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.
Held:
Page 291 U. S. 194
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.
63 F.2d 66 affirmed.
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.
MR. JUSTICE BRANDEIS delivered the opinion of the Court.
An unincorporated concern known as Edward Brown & Sons, of
San Francisco, has since 1896 acted as Pacific
Page 291 U. S. 195
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.
Page 291 U. S. 196
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.
Prior to 1923, overriding commissions on new business were
accounted income of the year in which the business was written, and
refunds of overriding commission on account of cancellations were
accounted expenses of the year of cancellation. The books of the
general agent have at all times been kept on the accrual basis.
Although no change was made in the method of accounting between the
general agent and its principals, there was
Page 291 U. S. 197
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.
The ratio of cancellations to premiums receivable having been
22.38 percent for the five years ending in 1923, the gross income
from overriding commissions on business written in 1923, amounting
to $236,693.31, was subjected on the books to a deduction of
$52,971.96, and this amount was credited to the "Return Commission"
account. Similarly, at the close of each of the years 1924, 1925,
and 1926, the credit balance in the "Return Commission" account was
adjusted so that it bore the same relation to the overriding
commissions on business written during the year as the total fire
insurance premiums cancelled in the preceding five-year period bore
to the gross premiums on business written during those years. The
ratio of cancellations for the five years ending in 1925 having
been 21.55 percent, and the total overriding commissions
$244,597.88, a deduction of $3,292.98 was made, representing the
net addition to the "Return Commission" account in 1925. The ratio
of cancellations to premiums for the five-year period ending in
1926 having been 21.13 percent, and the total overriding
commissions
Page 291 U. S. 198
$258,677.57, a deduction was made of $1,947.77 representing the
net addition to the "Return Commission" account in 1926. [
Footnote 2]
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"
Page 291 U. S. 199
account. Under the Revenue Acts, taxable income is computed for
annual periods. If the accounts are kept on the accrual basis, the
income is to be accounted for in the year in which it is realized,
even if not then actually received, and the deductions are to be
taken in the year in which the deductible items are incurred. What
is taxable as income is provided by the Revenue Act of 1921, c.
136, 42 Stat. 227, 237, 239. [
Footnote 4] Section 212(a) declares: "That in the case of
an individual the term
net income' means the gross income as
defined in § 213 less the deductions allowed by § 214." Section
214(a) declares:
"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.
Page 291 U. S. 200
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.
Page 291 U. S. 201
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.
The liability of Edward Brown & Sons arising from expected
future cancellations was not deductible from gross income, because
it was not fixed and absolute. In respect to no particular policy
written within the year could it be known that it would be
cancelled in a future year. Nor could it be known that a definite
percentage of all the policies will be cancelled in the future
years. Experience taught that there is a strong probability that
many of the policies written during the taxable year will be so
cancelled. But experience taught also that we are not dealing here
with certainties. This is shown by the variations in the
percentages in the several five-year periods of the aggregate of
refunds to the aggregate of overriding commissions. [
Footnote 7]
Brown argues that, since insurance companies are allowed to
deduct reserves for unearned premiums which may have to be
refunded, he should be allowed to make the deductions claimed as
being similar in character. The simple answer is that the general
agent is not an insurance company, and that the deductions allowed
for additions to the reserves of insurance companies are technical
in character, and are specifically provided for in the Revenue
Acts. These technical reserves are required to be made by the
insurance laws of the several states.
See Maryland Casualty Co.
v. United States, 251 U. S. 342,
251 U. S. 350;
United States v. Boston Ins. Co., 269 U.
S. 197;
New York Life Ins. Co. v. Edwards,
271 U. S. 109. The
"Return Commission" reserve here in question was voluntarily
established. Only a few reserves voluntarily established
Page 291 U. S. 202
as a matter of conservative accounting are authorized by the
Revenue Acts. Section 214 mentions only the reserve for bad debts
(in the discretion of the Commissioner), provided for in paragraph
7; those for depreciation and depletion, provided for in paragraphs
8 and 10, and the special provision concerning future expenses in
connection with casual sales of real property, provided for in
paragraph 11 of § 214(a) as amended by the Revenue Act of 1926. 26
U.S.C. § 955. Many reserves set up by prudent business men are not
allowable as deductions.
See Lucas v. American Code Co.,
280 U. S. 445,
280 U. S. 452.
[
Footnote 8]
Brown argues also that the Revenue Acts required him to make his
return "in accordance with the method of accounting regularly
employed in keeping the books," [
Footnote 9] and that, in making the deductions based on
the credits to "Return Commission" account, he complied with this
requirement. The Commissioner's oft-quoted [
Footnote 10] instruction of January 8, 1917 (No.
2433, 19 Treas.Dec.Int.Rev. 5) is relied upon:
"In cases wherein, pursuant to the consistent practice of
accounting of the corporation . . . corporations set up and
maintain reserves to meet liabilities, the amount of which and the
date of payment or maturity of which is not definitely determined
or determinable at the time the liability is incurred, it will be
permissible for the corporations
Page 291 U. S. 203
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.
Second. The Board of Tax Appeals did not err in
refusing to allocate to future years part of the overriding
commissions on business written during the taxable year. Brown
urges that the overriding commission is compensation for services
rendered throughout the life of the policy that the compensation to
be rendered in later years cannot be considered as earned until the
required services have been performed, and that the Revenue Acts
contemplate
Page 291 U. S. 204
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.
This proposed alternative method of computing the income from
overriding commissions was not employed by Edward Brown & Sons
either before or after 1923. Moreover, the Board concluded that
there "is no proof that the overriding commissions contain any
element of compensation for services to be rendered in future
years." The whole of the overriding commissions has at all times
been treated as income of the year in which the policy was written.
The Commissioner was of opinion that the method of accounting
consistently applied prior to 1923 accurately reflected the income.
He was vested with a wide discretion in deciding whether to permit
or to forbid a change.
Compare Bent v. Commissioner, 56
F.2d 99. It is not the province of the court to weigh and
determine
Page 291 U. S. 205
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.
Affirmed.
[
Footnote 1]
The duties required of and performed by the general agent are
described by the Board of Tax Appeals as follows:
"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."
[
Footnote 2]
For the year 1923, the deduction of $52,971.96, the entire
amount set up as a reserve, is in dispute. Similar figures were set
up for the years 1924, 1925, and 1926, but actual cancellations for
each of these later years were charged not against overriding
commissions, but against the return commission account as set up
and carried over from the preceding year. Thus, the amount in
dispute for each of the years 1925 and 1926 is not the entire
deduction from overriding commissions as made by the general agent,
but the difference between that figure and the amounts charged to
the "Return Commission" account, or, in other words, the net
adjustment or addition to the account. (There was no addition for
1924.)
Judge Wilbur concurred specially below, taking the ground, among
others, that the result of this method was a claim in 1923 for
deductions both of the entire reserve and of actual cancellations
during the year.
[
Footnote 3]
The amount of the deficiency for each year was affected by an
additional claim as a deduction of $3,000, which was disallowed. It
is not here in question.
[
Footnote 4]
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.
[
Footnote 5]
See also Vang v. Lewellyn, 35 F.2d 283.
[
Footnote 6]
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.
[
Footnote 7]
The taxpayer testified:
"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%."
[
Footnote 8]
Compare Barde Steel Products Corp. v. Commissioner 40
F.2d 412, 416;
Spring Canyon Coal Co. v. Commissioner, 43
F.2d 78.
[
Footnote 9]
"Sec. 212."
"
* * * *"
"(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."
[
Footnote 10]
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.
[
Footnote 11]
See also Industrial Lumber Co. v. Commissioner, 58 F.2d
123;
Jennings & Co. v. Commissioner, 59 F.2d 32.