Opinion ID: 1205077
Heading Depth: 2
Heading Rank: 4

Heading: are the claims paid by the underwritten title companies income to the title insurers?

Text: As noted earlier, all of the underwriting agreements at issue in this case allocate to the underwritten title companies the obligation to pay a portion of certain title insurance claims. The provisions for payment of claims in the underwriting agreements vary; some contemplate that the underwritten title company will pay claims up to a certain sum, while others provide that the underwritten title company will pay some or all of the claims due to its negligence in searching title. Title insurance differs from other insurance in that the preliminary title search is designed to eliminate risk by identifying any possible clouds on the title and excluding them from the coverage of the policy. Thus, the obligation of the underwritten title company to pay some portion of claims made under the title policy appears to serve the purpose of increasing the title company's incentive to perform its title search carefully. Although the title insurers [1] and the Board disagree vigorously on many issues in this case, they do agree that the characterization of any particular payment of a claim as income to the title insurer should not depend on whether the underwritten title company makes the payments directly to the insured or, instead, indirectly through the title insurer. We agree that the distinction between direct and indirect payment of claims has no legal significance. To hold otherwise would exalt form over substance, a practice that courts strive to avoid when interpreting tax law. (See United States v. Hendler (1938) 303 U.S. 564, 566 [82 L.Ed. 1018, 1019-1020, 58 S.Ct. 655], superseded by statute on other grounds as stated in Heverly v. Commissioner (3d Cir.1980) 621 F.2d 1227, 1239; Burnet v. Wells (1933) 289 U.S. 670, 677 [77 L.Ed. 1439, 1443, 53 S.Ct. 761].) (1) We begin our analysis with a discussion of the meaning of income, as title insurers are taxed on the basis of all income upon business done in this State. (Cal. Const., art. XIII, § 28, subd. (c).) Although the constitutional provision and the statutes dealing with taxation of title insurers do not define the term all income, we may look to our state's definition of gross income for guidance. Under California law, [g]ross income [is] defined by Section 61 of the Internal Revenue Code [26 United States Code section 61]. (Rev. & Tax. Code, § 17071 [definition for purposes of personal income tax]; see also Rev. & Tax. Code, § 24271 [bank and corporation tax law]; and Spurgeon v. Franchise Tax Board (1984) 160 Cal. App.3d 524, 528 [206 Cal. Rptr. 636] [the federal and California definitions of `income' are identical].) Accordingly, it is appropriate for us to look to federal as well as state authorities for an understanding of the meaning of the term income. However, our task is to determine whether title insurers realize income for purposes of California insurance tax law. In doing so, we must also consider the practical realities of the title insurance business in California. (2a) The Board contends that a title insurer realizes income when an underwritten title company pays its share of claims made under title policies. The majority of the Court of Appeal characterized such payments as payments made on behalf of the title insurers in discharge of the insurers' debts. In reaching that conclusion, the court emphasized that only the title insurer and the insured are parties to the title policy. The dissent below, on the other hand, correctly noted that a portion of the risk had, in effect, been contractually allocated to the underwritten title company through the underwriting agreement. As the dissent explained, the insurer has agreed, on an aggregate basis, to take in only 10 percent of all premiums on the assumption that the risk-sharing and actual claims pay out is approximately proportionate. It thus actually receives consideration from the insured commensurate with that portion of the risk which has not contractually shifted to the underwritten title company. The apportionment of premiums cancels the apportionment of liabilities. (Dis. opn. of Anderson, J.) On this basis, the dissent concluded that the underwritten title company's payment of claims did not result in income to the title insurer. As we will discuss, the dissent appears to have reached the correct result. (3) Income has been defined as undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion ( Commissioner v. Glenshaw Glass Co. (1955) 348 U.S. 426, 431 [99 L.Ed. 483, 490, 75 S.Ct. 473]) and as the accrual of some gain, profit or benefit to the taxpayer. ( Commissioner v. Wilcox (1946) 327 U.S. 404, 407 [90 L.Ed. 752, 754-755, 66 S.Ct. 546, 166 A.L.R. 884], overruled on other grounds in James v. United States (1961) 366 U.S. 213, 221 [6 L.Ed.2d 246, 254-255, 81 S.Ct. 1052].) Income may be in the form of a direct payment to the taxpayer. Additionally, the discharge of a taxpayer's indebtedness may constitute income to that taxpayer. (See United States v. Hendler, supra, 303 U.S. at p. 566 [82 L.Ed. at pp. 1019-1020] [[The taxpayer's] gain was as real and substantial as if the money had been paid it and then paid over by it to its creditors]; see also Old Colony Trust Co. v. Commissioner (1929) 279 U.S. 716, 729 [73 L.Ed. 918, 927-928, 49 S.Ct. 499]; Burnet v. Wells, supra, 289 U.S. at p. 677 [77 L.Ed.2d at p. 1443]; Diedrich v. Commissioner (1982) 457 U.S. 191, 195 [72 L.Ed.2d 777, 781-782, 102 S.Ct. 2414], superseded by statute as stated in Davis v. Commissioner (6th Cir.1984) 746 F.2d 357, 364.) Congress has defined gross income as all income from whatever source derived, including [i]ncome from discharge of indebtedness. (26 U.S.C. § 61(a)(12).) [2] Discharge of indebtedness does not constitute taxable income per se; rather, it is  income from discharge of indebtedness that is included within taxable income. (See, e.g., Commissioner v. Rail Joint Co. (2d Cir.1932) 61 F.2d 751, 752.) (2b) In order to determine whether the title insurers may be taxed on the claims paid by the title companies pursuant to the terms of the underwriting agreements, it is not enough to conclude that the insurers remain ultimately liable to the insured for these amounts. We must also consider whether the title insurers realize income, that is, whether the payment of claims results in an accession to wealth. The crux of the Board's argument is that the claims paid by the underwritten title companies constitute income to the title insurers because only the insurers are liable to the insured. The Board reasons that only the title insurer and the insured, not the underwritten title company, are parties to the title insurance contract, and that only the title insurer is authorized to issue title insurance policies under California law. Therefore, in the Board's view, obligations arising under the policy are the insurer's debts and the insurer realizes income when the underwritten title company either pays the insured directly or reimburses the insurer for claims made under the policy. However, in reality the answer is not as simple as the Board's argument suggests. The title insurer and the title company, through the underwriting agreement, have agreed to allocate the labor, risk, liability, and premium involved in the preparation and issuance of a contract of title insurance. The underwriting agreement is an arm's-length contract; each party has presumably agreed that the values of the performances are equal, and each has promised consideration in return for the other's promised performance. Under the agreement, the underwritten title company retains a portion of the premiums and undertakes certain obligations, among them searching title and paying a share of certain claims arising under the policy. The title insurer forgoes the portion of the premium attributable to the portion of the risk that is allocated to the underwritten title company. Nevertheless, the insurer remains liable to the insured and must pay the full amount of the claims if the underwritten title company fails to perform in accordance with its obligation under the underwriting agreement. (4a) The Board argues that an arrangement by which the insurer and the underwritten title company allocate the risks between them would make the underwriting agreement an illegal contract of insurance. California law forbids anyone to transact any class of insurance business without first being admitted by the Insurance Commissioner to such class. (Ins. Code, § 700. [3] ) The parties have stipulated that the underwritten title companies are not licensed or authorized to carry on the business of insurance in California. However, even if the underwriting agreements serve a risk-shifting function, we need not conclude that they are illegal insurance contracts. (5) Insurance is defined as a contract whereby one undertakes to indemnify another against loss, damage, or liability arising from a contingent or unknown event. (§ 22.) Case law has interpreted this statute as requiring two elements: (1) a risk of loss to which one party is subject and a shifting of that risk to another party; and (2) distribution of risk among similarly situated persons. [Citations.] ( Metropolitan Life Ins. Co. v. State Bd. of Equalization (1982) 32 Cal.3d 649, 654 [186 Cal. Rptr. 578, 652 P.2d 426].) (4b) The underwriting agreement does not appear to be a contract of insurance for two reasons. First, it does not appear to distribute the risk of liability for claims among similarly situated persons. Under the contract, the underwritten title company agrees to indemnify the insurer for a portion of its liability. There is no indication that the underwriting agreements distribute the risk among similarly situated title insurers. (6) Second, the mere fact that a contract contains these two elements [shifting and distribution of risk of loss] does not necessarily mean that the agreement constitutes an insurance contract for purposes of statutory regulation. ( Truta v. Avis Rent A Car System, Inc. (1987) 193 Cal. App.3d 802, 812 [238 Cal. Rptr. 806] [ Truta ].) Rather than simply look to whether the contract involves an assumption of a risk, we will instead ask `whether that [assumption of risk] or something else to which it is related in the particular plan is its principal object and purpose.' ( Transportation Guar. Co. v. Jellins (1946) 29 Cal.2d 242, 249 [174 P.2d 625] [ Jellins ]; see also 12 Appleman, Insurance Law and Practice (1981) § 7002, p. 14.) Following this reasoning, California courts have held that arrangements similar to those in this case were not illegal contracts of insurance. For instance, a car rental agreement containing an element of insurance was not an illegal contract of insurance because the insurance element was peripheral to the main purpose of the contract. ( Truta, supra, 193 Cal. App.3d at p. 814.) Likewise, a truck maintenance contract in which the contractor agreed to insure the vehicles for the owner with an authorized insurance company was held to be not an illegal contract because the main purpose of the contract was to supply labor. ( Jellins, supra, 29 Cal.2d at pp. 249, 252-253.) Further, a medical services corporation that provided medical services to low-income patients who paid monthly membership dues did not engage in the business of insurance illegally, because the principal purpose or object of the operation was service rather than indemnity. ( California Physicians' Service v. Garrison (1946) 28 Cal.2d 790, 809-810 [172 P.2d 4, 167 A.L.R. 306].) (4c) Based on this analysis, we conclude that the underwriting agreements are not illegal contracts of insurance. Their main function is not to require the underwritten title company to provide insurance, either to the title insurer or to the insured, but instead to require the underwritten title company to perform a title search and examination carefully and diligently as well as to carry out the formalities involved in the issuance of a title insurance policy. The indemnification provisions are secondary to the main object and purpose of the underwriting agreements. In fact, the agreements to indemnify appear to be designed, at least in part, to give the underwritten title companies an incentive to perform their title search in a nonnegligent manner, as the title companies are in the best position to eliminate possible risk. Therefore, the title company is not involved in the illegal practice of insurance even if an underwritten title company is deemed to have provided indemnification in connection with the main purpose of its contract with the title insurer. (2c) The parties have been unable to direct us to any case closely analogous to the one before us. However, none of the cases cited by the parties lead us to conclude that the title insurers realize income in the amount of the claims paid by the title companies. The Board asserts that we should follow cases holding that payments in discharge of legal obligations under a contract are income. (See, e.g., Robertson v. United States (1952) 343 U.S. 711, 713 [96 L.Ed. 1237, 1240, 72 S.Ct. 994] [ Robertson ].) However, the cases relied on by the Board for this proposition are clearly distinguishable. The Board cites Diedrich v. Commissioner, supra, 457 U.S. 191, 196-198 [72 L.Ed.2d 777, 782-784], which involved a gift structured so that the donee paid the gift tax rather than the donor. The court treated the transaction as a partial sale and held that the gift tax was income to the donor to the extent that the tax exceeded the donor's adjusted basis in the property. Similarly, in Old Colony Trust Co. v. Commissioner, supra, 279 U.S. 716, the court held that an employee realized income when his employer paid his income tax. ( Id. at p. 729 [73 L.Ed. at pp. 927-928].) The court stated that the payments were in consideration of services rendered by the employee and constituted gain derived by the employee for labor. ( Ibid. ) The form of the payment made no difference. ( Ibid. ) Likewise, in United States v. Boston & Maine Railroad Co. (1929) 279 U.S. 732 [73 L.Ed. 929, 49 S.Ct. 505], a lessee agreed to pay taxes as part of a lease agreement. The court held that these taxes constituted income to the lessor. ( Id. at pp. 734-736 [73 L.Ed. at pp. 930-931].) In each of these cases, the taxpayer realized a gain by being relieved of a tax obligation for which the taxpayer alone was liable. Such is not the case here, where the insurers and the title companies contracted in advance to divide the premium, labor, risk, and liability between themselves. The economic reality of the transaction is that the title insurer forgoes a portion of the premium and the underwritten title company receives that portion in return for its allocated share of the risk and liability. There is no gain to the title insurer when the title company performs its obligations under the underwriting contract. [4] The Board also relies on Burnet v. Wells, supra, 289 U.S. 670, and Robertson, supra, 343 U.S. 711. Although these cases shed light on the concept of income, neither is applicable to the case at hand. Burnet v. Wells held that the proceeds of a trust for the payment of insurance premiums constituted taxable income to the settlor, as provided by statute. ( Burnet v. Wells, supra, 289 U.S. at pp. 677, 680-681 [77 L.Ed. at pp. 1445-1446].) In Robertson, a composer won a prize for musical composition. The court held that the prize was income taxable to the composer, as it was compensation for his labor. ( Robertson, supra, 343 U.S. at pp. 713-714 [96 L.Ed. at pp. 1240-1241].) Again, these cases do not consider a situation in which the taxpayer has reached an arm's length agreement in advance with a third party by which that third party assumes certain risks in return for a consideration that reflects the value of those risks. [5] The Board would have us conclude that the discharge of indebtedness pursuant to a contract always constitutes income to the obligor. However, we must look to the substance of the transaction to determine whether the taxpayer actually realizes gain when the third party fulfills its obligations under the contract. Under the facts of this case, we cannot conclude that the claims paid by the underwritten title company constitute gains on the part of the title insurer. To summarize, from the outset the title insurer and the underwritten title company have divided the labor, risk, liability, and premiums between them. The title insurer takes in only that portion of the premium that compensates it for the risk that has not been contractually allocated to the underwritten title company. When the underwritten title company fulfills its obligation to the insurer by paying its portion of the claims, the insurer does not realize any additional gain. Since there is no gain, it follows that there is no income. Therefore, we hold that title insurers may not be taxed on the amount of the claims paid by the underwritten title companies.