Appendix — Commissioner v. Lincoln Savings & Loan Ass'n

Supreme Court brief1971

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IN THE

Supreme Court of the United States

OCTOBER TERM, 1970

No. 544

COMMISSIONER OF INTERNAL REVENUE,

Petitioner,

—V,——

LINCOLN SAVINGS AND LOAN ASSOCIATION

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF

APPEALS FOR THE NINTH CIRCUIT

INDEX

Page

Docket entries in the Tax Court of the United States

Relevant docket entries in the United States Court of -

peals for the Ninth Circuit

eR 10

Stipulation of facts _...________ 14

Stipulation Exhibit 4-D

Letter and Revision of Uniform Classification of Ac-

counts _

Stipulation Exhibit 14-N

Insurance Premium Notices

Stipulation Exhibit 15-0

Notice of Insurance Premium Prepayments —_..--.......-

ii INDEX

Stipulation Exhibit 16-P

California Modification of Uniform Classification of

Accounts for Section 404(d) Payments dinillnpesanidiitnse ss

Stipulation Exhibit 27-AA

Federal Home Loan Bank Board Instructions for Re-

pairing Section 404(d) Payments... =

Stipulation Exhibit 29-AC

FSLIC’s Section 404(d) Payments Accounts for Lincoln

Savings Loan Association a

Stipulation Exhibit 30-AD

Status of Insurance Premium Prepayment Account ___

Findings of fact and opinion of the Tax Court (Filed October

ih: MENU clinlenstdclidiiadeiiniliatcigtdannidktadpa tiie ied item oe

Decision of the Tax Court (Entered October 21, 1968) ____

Opinion of the United States Court of Appeals for the Ninth

Circuit (Filed February 83,1970). s—s—t

Judgment of the United States Court of Appeals for the

Ninth Circuit (Filed and entered February 8, 1970)

Order of the United States Court of Appeals for the Ninth

Circuit denying petition for rehearing (Filed March 18,

1970)

Order of thé Supreme Court of the United States granting

a Writ of Certiorari (Filed November 9, DOD smipenandien

TAX COURT OF THE UNITED STATES

Docket No. 325-67

LINCOLN SAVINGS AND LOAN ASSOCIATION, PETITIONER

COMMISSIONER OF INTERNAL REVENUE£, RESPONDENT

DOCKET ENTRIES

Date Filings and Proceedings

Jan. 16, 1967 PETITION FILED: FEE PAID Jan.

16, 1967; Served Jan. 17, 1967

Mar. 20, 1967 REQUEST by Resp. for trial at Los

Angeles, Calif. Action, Granted 3/21/

67; Served Mar, 23, 1967

Mar. 20, 1967 ANSWER filed by Resp. Served Mar.

23, 1967

Jan. 16, 1968 NOTICE of TRIAL April 8, 1968 at Los

Angeles, Calif. Served Jan. 16, 1968

Mar. 4, 1968 MOTION by petr. for leave to file

Amendment to Petition. Amendment

to Petition Lodged. Action, Granted

March 26, 1968; Served Mar. 27, 1968

March 6, 1968 NOTICE of filing of petr. motion for

leave to file amendment to petition

and hearing on March 27, 1968, if

objection filed by March 22, 1968.

Served March 6, 1968

March 26, 1968 Amendment to Petition filed; Served

Mar. 27, 1968

Date

Filings and Proceedings

April 8, 9, 10, 1968 TRIAL before Judge Raum—Los Apn-

April 24, 1968

April 29, 1968

May 27, 1968

May 29, 1968

June 24, 1968

June 26, 1968

geles, California

Stipulation of Facts w/attached exhibits

Respondent’s Amended Answer filed

and served

PARTIES shall file with the Court ex.

hibits #42, 44, 45 and 29AC.

BRIEFS due May 27, 1968

REPLY BRIEFS due June 26, 1968

SUBMITTED TO JUDGE RAUM UN-

DER SUBMISSION

TRANSCRIPT of Trial of Apr. 9 & 10,

1968, rec’d (2).

TRANSCRIPT of Trial of Apr. 8, 1968,

received.

BRIEF for Respondent filed; Served

May 29, 1968

BRIEF for Petitioner filed (20-P);

Served May 29, 1968

ENTRY OF APPEARANCE for petr.

by Victor L, Walch; Served June 7,

1968

JOINT MOTION to extend time from

June 26, 1968 to July 10, 1968 to file

Reply Briefs, Action, Granted 6/25/

68; Served Jun 26, 1968

MOTION by Cyrus A. Neuman for

leave to file Amicus Curiae Brief.

Action, Granted 6/26/68; Served Jun

27, 1968

Filings and Proceedings

July 10, 1968

July 11, 1968

Oct. 21, 1968

Jan. 13, 1969

Jan. 14, 1969

Jan. 24, 1969

AMICUS CURIAE BRIEF filed by

Cyrus A. Neuman. (Brief was served

on both petr. ard resp. by Cyrus A.

Neuman.)

REPLY BRIEF for Respondent filed.

Served July 11, 1968

REPLY BRIEF for Petitioner filed.

(Permission to file); Action (20-P.

copies); Served July 11, 1968

FINDINGS OF FACT AND OPINION

filed Judge Raum

Decision will be entered for the respond-

ent; Served Oct 21, 1968

DECISION enteref, Judge Raum.

Served Oct. 21, 1968

APPELLATE PROCEEDINGS

NOTICE of Appeal to USCA, Ninth

Cir., filed by petitioner. Served Jan.

14, 1969

NOTICE with copy of notice of appeal

sent to Lester R. Uretz, Chief Coun-

sel. Served Jan. 14, 1969

NOTICE, to parties, of assembling and

date for transmission of record.

Served Jan. 14, 1969

MOTION filed by Resp. to withdraw

Exs. 1-A, 2-B, & 3-C & substitute

copies. Action, Granted 1/27/69;

Served Jan. 27, 1969

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

Docket No. 23923

[Caption Omitted |

RELEVANT DOCKET ENTRIES

Date Filings and Proceedings

1969

Feb. 25 FILED FEB. 20, 1969, CERTIFIED TYPED

TRANSC. OF REC. (PLEADINGS, VOL I)

FILED ORIG. REPTR. TRANSC. IN THREE

VOLS (VOLS 2, 3, & 4 OF REC.)

FILED ORIG. EXHIBITS IN RM. 219 * * *

DOCKETED CAUSE & ENTERED APPEAR-

ANCES OF COUNSEL

a = *

Oct. 10 Argued and submitted to E[Ely]-Hu[Hufsted-

ler], CJJ & Thompson, DJ

+ * *

1970

Hufstedkr, CJ dis.

Feb. 2 ORDERED OPINION (THOMPSON) FILED

& JUDG. FILED & ENT.

eo a Filed opinion. Decision of Tax Ct. rev.

OF ne Filed & ent. judgment

Feb. 16 Recvd. appellee motion for ext of time in which

to file en banc petition for rehearing (panel)

Feb. 19 Filed order (E) extding time to 2/24 in which

appellee may file petition for rehearing

Filings and Proceedings

FILED 25 OF APPELLEES PETITION FOR

REHEARING EN BANC

Recvd. prae & entered appearance of counsel

for appellee-CIR

Filed order (E Hu & Thompson) denying

petition for rehearing rejecting suggestion for

rehearing en banc.

ISSUED JUDGMENT TO CLERK OF DIS-

TRICT COURT

TAX COURT OF THE UNITED STATES

{Caption Omitted}

PETITION

(Filed January 16, 1967)

The above-named petitioner hereby petitions for a re

determination of the deficiency set forth by the Commis.

sioner of Internal Revenue in his notice of defici

dated October 20, 1966 (Service symbols Form L-50,

Code 411:90D: PWK), and as the basis of its case alleges

as follows:

1. Petitioner is a corporation organized and existing

under the laws of the State of California with its prin-

cipal office at 630 West Sixth Street, Los Angeles, Cali-

fornia 90017. The return for the period involved here

was filed with the District Director of Internal Revenue

at Los Angeles, California.

2. The notice of deficiency (a copy of which is at-

tached and marked Exhibit A) was mailed to the peti-

tioner on October 20, 1966.

8. The deficiency as determined by the Commissioner

is in income tax for the calendar year 1963 in the sum

of $461,454.38, of which approximately $458,971.17 is in

dispute.

4. The determination of tax set forth in the notice of

deficiency is based upon the following errors:

(a) The Commissioner erred in disallowing a por-

tion of the federal insurance premium expense paid and

deducted on petitioner’s income tax return for the calen-

dar year 1968, namely, the sum of $882,636.86 out of a

total of $1,018,397.388 of federal insurance premium ex-

pense paid and claimed for the year 1963.

(b) The Commissioner erred in determining any

deficiency in petitioner’s income tax liability for the cal-

endar year 1963 in excess of the sum of $2,483.21.

5. The facts upon which petitioner relies as the basis

of this case are as follows:

(a) Petitioner is a stock corporation, organized and

existing under the laws of the State of California, en-

in the savings and loan business.

(b) Petitioner is a member of the Federal Home

Loan Bank system (referred to herein as “FHLB”).

Such membership is a necessity from a competitive busi-

ness standpoint in the sevings and loan business. As a

member of the FHLB system petitioner is required to

insure the savings accounts of its depositors with the

Federal Savings and Loan Insurance Corporation (re-

ferred to herein as “FSLIC”), in accordance with the

laws enacted by Congress.

(ec) The FSLIC was organized in 1934 to provide

stability to the savings and loan industry through insur-

ance of savings accounts. Prior to January 1, 1962 each

insured member was required to pay to the FSLIC an

annual premium of 1/12 of 1 percent of the total of its

savings accounts and creditor obligations, for insurance

by the FSLIC of its depositors’ savings accounts. Such

insurance premiums have created what is known as the

primary reserve on the books of the FSLIC, and have con-

sistently been deducted as ordinary and necessary busi-

ness expenses in carrying on the savings and loan busi-

ness. Petitioner paid such insurance premiums during

the year 1963 in the sum of $135,760.52, and the deduc-

tion thereof has been allowed by the Commissioner in the

notice of deficiency.

(d) On September 8, 1961, Congress enacted Pub-

lice Law 87-210, which, among other provisions, amended

Section 404 of the National Housing Act by adding sub-

sections “(d)”, “(e)”, “(f)”, and “(g)” to Section 404,

effective January 1, 1962. The Act as amended requires

each insured member to pay to the FSLIC annually an

additional insurance premium equal to 2 percent of the

net increase in all savings accounts of the insured mem-

ber during the preceding calendar year less the amount,

if any, of required additional investment in FHLB stock.

The additional insurance premium is credited on the

books of FSLIC to a so-called secondary reserve account.

Petitioner paid such additional insurance premium dur-

ing the taxable vear 1963 in the sum of $882,636.86 and

deducted such sum on its return for that year as an

ordinary and necessary business expense. The Commis-

sioner has disallowed such de*: ction, with the explana-

tion in the notice of deficiency that “you have failed to

establish that you are entitled to deductions in excess of

the amounts allowed.”

(e) The additional insurance premium thus disal-

lowed was an expense necessarily incurred by petitioner

as a condition to its continuing to engage in the savings

and loan business during the year 1963. It was an

ordinary expense of carrying on such business. Such ad-

ditional premium was therefore an allowable deduction as

an ordinary and necessary business expense under Section

162 of the Internal Revenue Code. The Commissioner’s

proposed disallowance thereof is erroneous and illegal.

(f) Petitioner is informed and believes, and there-

fore alleges, that the payment of the additional insurance

premium of the character involved here was required by

Congress in order to strengthen the FSLIC, because, due

to rapid growth of insured members, the ratio of the

FSLIC’s reserves to its potential liability had dropped

and it was deemed necessary that its reserves be built up

at a faster rate than was occurring under the Act prior

to its amendment in 1961. From petitioner’s standpoint

there was and is no practical difference between the prem-

ium payment under the original Act and the additional

insurance premium. Both were expenses incurred in

carrying on its business, and neither resulted in the ac-

quisition by petitioner of say asset having any ascertain-

able fair market value. Any possibility of the return to

petitioner of any portion of the additional insurance

premium was and is so remote, indefinite, and contingent

as to be negligible.

(g) The deduction of the additional insurance

premium should accordingly be allowed as claimed on pe-

titioner’s return for the taxable year 1968.

—

WHEREFORE, petitioner prays that this Court may

try the case, determine that the Commissioner erred as

alleged above, and grant such other and further relief as

may be proper in the premises.

/s/ A Calder Mackay

A. CALDER MACKAY

/s/ Adam Y. Bennion

ADAM Y. BENNION

/s/ Richard N. Mackay

RICHARD N. MACKAY

523 West Sixth Street, Suite 828

Los Angeles, California 90014.

COUNSEL FOR PETITIONER

[Jurat Omitted]

——

TAX COURT OF THE UNITED STATES

[Caption Omitted]

ANSWER

(Filed March 20, 1967)

THE RESPONDENT, in answer to the petition filed

in the above-entitled case, admits, denied and alleges as

follows:

1 and 2. Admits the allegations of paragraphs 1 and

2 of the petition.

8. Admits that the deficiency as determined by the

Commissioner is in income tax for the calendar year

1963 in the sum of $461,454.38 but denies the remaining

allegations of paragraph 3 of the petition. Alleges that

the entire deficiency is in dispute.

4. Denies the allegations of paragraph 4 of the peti-

tion and all subparagraphs thereunder.

5 (a). Admits the allegations of subparagraph (a) of

paragraph 5 of the petition.

(b). Admits that petitioner is a member of the Fed-

eral Home Loan Bank system (referred to herein as

“FHLB”) and that as a member of the FHLB system

petitioner is required to insure the savings accounts of its

depositors with the Federal Savings and Loan Insurance

Corporation (referred to herein as “FSLIC’”), in accord-

ance with the laws enacted by Congress. Denies the re-

maining allegations of subparagraph (b) of paragraph

5 of the petition.

(c). Admits the alle «ns of subparagraph (c) of

paragraph 5 of the petition.

(d). Admits the allegations of subparagraph (d) of

paragraph 5 of the petition except denies that the pay-

ments referred to as “additional insurance premiums”

constituted insurance premiums during the taxable year

1963.

(e)-(g), inclusive. Denies the allegations of sub-

paragraphs (e)-(g), inclusive, of paragraph 5 of the

petition.

6. Denies generally each and every allegation of the

petition not hereinbefore specifically admitted, qualified

or denied.

WHEREFORE, it is prayed that the deficiency deter-

mined by the respondent be in all respects approved.

/s/ Lester R. Uretz/DPC

LESTER R. URETZ

Chief Counsel

Internal Revenue Service

OF COUNSEL:

MELVIN L. SERRS

Regional Counsel

JAMES A. THOMAS

Attorney

Internal Revenue Service

JAT/emb (C)

TAX COURT OF THE UNITED STATES

{Caption Omitted]

AMENDED ANSWER

(Filed March 9, 1968)

THE RESPONDENT, in answer to the petition and

Amendment to Petition filed in the above-entitled case,

admits, denies and alleges as follows:

1 and 2. Admits the allegations of paragraphs 1 and 2

of the petition.

8. Admits that the deficiency as determined by the

Commissioner is in income tax for the calendar year

1963 in the sum of $461,454.38 but denies the remaining

allegations of paragraph 3 of the petition. Alleges that the

entitre deficiency is in dispute.

4. Denies the allegations of paragraph 4 of the petition

and subparagraphs (b) and (c) thereunder; * * *

* * * @

5 (a). Admits the allegations of subparagraph (a) of

paragraph 5 of the petition.

5 (b). Admits that petitioner is a member of the Fed-

eral Home Loan Bank system. Denies the remaining al-

legations of subparagraph (b) of paragraph 5 of the

petition.

(c). Admits the allegations of subparagraph (c) of

paragraph 5 of the petition.

(d). Admits the allegations of subparagraph (d) of

paragraph 5 of the petition except denies that the pay-

ments referred to as “additional insurance premiums”

constituted insurance premiums during the taxable year

1963.

(e)-(g), inclusive. Denies the allegations of sub-

paragraphs (e)-(g), inclusive, of paragraph 5 of the peti-

tion.

6. Denies generally each and every allegation of the

petition and amendment to petition not hereinbefore spe-

cifically admitted, qualified or denied.

WHEREFORE, it is prayed that the deficiency deter-

mined by the respondent be in all respects approved.

/s/ Lester R. Uretz

LESTER R. URETZ

Chief Counsel

Internal Revenue Service

OF COUNSEL:

AARON S. RESNIK

Acting Regional Counsel

JAMES A. THOMAS

Attorney

Internal Revenue Service

TAX COURT OF THE UNITED STATES

{Caption Omitted]

STIPULATION OF FACTS

(Filed April 9, 1968)

It is hereby stipulated that, for the purpose of this

case, unless otherwise provided, the following statements

may be accepted as facts and the exhibits attached as

true copies of the original documents; provided, however,

that either party may object to the admission of such

facts or exhibits or both on the grounds of materiality

and relevancy; and that either party may introduce other

and further evidence not inconsistent with the facts

herein stipulated:

1. Lincoln Savings and Loan Association (herein-

after—“petitioner” or “Lincoln Savings”) is a corpora-

tion organized and existing under the laws of the State

of California, having been incorporated on February 6,

1925. Its name, originally Lincoln Building & Loan As-

sociation, was changed on August 5, 1943 to Lincoln Say-

ings and Loan Association. At the date of the filing of the

petition in the instant case, petitioner’s principal office

was located at 630 West Sixth Street, Los Angeles, Cali-

fornia. Petitioner filed its tax returns for the calendar

years 1962, 1963 and 1964 with the District Director of

Internal Revenue at Los Angeles, California, copies of

which are attached hereto and marked Exhibits 1-A, 2-B

and 3-C, respectively.

2. All of petitioner’s outstanding stock (consisting of

2,500 shares with a par value of $100.00 per share) has

been owned since 1964 by First Lincoln Financial Cor-

poration, which is a corporation organized under the laws

of the State of California with its principal office in Los

Angeles, California. During 1962 and 1963, First Lincoln

Financial Corporation owned 98.88% of petitioner’s out-

standing stock. On December 31, 1963, First Lincoln

Financial Corporation had 1,402,654 shares of stock out-

standing, without par value, owned by approximately

2,800 shareholders. The stock of First Lincoln Financial

Corporation is traded over-the-counter.

8. On February 6, 1925, petitioner was licensed as a

savings and loan association by the Savings and Loan

Commissioner of the State of California, and since that

date at all times petitioner has been and remains a licensed

savings and loan association under the laws of the State

of California, transacting business in the Los Angeles

area. California licensed savings and loan associations

are regulated by Division II of the California Financial

Code (West’s Annotated California Codes, Financial Code,

Section 5,000, et seq.), and by regulations of the Califor-

nia Savings and Loan Commissioner, being Chapter 2 of

Chapter 10 of the California Administrative Codes, which

law and regulations are incorporated herein by reference.

Attached hereto and marked Exhibit 4-D is a copy of a

letter dated December 4, 1962, by the California Savings

and Loan Commissioner issued to all California licensed

savings and loan associations with an attached order

revising Subchapter 1 of Chapter 2 (the “Uniform Classi-

fication of Accounts”) of his regulations, effective Jan-

uary 1, 1963.

4. Upon application by it, petitioner on March 4, 1936,

became a member of the Federal Home Loan Bank of

Los Angeles (hereinafter—“FHLB”), and since that date

at all times petitioner has been and remains a member

of such bank. (Now the Federal Home Loan Bank of

San Franciso). Attached hereto and marked Exhibit 5-E

is a copy of petitioner’s certificate of membership dated

March 4, 1936.

5. Upon application by it, petitioner on June 6, 1938,

became an insured institution of the Federal Savings and

Loan Insurance Corporation (hereinafter—“FSLIC”) as

provided in Title IV of the National Housing Act, as

amended. Attached hereto and marked Exhibit 6-F is a

copy of the petitioner’s certificate of insurance.

6. Attached hereto and marked Exhibits 7-G and 8-H,

respectively, are copies of the petitioner’s Articles of In-

corporation and By-Laws.

7. Attached hereto and marked Exhibit 9-I is a copy

of the annual license under which petitioner was licensed

nag

and authorized to transact the business of a savings and

loan association in the State of California during the

calendar year 1963. Similar annual licenses have au-

thorized petitioner to transact such business during years

prior and subsequent to 1963.

8. The FSLIC is a corporation created by the laws of

the United States under the National Housing Act of

1934, (12 U.S.C.A. § 1724, et seq.). The FSLIC operates

under the direction of the Federal Home Loan Bank

Board (hereinafter—“FHLB Board’).

9. By statute, the FSLIC had an original capital stock

of $100,000,000, all of which was subscribed for originally

by the Home Owners Loan Corporation. This stock was

eventually transferred to the Secretary of the Treasury of

the United States. By amendments in 1950 to the National

Housing Act, the FSLIC was authorized and directed to

pay off and retire annually at par an amount of its capital

stock equal to 50% of its net income for the fiscal year.

On July 1, 1958, the FSLIC completed retirement of its

outstanding capital stock.

10. Prior to January 1, 1962, each insured institution

was required by Section 1727(a) of Title 12 of the United

States Code (12 U.S.C.A. § 1727(a)) to pay to the FSLIC

an annual premium of 1/12 of 1% of the total amount of

all savings accounts and creditors’ obligations, for insur-

ance by the FSLIC of its depositors’ savings accounts.

Such annual payments have consistently been deducted

as ordinary and necessary business expenses in carrying

on the savings and loan business.

11. On Sepember 8, 1961, Congress enacted Public

Law 87-210 which, among other provisions, amended Sec-

tion 404 of the National Housing Act. A copy of Public

Law 87-210 is attached hereto and marked Exhibit 10-J.

Hereinafter, payments made by the petitioner pursuant to

Section 1727(b) (1) of Title 12, United States Code (12

U.S.C.A. § 1727(b) (1) ) as amended will be referred to as

“Section 1727(b) payments,’ and payments made by the

petitioner pursuant to Section 1727(d) of Title 12 (12

U.S.C.A. § 1727(d)) will be referred to as “Section 1727

(d) payments.”

12. Attached hereto and marked Exhibits 11-K and

12-L, respectively, are copies of Senate Report No. 778

and House Report No. 823, both of the 87th Congress, 1st

Session, which reports accompanied the legislation re-

sulting in Public Law 87-210. Attached hereto and marked

Exhibit 13-M are copies of 5 schedules (identified as Ex-

hibit A, Exhibit B, Exhibit C, Schedule 1 and Schedule 2)

which were prepared in the Office of the Comptroller of

the FSLIC and submitted to the Senate Committee of

Banking and Currency subsequent to the printing of

Senate Report No. 778. These exhibits and schedules use

the same “assumptions” used in Exhibits A through E of

Senate Report No. 778.

13. During the calendar years 1962 through 1967, the

petitioner made payments to the FSLIC as follows:

Year § 1727(b) Payments § 1727(d) Payments

1962 $ 93,258.58 $ 126,759.48

1963 135,760.52 882,636.86

1964 196,412.86 450,829.68

1965 271,477.00 1,095,089.00

1966 317,427.60 1,226,064.76

1967 373,025.38 None

14. On its Federal income tax returns for the above

years, petitioner deducted all sums paid by it to the

FSLIC as listed above under both Section 1727(b) and

Section 1727(d) under “other deductions” as “Federal

insurance premiums.” Interest credited by the FSLIC to

petitioner’s pro rata share of the secondary reserve pur-

suant to Section 1727(e) (hereinafter—‘Section 1727

(e) interest”) was not reported on petitioner’s returns.

Upon examination of its returns for the taxable years

1962, 1963 and 1964, the Commissioner allowed the de-

duction for the amounts paid under Section 1727(b), but

disallowed the deduction for the amounts paid under

Section 1727(d).

15. Attached hereto and marked Exhibit 14-N are

copies of “Insurance Premium Notices” received by peti-

tioner from the FSLIC for the payment due under Sec-

tion 1727(b) for the calendar years 1962 through 1967.

Attached hereto and marked Exhibit 15-0 are copies of

“Notice of insurance premium prepayment” received by

petitioner from the FSLIC for the payments due under

a 1727(d) for the calendar years 1962 through

1967.

16. Attached hereto and marked Exhibit 16-P is a copy

of a memorandum dated May 21, 1962, which was issued

by the State of California, Division of Savings & Loan, to

all California licensed savings and loan associations. This

ruling was modified and incorporated into the “Uniform

Classification of Accounts” effective January 1, 19638, as

set forth in Exhibit 4-D at page 54 under the heading

“Contributions to the Secondary Reserve-FSLIC.” All sub-

sequent “Uniform Classification of Accounts” published

by the California Savings and Loan Commissioner have

required identical treatment of the “Contributions to the

Secondary Reserve-FSLIC” as set forth at page 54 of

Exhibit 4-D.

17. Attached hereto and marked Exhibits 17-Q, 18-R,

19-S, 20-T and 21-U, respectively, are copies of the peti-

tioner’s “Financial Statements” and “Accountant’s Re-

port” for each of the calendar years 1962 through 1966.

On petitioner’s balance sheet for the year 1962, the pay-

ments made pursuant to Section 1727(d) and the Section

1727(e) interest credited to petitioner’s account by the

FSLIC were included in “Other Assets.” Beginning with

1963, the Section 1727(d) payments and the Section 1727

(e) interest have been shown on the asset side of the

balance sheet as “Prepaid Federal Savings and Loan In-

surance Corporation Premiums.” The Section 1727 (d)

payments were not included as expense on any of the

“Statement of Operations” for the period 1962 through

1966. The interest credited to petitioner’s account pur-

suant to Section 1727(e) by the FSLIC for each of the

years 1962 through 1966 was included in miscellaneous

income on each of the “Statement of Operations” for the

year in which the interest was credited to petitioner’s

account by the FSLIC.

18. Attached hereto and marked Exhibits V, W, X, Y

and Z, respectively, are “Consolidated Financial State-

ments” for each of the years 1962 through 1966 for First

Lincoln Financial Corporation and subsidiaries. With re-

spect to the petitioner, the same financial figures set forth

on Exhibits 17-Q through 21-U were used in these consoli-

dated financial statements. For the calendar years 1962

through 1964, the Section 1727(d) payments by peti-

tioner together with its Section 1727(e) interest were

included on the asset side of the consolidated balance

sheets in “Other Assets.” For the calendar years 1965

and 1966, the Section 1727(d) payments and Section

1727(e) interest of petitioner is shown as “Prepaid Fed-

eral Savings and Loan Insurance Corporation premiums.”

19. The regulations of the FHLB Board require each

savings and loan association, which is a member of the

Federal Home Loan Bank system, to file, on forms pro-

vided by the Board, a semiannual report of its affairs as

of the end of each semiannual period. Printed instruc-

tions for the preparation of such reports are published

and distributed to each member. The “Introduction” to

these instructions provide “These instructions are pro-

vided to assist in the completion of monthly and semian-

nual reports by members of the Federal Home Loan Bank

system. Each reporting institution is urged to carefully

follow these instructions . . .” The instructions further

provide that the reports may be submitted on either a

cash or accrual basis, in conformity with the accounting

method used by the institution in keeping its books. At-

tached hereto and marked Exhibit 27-AA is a copy of

the FHLB Board instructions for reporting “Other As-

sets,” as in effect during the years 1962 through 1966.

Attached hereto and marked Exhibit 28-AB is a copy of

the report filed by petitioner with the FHLB Board for

the close of business December 31, 19638. In all of its

reports to the FHLB Board since 1962, the petitioner has

reported its pro rata share of the “Secondary Reserve”

in the same manner as set forth on Exhibit 28-AB.

20. Payments made by insured institutions pursuant

to Section 1727(d) have been credited on the books and

records of the FSLIC directly to an account entitled “Sec-

ondary Reserve.” Effective with the first payments pur-

suant to Section 1727(d) made by insured institutions,

the FSLIC has maintained separate accounts for each

insured institution showing, among other things, the

amount of payment pursuant to Section 1727(d), the in-

—

terest credited by the FSLIC to the account pursuant to

Section 1727(e), and the insured institution’s pro rata

share of the secondary reserve. Attached hereto and

marked Exhibit 29-AC is a copy of the account main-

tained by the FSLIC for the petition. Attached hereto

and marked Exhibit 30-AD are copies of “Status of In-

surance Premium Prepayment Account” as of December

31, 1963; December 31, 1965; December 31, 1966; and

December 31, 1967; received by petitioner on the FSLIC.

Petitioner believes that a similar document was received

from the FSLIC as of December 31, 1962 and December

31, 1964, but cannot locate such in its files and records at

the present time.

21. Attached hereto and marked Exhibits 31-AE, 32-

AF, 33-AG, 34-AH and 35-AlI, respectively, are copies

of the financial statements distributed by the FSLIC for

the fiscal year ended June, 1963, and calendar years 1964-

1967.

22. Attached hereto and marked Exhibit 36-AJ is a

copy of the “Rules and Regulations for Insurance of Ac-

counts’ issued by the FSLIC, which were in effect in

1963.

23. Attached hereto and marked Exh’bits 37 through

41, respectively, are copies of the annual reports of the

Federal Home Loan Bank Board for the calendar years

1962 through 1966, which were submitted to the Con-

gress of the United States pursuant to Section 1727(b)

of the Federal Home Loan Bank Act.

24. Members of the Federal Home Loan Bank system

are not required to insure the savings accounts of its de

positors with the FSLIC.

25. The petitioner concedes the correctness of all of

the adjustments made by respondent for the taxable year

ended December 31, 1963 (page 5 of the statutory notice),

with the exception of the adjustment (b) entitled “Fed-

eral Insurance Premuium Expense.”

26. Attached hereto and marked Exhibit 42 is a copy

of a report to the Congress of the United States by the

Comptroller General of the United States dated October

1964 regarding the audit of the FSLIC for the year

ended June 30, 1963. Attached hereto and marked Ex-

hibit 43 is a copy of a report to the Congress of the

United States by the Comptroller General of the United

States dated May 1967 regarding the audit of the FSLIC

for the period July 1, 1963 through December 31, 1965.

Respondent stipulates only to the authenticity of Exhibits

42 and 48, and reserve all other objections to the admis-

sion of these exhibits as evidenced in this case.

27. Attached hereto and marked Exhibit 44 in a copy

of the statement of John E. Horn, Chairman, Federal

Home Loan Bank Board, before the Subcommittee on

Financial Institutions of the Committee of Banking and

Currency, United States Senate, regarding S. 3158, 89th

Cong., April 4, 1966, together with a transmittal letter

by John E. Horn dated April 12, 1966, transmitting a

copy of such testimony to each insured savings and loan

association. Respondent stipulates only to the authenticity

of Exhibit 44, and reserves all other objections to the ad-

mission of this exhibit as evidence in this case.

28. Attached hereto and marked Exhibits 45, 46 and

47, respectively, are copies of the annual reports of the

California Savings and Loan Commissioner for the cal-

endar years 1959, 1963 and 1966.

29. Attached hereto and marked Exhibit 48 is a copy

of a report to the Congress of the United States by the

Comptroller General of the United States dated Decem-

ber 1961 regarding the audit of the FSLIC for the fiscal

year ended June 30, 1961. Attached hereto and marked

Exhibit 49 is a copy of a report to the Congress of the

United States by the Comptroller General of the United

States dated January 1963 regarding the audit of the

FSLIC for the fiscal year ended June 30, 1962. Respond-

ent stipulates only to the authenticity of Exhibits 48 and

49, and reserves all other objections to the admission of

these exhibits as evidence in this case.

/s/ Adam G. Bennion

Counsel for Petitioner

/s/ Lester R. Uretz

LESTER R. URETZ

Chief Counsel

Internal Revenue Service

STIPULATION EXHIBIT 4-D

Letter and Revision of Uniform

Classification of Accounts

540 Van Hess Avenue

San Francisco 2

PRESTON N. SILBAUGH 8460 Wilshire Blvd.

COMMISSIONER Los Angeles 5

EDMUND G. BROWN

GOVERNOR

STATE OF CALIFORNIA

DIVISION OF SAVINGS AND LOAN

Los Angles

December 4, 1962

TO: All State-Licensed Savings and Loan Associations

RE: Uniform Classification of Accounts

Attached is a copy of the Savings and Loan Commis-

sioner’s order in the above matter. It was filed with the

Secretary of State on November 29, 1962, and will become

effective on January 1, 1963.

The principal revisions made since the preceding Uniform

Classification of Accounts was filed on May 2, 1956, are

as follows:

Uniform Classification of Accounts

7. The following additional accounts have been pro-

vided :

Additions

Account Number

197 Contributions to Secondary

Reserve—F.S.L.1.C.

* . a *

—

Uniform Classification of Accounts

Questions of interpretation may be submitted to the office

of the Savings and Loan Commissioner, 3460 Wilshire

Boulevard, Los Angeles 5, or 540 Van Ness Avenue, San

Francisco 2.

We wish to thank those who offered suggestions to our

staff during the long course of revision. We especially

acknowledge the contributions of the California Savings

and Loan League, the Society of Savings and Loan Con-

trollers, the Committee for Savings and Loan of the Cali-

fornia State Society of Certified Public Accounts and the

many individual accounts, whose thoughtful comments did

much to enrich the product.

/s/ Preston N. Slibaugh

PRESTON N. SILBAUGH

Savings and Loan Commissioner

Enclosure

STATE OF CALIFORNA

DEPARTMENT OF INVESTMENT

DIVISION OF SAVINGS AND LOAN

ORDER ADOPTING, AMENDING, OR REPEALING

REGULATIONS OF THE SAVINGS AND LOAN

COMMISSIONER

After proceedings had in accordance with the provi-

sions of the Administrative Procedure Act (Gov. Code,

Title 2, Div. 3, Part 1, Chapter 4) and pursuant to the

authority vested by Section 5255 of the Financial Code,

and to implement, interpret, or make specific Section

8701 of the Financial Code, the Savings and Loan Com-

missioner hereby repeals, amends, revises and adopts his

regulations in Title 10, California Administrative Code,

as follows:

Adopts new Subcapter 1 of Chapter 2 to read:

a a ae J

CLASSIFICATION OF ACCOUNTS

ASSET ACCOUNTS

Account No. Account Name FHLBB

Annual Report

Exhibit “A”

Line No.

* _ e e

OTHER ASSETS

* a + eo

194 Prepaid Expenses and Deferred

Charges

194-1 Assessments (State License,

League Dues, etc.)

194-2 Surety Bond Premiums

)

194-3 Federal Savings and Loan )

Insurance Corporation )

Premiums )

)

194-4 Other Insurance Premiums )

) 14

194-5 Taxes )

)

194-6 Acquisition Cost of Loans )

)

194-7 Other Prepaid Expenses )

and Deferred Charges )

* * * *

197 Contribution to Secondary

Reserve—F.S.L.I.C 15

* * *

EXPLANATORY TEXT OF BALANCE SHEET AND

PROFIT AND LOSS ACCOUNTS

e * a *

194 Preferred Expenses and Deferred Charges

This account, if carried, shall reflect that portion of

expenses paid or accrved applicable to future periods

and shall indicate the proper segregation thereof in

the ledger according to the subaccounts set forth in

the Uniform Classification of Accounts under Account

No 194.

* * * *

197 Contributions to the Secondary Reserve—

FSLIC

This account shall be debited for the annual prepay-

ment to the FSLIC Secondary Reserve. Interest earned

on the prepayments is recorded by a debit to this

account and a credit to Account No. 407. Transfer

to the Primary Reserve is recorded by crediting this

account and debiting Account No. 511.

Both the interest and transfer entries are made at the

time of notification by the insurer.

STIPULATION EXHIBIT 14-N

INSURANCE PREMIUM NOTICES

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STIPULATION EXHIBIT 15-0

REMIUM PREPAYMENTS

NOTICE OF INSURANC

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STIPULATION EXHIBIT 16-P

CALIFORNIA MODIFICATION OF UNIFORM CLASSIFICATION

OF ACCOUNTS FOR SECTION 404(d) PAYMENTS

STATE OF CALIFORNA

DIVISION OF SAVINGS AND LOAN

DATE: May 21, 1962

TO: All State Licensed Savings and Loan Associations

RE: Procedure for Accounting for Prepayment of Fed-

eral Insurance Premiums Into the Secondary Reserve

In order that each association’s books and records shall

uniformly reflect the payment into the Federal Savings

and Loan Insurance Corporation’s Secondary Reserve,

the following accounting procedures are to be followed:

Explanation and Account Title Debit Credit

1, Payment of annual prepayment to FSLIC

Acct. No. 198—Sundry Debit Items—

prepayment to FSLIC Secondary Reserve Xxx

Acct. No. 102—Cash in Bank XXXX

2. Recording return credited to Secondary

Reserve

Acct. No. 198—Sundry Debit Items—

prepayment to FSLIC Secondary Reserve XXX

Acct. No. 408—Other Interest

Income—Income on FSLIC Secondary

Reserve xXxxx

8. Association notified by FSLIC that a

portion of the Secondary Reserve is

being transferred to the Primary Reserve

Acct, No. 511—FSLIC Insurance Premium

Expense or Prepaid Expense xxx

Acct. No. 198—Sundry Debit Items—

prepayment to FSLIC Secondary Reserve XXXX

—

Associations are requested to submit all questions of

doubtful interpretation to the San Francisco or Los

Angles offices of the Commissioner.

An excellent digest and summary of the revised require-

ments relative to Federal Home Loan Bank stock owner-

ship, Federal Savings and Loan Insurance Corporation

insurance premium, and the Federal Savings and Loan

Insurance Corporation Secondary Reserve payment is

given in the United States Savings and Loan League’s

Special Management Bulletin S#91.

/s/ Kenneth E. Scott

KENNETH E. SCOTT

Chief Deputy

Savings and Loan Commissioner

STIPULATION EXHIBIT 27-AA

FEDERAL HOME LOAN BANK BOARD INSTRUCTIONS FOR

REPAIRING SECTION 404(d) PAYMENTS

* * * *

Schedule D, Other Assets

Assets of the type specified in this schedule and assets

that cannot otherwise properly be reported under the as-

set categories set forth in Items 1 through 10 of Exhibit

I will be reported in Schedule D.

Member institutions insured by the Federal Savings and

and Loan Insurance Corporation will report on line 1 that

portion of the insurance premium paid to the Corporation

which is being carried on the books as a prepaid item to

be charged to operating expense in the next fiscal period.

An institution insured by the Federal Savings and Loan

Insurance Corporation will report on line 2 the amount

of its pro rata share in the Secondary Reserve estab-

lished by the Corporation from the premium prepayments.

Such-pro rata share includes earnings credited on the

premium prepayments by the Corporation. The statement

furnished by the Corporation each December shows the

total amount of the insured institution’s premium prepay-

ments and the earnings credited thereon by the Cor-

poration.

If the books of the reporting institution are kept on an

accrual basis, report on line 3 the amount of prepaid ex-

penses chargeable against operations of future periods.

Accrued interest on securities and other investments,

where accrued and recorded on the books, will be reported

on line 4. Accrued interest on mortgage loans and other

loans will not be included here, but will be reported in

Schedules A and B.

Line 5 will show, against concise but clear captions, the

amount of each other asset or group of assets which can-

not be reported properly against Items 1 to 10, inclusive,

or Exhibit I or under any of the preceding captions of

this schedule.

A newly insured mutual instiution may experience an op-

erating defiicit until such time as earnings permit it to

be self supporting. If the Corporation has required the

organizers and/or directors to pledge savings accounts to

protect the institution against such operating deficits, any

such deficit should be transferred to an account captioned

“Accounts Receivable Secured by Pledged Shares”. Any

balance in such an account should be shown as a part of

“Other Assets” on Exhibit I and detailed on Schedule D,

The totai of other assets shown on line 6 of this schedule

is to be reported at line 11 of Exhibit I.

STIPULATION EXHIBIT 29-AC

FSLIC’S SECTION 404(d) PAYMENTS ACCOUNTS

FOR LINCOLN SAVINGS LOAN ASSOCIATION

FEDERAL SAVINGS AND LOAN TNSURANCE CORPORATION

INSURANCE PREMIUM PREPAYMENT ACCOUNT ues

WCOLN SAVINGS & LOAN ASSOCIATION | REFERENCE CODES | S7EX

30 WEST SIXTH STREET 1. BILLIE IG 4. TRANSFER OF BALANC

8 ANGELES CALIFORNIA oa Soa

ACCOUNTS RECEIVABLE

REFERENCE ALL ACCOUNTS OF INSURED MEMBERS

DATE : -" YEAR smeieee INCRTASE OVER GROSS PREPAYMENT FHLB STOCK CR. NET AMOUNT OUE

p/31/63 . poe 1962} 134,873,645] OPENING BALANCES NEW SYS\TEM |

W764 /1! UVP=3| 1963] 196,620,129 | 61,746,484 [1, 234,929.68 | 784,100.00 | 450,829.68

5/28/64 |2' PP-94

12/31/64] 9 JVP= 7 ! .

& np/01/65 |1' UVP=5| 1964] 268,109,579 | 71,489,450 1, 429,789.00 | 334,700.00 1,095,089.00

wv 5/01/65 |2' PP133

ds 1/31/65 | 3! UVP=6 ies vee =

\/01/66|1' JVP=7| 1965) 329,412,817 | 61,303,238 [1,226,064.76 .00 1,226,064.76

5/31/66 |2! PP168

hi. 12/31/66 | 3! UVP=8 ?

fy 6/01/67 |1! UVP=9} 1966) 327,468,679 | 1,944,138- .00 .00 .00

irs 1/01/07 | 21 PP---|

a 1/31/67 | 3! UVP 10

hd 2/31/67 | 4! 368,568,921

see

FROM| ACCOUNT NO 4082 DUE TO MERGER

OVERSIZE PAGE SEE NEXT FRAME

STIPULATION EXHIBIT 29-AC 35

FSLIC’S SECTION 404(d) PAYMENTS ACCOUNTS

FOR LINCOLN SAVINGS LOAN ASSOCIATION

FEDERAL SAVINGS AND LOAN INSURANCE CORPORATION

DKT NO. 32S-b1

INSURANCE PREMIUM PREPAYMENT ACCOUNT 3:

REFERENCE CODES . | S7EXH. ADT-Ac Abcount no. 2066

1. BILLIE IG 4, TRANSFER OF BALANCE MOT DAY YEAR

2. PREPAYMENT 5. CREDIT OF REGULAR PREMIUM b C

3. RETURN 6. OTHER (SEE REMARKS) DATE saees _ S06ee-

ACCOUNTS RECEIVABLE PRO RATA SKARE OF SECONDARY RESERVE

ED MEMBERS

INCREASE OVER GROSS PREPAYMENT FHLB STOCK CR. NET AMOUNT OUE OR. CR. BALANCE

PRIOR YEAR

OPENING BALANCES NEW SYSTEM | 1,011,738.44

‘ , ' e 0 8 ° 8

61,746,484 (1,234,929.68 | 784,160.00] 450,829.68 SUE USSSE | Sewrnseees ee

450,829.68 | 1,485,519.54

. . uh,864.25| 1,530, 383.79

71,489,450 1,429,789.00 | 334,700.00 1,095,089.00

1,095,089.00 | 2,625,472.79

ne ee 77,231.97 | 2,702,704.76

61,303,238 11,226,064.76 .00 1L,226,064.76

1,226,064.76 | 3,928,769.52

132,295.86 | 4,060,065.38

1,944,138- 00 -00 -00

.00 | 4,060,065.38

171,832.97 | &,231,898.35

690,217.11 4,922,115.46

B2 DUE TO ms

ACCOUNT

INSURANCE PREMIUM PREPAYMENT

LINCOLN SAVINGS AND LCAN ASSOCIATION |

630 WEST SIXTH STREET

LOS ANGELES 17, CALIFORNIA

_ | a

ACCOUNTS RECEIVABLE

aT oR ALL ACCOUNT SOF INSURED MEMBERS | Gross Fi

eens December 31 December 3) INCREASE tier a STO¢

‘066 JUNE 1 6211961 90,741,802 |1960 | 84,403,828 | 6,337,974] 126,759.48

12,066 | JUNE 1 63}1962 | 134,873,645 | 1961 90,741,802 | 44,131,843] 882,636.86 |

PAYMENT RECORD

_- Dave st a. s.F 2:8. 8 om

: ‘ Perioo Ave .YEARLy BAL. RATE

}2,066|/MAY 31 62] PP-16 . 12

}2 066 DEC 31 62] JVP 1 6-1 TO 12-31-62 74,319 | .03151433 .

MAY 31 631 PP-Sh eo

OVERSIZE PAGE SEE NEXT FRAME

FOR REMAINDER OF PAGE

INSURANCE PREMIUM PREPAYMENT

DATE InsurRED _6-6-38 _

Account (certiFicaTe) No. <¥oo

ATION

ACCOUNTS RECEIVABLE

OUNTS OF UN SURED MEMBERS Gross FHL Bans Net Amount Due

31 Decemser 3) sia PRET AYMENT Stock CrReoit (cr)

41,802 |1960 84,403,828 | 6,337,974] 126,759.48 .00! 126,759.48

373,645 | 1961 90,741,802 44,131,843 882,636.86 .cO 882 ,636.86

PAYMENT RECORD

ee te ee ee ee

; Dr. Cr. BALANCE

PERIOD Ave .YEARLY BAL. RATE

126,759.48 126,759.48

1 TO 12-31-62 74,319 | .03151433 2,342.10 129,101.58

&82,636.85| 1,011,738 bh!

STIPULATION EXHIBIT 30-AD

STATUS OF INSURANCE PREMIUM PREPAYMENT

ACCOUNT

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ENDED NOVEMBER 10, 1906

TAX COURT OF THE UNITED STATES

51 T.C. No. 10

[Caption Omitted]

FINDINGS OF FACT AND OPINION

(Filed October 21, 1968)

Petitioner, a California savings and loan association,

insures the accounts of its depositors with the Federal

Savings and Loan Insurance Corporation (FSLIC). It

pays regular annual premiums for such insurance cover-

age, which are deductible. Such premiums are part of

FSLIC’s gross income, available to meet all current ex-

penses and losses, and to the extent not so used are trans-

ferred to FSLIC’s “Primary Reserve” to meet losses of

future years. Since 1962, petitioner has also been required

to make additional annual payments “in the nature of

* * * prepayment[s] with respect to future premiums.”

Such “prepayments” immediately become part of the

FSLIC’s “Secondary Reserve,” which is available to a

limited extent to meet future losses in the event of de-

pletion of all other resources of the FSLIC. Although

petitioner has no interest in the Primary Reserve, it has

a pro rata interest in the Secondary Reserve. That in-

terest is reflected in an account which is rendered to it

annually by the FSLIC showing the amount of the “pre-

payments” made by petitioner together with an annual

“return” computed upon the balance in the account at the

end of each year. The balance in such account is to be

used to discharge petitioner’s obligation to pay its regu-

lar insurance premiums in future years after the total

of FSLIC’s Primary Reserve and Secondary Reserve

reaches a certain level, but petitioner may transfer its

account (its pro rata interest in the Secondary Reserve)

to another insured institution in the event of merger,

consolidation or bulk sale, and may recover any unused |

balance in its account in cash if it terminates insurance :

with the FSLIC or liquidates. Petitioner’s pro rata share |

of the Secondary Reserve appears on its financial state- ©

ments and the consolidated statements of its parent as

an asset, and both State and Federal regulatory agencies

require that the “prepayments” be capitalized and not

expensed until used to pay premiums or cover losses. Held

the “prepayments” are also capital expenditures for Fed-

eral income tax purposes, deductible only in the years

and to the extent used to discharge petitioner’s obligation

to pay regular insurance premiums or to meet actual losses

of the FSLIC.

Adam Y. Bennion, A. Calder Mackay and Richard N.

Mackay, for the petitioner.

James A. Thomas, for the respondent.

The Commissioner determined a deficiency in petition-

er’s income tax of $461,454.38 for the year 1963. Peti-

tioner disputes so much of that deficiency as is based

upon the Commissioner’s disallowance of a deduction in

the amount of $882,636.86, which petitioner claimed as a

“Federal Insurance Premium” expense in that year. Peti-

tioner paid this amount to the Federal Savings and Loan

Insurance Corporation in 19638, as well as its regular

annual insurance premium for that year, as it was re-

quired to do by 12 U.S.C. sec.1727(d), which section

characterized the payment as an “additional premium

in the nature of a prepayment with respect to future pre-

miums.” The issue for decision is whether such payment

was an ordinary and necessary expense of petitioner’s

business in 1963, or whether it was a capital expenditure

deductible, if at all, only when actually used to discharge

petitioner’s obligation to pay regular annual insurance

premiums or to meet insurance losses of the Federal

Savings and Loan Insurance Corporation.

FINDINGS OF FACT

Some of the facts have been stipulated and, as stipu-

lated, are incorporated herein by this reference together

with accompanying exhibits.

Lincoln Savings and Loan Association (hereinafter

sometimes referred to as “petitioner”) is a corporation

organized under the laws of the State of California, in-

corporated on February 6, 1925. It’s name, originally

Lincoln Building & Loan Association, was changed on

—

August 5, 1943 to Lincoln Savings and Loan Association.

At the date of the filing of the petition in this case, peti-

tioner’s principal office was located at 630 West Sixth

Street, Los Angles, California. It filed its tax returns for

the calendar years 1962, 1963 and 1964 on the cash re-

ceipts and disbursements basis of accounting with the

district director of internal revenue, Los Angeles, Cali-

fornia.

All of petitioner’s outstanding stock (consisting of 2,500

shares with a par value of $100 per share) has been

owned since 1964 by First Lincoln Financial Corporation,

which is a corporation organized under the laws of the

State of California with its principal office in Los Angeles,

California. During 1962 and 19638, First Lincoln Financial

Corporation owned 98.88 percent of petitioner’s outstand-

ing stock. On December 31, 1968, First Lincoln Financial

Corporation had 1,402,654 shares of stock outstanding,

without par value, owned by approximately 2,800 share-

holders. Its stock is traded over-the-counter.

Petitioner was licensed as a savings and loan associa-

tion by the Savings and Loan Commissioner of the State

of California on February 6, 1925, and since that date

has been and remains a licensed savings and loan asso-

ciation under the laws of the State of California, trans-

acting business in the Los Angeles area. As such, it is

regulated by Division II of the California Financial

Code (West’s Annotated California Codes, Financial Code,

Section 5000, et seg.) and by regulations of the California

Savings and Loan Commissioner, which law and regula-

tions are incorporated herein by reference.

Petitioner is a member of the Federal Home Loan

Bank of San Francisco, one of twelve regional district

banks established and supervised by the Federal Home

Loan Bank Board (hereinafter sometimes referred to as

the FHLB Board) under authority of the Federal Home

Loan Bank Act of 1982. See 12 U.S.C. sec. 1428. These

banks provide additional liquidity and funds for mortgage

lending by making advances to member institutions as

needed to meet unusual or heavy withdrawal and credit

demands. As a condition of membership, each member

institution is required to purchase capital stock in its bank

——_

equal to one percent of its outstanding “unpaid loan

principal,” and to invest in such amounts of stock there-

after as is necessary to maintain this percentage. 12

U.S.C. sec. 1426(c). Prior to 1962 the statutory level was

two percent but thereafter, as part of a comprehensive

legislative plan calling for certain additional payments

by “insured institutions” to the Federal Savings and Loan

Insurance Corporation, as hereinafter set forth, the level

was reduced to one percent.

Since 1938, petitioner has been an “insured institution”

of the Federal Savings and Loan Insurance Corporation

(hereinafter sometimes referred to as the FSLIC), a cor-

poration created by the laws of the United States under

Title IV of the National Housing Act of 1934, 12 U.S.C.

sec. 1724 et seqg., and operated under the direction of the

FHLB Board, which is required by statute to insure the

accounts of all Federal savings and loan associations, and

is permitted to insure the accounts of qualified state

chartered savings and loan associations, such as petitioner.

12 U.S.C. sec. 1726. Members of the Federal Home Loan

Bank system are not required to insure the savings ac-

counts of their depositors with the FSLIC, unless they

are also Federally-chartered savings and loan associations.

Similarly, except for Federal savings and loan associa-

tions, any insured institution of the FSLIC may volun-

tarily terminate such insurance, provided adequate notice

is given to depositors and other technical requirements

are met; the FHLB Board may, however, direct an in-

voluntary termination of the insurance of any insured in-

stitution under certain conditions, though it has done so

only once in the history of the FSLIC. Petitioner placed a

great deal of emphasis in its advertising upon the fact

that it was a Federally insured institution and, in the

opinion of its management, loss of its insured status

with the FSLIC would cause a mass withdrawal of

savings by its depositors.

Prior to January 1, 1962, each insured institution was

required by section 1727(a) of Title 12 of the United

States Code (sec. 404(a) of the National Housing Act)

to pay an annual insurance premium to the FSLIC equal

to 1/12 of 1 percent of the total amount of its savings

Z 43

accounts and creditor obligations. Such premiums were

to be continued until the FSLIC’s reserve for losses

equalled or exceeded five percent of the insured accounts

and creditor obligations of all insured institutions (its

potential liabilities), and at such intervals thereafter as

might be required to keep the reserve fund at this level.

Public Law 87-210, 75 Stat. 482, pertinent parts of which

are set forth in the margin,’ amehded section 1727 of

* Public Law 87-210 amended section 404 of the National Housi

Act (12 U.S.C, sec. 1727) to read as follows. e

Sec. 1727. Primary and secondary reseryeg

(a) Establishment.

The Corporation shall establish a Primary Reserve which shall be

the general reserve of the Corporation ang’ . Secondary Reserve to

which shall be credited the amounts of tl, prepayments made by

insured institutions pursuant to subsectior, (d) of this section and

the credits made pursuant to the first 8@hiance of subsection (e)

of this — Rae vy"

(b) Premiums for insurance; amount; t; 5 ’

rules and regulations time of payment; waiver

(1) Each institution whose application rance roved

by the Corporation shall pay to the Corp’ inst in rag oa

as it shall prescribe, a premium for such jp surance equal to one-

twelfth of 1 per centum of the total aMOUnt of all accounts of the

insured members of such institution plus ®ny creditor obligations of

such institution. Such premium shall by paid at the time the

certificate is issued by the Corporation Ur gor section 1726 of this

title, and thereafter annually, except thay under regulations pre-

scribed by the Corporation such premium Muay be paid semiannually.

(2) If, at the close of any December 31, the Primary Reserve

equals or exceeds 2 per centum of the tots)’, mount of all accounts

of insured members and creditor obligatio,., of all insured institu-

tions as of such close, no premium unde paragraph (1) of this

subsection shall be payable by any insureg institution with respect

to its premium year beginning during the year commencing on

May 1 next succeeding such December 31, except that the foregoing

provisions of this sentence shall not be Applicable to any insured

institution with respect to any of the twerty premium years begin-

ning with the premium year commencing. with the date on which

such — is issued. nial

(8) e Corporation is authorized to |

regulations at is may determine to be n ace te cerns

accomplish the purposes and provisions of this subsection.

[ Footn

ote continued on page 44]

meer a

aren SANNA ta

1 [Continued]

(d) Prepayments; amount; credit to Secondary Reserve; amount

for newly insured institutions.

Each insured institution, except as otherwise provided in this

section, shall annually pay to the Corporation, at such time and in

such manner as the Corporation shall by regulations or otherwise

prescribe, an additional premium in the nature of a prepayment

with respect to future premiums of such institution under subsec-

tion (b) of this section equal to 2 per centum of the net increase

in all accounts of its insured members during the next preceding

calendar year, less an amount equal to any requirement, as of the end

of such calendar year, for the purchase of stock of the Federal

Home Loan Bank of which such institution is a member, calculated

in accordance with the provisions of subsection (c) of section 1426

of this title and without regard to any net increase during such

calendar year in its holdings of such stock, and such prepayments

shall be credited to the Secondary Reserve * * *.

(e) Credits to Secondary Reserve; availability for losses; as-

signment or transfer of share of Reserve.

The Corporation, in accordance with such regulations as it may

prescribe, shall credit to the Secondary Reserve, as of the close of

each calendar year a return on the outstanding balances of the

Secondary Reserve during such calendar year, as determined by

the Corporation, at a rate equal to the average annual rate of

return to the Corporation during the year ending at the close of

November 39 of such calendar year, as determined by the Corpora-

tion, on the investments held by the Corporation in obligations of,

or guaranteed as to principal and interest by, the United States.

Except as provided in subsections (f) and (g) of this section, the

Secondary Reserve shall be available to the Corporation only for

losses of the Corporation and shall be so available only to such

extent as other accounts of the Corporation which are available

therefor are insufficient for such losses. No right, title, or interest

of any institution in or with respect to its pro rata share of the

Secondary Reserve shall be assignable or transferable, whether by

operation of law or otherwise, except to such extent as the Corpora-

tion may by regulation or otherwise provide for transfer of such

pro rata share in cases of merger or consolidation transfer of bulk

assets as defined by the Corporation by regulation or otherwise for

the purposes of this sentence, and similar transactions as so defined.

(f) Cessation of prepayments; distribution of share of Sec-

ondary Reserve; reinstatement of reserve share; payment; waiver,

or other treat of accruals.

If (i) the status of an insured institution as an insured institution

is terminated pursuant to any provision of section 1730 of this title

or the insurance of accounts of an insured institution is otherwise

terminated, (ii) a conservator, receiver, or other legal custodian is

appointed for an insured institution under the circumstances and

for the purpose set forth in subsection (d) of section 1724 of this

title, or (iii) the Corporation makes a determination that for the

purposes of this subsection an insured institution has gone into

liquidation, the obligation of such institution to make prepayments

under subsection (d) of this section, including any prepayments

as to which such institution is obligated at the time of such termi-

nation, appointment, or determination, shall cease, and the Corpora-

tion shali pay in cash to such institution its pro rata share of the

Secondary Reserve, in accordance with such terms and conditions

as the Corporation may prescribe by regulations or otherwise, or, at

the option of the Corporation, the Corporation may apply the whole

or any part of the amount which would otherwise be paid in cash

toward the payment of any indebtedness or obligation, whether

matured or not, of such institution to the Corporation, then existing

or arising before such payment in cash * * *.

(g) Suspension of prepayments, resumption of obligation upon

insufficiency of aggregate reserves; cash distribution of shares of

Secondary Reserve.

If, at the close of any December 31, the aggregate of the Pri-

mary Reserve and the Secondary Reserve equals or exceeds 2 per

centum of the total amount of all accounts of insured members and

creditor obligations of all insured institutions but the Primary

Reserve does not equal or exceed such 2 per centum, no insured

institution shall be obligated to make any prepayment under sub-

section (d) of this section during the year beginning with May 1

next succeeding such close, and each insured institution’s pro rata

share of the Secondary Reserve shall be used to the extent available,

to discharge such institution’s obligation for its premium under

subsection (b) of this section for the premium year beginning in

such year; and the suspension of obligation to make such prepay-

ments and the use of such pro rata shares as provided in this

sentence shall continue unless and until the next sentence or the

last sentence of this subsection shall become operative. If, at the

close of any December 31 occurring before the last sentence of this

subsection shall become operative, the aggregate of the Primary

Reserve and the Secondary Reserve is not at least equal to 1534 per

centum of the total amount of all accounts of insured members and

creditor obligations of all insured institutions (i) the obligation

of insured institutions to make prepayments under subsection (d)

of this section shall resume on May 1 next following such December

31 and shall continue unless and until the first sentence or the last

sentence of this subsection shall become operative, and (ii) the use

of any insured institution’s pro rata share of the Secondary Re-

serve under the first sentence of this subsection shall terminate with

respect to its premium under subsection (b) of this section for the

premium year beginning during the calendar year commencing

on May 1 next succeeding such December 31, and such termination

shall continue unless and until the first sentence of this subsection

shall become operative. If, at the close of any December 31, the

Primary Reserve equals or exceeds such 2 per centum, the Corpora-

enc AE SO A RN a

——

Title 12 of the United States Code, effective January 1,

1962, to its present form. An annual insurance premium

at the rate of 1/12 of one percent is still required of all

insured institutions (provision for which is now made in

section 1727(b)(1)), though the point at which such

premiums are to cease and the level at which the FSLIC’s

general reserve is to be maintained has been lowered from

five to two percent of total insured savings and creditor

obligations of insured institutions. (Section 1727 (b) (2)).

But insured institutions are now required under the

amended provisions of section 1727, to make further

annual payments to the FSLIC (provided for in 12 U.S.C.

sec. 1727(d) and hereinafter sometimes referred to as

tion shall, at such time (which shall be the same for all insured

institutions and shall not be later than May 1 next succeeding

such close) and in such manner as the Corporation shal] determine,

pay in cash to each insured institution its pro rata share of the

Secondary Reserve and shall not, after such time, accept or receive

further prepayments under subsection (d) of this section.

Public Law 87-210 also amended section 6 of the Federal Home

Loan Bank Act (12 U.S.C. sec. 1426) to read as follows:

Sec. 1426. Capital stock.

am * * *

limitations; cancellation of oversubscriptions; aggregate unpaid

loan principal; reports and information.

(1) The original stock subscription of each institution eligi-

ble to become a member under section 1424 of this title shall be an

amount equal to 1 per centum of the subscriber’s aggregate unpaid

loan principal, but not less than $500. The bank shall annually, as

of the close of the calendar vear, adjust, at such time and in such

manner and upon such terms and conditions as the Federal Home

Loan Bank Board may by regulations or otherwise prescribe, the

amount of stock held by each member so that such member shal!

have invested in the stock of the Federal Home Loan Bank at least

an amount calculated in the manner provided in the next preceding

sentence (but not less than $500). If the bank finds that the in-

vestment of any member in stock is greater than that required under

this subsection it may, unless prohibited by said Board or by the

provisions of paragraph (2) of this subsection, in its discretion

and upon application of such member retire the stock of such

member in excess of the amount so required. Said Board, in its

discretion, may, by regulations or otherwise, provide for adjust-

ments in amounts of stock to be issued or retired in order that

stock may be issued or retired only in entire shares.

“section 1727(d) payments”) equal to two percent of

any net increase in the total amount of its insured ac-

counts during the previous year, reduced, however, by an

amount equal to any requirement, as of the end of such

year, for the purchase of stock in a Federal Home Loan

Bank of which the insured institution is a member. Public

Law 87-210 also amended section 6 of the Federal Home

Loan Bank Act (12 U.S.C. sec. 1426), to reduce the per-

centage of stock which a member of a Federal Home

Loan Bank is required to hold in relation to its outstand-

ing home mortgage loans, with certain exceptions relating

to stock already purchased, from two to one percent. It

was contemplated that, for most member institutions, the

section 1727(d) “prepayment requirement would be ap-

proximately offset” by the resulting reduction in outlays

for Federal Home Loan Bank stock which a member in-

stitution was theretofore (prior to 1962) required to

make. H. Rept. No. 828, 87th Cong., 1st Sess., p. 2.

Under the terms of section 1727, as amended by Public

Law 87-210, the FSLIC is directed to establish a “Pri-

mary Reserve,” and a “Secondary Reserve”. (Section

1727(a)). The Primary Reserve is credited annually with

the net incorae of the FSLIC, and thus represents its “re-

tained earnings.” Regular insurance premiums paid by

insured institutions under section 1727(b) (1) constitute

one of the major items of the FSLIC’s gross income, and,

to the extent that such premiums exceed expenses and in-

surance losses in any given year, they are thus trans-

ferred as part of FSLIC’s net income to the Primary

Reserve. Section 1727(d) payments, on the other hand,

though described in the statute as “additional pre-

mium[s] in the nature of * * * prepayment[s] with

respect to future premiums,” are not regarded as an

item of income by the FSLIC, which is required by sec-

tion 1727(a) to credit all such payments directly to the

“Secondary Reserve.” The FSLIC is also required to

credit the “Secondary Reserve” with an annual “return”

on the outstanding balances in that account at the end of

each year, computed “at a rate equal to the average an-

nual rate of return to the Corporation * * * on the invest-

ments held by the Corporation in obligations of, or guar-

anteed as to principal and interest by, the United States.”

nar rene

Section 1727 (e). Finally, whereas the “Primary Reserve”

is “the general reserve of the Corporation [i.e, the

FSLIC],” the “Secondary Reserve” is available “only for

losses of the Corporation and shall be so available only

to such extent as other accounts of the Corporation which

are available therefor are insufficient for such losses.”

Section 1727 (e).

Each insured institution maintains an interest in a

pro rata share of the “Secondary Reserve,” and though

its “right, title or interest” therein is not generally trans-

ferable or assignable, the FSLIC has authority to pro-

vide for the transfer of such pro rata share “in cases of

merger or consolidation transfer of bulk assets * * *

and similar transactions.” Section 1727(e). Moreover, an

insured institution is entitled to a cash refund of its pro

rata share in the event that (1) its status as an insured

institution is terminated, or (2) a conservator, receiver,

or other legal custodian is appointed for the purpose of

liquidating the assets of the institution, or (3) the FSLIC

determines that such institution has gone into voluntary

liquidation. Section 1727 (f).

When, at the close of any December 31, the aggregate

of the Primary Reserve and the Secondary Reserve equals

or exceeds two percent of the total amount of all insured

accounts and creditor obligations of all insured institu-

tions, the obligation of insured institutions to make sec-

tion 1727(d) payments will be suspended for the fol-

lowing year and all succeeding years; the obligation to

make section 1727(d) payments is to resume in the year

following any December 31 on which such aggregate

amount falls below 134 percent of all insured accounts

and creditor obligations, and is to terminate permanently

when the amount in the Primary Reserve alone equals

or exceeds two percent of such accounts and obligations.

In any year in which the obligation to make section 1727

(d) payments is suspended, as described above, the pro

rata share of each insured institution in the Secondary

Reserve will be used, to the extent available, to dis-

charge its obligation to pay the regular insurance pre-

mium for that year. After the Primary Reserve alone

reaches the two percent level, each insured institution is

—

entitled to the return of its pro rata share of the Sec-

ondary Reserve, if any, in cash. Section 1727(g).

A schedule appearing shortly hereinafter sets forth

estimates of the reserve position of the FSLIC in terms

of the expected ratio of the Primary Reserve, the Sec-

ondary Reserve, and the aggregate of the Primary and

Secondary Reserves to the total of all accounts and credi-

tor obligations of all insured institutions for the years

1962-1995. These estimates, prepared in the Office of the

Comptroller of the FSLIC and submitted to the Senate

Committee on Banking and Currency in connection with

that Committee’s consideration of the bill which became

Public Law 87-210, were based upon certain assumptions,

viz:

1. No insurance losses.*

2. Premium income computed on annual billing basis

of one-twelth of 1 percent.

8. Investment income based on annual average rate

of return of 3 percent.

4. Operating expenses based on current rate of ex-

penditure equal to 3.7 percent of premium income.

5. Mortgage loans held estimated at 96 percent of

total savings capital.

6. Net home mortgages estimated at 90 percent of

mortgage loans held.

7. Annual growth in savings of $7 billion plus divi-

dends at an annual rate of 3 percent.

In addition to the foregoing estimates, the schedule also

shows the actual percentage of the aggregate of the Pri-

mary and Secondary Reserves to the total amount of all

accounts and creditor obligations of insured institutions

during the years 1963-1967, as shown on the financial

statements of the FSLIC for those years. The schedule

described above is as follows:

2 The FSLIC, during the 27 years of its existence prior to June 30,

1961, had incurred net insurance losses of only $5.1 million, approxi-

mately 1.1 percent of its cumulative gross income.

eee oa]

ASRS AR AOS Ae TA a a oe

ee ee ae

—- of

Primary Secondary any ae

reserve— reserve— sooeneary want

estimated estimated Estimated Act

December 31 ratio ratio ratio rat

1962 0.642 0.227 0.869

1963 0.661 0.417 1.078 *]

1964 0.685 0.581 1.266 1

1965 0.712 0.723 1.435 1

1966 0.741 0.849 1.590 1

1967 0.773 0.963 1.736 1

1968 0.807 1.067 1.874

1969 0.842 1.148 1.990

1970 0.879 1.177 2.056

1971 0.917 1.052 1.969

1972 0.956 0.985 1.891

19738 0.996 0.825 1.821

1974 1.036 0.720 1.757

1975 1.078 0.620 1.699

1976 1.121 0.667 1.787

1977 1.164 0.710 1.874

1978 1.208 0.752 1.960

1979 1.252 0.792 2.045

1980 1.298 0.696 1.994

1981 1.343 0.603 1.946

1982 1.390 0.512 1.902

1983 1.487 0.424 1.860

1984 1.484 0.338 1.822

1985 1.532 0.258 1.785

1986 1.580 1.171 1.751

1987 1.629 0.218 1.848

1988 1.679 0.264 1.943

1989 1.729 0.309 2.088

1990 1.779 0.226 2.005

1991 1.830 0.145 1.975

1992 1.881 0.074 1.955

19938 1.982 1.982

1994 1.984 1.984

1995 2.037 2.037

* As of June 30, 1963.

)

}

In summary, according to the FSLIC projections in

1961, the aggregate of the Primary Reserve and the

Secondary Reserve would equal or exceed two percent

of all insured accounts and creditor obligations of all

insured institutions by 1970, and all section 1727(d)

payments, together with all amounts credited thereon,

would be consumed in discharging the obligation of in-

sured institutions to pay regular insurance premiums by

the time that the Primary Reserve itself reaches the two

percent level in 1995.

During the years 1962 through 1967, petitioner re-

ceived annual “Insurance Premium Notices” from the

FSLIC charging it with “Annual Premium[s] at rate of

1/12 of 1%” (of its insured accounts and creditor obliga-

tions) in the following amounts:

Year: Premiums

1962 $ 98,258.58

1963 135,760.52

1964 196,413.86

1965 271,477.00

1966 $17,427.60

1967 373,025.38

All such sums were paid by petitioner to the FSLIC in

the year assessed.

During each of those same years, petitioner also re-

ceived from the FSLIC a separate “Notice of Insurance

Premium Prepayment.” which set forth the amounts due

from petitioner, and the manner in which computed, gen-

erally as follows:

Increase in

accounts of

petitioner’s

insured Gross pre-

members payment

(depositors) (2% of

during pre- __ increase in FHLbank Net amount

Year ceding year prior year) stock credit due Junel

1962 $ 6,387,974 $ 126,759.48 0 $ 126,759.48

1963 44,131,843 882,636.86 0 882,636.86

1964 61,746,484 1,234,929.68 $784,100.00 450,829.68

1965 71,489,450 1,429,789.00 $34,700.00 1,095,089.00

1966 61,808,288 1,226,064.76 0 1,226,064.76

1967 (1,944,138) 0 0 0

——

All such section 1727(d) payments billed to petitioner

were paid by it to the FSLIC in the year due.

All section 1727(d) payments have been credited on the

books and records of the FSLIC directly to its “Secondary

Reserve.” Effective with the first of such payments, the

FSLIC has maintained separate accounts for each in-

sured institution and annually forwards statements to

such institutions showing, among other things, the total

amount of section 1727(d) payments made to that time,

the interest credited annually by the FSLIC to the ac.

count pursuant to section 1727(e), and the insured in-

stitution’s pro rata share of the Secondary Reserve. Peti-

tioner’s account, No. 2066, reflects the following:

Annual return Pro rata share of secondary reserve

Sec. 1727 (d)

Date payment Rate Amount Debit Credit Balance

May $81, 1962 $ 126,759.48 $ 126,759.48 $ 126,759.48

Dec. 31, 1962 3.151488% $ 2,242.10 2,342.10 129,101.58

May 31, 1968 82,636.86 882,636.86 1,011,788.44

Dec. 31, 1963 3.549594% 22,951.42 22,951.42 1,034,689.86

May 28, 1964 450,829.68 450,829.68 1,485,519.54

Dec. 31, 1964 (1) 44,864.25 44,864.25 1,580,383.79

June 1, 1965 1,095,089.00 1,095,089.00 2,625,472.79

Dec. 31, 1965 3.555086 % 77,231.97 77,231.97 2,702,704.76

June 1, 1966 1,226,064.76 1,226,064.76 $,928,769.52

Dec. 31, 1966 3.837323 % 131,295.86 131,295.86 4,060,065.38

June 1, 1967 0 0 4,060,065.38

Dec. 31, 1967 4.232271% 171,832.97 171,882.97 4,231,898.85

Dec. 31, 1967 2690,217.11 4,922,115.46

2 Not in record.

a Transferred from the account of another savings and loan association due to merger.

Section 8701 of the California Financial Code authorizes

the Savings and Loan Commissioner to establish a uni-

form classification of accounts for savings and loan asso-

ciations and to prescribe the manner in which such ac-

counts are to be kept. On May 21, 1962, the California

Savings and Loan Commissioner issued an order pre-

scribing the procedure for accounting for section 1727

(d) payments, which order was modified and incorporated

into the “Uniform Classification of Accounts” effective

January 1, 1963, and, as modified, has remained effective

for all subsequent periods. The “Uniform Classification of

Accounts” requires each California savings and loan as-

sociation to treat section 1727(d) payments as an asset,

in an account entitled “Contributions to Secondary Re-

serve—FSLIC;” to treat the return credited to its pro

rata share of the Secondary Reserve as income when noti-

fied by the FSLIC that such return has been credited to

its account; and to treat transfers made from its pro

rata share of the Secondary Reserve to discharge its ob-

ligation to pay regular annual premiums as expenses

when notified of such transfer.

On petitioner’s balance sheet for the year 1962, its sec-

tion 1727(d) payment for that year, and the statutory

interest credited thereon, were included in “Other Assets a

beginning in 1963, all section 1727(d) payments have

been shown, on the asset side of the balance sheet, as

“Prepaid Federal Savings and Loan Insurance Corpora-

tion Premiums.” Such payments were not included as an

expense on any of its income statements for the periods

1962 through 1966. The interest credited to petitioner’s

account pursuant to section 1727(e) by the FSLIC for

each of the years 1962 through 1966 was included in mis-

eellaneous income for the year in which the interest was

credited to petitioner’s account by the FSLIC. These items

were similarly treated on the Consolidated Financial

Statements of petitioner’s parents, First Lincoln Finan-

cial Corporation, and its subsidiaries. All of petitioner’s

financial statements for the years 1962 through 1966,

and all consolidated financial statements of its parent

for those years, were audited by the firm of Peat, Mar-

wick, Mitchell & Co., certified public accountants, which

submitted accompanying “Accountant’s Reports” stat-

ing that the financial position of petitioner (or its parent)

had been presented fairly therein, “in conformity with

generally accepted accounting principles applied on a

basis consistent with that of the preceding year.”

The regulations of the FHLB Board require each sav-

ings and loan association which is a member of the Fed-

eral Home Loan Bank system to file, on forms provided

by the Board, a semi-annual report of its affairs as of

the end of each semiannual period. Printed instructions

for the preparation of such reports are published and

distributed to each member. The “Introduction” to these

instructions states that: “These instructions are provided

—

to assist in the completion of monthly and semiannual

rts by members of the Federal Home Loan Bank Sys-

tem. Each reporting institution is urged to carefully foj-

low these instructions * * *.” Under the heading “Sched-

ule D, Other Assets,” each institution insured by the

FSLIC is instructed to report in that category ‘

amount of its pro rata share in the Secondary Reserve

established by the Corporation from the premium pre

payments.” In all of its reports to the FHLB since 1962

petitioner has reported its pro rata share of the Sec

ondary Reserve .@8 an asset under the heading “Other

On its Federal income tax returns for the years 1962,

1963 and 1964, petitioner deducted both its section 1727

(b) (1) regular premium payments and its section 1727

(d) payments under “other deductions” as “Federal in-

surance premiums.” Upon examination of its returns for

those years, the Commissioner allowed the deduction for

amounts paid under section 1727(b) (1), but disallowed

a deduction for all section 1727(d) payments. In its peti-

tion to this Court, petitioner put in issue the greater part

by the Commissioner for 1963 with the exception of his

disallowance of a deduction of $882,636.86, the amount

of the section 1727(d) payment made by petitioner in

that year.

OPINION

RauM, Judge: Petitioner, a Savings and loan asso-

ciation licensed by the State of California and doing busi-

ness in the Los Angeles area, has since 1938 insured the

savings accounts of its depositors with the Federal Say-

ings and Loan Insurance Corporation (the “FSLIC”),

pursuant to the provisions of Title IV of the National

Housing Act, as amended. (12 U.S.C. sec. 1724 et seq.)

It pays an annual “premium for such insurance” in an

amount equal to 1/12 of one percent of the total amount

* There was no deficiency in petitioner’s income tax in the other

years.

--™

of all its savings accounts and creditor obligations, as

provided in section 1727(b) (1). Since 1962, as the result

of amendments made to the National Housing Act, peti-

tioner has been required to make further annual pay-

ments to the FSLIC under section 1727(d), hereinafter

sometimes referred to as “Sec. 1727(d) payments”, equal

to two percent of any net increase in its insured accounts

during the previous year, but reduced in the case of an

insured institution, such as petitioner, which is also a

member of a Federal Home Loan Bank, by the amount

of any required purchase of stock in such Bank for that

year. These section 1727(d) payments are described in

the statute as “additional premium([s] in the nature of

* * * prepayment[s] with respect to future premiums.”

In 1963, the only year here in issue, petitioner paid its

annual insurance premium for the year in the amount of

$135,760.52, and made its section 1727(d) payment in the

amount of $882,636.86. Both sums were deducted on its

1963 Federal income tax return as “Federal insurance

premiums.” The Commissioner, while not disputing peti-

tioner’s right to deduct its regular annual insurance pre-

mium, disallowed in full the’ deduction of $882,636.86

claimed for the additional section 1727(d) payment. The

sole issue for decision is whether this latter payment was

an ordinary and necessary expense of petitioner’s business

in 1963, or a capital expenditure deductible, if at all,

only in later years to the extent that it ceased to be an

asset of petitioner.

Although described in the statute as “an additional

premium in the nature of a prepayment with respect to

future premiums,” the section 1727(d) payment is neither

an “additional premium,” in the sense of being a mere

increase in the annual insurance premium as contended by

petitioner, nor a “prepayment with respect to future pre-

miums,” at least insofar as the ordinary prepaid insurance

premium is taken as a standard. The National Housing

Act is not, of course, a revenue statute, and the label at-

tached to section 1727(d) payments therein is not, and

was not intended to be, conclusive in the determination

of how these payments should be treated for Federal tax

purposes. See McMillan Mortgage Company, 36 T.C. 924,

928. The label is at any rate ambiguous, though if we

were to give it binding effect here, we should most cer-

tainly adopt the characterization of “prepayment” as

controlling, and would therefore have to deny petitioner

4 current deduction for its section 1727 (d) payment under

a long line of decisions by this Court holding that prepaid

insurance premiums are capital expenditures to be ex-

20 T.C.M. 78, 86. See and compare Commissioner y, Boyl-

ston Market Ass’n., 181 F. 2d 966 (C.A. 1), affirming a

Memorandum Opinion of the Board of Tax Appeals, with

Waldheim Realty and Investment Company v. Commis.

sioner, 245 F. 2d 823 (C.A,. 8), reversing 25 T.C. 1216.

But regardless of whether the section 1727(d) payment

analysis of the substantive provisions of section 1727

convinces us that this payment, however labeled, is in the

nature of a capital outlay and is therefore not deductible

as an expense in the year that it is made.

so used, they are transferred, as part of the FSLIC’s net

income for the year, to the “Primary Reserve,” the

FSLIC’s general reserve which contains its cumulative

net income or “retained earnings” and which is available

to meet the FSLIC’s insurance losses if its income in any

year is insufficient for this purpose. Section 1727(d)

payments, on the other hand, are not considered as in-

come by the FSLIC, and are not ordinarily available to

meet the annual expenses and losses of the Corporation.

Instead, the FSLIC is required by statute to credit all

such payments directly to a “Seconary Reserve,” which

is to be used “only for losses of ‘he Corporation and

shall be so available only to such ext:nt as other accounts

of the Corporation which are availible therefor are im-

sufficient for such losses.” Section 1727(e). (Emphasis

added.) Thus, instead of being takea into income, freely

available to meet expenses and losses of the current year,

the section 1727(d) payment is credited directly to an ac-

count, rather like a capital account, which may be applied

against losses only in the event that the regular insur-

ance premiums for the year, the corporation’s other in-

come, and its retained earnings of prior years have all

been depleted. It cannot, therefore, be accurately termed

a premium for insurance coverage in the year of payment,

but, at least initially, is in reality a capital investment

in the FSLIC, part of a pool or capital available to the

FSLIC for the payment of losses in the event of emer-

gency.

Furthermore, when the regular insurance premiums

paid by insured institutions under section 1727(b) (1)

are received by the FSLIC, they lose their distinctive

character as premiums and become merely part of the

gross income of the corporation; the insured institution

retains no rights in respect of such sums, other than the

right to insurance coverage for the current year, and its

premium, once paid, is lost to it forever. Payments made

under section 1727(d), however, stand on quite a dif-

ferent footing. Such payments, as noted ab ve, are im-

mediately segregated in the “Secondary Reserve,” and

the FSLIC is directed by statute to credit the outstand-

ing balance in this account, on am annual basis, with a

“return” computed “at a rate equial to the average an-

nual rate of return to the Corporatiion * * * on the invest-

ments held by the Corporation jn obligations of, or

guaranteed as to principal and imterest by, the United

States.” Section 1727(e). What iis more, each insured

institution maintains an interest ijn a pro-rata share of

the Secondary Reserve, and is amnually furnished with

a statement of its account by the FSLIC, which keeps a

separate account for each insured ifnstitution. That annual

5 POTEET

statement discloses all section 1727(d) payments made by

the insured institution, the interest or return earned by

the account, any debits that may have been charged

against the account, and, finally, the new balance in the

account as of the end of the year. Thus, for the years

1962-1967, petitioner’s account, set forth in our findings,

reflects various credits (section 1727(d) payments and

interest or return), no debits, and a balance of $4,922.

115.46 in its favor, representing its pro rata share in

the Secondary Reserve as of December 31, 1967.

While petitioner's pro rata share of the Secondary

Reserve is not, as a general rule, assignable or trans-

ferable, “by operation of law or otherwise,” the value

of such share may be fully realized through its transfer

to another insured institution in a merger, consolidation

or bulk sale; petitioner may even receive the value of its

share from the FSLIC in cash if (1) its insured status is

terminated, either voiuntarily or involuntarily, (2) it

goes into liquidation, voluntarily are involuntarily, or (3)

the obligation to make section 1727(d) payments is per-

manently terminated and the Secondary Reserve dis-

tributed before the value of its share has otherwise been‘

fully recovered. See p. ——, infra. Moreover, assuming

petitioner does not realize the value of its pro rata share

in one of the above ways, it is reasonably assured of

receiving full value therefor in the form of insurance

coverage in future years when its share of the Secondary

Reserve is used to pay its regular section 1727(b) (1)

premiums. To the extent that the petitioner’s share is so

used, entries will undoubtedly be made in the debit column

of its account which will be reflected in the balance ap-

pearing as of the end of each such year. Also, to the ex-

tent that any losses may be charged in any year against

the Secondary Reserve, petitioner’s pro rata share thereof

should similarly appear in the debit column, thereby also

adversely affecting its balance as of the end of such year.

And to the extent that any such debits are charged against

petitioner’s balance in any particular year, whether for

regular section 1727(b) (1) premiums or for losses, it

would seem that petitioner would be entitled to deductions

in those amounts for any such year. Cf. Rev. Rul. 66-49,

1966-1 C.B. 36, 37.

—

As already noted, the Secondary Reserve is available

for the payment of losses, but only to a very limited ex-

tent. It has, however, never been used for this purpose,

nor, on the basis of the FSLIC’s past loss experience, does

such use appear to be likely. At the time that Congress

considered Public Law 87-210, in 1961, net insurance

losses of the FSLIC had absorbed only 1.1 percent of its

income over its entire existence, H. Rept. No. 828,

87th Cong. Ist Sess. p. 2 (1961); S. Rept. No. 778, 87th

Cong. Ist Sess. p. 2, and the financial statements of the

FSLIC put in evidence by the parties, covering all the

thereafter through December 31, 1967, reveal no

year in which the net insurance losses of the FSLIC ex-

ceeded even its investment income, much less the annual

premiums for the year and/or the Primary Reserve, both

of which must be fully consumed before the Secondary

Reserve can be utilized. The Primary Reserve alone stood

at $921,669,395 on December 81, 1967, while the cumula-

tive net losses of the FSLIC from June 27, 1934 through

December 31, 1967, totalled only $105,610,365. Of course,

an event of catastrophic proportions, another Great De

pression, could conceivably wipe out the Secondary Re-

serve, but the probability that such an event will occur

is simply incalculable. It is certainly not an event that

could reasonably be anticipated as of any particular time,

and if any event should occur requiring a charge against

the Secondary Reserve in respect of any loss, petitioner’s

pro rata share thereof would then be deductible, as has

already been pointed out. But there do not appear to be

any greater hazards in this respect than attach to the

capital investment made by a stockholder in a commercial

bank or an insurance company.

Though it is clear that “prepayments” under section

1727(d) are not really insurance premiums, at least

not in the year in which they are paid, a further examina-

tion of the provisions of Public Law 87-210 also reveals

sharp differences between such “prepayments” and the

| ordinary prepaid insurance premium. While the average

| prepaid insurance premium gives rise to an obligation on

the part of the insurer to provide coverage for some

definitely ascertainable period of time, usually not more

than two or three years from the date of the policy, the

FSLIC incurs no such obligation upon its receipt of a

section 1727(d) payment. The obligation to provide in-

surance coverage does not arise until the section 1727 (d)

payment is actually used to discharge the obligation of

the insured institution to pay a regular section 1727 (b)

(1) insurance premium, which event is contingent upon

the ratio of the FSLIC’s reserves to its potential lia-

bilities attaining certain levels. Moreover, since the sec-

tion 1727(d) payment credited to the Secondary Reserve

is subject to accretion through the annual “return” credited

annually by the FSLIC on the outstanding balance in

such reserve, and at least theoretically to depletion in the

event the reserve is used to meet losses in an emergency

situation, and since the regular annual premium required

by section 1727(b) (1) is itself a percentage of the in-

sured institution’s accounts and creditor obligations, and

thus varies from year to year, there is no way of predict-

ing with certainty the number of years of insurance cov-

erage which will be procured by each section 1727(d)

payment, much less the precise years which will be cov-

ered. Thus, unlike the common prepaid insurance pre-

mium, the section 1727(d) payment is not simply “an

exhaustible asset with a determinable life’ whose value

may be allocated “ratably over the term for which the

premium is paid,” see George S. Jephson, supra, 87

B.T.A. 1117, 1120; Higginbotham-Bailey-Logan Co.,

supra, 8 B.T.A. 566, 577, the life of the asset created by

the section 1727(d) payment is not determinable on the

date of payment, and its usefulness will not be ratably

spread over the period of that life.

For the period of time prior to its use to discharge the

obligation of the payor institution to pay regular annual

premiums required by section 1727(b) (1), the section

1727(d) payment will simply constitute part of the capital

of the FSLIC. Under the terms of the statute, section

1727(g), the pro rata share of each insured institution

in the Secondary Reserve will be used to pay its regular

annual premiums, and the obligation of insured institu-

tions to make section 1727(d) payments will concurrently

be suspended, only after the aggregate of the FSLIC’s

Primary and Secondary Reserves equals or exceeds two

percent of the total amount of all savings accounts and

creditor obligations of institutions insured by the FSLIC.

The obligation to make section 1727 (d) payments will,

however, resume, if the aggregate of the two reserves

subsequently falls below 134 percent of the FSLIC’s po-

tential liabilities, and, until such aggregate again reaches

the two percent level, the use of the pro rata share of

each insured institution to pay its regular annual pre-

miums must also cease. It is not until the FSLIC’s Pri-

mary Reserve alone equals or exceeds two percent of its

potential liabilities that the obligation to make section

1727(d) payments will permanently terminate, at which

time insured institutions are entitled to the refund of

their pro rata share of any amount remaining in the Sec-

ondary Reserve. Clearly then, the effect of these provisions

is to require insured institutions to make and keep capital

investments in the FSLIC, until it has retained enough

of its own earnings (in the Primary Reserve) to provide

in the opinion of Congress, adequate protection for in-

sured savers.

To be sure, the asset acquired by petitioner by vir-

tue of its section 1727(d) payments, i.e., its pro rata

share of the FSLIC’s Secondary Reserve, differs in many

respects from the usual capital investment. Petitioner is

required by law to make the investment, at least as long

as it wishes to insure its accounts with the FSLIC, cf.

Hotel Sulgrave, Inc., 21 T.C. 619, the amount of the in-

vestment is determined by the growth of its business, i.e,

the increase in its savings accounts, and the asset so ac-

quired is ordinarily not transferable to others. But these

differences, though perhaps not insignificant for other

than tax purposes, cannot alter the fact that the section

1727(d) payment does not actually provide insurance

coverage for petitioner in the year of payment, and is not

an ordinary and necessary expense of that year; it results

in the acquisition of an asset which, if held to “maturity”

and not transferred in a merger, consolidation or bulk

sale, and not refunded in the event of a termination of

insurance or liquidation, will result in benefits, in the

form of insurance coverage, in future years. In these

—

circumstances, it is a matter of no consequence whether

petitioner is a cash or accrual basis taxpayer, for the

rule is the same for both that: “If an expenditure results

in the creation of an asset having a useful life which

extends substantially beyond the close of the taxable year,

such an expenditure may not be deductible, or may be

deductible only in part, for the taxable year in which

made.” Regs. sec. 1.461-1(a) (1) and (2). Moreover, we

need not look far to find a similar investment which,

though possessing many of these same peculiar attributes,

is nevertheless a capital expenditure. An example readily

at hand lies in the payment by petitioner of amounts re-

quired by section 6 of the Federal Home Loan Bank Act,

12 U.S.C., section 1426(c), for the acquisition of capital

stock in its Federal Home Loan Bank, a payment which

we think is closely analogous to the section 1727 (d) pay-

ment here, and which petitioner has consistently capi-

talized rather than expensed in the year of payment.

Membership in a Federal Home Loan Bank entitles a

savings and loan association to obtain advances from such

Bank, up to certain limits, upon the security of its home

mortgages and obligations of or guaranteed by the United

States, 12 U.S.C. section 1430(a); it thus serves the im-

portant function of providing members with a source of

additional liquidity and funds for mortgage lending. As

a condition of membership, the savings and loan associa-

tion must initially purchase stock in one of twelve regional

Home Loan Banks, depending upon the district in which

it is located, equal to one percent of such association’s

“aggregate unpaid loan principal,” * and must purchase

such additional amounts of stock thereafter as is necessary

to maintain this ratio at the close of each succeeding

calendar year. 12 U.S.C. sec. 1426(c) (1). Amounts so

invested are not ordinarily transferable, and, in general,

are returnable to the member only upon its withdrawal

from membership. Also, if at the time of withdrawal

the FHLB Board finds that the paid-in capital of the

member’s Federal Home Loan Bank is or is likely to be

* Defined as the aggregate unpaid principal of its home mortgage

loans, home-purchase contracts, and similar obligations, 12 U.S.C.

sec. 1426(c) (4).

impaired as a result of losses in or depreciation of the

assets held by such Federal Home Loan Bank, the amount

to be paid the member in retirement of its stock is re-

duced by its pro rata share of the amount of the impair-

ment. 12 U.S.C. sec. 1426(i). The similarities between

the mandatory payments made by petitioner to its Fed-

eral Home Loan Bank and those made to the FSLIC are

thus strikingly apparent.’ True, petitioner did not re

ceive any pieces of paper to evidence its pro rata share

of the Secondary Reserve, though one could imagine a

redeemable preferred stock which incorporated all the

provisions of sections 1727(d), (e), (f) and (g) as

described above, which might have been issued in exchange

for such payments. But it acquired an asset nevertheless,

if evidenced only by the annual statements sent to peti-

tioner every year showing the status of such pro rata

share. That the section 1727(d) payment made to acquire

that asset was mandatory and based upon the volume

of petitioner’s business, and that the asset itself was non-

transferable and subject to a limited extent to the losses

5’ Petitioner argues that the legally compelled investments made

in its Federal Home Loan Bank are fundamentally distinguishable

from the section 1727(d) payments here by virtue of the fact

that it is entitled to dividends on its Federal Home Loan Bank

stock which are immediately available for its use, and the further

fact that the Federal Home Loan Bank may, “in its discretion,”

retire the stock of any member to the extent that it exceeds the

required ratio. Although these are distinctions, they are neverthe-

less distinctions without a difference here. We do not consider it

significant thaf petitioner’s annual dividends on its Federal Home

Loan Bank stock are distributed to it rather than being credited

to its account, nor do we think it important that petitioner may

receive some of the funds invested in the Federal Home Loan Bank

before it begins to receive, actually or constructively, its section

1727(d) payments. Moreover, assuming that it remains a member

of both the Federal Home Loan Bank and the FSLIC indefinitely,

petitioner will certainly receive its total investment in the FSLIC

before it receives the money it has invested in its Federal Home

Loan Bank, for while there is a definite limit on petitioner’s com-

mitment to the FSLIC, there is none on its commitment of funds

to the Federal Home Loan Bank. At any rate, the question of when

such investments or the return thereon, will be redeemed is simply

a questicn of timing; the important point is that both are in fact

capital in vestments.

ane

of the corporation in which the funds were invested, does

not make it any more an ordinary and necessary expense,

nor less a capital expenditure, than the required invest-

ments made by petitioner in its Federal Home Loan Bank,

Moreover, the section 1727(d) payments, which are

measured by the net increase of the institution’s insured

accounts during the preceding year, were in fact regarded

by Congress, in part at least, as being a substitute for

investments in the capital stock of the Federal Home Loan

Banks which member institutions were theretofore re

quired to make. A member institution was formerly ob-

ligated to purchase and hold such capital stock equal to

two percent of its outstanding home mortgage loans, but

when its obligation to make the section 1727(d) payments

commenced in 1962, the two percent level in respect of

the capital stock was simultaneously reduced to one per-

cent. It is clear that Congress regarded these as interre-

lated events,* and in our judgment the 1727(d) payments

represented capital outlays by the member institution

just as much as its investment in the stock of its regional

Federal Home Loan Bank.

The legislative history of Public Law 87-210, which

amended section 1727 to its present form in 1961, does

not of course deal with the manner in which section

1727(d) payments should be treated for Federal tax pur-

poses, but it is certainly not inconsistent with anything

we have said here. The decade preceding the enactment

of the bill witnessed a tremendous increase in the growth

of institutions insured by the FSLIC, and a concomitant

growth in the total amount of savings insured by the Cor-

poration. But, in that same decade, the FSLIC was re-

quired by Congress to use its income to retire all of its

captal stock, in the amount of $100,000,000, from the

United States Treasury. The result was a decline in the

ratio of the reserves of the FSLIC to its potential liabilities

during this period from 0.848 percent to 0.661 percent.

See S. Rept. No. 778, 87th Cong., 1st Sess., pp. 2, 12;

Hearings Before Subcommittee No. 1 of the Committee on

Banking and Currency, House of Representatives, 87th

Cong., 1st Sess., on H.R. 7108 and H.R. 7109, pp. 10, 39.

* See infra, p. ——.

Public Law 87-210 was “designed to add new strength”

to the FSLIC by requiring insured institutions to make

so-called “premium prepayments” which, it was hoped,

“would result in a marked acceleration in building up the

Corporation’s reserves.” H. Rept. No. 823, 87th Cong., 1st

Segs., p. 2 (1961); S. Rept. No. 778, supra, pp. 1-2.

Petitioner emphasizes that Congress spoke in terms of

building up the FSLIC’s reserves, that section 1727 (d)

payments are in fact credited to a “Secondary Reserve,”

and concludes that a necessary corollary is that payments

made to a reserve must be insurance premiums. This is

no more than semantic word play. The truth of the mat-

ter is that, for the reasons outlined at the beginning of

this opinion, section 1727(d) payments cannot be con-

sidered merely additional insurance premiums. Had Con-

gress felt that the premium income of the FSLIC was

inadequate to meet expenses and losses, it could easily

have increased the regular annual premium to what it

considered a more realistic level, without enacting all the

complicated provisions which govern section 1727(d)

payments. But, in fact, during the entire life of the cor-

poration its total expenses had, to 1961, amounted to

only 3.7 percent of its gross income while net insurance

losses had absorbed “a mere 1.1 percent of the gross in-

come.” Hearings, supra. p. 10. Cf. H. Rept. No. 823,

supra, p. 2, S. Rept. No. 778, supra, p. 2. What was

needed was additional capital, not additional premium

income, which would serve as a buffer until the FSLIC

had accumulated enough of its own income to bring its

“Primary Reserves,” the true insurance reserve, to the

desired two percent level.’ True, Congress called the ac-

7 Compare the statement of Everett C. Sherbourne, vice-chairman,

Federal Legislation Committee, National League of Insured Sav-

ings Associations, Hearings, supra p. 45. “From the standpoint of

the loss experience of the Corporation, we do not believe the reserve

would be inadequate * * *. There is, however, an inadequacy of

working capital.” This witness went on to explain that the FSLIC

does not “sit idk by, wait for a loss to occur, and then pay out

insurarce * * *”, Lut hag authority to take steps, such as the making

of loans to institutions in danger of failing, which “may involve

substcrtial cash disbursements without ultimate loss to the Corpo-

ration,”

The savings and loan industry supported Public Law 87-210, see

count to which this additional capital was credited a

“Secondary Reserve,” but since such “reserve” served

the same function as a capital account, and was available

for losses “only to such extent as other accounts of the

Corporation which are available therefor are insufficient

for such losses,’ Congress’ use of the terminology of the

insurance industry should not confuse the issue. And

what, after all, is the capital account of any corporation

if not a “Secondary Reserve,” a pool of capital available

to creditors in the event that the corporation’s current

income and retained earnings are not sufficient to satisfy

their claims?

As has previously been pointed out, at the same time

and in the same measure directing insured institutions to

make these additional section 1727(d) payments to the

FSLIC, Congress reduced the ratio of stock which mem-

bers of a Federal Home Loan Bank were required t

hold against their “unpaid loan principal” from two to

one percent. It was contemplated that “[f]or most institu-

tion, this prepayment requirement [i.e., section 1727(d)

payments] would be approximately offset by reducing the

stock the institution must purchase in its Federal home

loan bank.” See H. Rept. No. 823, supra, p. 2; S. Rept.

No. 778, supra, pp. 1-2. In essence, then, Public Law 87-

210 provided that furids which would otherwise have

gone into the capital structure of the Federal Home Loan

Banks, which already had “more than sufficient [amounts

invested in capital stock] to meet the criterion of ade-

quate capitalization,” see Hearings, supra, p. 9, would

be channeled instead to the FSLIC’s Secondary Reserve,

which is itself essentially a capital account, though more

temporary in nature. Moreover, to the extent that an in-

sured institution is required to purchase additional stock

in its Federal Home Loan Bank, its section 1727(d)

payment to the FSLIC is reduced by the amount of stock

so purchased. Clearly, if the section 1727(d) payments

represented actual insurance premiums needed by the

—— ooo

its “longstanding position” that savings and loan associations

should finance “their Insurance Corporation” rather than “rely

on taxpayer funds for this purpose.” See S. Rept. No. 378, 89th

Cong., 1st Sess., pp. 71-72 (1965).

-—

FSLIC to meet its expenses and losses, rather than mere-

ly a capital cushion for the FSLIC, this arrangement

would not have been feasible. The fungibility of capital

stock payments to the Federal Home Loan Bank and sec-

tion 1727(d) payments to the FSLIC under Public Law

97-210 strongly suggests that Congress thought of both

as serving roughly the same purpose.

The conclusion then, is inescapable that section 1727

(d) payments result in the creation of an asset in the

nature of a capital investment which should, however,

eventually be used to provide insurance coverage in fu-

ture years, and that for Federal income tax purposes at

least, such payments must be capitalized and deducted

from gross income only in the years and to the extent

actually used to provide such insurance coverage or ac-

tually drawn upon to meet losses. Regs. section 1.461-1

(a), supra. Nor are we convinced by petitioner’s argu-

ment and the testimony of its expert witnesses, that even

as a matter of general accounting practice a section

1727(d) payment should be written off immediately be-

cause of uncertainty as to whether and when it will bene-

fit the insured institution. We have already demonstrated

that, for all practical purposes, these payments will

definitely be used to discharge the obligation of the in-

sured institution to pay regular annual premiums in fu-

ture years, assuming it has not previously transferred

its pro rata share of the Secondary Reserve or received a

cosh payment in respect thereof from the FSLIC. Even

the years in which the Secondary Reserve will be avail-

able for such use are not wholly a matter of conjecture,

for the Office of the Comptroller of the FSLIC has made

projections in this regard, showing, inter alia, that the

aggregate of the Primary and Secondary Reserves of the

FSLIC will equal or exceed two percent of the FSLIC’s

potential liabilities by 1970, and will thereafter be avail-

able for payment of regular annual premiums in subse-

quent years (except those in which the aggregate of the

reserves falls below 134 percent of the FSLIC’s potential

liabilities, as disclosed in the projection) until 1995, when

the Primary Reserve is expected to equal or exceed the

two percent ratio by itself.* See Findings of Fact, p. —

supra.

Moreover, the fact of the matter is that both the Cali-

fornia Savings and Loan Commissioner and the FHLB

Board require that section 1727(d) payments be capi-

talized and shown on the financial statements of insured

institutions as an asset, to be expensed only in the years

in which actually used to satisfy the insured institution’s

obligation to pay a regular section 1727(b) insurance pre

mium. It is, of course, well established that methods of

accounting prescribed by regulatory agencies are not con-

trolling for Federal tax purposes. Old Colony R. Co. vy.

Commissioner, 284 U.S. 552, 562; Bellefontaine Federal

Savings and Loan Association, 33 T.C. 808, 811-812, but

where, as here, the accounting treatment prescribed for

a particular expenditure appears to be prompted not by

any particular statutory or regulatory requirements (in-

deed, it would seem that agencies charged with the super-

vision of financial institutions would be quite anxious that

the assets and net income of such institutions not be over-

stated) but rather to be based upon sound accounting

principles, it should not be wholly disregarded. Further-

more, the financial statements of both petitioner and its

parent, the First Lincoln Financial Corporation reported

the section 1727(d) payments here in issue as assets, not

expenses, and the firm of certified public accountants

which audited such financial statements was able to state,

in the Accountant’s Report preceding such financial state-

ments, that they presented fairly the financial position of

8 The projections made by the FSLIC are, of course, based on a

number of assumptions, and are not infallible. Still, they have been

proven relatively accurate for the first five years since the enact-

ment of Public Law 87-210, and, in its annual report for 1966, the

FHLB Beard (which administers the FSJIC) stated that it ex-

pected the aggregate of the Primary and Secondary Reserves to

reach the two percent level by 1971, as compared to the prediction

of 1970 in the original FSLIC estimate. To be sure, these estimates

will not allow an insured institution to compute with pinpoint

accuracy the years in which its section 1727(d) payments will be

used to provide insurance coverage, but they do at least allow it to

make a rough approximation.

—_

;

ee |

petitioner and its parent “in conformity with generally

accepted accounting principles * * *.”

We are aware that the same issue that confronts us

here was raised, and recently decided in favor of the tax-

payer, in First Federal Savings & Loan Ass’n of St.

Joseph v. United States, 22 AFTR 2d 5238 (W.D. Mo.

1968),° the only case in which the issue herein has been

adjudicated. The District Court there refused to follow

Rev. Rul. 66-49, 1966-1 C.B. 35, in which it was stated

that section 1727(d) payments were not deductible as

ordinary and necessary expenses. The court held that

section 1727(d) payments were deductible in the year of

payment, relying on the fact that insured institutions are

“subject to the basic liability” to make such payments,

that the funds were “paid with respect to insurance cov-

erage and * * * [were] based, to a certain extent, upon

the risk of loss,” and “of even more significance,” upon

the fact that such payments “were subject to being com-

pletely consumed in the event of a loss.” We have al-

ready expressed our opinion on these matters, and, being

of the view that section 1727(d) payments are nonde-

ductible capital expenditures, we respectfully decline to

follow the holding of the District Court. Though we prefer

to rest our holding upon the reasons set forth in this opin-

ion, we do agree with the conclusion reached in Rev. Rul.

66-49 that section 1727(d) payments are not ordinary and

necessary expenses in the year of payment and are not

deductible until they are used to pay regular premiums or

losses, or the possibility of their return to the institutions

®* That case involved a Federal savings and loan association

which, unlike petitioner, a state-chartered association, was required

and not merely permitted to insure its accounts with the FSLIC.

Thus, it did not have the option, available to petitioner, of termi-

nating its insured status without going into liquidation, while

petitioner, theoretically at least, could cease being an insured

institution of the FSLIC, receive its pro rata share of the Secon-

dary Reserve in cash, and still remain in business. We need not

discuss further whether this alternative was open to petitioner

as a practical matter, and do not express any opinion as to the

significance of this distinction, for our disagreement with the

District Court’s opinion goes to the more basic issue of the inherent

nature of the section 1727(d) payment.

is otherwise precluded. Rev. Rul. 66-49, su 19

C.B. 36, 37." ea ae

Because of the unusual nature of the section 1727(d)

payments in issue, the remaining cases and rulings cited

by both petitioner and respondent are, for the most part,

distinguishable on their facts. Thus, cases cited by peti-

tioner for the proposition that an ordinary and neces-

sary business expense is not rendered nondeductible be

cause there remains after payment a contingent possibility

of future recovery, e.g., Alleghany Corporation, 28 T.C.

298, 305; Electric Tachometer Corp., 37 T.C. 158; and

ef. I.T. 2764, XIII-1 C.B. 45, IT. 3632, 1943 C.B. 114"

Rev. Rul. 62, 1953-1 C.B. 71, are of no help to petitioner

here since it failed to establish the necessary initial foun-

dation required by these® cases; i.e., that the amount of

$882,636.86 paid by it to the FSLIC in 1963 pursuant

to section 1727(d) constituted an ordinary and n

expense of that year. Cf. Harry W. Williamson, 37 T.C.

941, 944. Nor, on the other hand, were these payments

2°Tt was also held in Rev. Rul. 66-49 that the annual return

credited to each insured institution on amounts in its pro rata share

of the Secondary Reserve does not constitute taxable income to an

inaured institution on the cash basis until actually or constructively

received by it, either by way of refund or by its use to discharge

the insured institution’s obligation to pay annual premiums. Peti-

tioner, while of course not disparaging the Commissioner’s position

on this matter, claims it is inconsistent with his position on the

deductibility of the section 1727(d) payments. The question of

when this annual “return” must be included in the income of a cash

basis taxpayer is not now before us, and we express no opinion

thereon. We do note, however, that the position we take here, that

section 1727(d) payments are nondeductible capital expenditures, is

not inconsistent with the Commissioner’s position as to the time for

inclusion of the annual return on income.

11].T. 2764, relied upon by petitioner, was declared obsolete in

Rev. Rul. 68-100, 1968-9 I.R.B. 24. It involved payments made to a

temporary insurance fund set up by the Federal Deposit Insurance

Corporation in the first days of its creation, and relied upon G.C.M.

8474, IX-2 C.B. 281, which was shortly thereafter revoked by the

Commissioner. G.C.M. 18290, XIII-2 C.B. 318. See text concerning

the Texas State Depositor’s Guaranty Fund, p. ——, infra. I.T. 3632,

another ruling cited above upon which petitioner relies, cited as its

only authority I.T. 2764. Both I.T. 2764 and I.T. 3632, however, are

also distinguishable on their facts, as is noted above.

—

merely security deposits in the natatyre of a reserve for

contingent liabilities as suggested.q by respondent. Cf.

Spring Canyon Coal Co. v. Comminissioner, 48 F. 2d 78

(C.A. 10), certiorari denied 284 Uys. 654; Wayne Title

& Trust Co. v. Commissioner, 195 5 F 94 401 (C.A. 8);

Wolfington Body Co. v. Smith, 999 pF Supp. 788 (E.D.

Pa.). Compare Weber Paper ComPonany v. United States,

204 F. Supp. 394 (W.D. Mo.) affirmed, 820 F. 2d 199

(C.A. 8), with Rev. Rul. 60-275, 19(960-2 C.B. 43. Perhaps

most closely approximating the ‘SitUéyation in this case are

those cases and rulings involving P8Yayments made by Texas

State banks during the 1920’s to the Texas State De

positor’s Guaranty Fund, which, be,..ayse they shed some

light on the section. 1727(d) payments involved herein,

we now set forth in some detail.

Texas statutes required every statate bank to protect its

depositors either by a bond or policiiey of insurance, or by

becoming a contributor to the Deposi,.i+o.. Guaranty Fund.

If the latter method was elected, the... pank was required to

make annual contributions to the . Fund based upon its

average deposits, one-fourth in cash h to the State Treasury

on which the bank was entitled to int nterest, though not pay-

able until its liquidation or withdr; rawal from the Fund,

and three-fourths as a deposit on i! i+. pooks to the credit

of the State Banking Board. Thes,.., “regular contribu-

tions” were to continue until the Fupind contained five mil-

lion dollars. If a contributing bank fi ¢, 5) ed, whatever money

was needed to pay its depositors ., a.’ taken from the

Fund, which was then immediately ly reimbursed by a spe-

cial cash assessment levied on thq},, contributing banl

Such “special assessments” could not ot exceed two t of

a bank’s total average daily depos)... in any -seongened

so that, in any year in which losses es exceeded this amount,

recourse was had to the Fund its¢t self, sah the @ we

contributions” to the Fund would DD vememe wate it °s —

reached five million dollars. Each ch participating bank’s

pro rata share of the Fund was ret turn able to it upon its

withdrawal from the Fund or UPON on its liquidation.

The proper treatment to be acCO, worded the ie ats

tributions to the Fund for Federal) tania cg

became a matter of some controv. ersy. The Fs ape

Internal Revenue first held that they were deductible as

“necessary business expenses,” I.T. 1258, I-1 C.B. 281,

but soon revoked this ruling in I.T. 2208, IV-2 C.B. 81,

The position was then taken that the contributions were

not deductible since they “remain assets of such partici-

pating banks. Each participating bank retains at all times

an interest in the fund equal to the unexpended portion

of its contributions thereto, the amount whereof is readily

determinable * * *”. S.M. 3877, IV-2 C.B. 79. The Board

of Tax Appeals did not agree with this approach, holding

in First State Bank of Bracketville, 9 B.T.A. 975, fol-

lowed in First State Bank of Weimar, 10 B.T.A. 396, that

such contributions were deductible since they were paid

“pursuant to a definite liability fixed by law.” First State

Bank of Bracketville, 9 B.T.A. 975, 980. The Bureau

thereupon modified its position to conform to that of the

Board of Tax Appeals. G.C.M. 8474, IX-2 C.B. 281.

However, the Board was again confronted with this

issue in Wichita State Bank & Trust Co., 27 B.T.A. 822.

In that case, the taxpayer bank had withdrawn from the

Fund and had received its pro rata portion thereof, and

the issue raised was whether such amount was includible

in its income. The Commissioner said it was, relying on

his newly revised position on this matter following the

Bracketville and Weimar cases, contending that since the

regular contributions to the fund were deductible, their

return to the taxpayer constituted taxable income. The

Board, following its prior decisions, agreed. On appeal, in

an opinion which we now think correctly disposed of this

matter, the Fifth Circuit reversed the Board on this issue,

holding that the regular contributions were not ordi-

nary and necessary expenses but nondeductible capital

expenditures. Wichita State Bank & Trust Co. v. Com-

missioner, 69 F. 2d 595 (C.A. 5). Keeping in mind the

similar characteristics of these “regular contributions”

and the section 1727(d) payments here in issue, the fol-

lowing comments of the Fifth Circuit are instructive (69

F. 2d at 596):

* * * That fund [i.e., the permanent five million

dollar Guaranty Fund] is not intended to be lost or

consumed, but is to stand as a reservoir drawn on

—

to provide prompt payment to depositors, but to be

at once replenished by the special assessments. It is

analogous to the capital of an insurance company.

Each bank owns its pro rata part in it, which it ought

ultimately to get back. * * * We think the contribu-

tions to the $5,000,000 Guaranty Fund, while made

annually instead of in a lump sum, were essentially

capital investments and ought to be dealt with as

such.

Here the matter of the “regular contributions” was finally

settled, the Commissioner indicating agreement with the

Fifth Circuit’s opinion by reinstating S.M. 3877. G.C.M.

13290, XITII-2 C.B. 313.

We hold that the section 1727(d) payment of $882,-

636.86 made by petitioner in 1963 was a nondeductible

capital expenditure, that the Commissioner correctly dis-

allowed a deduction for this sum, and that the deficiency

determined in petitioner’s income tax for 1963 in respect

of that disallowance was proper.

Petitioner has made an alternative argument that the

Commissioner’s attempt to assess and collect the deficiency

here violated its constitutional rights under either Article

II, section 8 (directing the President to “take care that

the laws be faithfully executed”) or the Fifth Amend-

ment to the Constitution (the due process clause). Peti-

tioner relies on the fact that in the First Federal Savings

& Loan Ass’n of St. Joseph case, discussed above, a tax

refund suit in which the taxpayer savings and loan

association sued to recover taxes which it alleged were

erroneously paid for 1963, 1964 and 1965 due to its fail-

ure to deduct section 1727(d) payments made in those

years, the Government tried to settle by offering to pay

the amount sought by the taxpayer and to dismiss the

action with prejudice, though it did not wish the terms

of the settlement to be included in the final stipulation.

It should be noted that the taxpayer refused this offer,

and the District Court went to extraordinary lengths in

ruling that the refund suit had not become moot. The

District Court thereupon adjudicated the issue on the

merits in the taxpayer’s favor. Petitioner nevertheless

contends that the mere fact that the offer of settlement

was made to the taxpayer in the St. Joseph casé is fata]

to the determination of the deficiency herein on Consti-

tional grounds. We think that the point is without merit,

The position taken by the Commissioner in this case

in respect of section 1727(d) payments made to the

FSLIC is the same as that in Rev. Rul. 66-49, published

in Cumulative Bulletin 1966-1, p. 36. We have carefully

examined that position, as it relates to the facts of this

case, and have found the deficiency determined by the

Commissioner in petitioner’s income tax for 1963 was

justified by the provisions of the Internal Revenue Code

of 1954. We cannot and will not go further and examine

the Commissioner’s reasons and motives for determining

the deficiency in this case and defending his position in

response to the petition for a redetermination filed by

petitioner in this Court. See Charles Crowther, 28 T.C.

1298, 1801, affirmed 269 F. 2d 292, 293 (C.A. 9). Peti-

tioner has no ground to object merely because some other

taxpayer may have been offered a windfall as a result

of the Government’s litigation strategy. Whatever may

have been the Government’s litigation strategy in attempt-

ing to dispose of the St. Joseph case, it is not a matter

about which the petitioner herein has any standing to

complain. The history of litigation over the years has been

marked by efforts of private litigants as well as the

Government to select test cases in such manner as may be

thought to further their respective best interests, and

the refusal to press some other case has never been thought

to create any rights in favor of parties to a case where

similar concessions have not been made. Petitioner has

been accorded due process of law in the review of the

deficiency determined against it by the Commissioner

herein and the fact that it has not been offered a windfall,

if indeed the offer of settlement in the St. Joseph case was

such, does not rise to the level of an infringement of its

constitutional rights.

Reviewed by the Court.

Decision will be entered for the respondent.

_—

TAX COURT OF THE UNITED STATES

WASHINGTON

[Caption Omitted]

DECISION

(Entered October 21, 1968)

Pursuant to the determination of the Court, as set

forth in its Findings of Fact and Opinion, filed October

21, 1968, it is

ORDERED AND DECIDED: That there is a de-

ficiency in income tax for the year 1963 in the amount

of $461,454.38.

/s/ ARNOLD RAUM

Judge

EE meee

UNITED STATES COURT OF APPEALS FOR THE

NINTH CIRCUIT

No. 23,923

LINCOLN SAVINGS AND LOAN ASSOCIATION, APPELLANT

Vv.

COMMISSIONER OF INTERNAL REVENUE, APPELLEE

February 3, 1970

On Appeal from the Decision of the Tax Court of the

United States

Before ELY and HUFSTEDLER, Circuit Judges, and

THOMPSON," District Judge.

THOMPSON, District Judge:

We are asked to review a determination by the Tax

Court. A deduction of $882,636.86 from Appellant’s gross

income for 1963 was contested. The Tax Court held that

Appellant’s payment, made for inclusion in the Secondary

Reserve Account of the Federal Savings and Loan In-

surance Corporation (FSLIC) resulted in the acquisition

of a capital asset rather than constituting an ordinary

and necessary business expense deductible in the year

paid as contemplated by 26 U.S.C. § 162(a).

Jurisdiction and scope of review are governed by 26

U.S.C. § 7482.

The Tax Court, in its published opinion, Lincoln Say-

ings and Loan Association, Petitioner v. Commissioner

of Internal Revenue, Respondent, Docket No. 325-67,

51. T.C. 82, made a comprehensive and accurate statement

of the facts. Also in that opinion, as well as in First

Federal Savings and Loan Association of St. Joseph v.

United States, 288 F. Supp. 477 (W.D. Mo. 1968), and

in Washington Federal Savings and Loan Association of

Miami Beach v. United States, 304 F. Supp. 1072 (S.D.

Fla. 1969), we find extensive expositions of the applicable

* Hon. Bruce R. Thompson, United States District Judge, Reno,

Nevada, sitting by designation.

statutes and legislative history. Whatever may be said in

favor of the proliferation of the printed legal word which

has attended the effort of judicial draftsmen to make

each opinion an integrated, comprehensive whole, in this

situation, where we are concerned with unique and spe-

cialized statutory provisions having a tax impact only

on one particular segment of the economy, the savings

and loan institutions, we discern no advantage in repeat-

ing all the arguments, contentions and responses made

by the parties here which have been thoroughly consid-

ered in the referenced opinions. Neither is it useful to

restate the facts in detail, a statement which required

twenty-three typewritten pages of the Tax Court opinion.

We are writing with the assumption that the reader

is familiar with the opinions to which reference has

been made.

The taxpayer here is a state-chartered savings and loan

association. The St. Joseph and Miami Beach opinions,

supra, concerned federal savings and loan associations.

The federal institutions are required by law to insure

deposits with FSLIC and so to make the premium pay-

ments to the Secondary Reserve. A state-chartered insti-

tution is not required by law to insure deposits with

FSLIC. In this respect, the cases differ. The Tax Court,

however, found as a fact that “in the opinion of its (tax-

payer’s) management loss cf its insured status with the

FSLIC would cause a mass withdrawal of savings by its

depositors”, and quite properly refused to distinguish the

St. Joseph case on account of the difference we have noted.

We deem both the St. Joseph and Miami Beach opinions

to be persuasive authority in support of the contentions

of this taxpayer and we adopt the cogent arguments in

those opinions by reference, without repetition.

The Tax Court opinion approves Revenue Ruling 66-49

(Internal Revenue Bulletin, C.B. 1966-1, January-June

1966, p. 36). The headnote summarizes the ruling.’ Such

1“The additional premium prepayments which an insured savings

and loan institution is required to pay to the Federal Savings and

Loan Insurance Corporation under the provisions of section 404 of

the National Housing Act, as amended, are not deductible when

paid and may be deducted only when any possibility of their return

—

rulings, unlike Treasury Regulations, do not have the

force of law and are at most merely persuasive. We

think the revenue ruling is wrong.

The question presented is whether the premium pay-

ments under 12 U.S.C. §1727(d), which the taxpayer

made into the Secondary Reserve of FSLIC, were de

ductible as “ordinary and necessary expenses paid or in-

curred during the taxable year in carrying on any trade

or business.” 26 U.S.C. § 162(a). The Tax Court said no,

and characterized the expense as a nondeductible capital

expenditure. 26 U.S.C. § 262. In doing so, the Court em-

phasized the way the Secondary Reserve was accounted

for and managed by FSLIC. It pointed out that Section

1727(d) payments “are not considered as income by the

FSLIC”; are used “only for losses of the corporation * * *

to such extent as other accounts * * * are insufficient”;

that the Secondary Reserve account is “rather like a cap-

ital account”; that the Secondary Reserve is “part of a

pool of capital available to the FSLIC * * * in the event

of emergency.” We think the emphasis upon the treatment

of the receipt by the payee, FSLIC, is mistaken and that

in determining whether an expense is an ordinary and

necessary expense of doing business, the focus should

be on the taxpayer and the taxpayer’s business, not on

is precluded. With respect to an accrual basis institution, earnings

on such premiums are not includible in the gross income of that

institution until such time as the earnings are no longer available

for losses of the FSLIC. With respect to a cash basis institution,

earnings on such premiums are includible in the gross income of the

institution credited therewith only when such earnings are used to

pay its obligations or become available to that institution without

substantial restriction or limitation.” Internal Revenue Bulletin,

C.B. 1966-1, January-June 1966, p. 36.

2 Macey’s Jewelry Corp. v. United States, 387 F.2d 70, 72 (5th

Cir. 1967); United States v. Bennett, 186 F. 2d 407, 410 (5th

Cir. 1951); cf. Skidmore v. Swift & Co., 323 U.S. 184 (1944);

United States v. Jefferson Co. Bd. of Educ., 372 F. 2d 886, 858

(5th Cir. 1966); Tandy Leather Co. v. United States, 347 F. 2d

693 (5th Cir. 1965); Norton Mfg. Corp. v. United States, 288 F.

Supp. 829, 835 (N.D. Ill. 1968) ; Pauley v. United States, 68 U.S.T.C.

para. 9280 (S.D. Cal. 1963) ; Kaiser v. United States, 262 F. 2d 367,

870 (7th Cir. 1958), aff’d, 363 U.S. 299 (1960).

what the payee does with the money paid. This is not to

say that rights retained by the taxpayer are to be

ignored.

Obviously, the payment made to the Secondary Reserve

has hybrid characteristics. If this were not so, there would

be no lawsuit. The tax impact of the payment must de-

pend upon whether it is more like a capital investment

or a business expense.

In opting for the business expense treatment of this

expenditure, we first consider whether the revenue ruling

to the contrary is inconsistent with the annual accounting

concept of income determination and income tax assess-

ment. We think that it is. The importance of this con-

cept was emphasized in Security Mills Co. v. Comm’r,

821 U.S. 281 (1944), where the Court said:

“The rationale of the system is this: ‘It is the

essence of any system of taxation that it should

produce revenue ascertainable, and payable to the

government, at regular intervals. Only by such a

system is it practicable to produce a regular flow of

income and apply methods of accounting, assessment,

and collection capable of practical operation.’

“This legal principle has often been stated and

applied. The uniform result has been denial both

to Government and to taxpayer of the privilege of

allocating income or outgo to a year other than the

year of actual receipt or payment, or, applying the

accrual basis, the year in which the right to re-

ceive, or the obligation to pay, has become final and

definite in amount.”

To treat the payments of premiums to the Second-

ary Reserve as the acquisition of a capital asset is a

departure from the basic concept of accounting for re-

ceipts and disbursements in the year when made (on cash

basis accounting). So, it is not just a matter of choosing

one treatment or the other. On the contrary, persuasive

reasons should appear to justify the departure.

The Commissioner’s ruling also ignores another of the

most fundamental concepts of federal income taxation.

Both federal income taxation and generally accepted

principles of the accounting profession assume that a

corporate taxapyer is a “going concern” and will continue

indefinitely. Ascertainment of revenue at the end of the

accounting period does not hinge upon determination of

liquidation value of closing inventories, nor is apprecia-

tion or depreciation in value of balance sheet assets con-

sidered. This concept is so basic that Congress felt com-

pelled to provide a specific exemption for corporations

formed or acquired primarily for liquidation. 26 U.S.C,

§ 341 (1964). Accordingly, to give consideration to the

possibilities of reimbursement because of liquidation or

receivership is inconsistent with this principle. The pos-

sibility of reimbursement by the taxpayer’s voluntary act

of termination of coverage is in the same category. The

Tax Court found that Appellant’s management believed

that termination of insurance would cause mass with-

drawal by its depositors and, ultimately liquidation. The

Court also found that all but an insignificant portion of

the savings and loan industry thought it necessary to have

insurance coverage. Therefore, the practical realities re

quire the conclusion that termination of coverage is not

a proper consideration in determining the finality of the

disbursement in issue. Termination here is deemed tanta-

mount to liquidation or receivership.

We also believe that the revenue ruling is inconsistent

within itself. It declares (1) that the payments to the

Secondary Reserve were not deductible until any possi-

bility of their return was precluded; also (2) that earn-

ings on the Secondary Reserve are taxable to the tax-

payer only when they become available to it without sub-

stantial restriction or are paid out for its benefit. When

we consider that under the “claim for right” doctrine,

there must be an impossibility of even constructive pos-

session to defeat taxation of income and that a non-con-

tractual obligation of repayment will not defeat it (James

v. United States, 366 U.S. 218 (1961)) in the context of

the “all events” test fixing the accounting period for the

allowance of deductions as the one in which ail events

had occurred which fixed the amount and the fact of the

liability (United States v. Anderson, 269 U.S. 422 (1926);

Dixie Pine Co. v. Comm., 320 U.S. 516 (1944); United

| 81

States v. Consolidated Edison Co., 366 U.S. 380 (1961)),

there is an incongruity in a ruling that the income credited

to the Secondary ‘Reserve allocated to the taxpayer was

not then taxable because of the restrictions on its use,

while at the same time these same restrictions precluded

deduction of the premium payments as business ex-

ses. If there were so many restrictions on the funds

paid to FSLIC that the income derived therefrom was not

even constructively received and was not taxable when

credited, a fortiori these same restrictions on reimburse-

ment or recapture of the Kunds made the payment final

and deductible in the year it was made. All events had

occurred which fixed the amount and the fact of the

liability. of

From the point of view of Congressional policy, we

should observe that the rule of\ United States v. Con-

solidated Edison Co., 366 U.S. 380 (1961), holding that

a contested tax liability paid under protest could be de-

ducted not in the year of payment but only in the year

liability became fixed and final has been reversed by Con-

gress. 26 U.S.C. § 461(f).4 The Senate Report, in ex-

planation of the 1964 amendment, states, in part: “The

objective of the reporting of items of income and deduc-

tion under the internal revenue laws generally is to

realistically and practically match receipts and disburse-

ments attributable to specific taxable years. The internal

revenue laws contain a number of adjustments designed

to accomplish this result. Your committee believes that

allowing the deduction of items in the year paid, even

though they are still being contested in the courts or

otherwise, more realistically matches these deductions up

8“(f) Contested liabilities. —-If—

“(1) the taxpayer contests an asserted liability,

“(2) the taxpayer transfers money or other property to provide

for the satisfaction of the asserted liability,

“(3) the contest with respect to the asserted liability exists after

the time of the transfer, and

“(4) but for the fact that the asserted liability is contested, a

deduction would be allowed for the taxable year of the transfer

(or for an earlier taxable year),

“then the deduction shall be allowed for the taxable year of the

transfer.” 26 U.S.C. § 461(f).

_ —

with the income to which they relate than would the post-

ponement of the deduction, perhaps for several years, until

the contest is settled.” U.S. Cong. & Adm. News, &&h

Cong., 2nd Sess., p. 1773.

This reaffirmation of basic Congressional policy ob-

viously is not specific authority for our particular prob-

lem. It, nevertheless, should incline us to recognizing

deductions in the year payment is made rather than to

postpone them because of contingent and sometimes quite

illusory possibilities of recapture.

The payments made by this taxpayer into the Sec.

ondary Reserve of FSLIC meet the tests of n

business expenses. The expense is “appropriate and

ful” for the “development of the taxpayer’s business,”

Commissioner v. Tellier, 383 U.S. 687 (1966). To say that

they are also “ordinary” is to beg the question which faces

us inasmuch as “ordinary” is a qualification designed to

exclude expenditures “in the nature of capital expendi-

tures which, if deductible at all, must be amortized over

the useful life of the asset.” Commissioner v. Tellier,

supra. These payments, nevertheless, fulfill our concep-

tion of an “ordinary” business expense. It is a recurring

annual expense geared primarily to acceleration of the

taxpayer’s business; that is, the increase in the accounts

of the insured members. It is an expense which, from

a practical point of view, has to be paid to stay in busi-

ness. It must be paid regardless of whether income is

available for the purpose. The obligation is not associated

with an increase of the taxpayer’s income. On the con-

trary, it is generated because of an increase in the tax-

payer’s liabilities. When these identifying brands are

present, it is practical and essential that the character

of the expenditure as an ordinary, as well as necessary,

business expense be recognized. Otherwise, the impact of

the tax may destroy the business.

For the reasons stated, in addition to those articulated

in the St. Joseph and Miami Beach cases, supra, we deem

Revenue Ruling 66-49 to be unreasonable. The decision

of the Tax Court is reversed.

——

HUFSTEDLER, Circuit Judge:

I respectively dissent. There is nothing in the record

to support the majority’s statement that the payments

are a “recurring annual expense.” ‘\) the contrary, the

Tax Court found that in all likelihood the section 1727

(d@) payments would be required for a duration of only

a few years (until approximately 1971) and that there-

after the suspension provisions of 1727(g) would be in

effect. The taxpayer’s pro rata share of the Secondary

Reserve would then be used to discharge its premium ob-

ligations under section 1727(b). “[F Jor all practical pur-

poses, [the section 1727(d)] payments will definitely be

used to discharge the obligation of the insured institution

to pay regular annual premiums in future years, assum-

ing it has not previously transferred its pro rata share

of the Secondary Reserve or received a cash payment in

respect thereof from the FSLIC.” (51 T.C. at 102).

For this and the other reasons expressed by the unani-

mous Tax Court, I would affirm on the ground that the

yments are “in the nature of a prepayment with re-

spect to future premiums,” and are not therefore de-

ductible as an ordinary and necessary business expense in

the year made.

UNITED STATES COURT OF APPEALS FOR THE

NINTH CIRCUIT

No, 23923 (Tax Ct No. 325-68)

{Caption Omitted]

Upon Petition to Review a Decision of The Tax Court

of the United States

(Filed and entered Feb. 3, 1970)

JUDGEMENT

This Cause came on to be heard on the Transcript of

the Record from The Tax Court of the United States

and was duly submitted.

On Consideration Whereof, it is now here ordered and

adjudged by this Court, that the Decision of the said Tax

Court of the United States in this Cause be, and hereby is

reversed.

UNITED STATES COURT OF APPEALS FOR THE

NINTH CIRCUIT

[Caption Omitted]

Excerpt from Proceedings of Wednesday,

March 18th, 1970

Order Denying Petition for Rehearing

Before: ELY and HUFSTEDLER, Circuit Judges, and

THOMPSON, District Judge.

On consideration thereof, and by direction of the Court,

It is ordered that the petition of appellee filed February

20, 1970 and within time allowed therefor by rule of

court, for a rehearing of above cause be, and hereby

is denied, and rejecting suggestion for rehearing en banc.

SUPREME COURT OF THE UNITED STATES

No. 544, October Term, 1970

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

LINCOLN SAVINGS AND LOAN ASSOCIATION

ORDER ALLOWING CERTIORARI. Filed November 9,

1970

The petition herein for a writ of certiorari to the

United States Court of Appeals for the Ninth Circuit is

granted.

W ov. 8. coveenment paimtine orrice; 1970 410345 353

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.