Source: https://supreme.justia.com/cases/federal/us/291/193/
Timestamp: 2019-04-22 04:29:08+00:00

Document:
A general agent of fire insurance companies received "overriding commissions" on the business written each year, subject however to the contingent liability that, when any of the policies was cancelled before its term had run, a part of the commission thereon, proportionate to the premium money repaid the policyholder, must be charged against the agent in favor of the company. In his accounts and income tax returns involved in this case, he deducted from the accrued commissions of each year a sum entered in a reserve account to represent that part of them which, according to the experience of earlier years, would be returnable because of cancellations.
1. That the deduction were not "expenses paid or incurred" in the taxable years. Section 214, Revenue Acts of 1921, 1924, and 1926. P. 291 U. S. 198.
2. Although a liability accrued may be treated as an expense incurred, a contingent liability is not an accrued liability unless so designated specifically by statute. P. 291 U. S. 200.
3. The reserve set up is not akin to the reserves required of insurance companies, nor is it to be classed with the reserves voluntarily established as a matter of conservative accounting which are specifically authorized by the Revenue Acts. P. 291 U. S. 201.
4. Under § 212(b), it was within the discretion of the Commissioner to require the taxpayer to adhere to a method of accounting previously used in the business deduction of the return commissions accrued during the tax year from the "overriding commissions" accrued during that year if, in the Commissioner's opinion, the older method would more clearly reflect the net income. P. 291 U. S. 202.
5. It was likewise within the province of the Commissioner to reject an alternative method proposed by the taxpayer -- viz, a prorating of the overriding commissions over the lives of the policies and deduction of return commissions as they accrued. P. 291 U. S. 203.
Certiorari, 290 U.S. 607, to review the affirmance, on appeal, of an order of the Board of Tax Appeals (22 B.T.A. 678), sustaining three deficiency assessments of income taxes.
Coast General Agent for fire insurance companies. [Footnote 1] In 1923, Arthur M. Brown conducted the concern alone. In 1925 and 1926, he and his son Arthur M. Brown, Jr., conducted it as partners. The general agent receives as compensation from its principals, among other things, a so-called "overriding commission" on the net premiums derived from business written through the local agents. The question for decision is how the income of the petitioner, Arthur M. Brown, derived from overriding commissions during the years 1923, 1925, and 1926, should be calculated for purposes of the federal income tax. The Commissioner of Internal Revenue held that, in determining income, the gross overriding commissions on business written during the year should not be subjected to any deduction on account of cancellations expected to occur in later years. The taxpayer contends that either the gross overriding commissions should be subjected to such a deduction, or that parts of the gross overriding commissions should be allocated as earnings of future years.
The term "net premium," as used in providing for overriding commissions, means the gross premium on the business written less the return premium and the net cost of any reinsurance. Fire insurance policies are written for periods of one, three, or five years, with the right of cancellation by either party at stipulated rates of premium return. Premiums being payable in advance (subject to the 60-day grace period), a return premium is paid to the policyholder in case of cancellation, and the general agent, who receives the premium, pays the return premium. The company writing a policy frequently reinsures in another company a part of its contingent liability, and the general agent, who makes the payments for reinsurance, receives, in case of cancellation, a return of a proportionate part of the cost of the cancelled reinsurance. The general agent makes to each principal remittances on monthly balances, crediting itself, among other things, with the overriding commissions on premiums receivable, with the return premiums paid, and with the net amount paid for reinsurance, and charging itself, among other things, with a proportionate part of any overriding commissions previously credited in respect of any business which has been cancelled during the month. Thus, whenever there is a cancellation and a return or credit of a portion of the premium and of the cost of any reinsurance, the general agent returns to the company or charges itself with a corresponding portion of the overriding commission.
set up on the books of the concern at the close of 1923, for the first time, a liability account entitled "Return Commission." In it was recorded an estimate of the liability expected to arise out of the general agent's obligations to refund to the companies a proportionate part of the overriding commission received because of cancellations which it was expected would occur in future years. The estimate was based on the experience of the preceding five years. Thus, on the books, the year's income from overriding commissions was reduced by the amount of refunds which, it was estimated, would have to be made in future years. This changed method of accounting has been followed ever since, and the difference in the method of calculating the general agent's income has been reflected in the returns made by Brown of his taxable income.
In making his federal income tax return for the years 1923, 1925, and 1926, Brown claimed as deductions the benefit of the credits so made to the "Return Commission" account. The Commissioner of Internal Revenue disallowed these deductions, and accordingly assessed to Brown for 1923 a deficiency of $17,923.03; for 1925, a deficiency of $1,520.19, and for 1926, a deficiency of $944.30. [Footnote 3] The Commission's determinations were sustained by the Board of Tax Appeals, 22 B.T.A. 678, and its order was affirmed by the Circuit Court of Appeals. 63 F.2d 66. Certiorari was granted by this Court because of alleged conflict with the decision of the Circuit Court of Appeals for the Fourth Circuit in Virginia-Lincoln Furniture Corp. v. Commissioner, 56 F.2d 1028, and other cases.
First. The Commissioner properly disallowed the deduction on account of the credits to the "Return Commission"
"That, in computing net income, there shall be allowed as deductions: 1. All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."
The only relevant deductions allowable by law are those provided for in § 214, and the burden rests upon the taxpayer to show that he was entitled to the deduction claimed. Reinecke v. Spalding, 280 U. S. 227, 280 U. S. 232.
The overriding commissions were gross income of the year in which they were receivable. As to each such commission, there arose the obligation -- a contingent liability -- to return a proportionate part in case of cancellation. But the mere fact that some portion of it might have to be refunded in some future year in the event of cancellation or reinsurance did not affect its quality as income. Compare American National Co. v. United States, 274 U. S. 99. When received, the general agent's right to it was absolute. It was under no restriction, contractual or otherwise, as to its disposition, use, or enjoyment. Compare 286 U. S. Burnet, 286 U.S.
417, 286 U. S. 424. [Footnote 5] The refunds during the tax year of those portions of the overriding commissions which represented cancellations during the tax year had, prior to the tax return for 1923, always been claimed as deductions, and they were apparently allowed as "necessary expenses paid or incurred during the taxable year." The right to such deductions is not now questioned. Those which the taxpayer claims now are of a very different character. They are obviously not "expenses paid during the taxable year." They are bookkeeping changes representing credits to a reserve account.
These charges on account of credits to the "Return Commission" reserve account are claimed as deductions on the ground that they are expenses "incurred . . . during the taxable year." It is true that, where a liability has "accrued during the taxable year," it may be treated as an expense incurred, and hence as the basis for a deduction, although payment is not presently due, United States v. Anderson, 269 U. S. 422, 269 U. S. 440-441; American National Co. v. United States, 274 U. S. 99; Aluminum Castings Co. v. Routzahn, 282 U. S. 92, and although the amount of the liability has not been definitely ascertained. United States v. Anderson, supra. [Footnote 6] Compare Continental Tie & Lumber Co. v. United States, 286 U. S. 290, 286 U. S. 296. But no liability accrues during the taxable year on account of cancellations which it is expected may occur in future years, since the events necessary to create the liability do not occur during the taxable year. Except as otherwise specifically provided by statute, a liability does not accrue as long as it remains contingent. Weiss v. Wiener, 279 U. S. 333, 279 U. S. 335; Lucas v. American Code Co., 280 U. S. 445, 280 U. S. 450-452; compare 271 U. S. Co.
v. Edwards, 271 U. S. 109, 271 U. S. 116; Ewing Thomas Converting Co. v. McCaughn, 43 F.2d 503; Highland Milk Condensing Co. v. Phillips, 34 F.2d 777.
to deduct from their gross income the amounts credited to such reserves each year, provided that the amounts deductible on account of the reserve shall approximate as nearly as can be determined the actual amounts which experience has demonstrated would be necessary to discharge the liabilities incurred during the year and for the payment of which additions to the reserves were made."
The accrual method of accounting had been regularly employed by Edward Brown & Sons before 1923, but no "Return Commission" account had been set up. Moreover, the method employed by the taxpayer is never conclusive. If, in the opinion of the Commissioner, it does not clearly reflect the income, "the computation shall be made upon such basis and in such manner" as will, in his opinion, do so. United States v. Anderson, 269 U. S. 422, 269 U. S. 439; Lucas v. American Code Co., 280 U. S. 445, 280 U. S. 449; Lucas v. Ox Fibre Brush Co., 281 U. S. 115, 281 U. S. 120; compare Williamsport Wire Rope Co. v. United States, 277 U. S. 551; Lucas v. Structural Steel Co., 281 U. S. 264. [Footnote 11] In assessing the deficiencies, the Commissioner required, in effect, that the taxpayer continue to follow the method of accounting which had been in use prior to the change made in 1923. To so require was within his administrative discretion. Compare Bent v. Commissioner, 56 F.2d 99.
that, where books are kept on the accrual basis, the income shall be accounted for as it is earned. He suggests, therefore, as an alternative method of ascertaining the income, that the commissions on each year's writing be prorated over the life of the policies.
Under this alternative proposal, the practice of making deductions prevailing prior to 1923 would remain unchanged, but the method of ascertaining the gross income of the taxable year would be subjected to a far-reaching change. The proposal is that all policies be deemed to have been written on July 1; that, of the overriding commission on one-year policies, one-half should be returned as income of the year in which the policy was written, the other half as income of the next year; that, of the commissions on three-year policies, one-sixth should be returned as income of the year in which the policy was written, one-third as the income of each of the next two years, and one-sixth as income of the fourth year, and that, of the commission on five-year policies, one-tenth should be returned as income of the first year, one-fifth as income of each of the next four years, and one-tenth as income of the sixth year.
the relative merits of systems of accounting. Lucas v. American Code Co., 280 U. S. 445, 280 U. S. 449.
The deductions here claimed, not being authorized specifically either by the Revenue Acts or by any regulation applying them, were properly disallowed. So far as the decision in Virginia-Lincoln Furniture Corp. v. Commissioner, 56 F.2d 1028, may be inconsistent with this opinion, it is disapproved.
"The firm appointed and removed local agents, accepted service of process, adjusted losses under policies, received and acknowledged service of proof of loss, issued, countersigned, and cancelled policies, received and receipted for premiums, surveyed all risks offered, and accepted or rejected the same, represented its principals on the Pacific Board of Underwriters, computed and paid commissions due local agents, ceded or reinsured certain lines of business with treaty or other companies, computed and paid return premiums on cancelled policies, secured return of premium on cancelled reinsurance, rendered all reports required of its principals by the authorities of political subdivisions in the territory in which it operated, attended to the payment of all license fees and taxes, furnished all necessary printed matter, except policy blanks, to local agents, transferred insurance by indorsement, determined whether its principals should participate in special pools, and generally attended to all the affairs of its principals in the territory in which it operated."
Sections 212, 213, and 214 of the Revenue Act of 1924, c. 234, 43 Stat. 253, 267-270, and the corresponding sections of the Revenue Act of 1926, c. 27, 44 Stat. 9, 23-27 contain provisions identical with those quoted above, except that § 206 of those acts is also referred to as defining deductions.
See also Vang v. Lewellyn, 35 F.2d 283.
See also Uncasville Mfg. Co. v. Commissioner, 55 F.2d 893, 895; Ocean Accident & Guarantee Corp. v. Commissioner, 47 F.2d 582. Compare Commissioner v. Old Dominion S.S. Co., 47 F.2d 148.
"From my experience in the insurance business, I would say that approximately the general ratio of cancellations to business written, depending on the year, runs between 20% and 25%."
Compare Barde Steel Products Corp. v. Commissioner 40 F.2d 412, 416; Spring Canyon Coal Co. v. Commissioner, 43 F.2d 78.
"(b) The net income shall be computed . . . in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if . . . the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as, in the opinion of the Commissioner, does clearly reflect the income."
United States v. Anderson, 269 U. S. 422; American National Co. v. United States, 274 U. S. 99, 274 U. S. 101; Niles Bement Pond Co. v. United States, 281 U. S. 357, 281 U. S. 359; Aluminum Castings Co. v. Routzahn, 282 U. S. 92, 282 U. S. 98.
See also Industrial Lumber Co. v. Commissioner, 58 F.2d 123; Jennings & Co. v. Commissioner, 59 F.2d 32.

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