.
* Home Mutual contended, both in its petition for reargument and
at oral argument before the court sitting en banc that the relevant
provisions of the statute as applied by the Commissioner should be
held unconstitutional, but that this result could be avoided by
invoking the exclusionary aspect of the tax benefit rule.
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law escaped taxation. There is no dispute that, subject
to certain limitations concerning harshness or ar-
bitrariness of impact, Congress has the power to
retroactively tax income, see e.g., Lynch v. Hornby,
247 U.S. 339, 343 (1918); Brushaber v. Union Pacific
Railroad, 240 U.S. 1 (1916), but a statute will not be
construed to do so in the absence of a “clear, strong,
and imperative” declaration that such was the intent
of Congress. Shwab v. Doyle, 258 U.S. 529, 535 (1922),
quoting United States v. Heth, 3 Cranch 398, 413; see
also Rose v. Commissioner, 55 T.C. 28 (1970). In the
present case, quite simply, there is nothing expressed
in the text of the relevant statute or in its legislative
history capable of satisfying this requirement, and
intent may not be inferred from the language of the
Act.?
Clearly Congress intended to enact a valid statute,
and it seems far more likely that Congress, in
3 It is not sufficient that an intent to levy a retroactive tax might
reasonably be suggested by the terms of the statute. In Shwab,
supra, the court found that the Act there in question “provided that
.. a tax was to be imposed upon the transfer of the net estate of
every decedent dying after passage of the act, ‘to the extent of any
transfer [made] ... in contemplation of ... death ...’” and that
transfers made within two years of death without receipt of fair
consideration were rebuttably presumed to have been made for
ch a purpose. 258 U.S. at 532 (emphasis added). The court
nonetheless held that the Act should not be construed to apply to
transactions completed before the Act became law and therefore
held that the value of a trust created fifteen and a half months
before passage of the Act was not taxable to the decedent’s estate.
It reasoned that “a statute should not be given a retroactive
operation unless its words make that imperative and this [could
not] be said of the words of the Act” then before the court. 258 U.S.
537.
Thus, in the present case, an intent on the part of Congress to
retrospectively tax income should not be inferred from the
language of the statute even though literal adherence to its terms
might suggest such an intent.
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designing a system consistent with the tax benefit
rule, permitting the deduction of the estimated amount
of a loss incurred after the effective date of the statute,
but including in income in a later year the difference
between the estimate and the lower amount of a
settlement, intended that the principle of the tax
benefit rule apply as well to an advantageous settle-
ment after the effective date of the statute of a loss
previously incurred.
Accordingly, I would affirm the Tax Court on this
issue. I concur in Part III of the majority panel
opinion.
PELL, Circuit Judge, dissenting in part, con-
curring in part.
While continuing to adhere to the views expressed
in my dissent-concurrence to the opinion of Judge
Tone, I also concur and join in the dissent-concurrence
of Chief Judge Fairchild filed in the present en banc
proceedings.
With all due respect to the majority per curiam
opinion, it appears to me that it indulges in semantic
unreality to avoid recognizing that in fact this
taxpayer is being required to treat as taxable income a
recovery from which it never had any benefit.
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APPENDIX B
OPINION OF U.S. TAX COURT
Home Mutual Insurance Company, Petitioner v.
Commissioner of Internal Revenue, Respondent
Docket No. 6587-75. Filed September 18, 1978.
Petitioner estimated its unpaid losses as of
Dec. 31, 1962, when underwriting income first
became taxable by an examination of each
filed claim. In each of its subsequent taxable
years it settled claims pending on Dec. 31,
1962, for less than the estimate. Held,
petitioner is entitled to an adjustment in each
of its taxable years for the difference between
the amount of the estimated claim pending on
Dec. 31, 1962, and the amount for which the
claim was subsequently settled. Held, further,
the special transitional underwriting loss
reduction provided by sec. 821(e), I.R.C. 1954,
app!icable to the taxable years 1965, 1966, and
1967, is allowable only against statutory
underwriting income after allowance of the
protection against loss deduction permitted by
sec. 824.
Paul A. Pakalski and Michael T. Hart, for the
petitioner. Nelson E. Shafer, for the respondent.
OPINION
GOFFE, Judge: The Commissioner determined
deficiencies in petitioner’s Federal mutual insurance
company income taxes for the taxable years 1966 and
1971 in the respective amounts of $29,906.21 and
$18,624.50. The issues for decision are as follows:
(1) Should petitioner be permitted to adjust its
estimate of unpaid losses as of December 31, 1962, in
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£
o
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each of its subsequent taxable years based strictly
upon settlements of its claims which had _ been
estimated on that date;
(2) In the alternative, must recoveries (salvage
and subrogation) on losses paid prior to January 1,
1963, be offset against losses incurred in a subsequent
year for purposes of computing statutory underwriting
income; and
(3) Is the special transitional underwriting loss
an allowable reduction to the full extent of un-
derwriting gain before the protection against loss
deduction under section 824,! of the Internal Revenue
Code, or only to the extent of statutory underwriting
income after allowance of the protection against loss
deduction.
The case was submitted upon a complete stipula-
tion of facts. The stipulation of facts and exhibits
attached thereto are incorporated by this reference.
Home Mutual Insurance Co. (petitioner) is a
mutual casualty insurance company with its principal
office at Appleton, Wis. Petitioner filed Federal mutual
insurance company income tax returns (hereinafter
referred to as returns) for the taxable years 1963, 1964,
1965, 1966, and 1967 with the District Director of
Internal Revenue, Milwaukee, Wis., and like returns for
the taxable years 1971 and 1972 with the Internal
Revenue Service Center, Kansas City, Mo. Petitioner
filed an amended return for the taxable year 1963 with
the District Director of Internal Revenue, Milwaukee,
Wis., on June 9, 1965.
All section references are to the Internal Revenue Code of 1954,
as amended.
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In each State (Wisconsin and 16 other States)?
where petitioner is authorized to act as an insurer,
petitioner is required to file statements of its financial
condition and the results of its annual operations.
These annual statements are presented on forms
prescribed by the National Association of Insurance
Commissioners and completed in accordance with
instructions prepared by that organization.
A brief history and explanation of the general
scheme of taxation of mutual fire and casualty
insurance companies is in order to aid an understand-
ing of the issues in this case. The Revenue Act of 1962
(Pub. L. 87-834) drastically increased the tax on mutual
fire and casualty insurance companies. Prior to that
time such companies were taxed under one of two
formulas which produced the higher tax. Under one
formula they were taxed at ordinary corporate rates on
their investment income and were not taxed on their
income from premiums (underwriting income). Under
the other formula they paid a tax of 1 percent on their
gross investment income plus their premium income
less policyholder dividends. At the same time stock fire
and casualty insurance companies were taxed at
ordinary corporate income tax rates on their invest-
ment income and underwriting income. The 1962 Act
was designed to tax the mutual companies on much
the same basis as the stock companies, recognizing
however, that while a stock company could pay
extraordinary losses out of paid-in capital as well as
accumulated profits, a mutual company was able to
pay extraordinary losses only out of retained un-
derwriting income. H. Rept. 1447, 87th Cong., 2d Sess.
(1962), 1962-3 C.B. 446; S. Rept. 1881, 87th Cong., 2d
Sess. (1962), 1962-3 C.B. 761. The 1962 Act, therefore,
* Idaho, Indiana, Kansas, Kentucky, Louisiana, Michigan,
Minnesota, Missouri, Montana, Nevada, North Dakota, Oklahoma,
Oregon, South Dakota, Utah, and Washington.
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established a new scheme of taxation for mutual fire
and casualty insurance companies under which they
would be taxed for taxable years commencing after
December 31, 1962, on both their investment income
and underwriting income with certain modifications.
Under the 1962 Act, which became sections 821
through 826 of the Internal Revenue Code of 1954, as
amended, a normal tax and surtax were imposed on
“mutual insurance company taxable income.”
Mutual insurance company taxable income con-
sists of taxable investment income and _ statutory
underwriting income with certain’ specified
modifications. The case before us involves statutory
underwriting income. That term, in general, means the
premiums earned on insurance contracts less expenses
incurred, losses incurred, deductions allowable under
section 832(c), and modifications with which we are
not concerned in this case.
1. Loss Incurred Deduction
The deduction allowed agains. statutory
underwriting income for losses incurred is computed
under section 832(b)(5) which provides:
SEC. 832(b)(5) Losses Incurred. — The
term “losses incurred” means losses incurred
during the taxable year on insurance con-
tracts, computed as follows:
(A) To losses paid during the taxable year,
add salvage and reinsurance _ recoverable
outstanding at the end of the preceding
taxable year and deduct salvage and rein-
surance recoverable outstanding at the end of
the taxable year.
(B) To the result so obtained, add all
unpaid losses outstanding at the end of the
an,
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taxable year and deduct unpaid losses outstan-
ding at the end of the preceding taxable year.
The first issue presented for decision involves the
deduction for losses incurred for each of the taxable
years 1963 through 1966 and 1971, liabilities for the
first 3 years properly being before the Court by reason
of loss carryovers.
The following schedule reflects the loss incurred
deduction involved in each of the years:
Taxable Claimed on Determined Claimed in Amount in
year tax return in statutory amended dispute
notice petition
1963. . 1$3,148,344.52 $3,071,255.44 $3,287,553.53 $216,298.09
1964.... 3,023,573.82 3,004,779.83 3,111,107.06 106,327.23
1965.... 3,002,569.02 2,993,200.41 3,016,564.59 23,364.18
1966.... 3,563,129.09 3,547,468.39 3,569, 133.90 21,665.51
1971.... 5,339,165.39 5,339, 165.39 5,340,329.39 1,164.00
‘Amended tax return.
The adjustments to the loss incurred deduction made
by the Commissioner in his statutory notice of
deficiency were based upon his determination that loss
recoveries in each of the years were not excludable
from the related loss incurred deductions. Petitioner
challenges that determination in the alternative.
Petitioner’s primary contention is that it is entitled to
additional unpaid loss deductions brought about by
satisfying claims during each of the years reflected
above for less than was estimated as of December 31,
1962, to be its liability for such claims pending on that
date.
Petitioner, on its annual statement as of December
31, 1962, reported its unpaid losses at $2,729,746. This
amount represented petitioner’s evaluation of the
amount of money necessary to meet all contingencies
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of claims against its insurance policies on that date. It
was composed of $2,600,472 for losses which had been
reported to it by its policyholders and analyzed case-
by-case to ascertain the projected ultimate liability and
$129,274, representing an estimate of the losses
incurred but not reported to petitioner by its policy-
holders as of December 31, 1962. Prior to December 31,
1962, the loss incurred account on petitioner’s books
and records and financial statements had no effect on
the Federal taxation of petitioner’s income because
mutual insurance companies were not taxable on
underwriting income prior to the taxable year 1963.
The loss incurred account as of December 31, 1962, did,
however, affect petitioner’s tax liabilities for taxable
years beginning with the taxable year 1963 because of
the manner in which the loss incurred deduction is
computed. The unpaid losses outstanding at the end of
the taxable year are added to the losses paid during
the taxable year and the unpaid losses at the
beginning of the taxable year are deducted from that
total. Sec. 832(b)(5), supra. The portion of petitioner’s
unpaid loss deduction which was estimated for losses
not yet reported as of December 31, 1962 ($129,274),
was converted during the taxable year 1963 to reported
losses. As losses were reported to the petitioner by
policyholders in 1963 petitioner evaluated its liability
for the claims, added such estimated liability to the
portion of its losses incurred for reported losses, and
reduced the portion attributable to unreported losses.
Petitioner’s unpaid loss account balance at
December 31, 1962, affected not only its loss incurred
deduction for the taxable year 1963 but all of its
taxable years through 1975 because all of the claims
pending on December 31, 1962, were not finally settled
until 1975. In 1963 and each of the subsequent years
petitioner evaluated its unpaid losses in like manner as
of December 31 which not only included claims filed in
each year but also the unsettled claims which had
A-45
been pending on December 31, 1962, which it had
evaluated as of December 31, 1962. The unpaid loss
evaluation for December 31, 1963, and subsequent
dates, unlike the evaluation on December 31, 1962,
affected petitioner’s loss incurred deduction and its tax
liability for each immediately preceding and each
immediately succeeding taxable year because of the
effect on the formula prescribed by section 832(b)(5),
supra, i.e., beginning and ending of the year balances
of unpaid losses.
The parties have stipulated the following descrip-
tion of the method employed by petitioner in account-
ing for the settlement of claims: “As each claim was
disposed of, net payments were charged to the losses
incurred account while the balance in the unpaid loss
account for such claim was credited to the losses
incurred account, thus clearing the unpaid loss account
for that claim.” Although the description of accounting
for settlement of the claims (unpaid losses) which were
pending as of December 31, 1962, is not a very clear
statement of how petitioner accounted for such items,
the result is not in dispute. Because petitioner
(subsequent to December 31, 1962) settled claims
pending at December 31, 1962, for amounts less than it
estimated them to be on that date, petitioner
understated its deduction for losses incurred in the
aggregate amount of $402,314.59 between January l,
1963, and December 31, 1975. Such understatements of
the loss incurred deduction can best be understood by
some examples.
Section 832(b)(5) provides for computation of the
loss incurred deduction as follows:
1. Losses paid during the taxable year.
+ 2. Salvage and reinsurance recoverable at the
end of preceding taxable year.
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- 3. Salvage and reinsurance recoverable at the
end of the taxable year.
+ 4. Unpaid losses at the end of the taxable year.
- 5. Unpaid losses at the end of the preceding
taxable year (or beginning of taxable year).
= 6. Loss incurred deduction.
Ii is readily apparent that in all events the unpaid
losses at the beginning of the taxable year will reduce
the loss incurred deduction. If the unpaid losses at the
beginning of any taxable year after January 1, 1963,
are overestimated and such estimated loss is paid for
less than the estimated amount, such overestimation
will merely shift the impact of the overestimate from
one taxable year to another. But an overestimate of the
amount of unpaid losses as of December 31, 1962, does
not merely shift the impact from one taxable year to
another because the amount of unpaid losses on
December 31, 1962, affects petitioner’s tax liability for
the first time as it was not taxable on underwriting
income for prior taxable years. Because the amount of
unpaid losses on December 31, 1962, reduces the loss
incurred deduction for 1963 the effect of overstating
that amount results in offsetting either the losses paid
or the unpaid losses pending at the end of 1963
portions of the deduction to which petitioner would
otherwise be entitled.
For example, assume that petitioner estimated all
of its unpaid losses at $1 million on December 31, 1962,
and included was a claim estimated at $500,000 which
was settled in 1963 for $200,000. Assume further that
during 1963 petitioner paid claims not pending on
December 31, 1962, in the amount of $100,000 and on
December 31, 1963, in addition to the unpaid losses
which were pending on December 31, 1962, and not
settled during 1963, it had unpaid losses of $800,000
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which were reported to petitioner by the policyholders
during 1963. When petitioner settled the $500,000 claim
for $200,000, it reduced the unpaid loss account by
$500,000 because the settled claim no _ longer
represented a liability of petitioner to the policyholder.
Because salvage and reinsurance recoverable are not
involved, petitioner’s loss incurred deduction would be
computed as follows, applying the formula set forth
above:
1. Losses paid in 1963 ............... $300,000
+ 4, Unpaid losses at 12/31/63
($1,000,000 - $500,000 + $800,000). . 1,300,000
1,600,000
- 5. Unpaid losses at 12/31/62......... 1,000,000
= 6. Loss incurred deduction ............ 600,000
If petitioner had estimated the claim in the example at
the amount it was settled for ($200,000) instead of its
overestimate ($500,000), line 6 above would be $900,000
as follows:
Lh. * EQN OO Wt BOE oo eisvcas ce cds $300,000
+ 4, Unpaid losses at 12/31/63
($700,000 - $200,000 + $800,000) ...1,300,000
1,600,000
- 5. Unpaid losses at 12/31/62.......... 700,000
= 6. Loss incurred deduction............. 900,000
It is apparent, therefore, that petitioner would have
been deprived of $300,000 of its loss incurred deduc-
tion.
The formula which the Code prescribes for com-
putation of the loss incurred deduction is similar to the
following formula used in the computation of cost of
goods sold where inventories are utilized:
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Beginning inventory
+ Purchases
- Ending inventory
= Cost of goods sold
At the end of each of the taxable years involved,
petitioner had the facts available to adjust that portion
of its opening balance in the unpaid loss account for
claims existing on December 31, 1962, which were
settled during such taxable year. Because the ad-
justment could be made within the taxable year
involved in closing the books for that year there is no
violation of the concept of the annual accounting
period. Such an adjustment is similar to an adjustment
of an inventory. We have long held that a taxpayer is
permitted to adjust inventories to conform to the facts
in years before the Court. Elm City Nursery Co. v.
Commissioner, 6 B.T.A. 89 (1927). In that case the
taxpayer deliberately inflated inventory figures on its
balance sheets to present a better financial picture for
borrowing funds to finance the operations of the
business. The Commissioner based his determination
of tax upon the inflated amounts appearing on the
books of the taxpayer. We found that the taxpayer
proved that the books did not correctly reflect the
beginning and ending inventories and we adjusted the
cost of goods sold accordingly. The Commissioner
acquiesced in that decision. VI-2 C.B. 2.
In Baumann Rubber Co. v. Commissioner, 4 B.T.A.
671 (1926), the taxpayer adjusted its opening inventory
for crude rubber it had failed to include. The Com-
missioner, in his statutory notice of deficiency, allowed
a lesser amount to be added to the opening inventory
which could be substantiated and which we upheld.
These cases demonstrate that a taxpayer’s begin-
ning inventory is not etched in concrete if an
appropriate adjustment is proposed during the correct
accounting period before the Court. We see no reason
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why the same reasoning should not be applied to the
original estimate of unpaid losses of petitioner at
December 31, 1962.
Respondent opposes the adjustment on several
grounds. First, he argues that the unpaid loss account
is not an accrual in the traditional accounting sense.
We recognize that the unpaid loss entry at the end of
each accounting period is nothing more than an
educated guess as to petitioner’s liability for claims
filed during that year against insurance policies which
are in force and effect on that date. We fail to see,
however, why an adjustment should be precluded for
that reason. Recognizing the amount to be an estimate
to us seems all the more reason to permit adjustment
of the amount in the annual accounting period during
which transactions occur, making it apparent that the
estimate is incorrect. The hindsight which respondent
abhors occurs within the annual accounting period.
That is not the same situation as adjusting an account
in a subsequent accounting period long after ordinary
business transactions demonstrate the error of the
estimate.
The need to permit petitioner to adjust for the
overestimation of unpaid losses as of December 31,
1962, is even more compelling in view of its being the
first time that the unpaid loss account had any
bearing on petitioner’s tax liability. In Rev. Rul. 58-
126, 1958-1 C.B. 13, which respondent vainly tries to
distinguish, the Commissioner held that a savings and
loan association could adjust its reserve for losses in
1957 established prior to 1952 when it was not subject
to taxation without resulting in the production of
income unless it diminished the reserve below the
additions to the reserve after 1951 and less chargeoffs
for bad debt losses after 1951 and plus recoveries
charged to the reserve after 1951. If the reserve were so
diminished, gross income was held to be realized to the
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extent of the diminution. We hold that the same
rationale should apply here and petitioner is entitled to
make the adjustments which it proposes.
Respondent also relies upon Pacific Mutual Life
Insurance Co. v. Commissioner, 48 T.C. 118 (1967),
revd. on other grounds. 413 F.2d 55 (9th Cir. 1969).
That case is distinguishable. The taxpayer adjusted its
beginning reserves for certain categories of insurance
based upon payments of some claims and upon a
revaluation, using methods different from those
originally used when the reserves were established. We
found that the taxpayer had used “actuarial hind-
sight” in adjusting its beginning reserves downward.
Petitioner here does not advocate such a procedure; its
hindsight is strictly based upon actual settlements of
the pending claims during the years it proposes
adjustments. In the instant case petitioner does not
rely upon “actuarial hindsight” but, instead, on
“actuality hindsight.” Petitioner here actually settled
the claims, previously estimated, for which it seeks
adjustment. The methods employed in establishing
reserves for future claims to be filed against life
insurance policies and those for casualty insurance
policies are vastly different. In the case of life
insurance the estimate is based upon averages or
probabilities which are actuarily developed. By con-
trast, reserves for claims against casualty insurance
policies which are involved here, are based upon
applying the factor of settlement experience to each
claim which has been actually filed.
Petitioner here proved what Pacific Mutual failed
to prove; i.e., the exact liability incurred with respect to
the claims included in the December 31, 1962, estimate.
See Pacific Mutual Life Insurance Co. v. Com-
missioner, supra, at 130, 131. Such failure of proof by
Pacific Mutual led us to state at page 131, “we cannot
conclude that the reserves in question were either
~~
A-51
overstated or understated.” In the instant case
respondent raises no such question; he recognizes that
the reserve on December 31, 1962, was overstated. In
Pacific Mutual we also held that the legislative history
of the applicable section (not the section involved here)
did not support the taxpayer’s position. There is no
legislative history for section 832(b)(5) to examine in
the instant case. Moreover, there is no showing that
the taxpayer relied upon Rev. Rul. 58-126, supra, in
Pacific Mutual.
Although we hold for petitioner, we cannot agree
with its reasons for permitting the adjustments.
Petitioner attempts to characterize the overestimation
of the unpaid loss account as resulting in an
overstatement of income. Such characterization is
erroneous. The overestimation had no bearing upon
petitioner’s gross income from its underwriting ac-
tivities. The overestimation affected its deduction for
losses incurred. After making such an erroneous
characterization, petitioner argues the applicability of
the tax benefit rule. We know of no case which holds
that the absence of a tax benefit in the prior year gives
rise to a deduction in the current year. Here, there was
no tax benefit in the prior year. Cf. Tennessee Carolina
Transportation, Inc. v. Commissioner, 65 T.C. 440
(1975), affd. 582 F.2d 378 (6th Cir. 1978). Indeed, we
have recognized that, although we have not identified
our theory as the tax benefit rule, when a casualty
insurance company releases its excessive reserves, it
constitutes taxable income only to the extent that the
amount released consists of amounts previously
deducted. Dallas Title & Guaranty Co. v. Com-
missioner, 40 B.T.A. 1022, 1031 (1939), revd. on other
grounds 119 F.2d 211 (5th Cir. 1941). See also
Maryland Casualty Co. v. United States, 251 U.S. 342
(1920). However, the taxpayer must prove what portion
of the released reserve did not create a deduction in a
> an
A-52
prior taxable year. Massachusetts Fire & Marine
Insurance Co. v. Commissioner, 16 B.T.A. 625 (1929).
Petitioner also relies upon the Commissioner’s
audit policy to demonstrate that the unpaid loss
account as adjusted is within the percentage of
tolerance that a revenue agent is to allow. This
argument is unpersuasive.
2. Recoveries of Losses Paid Prior
to January 1, 1963
Because we have held that petitioner may adjust
its estimate of unpaid losses pending on December 31,
1962, it is unnecessary for us to decide its alternative
position as to the treatment of recoveries on losses
paid prior to January 1, 1963.
3. Special Transitional Underwriting Loss
This issue involves the appropriate point at which
the special transitional underwriting loss may be
utilized to reduce statutory underwriting income; 1.e., is
it allowable against underwriting gain before the
protection against loss (PAL) deduction or allowable
against statutory underwriting income after the
protection against loss deduction?
Petitioner sustained underwriting losses
aggregating $936,698.29 for the taxable years 1957
through 1961. Such losses may be allowed as a special
transitional underwriting loss under section 821(e) for
petitioner’s taxable years 1965, 1966, and 1967.
Because we have adopted petitioner’s position with
respect to adjustments for the overestimation of unpaid
losses as of December 31, 1962, we need not consider
petitioner’s alternative contention as to respondent’s
restoring to underwriting gain recoveries on claims
A-53
settled prior to January 1, 1963. Petitioner’s
underwriting gain is, therefore, properly computed as /
follows:
1965 1966 1967 |
Underwriting gain per statutory
notice of deficiency $102,083.01 $60,672.28 $287,609.39
Adjustments for overestimation
of unpaid losses at Dec.
31,1962 23,364.18 21,665.51 16,518.47
271,090.92
Recoveries on claims 13,987.39
Underwriting gain
redetermined 78,718.83 39,006.77 275,078.31
'This adjustment for recoveries on claims settled prior to Dec. 31,
1962, was not proposed in the statutory notice of deficiency but
petitioner assumes this adjustment in all the computations in its
brief; it will, therefore, be deemed a concession by petitioner.
The table on p. 956 [A-55] depicts the parties
respective positions as to the appropriate point at
which to allow the special transitional underwriting
loss:
Section 821(e)(2) applicable to the years before the
Court allows a reduction of statutory underwriting
income for the underwriting losses of the 5 preceding
taxable years not previously utilized.®
% SEC. 821(e)(2) Reduction of Statutory Underwriting Income. —
For purposes of this part, the statutory underwriting income of a
company described in paragraph (1) for the taxable year shall be
the statutory underwriting income for the taxable year (determined
without regard to this subsection) reduced by the amount by
which — :
(A) the sum of the underwriting losses of such company for the
5 taxable years immediately preceding January 1, 1962, exceeds
(B) the total amount by which the company’s statutory
underwriting income was reduced by reason of this subsection for
prior taxable years.
A-54
Section 823(a) provides for the determination of
statutory underwriting income.‘ In summary, that
section determines statutory underwriting income
under sections 831 and 832, and allows a deduction
under section section 824(a).
Petitioner argues that section 821(e)(2) and section
824(a)(1) both allow deductions, that they are “locked
in a collision course” and legislative history supports
allowance of the special transitional underwriting loss
as a deduction against underwriting gain. We disagree.
Section 821(e)(2) provides for a _ reduction of
statutory underwriting income for the previous years’
underwriting losses. Because it provides for a reduction
of the statutory underwriting income, it is necessary to
refer to section 823(a) which determines the statutory
underwriting income and that section, together with
sections 831 and 832, clearly allow the PAL deduction
against underwriting gain in computing statutory
underwriting income.
4 SEC. 823. DETERMINATION OF STATUTORY
UNDERWRITING INCOME OR LOSS.
(a) In General. — For purposes of this part —
(1) The term “statutory underwriting income” means the
amount by which —
(A) the gross income which would be taken into account in
computing taxable income under section 832 if the taxpayer
were subject to the tax imposed by section 831, reduced by the
gross investment income, exceeds
(B) the sum of (i) the deductions which would be taken into
account in computing taxable income if the taxpayer were
subject to the tax imposed by section 831, reduced by the
deductions provided in section 822(c), plus (ii) the deductions
provided in subsection (c) and section 824(a).
(2) The term “statutory underwriting loss” means the excess of
the amount referred to in paragraph (1) (B) over the amount
referred to in paragraph (1) (A).
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A-56
There is no ambiguity in the statutory scheme, and
the legislative history does not conflict with our
interpretation.
Decision will be entered under Rule 155.
Reviewed by the Court.
CHABOT, J., dissenting: The majority allow a
mutual casualty insurance company to deduct the
amounts by which it overestimated its losses (as of
Dec. 31, 1962), the deductions being allowed when the
actual losses were specifically determined. I would not
allow these deductions, and so I respectfully dissent.
The deductions are not provided for in the statute.
See New Colonial Ice Co. v. Helvering, 292 U.S. 435
(1934). The legislative history does not indicate a
congressional intent to provide such deductions. The
deductions are not provided for in regulations.
The statutory provision for calculation of the
losses incurred deduction of mutual insurance
companies had been enacted 42 years before it was
first applied to mutual companies.! The provision
initially applied to stock companies. There is no
evidence that this provision was applied to stock
companies with respect to December 31, 1921,
estimates in the manner in which the majority now
seek to apply it to mutual companies with respect to
their December 31, 1962, estimates.
Would the majority require that a company which
had underestimated its losses take into income the
amount by which the losses are finally determined to
exceed the original estimates? I find no authority for
any such income inclusion, yet such an inclusion
appears to be the necessary logical consequence to the
majority’s holding in the instant case.
1 Sec. 246(a)(6), Revenue Act of 1921, Pub. L. 67-98.
A-57
The majority note that failure to grant the relief
requested will result in petitioner never being able to
compensate for its original overestimation. This same
point was dismissed in Pacific Mutual Life Insurance
Co. v. Commissioner, 48 T.C. 118 (1967), revd. on other
grounds 413 F.2d 55 (9th Cir. 1969), as follows (48 T.C.
at 127):
Petitioner contends that beca
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