*157 Decision will be entered under Rule 50.
1. Held, that petitioner was not entitled to deduct or exclude 15 percent of the premiums received on title insurance as "unearned premiums" within the meaning of sec. 832(b)(4), I.R.C. 1954.
2. Held, that claims paid by petitioner pursuant to policies of title insurance were properly deducted as "losses incurred during the taxable year on insurance contracts" within the meaning of sec. 832(b) (5), I.R.C. 1954.
3. Held, that petitioner was entitled to the surtax exemption as provided in sec. 11(c), I.R.C. 1954, for the years in issue.
*839 Respondent determined deficiencies in petitioner's income tax as follows:
| Year | Deficiency |
| 1962 | $ 45,125.37 |
| 1963 | 29,831.76 |
| 1964 | 48,450.66 |
| Total | 123,407.79 |
*840 Concessions have been made by both parties so that the remaining issues for decision are:
(1) Is the petitioner entitled to deduct or to exclude from gross income an amount equal to 15 percent of the premium received on account of the issuance of a policy of title insurance as "unearned premium" within the meaning of section 832(b)(4)? 2
*160 (2) Were the amounts paid out and deducted by the petitioner as "claims expense" in its income tax returns deductible as losses incurred within the meaning of section 832(b)(5)?
(3) Was the petitioner entitled to the surtax exemption under section 11(c) of the Code?
FINDINGS OF FACT
Some of the facts have been stipulated and the stipulation of facts, together with the attached exhibits, are incorporated herein by this reference.
Petitioner, a corporation organized under the laws of the State of Alabama, maintained its principal office in Valdosta, Ga., at the time it filed its petition. Petitioner filed corporation tax returns for the calendar years 1961 through 1964 with the district director of internal revenue, Birmingham, Ala.
Petitioner was incorporated June 27, 1960, under the laws of the State of Alabama, as Modern Home Title Insurance Co. The certificate of incorporation was filed for record in the Office of the Judge of Probate of Montgomery County, Ala. By amendment to the certificate of incorporation, dated January 10, 1963, the name of the company was changed to Modern Home Fire & Casualty Insurance Co. The certificate of incorporation was further amended to provide*161 additional authority for the company to engage in and carry on a fire and casualty insurance business in all of its aspects and to issue policies covering all types and kinds of risks, losses, and casualties generally associated with such business.
The authorized capital stock, as set forth in the certificate of incorporation was $ 100,000, divided into 1,000 shares of common stock of the par value of $ 100 per share. Petitioner commenced business with paid-up capital of $ 100,000 and paid-in surplus of the same amount, derived from the sale of 1,000 shares of common stock for $ 200 per share. In 1963 an additional amount of $ 100,000 was contributed to the corporation's capital surplus.
From the date of organization until November 1965 petitioner's operations were conducted in its principal office located in Montgomery, *841 Ala. Since November 1965 the company's operations have been directed from its offices in Valdosta, Ga.
Petitioner filed standard reports and annual statements with the Insurance Department of the State of Alabama during the years 1961 through 1964. The company is, and has been, licensed each year by the State of Alabama to carry on an insurance business*162 and has not been licensed in any other State. It has been periodically examined by the Insurance Department of the State of Alabama. Each year petitioner has paid the Alabama insurance premium tax and for Alabama shares tax purposes (Ala. Code tit. 51, sec. 25 (1958)) it has been classified by the State Department of Revenue as an insurance company.
There is no statutory authority or regulation under the insurance laws in the State of Alabama which requires a title insurance company to maintain an unearned premium reserve. Nevertheless, at about the time the petitioner was organized, discussions were had with the representatives of the Department of Insurance following which petitioner transmitted a letter dated July 27, 1960, addressed to the Honorable Edmon L. Rinehart, Superintendent of Insurance, State of Alabama, as follows:
Pursuant to our conversation of July 22, I am writing you for confirmation of our proposed plan of setting up reserves for liability under the title policies issued by the Modern Home Title Insurance Company, Montgomery, Alabama.
It is readily agreed that our operations will necessitate the maintenance of a larger reserve than that required by the Georgia*163 Department for policies issued only after a title search. We proposed to set aside and maintain a reserve not less than 15% of the single premium. We believe that this will be adequate since our policy is a Mortgagee's Policy and the limit of liability under the policy is the amount of the unpaid balance of the mortgage. We intend to maintain the reserve until such time as the mortgage referred to in the policy is satisfied by payment of [sic] refinancing. In the event of refinancing, another policy will be issued.
Nearly all of our policies will have a five year duration. When our records indicate that the mortgage is satisfied or when we are notified by the mortgage servicing company that the mortgage is satisfied prior to the original date of termination then we can take down the amount held in reserve. In those rare cases where a foreclosure sale is necessary and the state laws require that the insurance follow ownership in the land, the [sic] we will maintain the reserve for the full twenty years.
This proposed method of determining the amount of reserve to be set aside each year is naturally in lieu of statutory requirements and will be followed if experience proves that*164 it is sufficient. At any time the experience indicates the contributions each year is [sic] not sufficient we will adjust the percentage of gross permiums [sic] accordingly.
A letter for our files indicating that the above proposal is satisfactory with you as Superintendent of Insurance of Alabama will be sincerely appreciated.
By letter dated August 8, 1960, addressed to Mr. C. E. Crawford, Modern Home Title Insurance Company, Montgomery, Alabama, the *842 Honorable Edmon L. Rinehart, superintendent of insurance, State of Alabama, replied as follows: "The arrangement as outlined in your letter of July 27, 1960 is approved by me."
In order to comply with Alabama statutory requirements (Ala. Code tit. 28, sec. 70 (1958)), during the taxable period involved, petitioner had on deposit with the treasurer of the State of Alabama for the protection of all policyholders and creditors, U.S. Government bonds with a par value of $ 150,000.
With the exception of a small amount of fire and extended-coverage business written in 1963, the operations of petitioner have been confined to insuring title to real property on which are located homes constructed by Modern Homes Construction Co.
Modern*165 Homes Construction Co. (hereinafter sometimes referred to as the construction company) was incorporated in Florida on October 1, 1956, with its principal office located in Valdosta, Ga.
During the taxable years 1961 through 1964 the construction company was engaged in selling, constructing, and financing shell homes, principally in the Southern and Southwestern States. The construction company had 48 local sales offices in 12 States. The business was conducted by it in conjunction with the following subsidiaries and affiliated corporations:
| Modern Homes Supply Co. | Modern Homes Mortgage Co. |
| Modern Homes Finance Co. | Modern Home Fire and Casualty |
| Modern Homes Insurance Agency, Inc. | Insurance Company. |
| Modern Homes Development & | Modern Home Life Insurance Co. |
| Finance Co. |
The shell homes sold by the construction company were made of wood on concrete foundation blocks. The outside of the homes was completely finished by including roofing, doors, windows, screens, and painting. The inside was unfinished except for floors, ceiling joist, partitions, studding, and closet framing and was substantially completed without assistance from the company by the customer or by contractors*166 employed by the customer.
The construction company estimated that the cost of finishing the shell home to the average customer was about $ 2,000 to $ 3,000 if all materials, fixtures, and equipment necessary to finish the home were purchased from outside sources and outside labor was employed. Most customers substantially reduced this cost by partially finishing their homes with their own labor.
Approximately 90 percent of the construction company's sales were of shell homes on a credit basis. The construction company received the customer's promissory installment note secured by a first mortgage. At that time shell homes did not qualify for loans guaranteed or insured by the Federal government or generally for financing from conventional sources prior to the completion of the homes.
*843 Until 1961 the construction company financed homes for customers with funds made available by commercial finance companies at effective annual interest rates ranging from 10 percent to 14 percent. After 1961 the construction company, through its subsidiaries, financed substantially all of its mortgage notes receivable.
The principal business of petitioner during the taxable year was the *167 issuance of title insurance to Modern Homes Finance Co. or an affiliated corporation, Modern Homes Mortgage Co., under a standard form contract which is designated as a "Mortgagee's Policy." When the construction company sold a home to a customer, it took from him the following documents:
(1) A sales contract,
(2) An affidavit of the customer certifying that he owned the property in fee simple, and
(3) A promissory note executed by purchaser and secured by,
(4) A first mortgage on the real property on which the house was located.
Modern Homes Finance Co. purchased these instruments (referred to as "shell housing paper") from the construction company, obtaining funds for this purpose by pledging eligible shell housing paper as security for loans from banks, insurance companies, and other lending institutions, or by private sale of debentures collateralized by pledge and assignment of the shell housing paper.
Whenever a shell home was sold by the construction company and the shell housing paper acquired by the finance company, the title to the property was insured by petitioner under a so-called mortgagee's policy. Prior to the organization of the petitioner, similar policies of title*168 insurance were purchased from nonaffiliated companies. The terms of such policies were in all material respects identical to the policies issued by the petitioner. Contracts were entered into on the basis of the purchaser's affidavit of fee simple title without any preceding title examination. The petitioner was paid a premium of $ 40 for each title insured, which rate prevailed throughout the period involved. The petitioner set up on its books a reserve equal to 15 percent of the premiums received in each year. When the liability of the petitioner on account of the title policy was discharged, either through default and resale of the property or by payment of the mortgage, the reserve was taken into income.
The purpose for the insurance was to reimburse the mortgagee for the cost of discharging any prior lien or encumbrance against the property on which the mortgaged home was located. The title insurance contract provides as follows with respect to losses:
1. If any Insured acquires said land or any part thereof by foreclosure, trustee's sale, or conveyance of said property to Insured for the purpose of avoiding the expense of foreclosure or trustee's sale, or by other legal*169 manner *844 in satisfaction of said indebtedness, or any part thereof, this Policy shall continue in force in favor of such Insured, subject to all of the conditions and stipulations hereof.
2. The Company at its own cost shall without undue delay defend the Insured in all litigation consisting of actions or proceedings commenced against the Insured or defenses, restraining orders, or injunctions interposed against a foreclosure or sale of said land in satisfaction of said indebtedness, which litigation is founded upon a defect, lien or encumbrance insured against by this Policy, and may pursue such litigation to final determination in the Court of last resort. In case any such action or proceeding shall be begun or defense interposed, or in case knowledge shall come to the Insured of any claim of title or interest adverse to the title as Insured, or which might cause loss or damage for which the Company shall or may be liable by virtue of this Policy, the Insured shall at once notify the Company thereof in writing. If such notice shall not be given to the Company within ten days of the receipt of process or pleadings or if the Insured shall not, in writing, promptly notify*170 the Company of any defect, lien or encumbrance insured against which shall come to the knowledge of the Insured in respect to which loss or damage is apprehended, then all liability of the Company in regard to the subject matter of such action, proceeding or matter shall cease and terminate; provided, however, that failure to notify shall in no case prejudice the claim of any Insured unless the Company shall be actually prejudiced by such failure and then only to the extent of such prejudice. In all cases where this Policy permits or requires the Company to prosecute or defend any action or proceeding, the Insured shall secure to it the right to so prosecute or defend such action or proceeding, and all appeals therein, and permit it to use, at its option, the name of the Insured for such purpose. The word "knowledge" in this paragraph means actual knowledge and does not refer to constructive knowledge or notice which may be imputed to the Insured by reason of any public record or otherwise.
3. If any Insured shall in good faith contract to sell the evidence of indebtedness and mortgage or deed of trust described in Schedule A, or having acquired said land as in paragraph 1 hereof*171 provided, in good faith contracts to sell the same, and any such contract fails, or if the successful bidder at a foreclosure or trustee's sale refuses to complete the purchase, because of alleged defects in the title to said land, and, in any of such events, the said title has been declared by a Court of Competent jurisdiction to be defective or encumbered or otherwise unmarketable by reason of any defect, lien, or encumbrance insured against by this Policy, the Company at its option shall either (a) pay such Insured the amount of this Policy, (b) purchase said indebtedness, (c) establish the marketability of the title by decree of Court, or (d) otherwise save the Insured harmless. In the event of any litigation involving refusal of title because of defects insured against hereunder, the Company will, at its own cost, promptly and diligently prosecute such action as may be available to establish title as insured, and if such action is not successful, will reimburse the Insured for all costs and attorneys' fees in said litigation involving refusal of title.
4. The Company reserves the option to pay, settle, or compromise for or in the name of the Insured, any claim insured against*172 or to pay this Policy in full, and payment or tender of payment of the full amount of this Policy shall terminate all liability of the Company hereunder. In such cases the Company shall be liable to pay in addition all costs and attorneys' fees incurred by it.
5. Whenever the Company shall have settled a claim under this Policy, all right of subrogation shall vest in the Company unaffected by any act of the *845 Insured, except that the Insured may release or substitute the personal liability of any debtor or extend or otherwise modify the terms of payment, provided such act does not result in any loss of priority of the lien of the mortgage or deed of trust herein, but such subrogation shall be in subordination to the lien of the Insured under its said mortgage or deed of trust and to the right of the Insured to receive and be fully paid the amount of principal and interest and other sums, if any, secured by said mortgage or deed of trust. If loss of priority should result from any act of the Insured, such act shall not void this Policy, but the Company, in that event shall be required to pay only that part of any losses insured against hereunder which shall exceed the amount, *173 if any, lost to the Company by reason of the impairment of the right of subrogation. The Insured, if requested by the Company, shall transfer to the Company all rights, securities, and remedies against any person or property necessary in order to perfect such right or subrogation.
6. The Company has the right and option, in case any loss is claimed under this Policy, to pay to the Insured the entire indebtedness secured by said mortgage or deed of trust to the Insured, together with all costs and attorneys' fees which the Company is obligated hereunder to pay, in which case the Company shall become the owner of, and the Insured shall at once assign and transfer to the Company said mortgage or deed of trust and the indebtedness thereby secured and such payment shall terminate all liability under this Policy and the Insured shall surrender the same.
7. A statement in writing of any loss or damage for which it is claimed the Company is liable under this Policy shall be furnished to the Company within sixty days after such loss or damage shall have been determined and no right of action shall accrue to the Insured under this Policy until thirty days after such statement shall have been*174 furnished, and no recovery shall be had by the Insured under this Policy unless action shall be commenced thereon within one year (five years if the land covered by this Policy is situated in either the State of Kansas or the State of Nebraska) after expiration of said thirty day period. Failure to furnish such statement of loss or damage, or to commence such action within the time hereinbefore specified, shall be a conclusive bar against maintenance by the Insured of any action under this Policy.
8. The Company will pay, in addition to any loss insured against by this Policy, all costs imposed upon the Insured in litigation carried on by the Company for the Insured, and all costs and attorneys' fees in litigation carried on by the Insured with written authorization of the Company or as provided in paragraph 3 of the conditions and stipulations hereof but not otherwise. The Company will not be liable for loss or damage by reason of defects, claims, or encumbrances created subsequent to the date hereof (excepting any statutory lien for labor or material insured against by this Policy) or for defects, claims or encumbrances created or suffered by the Insured claiming such loss or *175 damage, or existing at the date of this Policy and known to the Insured claiming such loss or damage at the date such Insured claimant acquired an insurable interest but not known to the Company or disclosed to it in writing by the Insured. The liability of the Company under this Policy shall in no case exceed in all the actual loss of the Insured and cost and attorneys' fees which the Company is obligated hereunder to pay. All payments under this Policy shall reduce the amount of the insurance pro tanto and no payment shall be made without producing this Policy for endorsement of such payment unless the Policy be lost or destroyed, in which case proof of such loss or destruction shall be furnished to the satisfaction of the Company. Payment in full by any person or voluntary *846 satisfaction or release by the Insured of the mortgage or deed of trust described in Schedule A shall terminate all liability of the Company under this Policy, except as provided in Condition 1.
When it later developed that a purchaser did not have clear title to the property, the petitioner was called either to discharge the prior lien or to reimburse the mortgagee for the cost of discharging such*176 liens. Usually when such a situation developed, the mortgagor was in default and the property was being repossessed. As a matter of course the petitioner paid the claim upon submission of a statement or other proof of claim by the mortgagee without independent investigation and took no action to assert any further rights against the mortgagor. The reason that the petitioner did not pursue its rights against the mortgagors was that petitioner's experience indicated that its right of subrogation was of little or no value. The petitioner knew that the mortgagors were of limited means and, in the usual case, once the mortgagors lost their property they had little else of value that could be recovered by the petitioner. To the petitioner's knowledge and belief, this practice was also followed by the nonaffiliated insurance companies that wrote title insurance for the construction company prior to the organization of the petitioner.
Petitioner's deductions, which were based on a schedule of claims, were as follows:
| Total payments | ||
| Number | as shown on the | |
| Year | of claims | schedule of claims |
| 1962 | 12 | $ 7,264.71 |
| 1963 | 8 | 6,043.31 |
| 1964 | 25 | 33,066.96 |
| Total | 45 | 46,374.98 |
*177 Prior to June 1960 the construction company also purchased from outside sources accident and health insurance policies on the individual purchasers of its homes in order to secure payment on the mortgages in the event of sickness or disability. At about the same time that the petitioner was organized, the principal stockholders of the construction company also organized Modern Home Life Insurance Co. (the petitioner in docket No. 1380-68) to write these policies. Both the petitioner and Modern Home Life Insurance Co. were organized as electing small business corporations under subchapter S of the Code.
In 1961 all of the stock of the construction company was owned equally by Ralph S. DeLoach and members of his family and J. W. Wells and members of his family. In that year the construction company "went public" by selling through investment bankers an aggregate of $ 5,500,000 principal amount of 6-percent subordinated debentures and 550,000 shares of common stock for a gross consideration *847 of $ 10,450,000. After this transaction, the Wells and DeLoach families owned about 60 percent and the public 40 percent of the stock of the construction company. This offering was *178 duly registered with the Securities and Exchange Commission and the securities sold pursuant to a prospectus complying with applicable laws and regulations of the SEC. The prospectus set forth in detail the business history of the two insurance companies and the terms of the proposed acquisition of those companies by Modern Homes Construction Co.
At the time of organization all of petitioner's capital stock was equally owned by Ralph S. DeLoach and members of his family and J. W. Wells and members of his family. From 1960 through 1963, J. W. Wells had a personal net operating loss carry over for income tax purposes of approximately $ 500,000. The DeLoach and Wells families were aware of the generally beneficial tax treatment afforded electing small business corporations when they organized petitioner. However, their principal purpose in organizing petitioner was not to allow J. W. Wells to offset his net operating losses against his share of the income of petitioner.
During the year 1961, petitioner effectuated a reorganization whereby the shareholders exchanged all the stock of petitioner for stock of Modern Homes Construction Co. In 1964 a second reorganization took place in*179 which all of the outstanding stock of petitioner was acquired by Modern Homes Finance Co., a wholly owned subsidiary of Modern Homes Construction Co. Petitioner and Modern Home Life Insurance Co. were wholly owned subsidiaries of the construction company until 1964 when the construction company transferred its stock in these corporations to its wholly owned subsidiary, Modern Homes Finance Co.
There is no indication in the record that the organization and subsequent acquisition of petitioner were related transactions, or that they were part of a plan to avoid tax by securing the benefit of an additional surtax exemption.
The principal purpose for the acquisition of petitioner by Modern Homes Construction Co. was not to secure the benefit of an additional corporate surtax exemption that Modern Homes Construction Co. and the DeLoach and Wells families would not enjoy but for the acquisition. For the taxable period under review the corporate surtax exemptions are allowable to petitioner.
OPINION
Issue 1. -- Taxability of Premium ReserveThe petitioner contends that 15 percent of the premiums received on account of writing title insurance should properly be excluded or *848 *180 deducted from gross income as "unearned premiums" within the meaning of section 832(b)(4). That section provides, in part, as follows:
(4) Premiums earned. -- The term "premiums earned on insurance contracts during the taxable year" means an amount computed as follows:
(A) From the amount of gross premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance.
(B) To the result so obtained, add unearned premiums on outstanding business at the end of the preceding taxable year and deduct unearned premiums on outstanding business at the end of the taxable year.
The law governing such reserves in the case of title insurance appears to be well settled. The courts have held that the term "unearned premiums" is limited to the amount of the premium required to be set aside as a reserve and taken into income in a later year pursuant either to State law governing the writing of such insurance or pursuant to regulations adopted under authority granted by State law. Early v. Lawyers Title Ins. Corporation, 132 F. 2d 42 (C.A. 4, 1942); Title & Trust Co., 15 T.C. 510 (1950),*181 affd. 192 F. 2d 934 (C.A. 9, 1951); City Title Ins. Co. v. Commissioner, 152 F. 2d 859 (C.A. 2, 1946), affirming a Memorandum Opinion of this Court; Title & Trust Co. of Florida v. United States, 243 F. Supp. 42 (M.D. Fla. 1965), affirmed per curiam 360 F. 2d 285 (C.A. 5, 1966).
In Early v. Lawyers Title Ins. Corporation, supra, the court approved the exclusion from gross income of that portion of title insurance premiums required by a Virginia State statute to be set aside in an "unearned premium" reserve, because the court concluded that the State statute gave to that portion of the premium so reserved all of the attributes of "unearned premiums," that is, withdrew it from the power of the company to use for the company's general purposes for a specified period of time which was commensurate with the period of probable loss. This Court in Title & Trust Co., supra, followed the Fourth Circuit's decision in the Early case when a title insurance company set up an "unearned premium" reserve in compliance with the directive*182 of the Oregon insurance commissioner issued pursuant to Oregon statutes.
However, in City Title Ins. Co. v. Commissioner, supra, as it could not be determined whether funds in a reserve established under a New York statute would ever be released and thus subject to tax, no part of the reserve was excluded from gross income. The same result was reached in Title & Trust Co. of Florida v. United States, supra, when an "unearned premium" reserve was established under a Florida statute that did not insure the return of the amounts placed in reserve to income.
The petitioner concedes that the laws of the State of Alabama do not *849 require a title insurance company to maintain an unearned premium reserve. However, the petitioner argues that since petitioner was authorized to write casualty insurance, with respect to which such laws provide for a premium reserve, and since the title insurance written by the petitioner was analogous to casualty insurance, the commissioner of insurance of the State of Alabama was authorized to prescribe and to require the maintenance of a premium reserve in the case of the petitioner. *183 Assuming the latter, the petitioner relies on an exchange of correspondence for the exercise of such authority.
We must reject the petitioner's reasoning. First, the laws of Alabama did not require the petitioner to be authorized to write casualty insurance in connection with its title policies. The petitioner wrote such policies for more than 2 years before amending its charter in order to enable it to write casualty insurance. As a matter of fact, when the exchange of correspondence occurred, the petitioner's authority was limited to the writing of title insurance.
Secondly, while the title insurance written by the petitioner might differ from the more conventional policy of title insurance in that no effort was made to determine whether the mortgagee had a clear title at the time the policy was written, such insurance does not thereby become "casualty" insurance. The subsequent discovery of a prior judgment or lien against the owner of the property, which might well have been discovered if an investigation had been made when the policy was written, is not a "casualty" as that term is commonly understood. 3
*184 Finally, the record does not show that the Commissioner of insurance had authority to prescribe by regulation, or otherwise, an unearned premium reserve for the writing of title insurance. It can well be understood why such a reserve would be "acceptable" to the Commissioner of insurance since it obviously enhances the security of the insurance. He would have no reason to object. This does not mean, however, that he would have any authority to require a reserve.
Issue 2. Deductibility of Claims ExpensesSection 832(c) provides, in part, as follows:
(c) Deductions Allowed. -- In computing the taxable income of an insurance company subject to the tax imposed by section 831, there shall be allowed as deductions:
* * * *
(4) losses incurred, as defined in subsection (b)(5) of this section;
*850 Section 832(b)(5) provides, in part, as follows:
(5) Losses incurred. -- The term "losses incurred" means losses incurred during the taxable year on insurance contracts. * * *
It is obvious from the record that the petitioner adopted a course of conduct in its business which would, in the opinion of its officers, result in the maximum realization of profit. The petitioner was organized*185 to take over a function, essential in the financing of the purchase of the shell homes sold by the construction company, which formerly had been fulfilled by unrelated insurers. These were unfinished houses sold on credit to purchasers who did not generally have the resources to purchase the more conventional house or to finance such a purchase through conventional sources. In that type of market, the cost of title insurance would have to be at a minimum. The method of operation became a question of economics.
At the time of the purchase, no investigation was made to determine whether the purchaser had a clear title to the land on which the home would be located. The purchaser's affidavit was accepted as sufficient. If a lien was subsequently discovered which took priority over the lien of the mortgagee, either the construction company or the mortgagor would take whatever action was necessary in order to discharge that lien and submit a claim to the petitioner for the resulting "loss." Without undertaking any independent investigation the petitioner paid that claim. Although the petitioner had the right of subrogation, it did not thereafter attempt to recover the amount from*186 the purchaser. As the witness testified, this would be impractical.
The respondent apparently accepts the fact that in the case of such claims a lien was asserted which came within the terms of the policy and that the amount of the claim represented the cost of discharging that lien. The respondent's position seems to be that the petitioner should not be permitted to deduct the amount paid on the claim because it did not pursue its right to subrogation against the purchaser. Therefore, the respondent argues that there was not a "closed transaction."
The respondent ignores the practicalities of the marketplace. The petitioner's election not to pursue its right of subrogation was a business decision. That decision was based on petitioner's experience and grounded in the petitioner's reasonable belief that its rights against the mortgagors were of little or no value. A taxpayer certainly cannot be held accountable for failing to pursue its remedies before deducting a loss if based on its experience in the business the taxpayer concludes that to do so would on the average only result in a greater loss. We must recognize that private business looks upon the collection of its accounts*187 in a more practical light than does the Government.
While the respondent also argues that some effect should be given *851 to the relationship between the insured and the insurer, the procedure adopted by the petitioner did not differ materially from the procedure followed by its predecessors who were wholly unrelated to the insured. The premium charge was the same.
Issue 3. The Surtax ExemptionModern Homes Construction Co. acquired the stock of petitioner from the DeLoach and Wells families in 1961. It is the respondent's contention that the principal purpose for the formation of the petitioner and the subsequent acquisition of the stock of petitioner was to avoid Federal income tax on the profits of petitioner by securing the benefit of an additional surtax exemption.
In 1960, and prior years, the stock of Modern Homes Construction Co. was owned equally by the DeLoach and Wells families. During that time, Modern Homes Construction Co. and its affiliated corporations purchased title insurance covering mortgages on houses sold by Modern Homes Construction Co. and accident and health insurance policies on the individual purchasers of these homes from unrelated insurance*188 companies. After its organization in June 1960 petitioner insured title to the real property on which Modern Homes Construction Co. had built houses. After its organization in the same month, Modern Home Life Insurance Co. insured payments on the indebtedness to affiliates of Modern Homes Construction Co. in the event of injury or sickness of a purchaser of a home constructed by Modern Homes Construction Co. The stock of both these insurance companies was owned equally by the DeLoach and Wells families. Both insurance companies were small business corporations that had elected, pursuant to section 1372(a), not to be subject to corporate income tax, but to have all their income taxed directly to their shareholders. Since there was no tax imposed on the petitioner under section 11, there was correspondingly no surtax exemption available to it.
In 1961 the stock of both insurance companies was transferred to Modern Homes Construction Co. This transfer resulted in the termination of the previous elections of tax treatment as small business corporations, and this also made surtax exemptions available.
Relying on section 269, 4 respondent contends that petitioner was *852 initially*189 formed and subsequently acquired with tax avoidance as the "principal purpose." The primary issue for decision, for purposes of applying section 269, is whether the "principal purpose" in acquiring the petitioner was the evasion or avoidance of tax by securing the benefit of an additional surtax exemption. This is a question of fact, Commissioner v. Chelsea Products, Inc., 197 F. 2d 620 (C.A. 3, 1952), affirming 16 T.C. 840">16 T.C. 840, to be determined on the basis of the acquirers' purpose at the time control is acquired. See Bush Hog Manufacturing Co., 42 T.C. 713">42 T.C. 713 (1964). Respondent's determination is presumptively correct and the burden of showing the absence of the prohibited "principal purpose" is upon the petitioner. House Beautiful Homes, Inc. v. Commissioner, 405 F. 2d 61 (C.A. 10, 1968), affirming a Memorandum Opinion of this Court.
*190 At the time the petitioner was organized the DeLoach and Wells families were aware of the generally beneficial tax treatment available to electing small business corporations. The primary benefit is that such entities are not subject to corporate income tax under section 11. This benefit, of course, does not indicate that petitioner was organized for the principal purpose of evasion and avoidance of income tax by securing the benefit of a surtax exemption.
The respondent states on brief that the organization of the petitioner as an electing small business corporation is not a bar to the application of section 269, citing Joe (Joseph) Dillier, 41 T.C. 762">41 T.C. 762 (1964). The respondent then raises, as a secondary issue, the question of whether the election itself was for the "principal purpose" of avoidance of income tax due to the fact that J. W. Wells could offset his large net operating loss carryover against his share of the income of the petitioner.
We take this to be an argument by the respondent that the tax treatment of the shareholders of an electing small business corporation, and specifically the requirement of section 1373 that shareholders*191 report certain amounts as constructive distributions from such a corporation, is an "other allowance" within the meaning of section 269, and therefore that section permits disallowance to petitioner of its status under subchapter S leaving it to be taxed like any ordinary business corporation, but without the benefit of the surtax exemption.
Joe (Joseph) Dillier, supra, involved the application of section 269 to surtax exemptions claimed by multiple corporations, one of which was an electing small business corporation. The taxpayer in that case argued that the fact that one of the corporations voluntarily gave up its surtax exemption supported his contention that the obtaining of additional surtax exemptions was not the principal purpose of organizing the multiple corporations. We dismissed this argument noting that the fact that one corporation could not claim a surtax exemption *853 as it was not subject to tax did not make the surtax exemptions less beneficial to the other corporations. Our decision in Joe (Joseph) Dillier, supra, does not support the position taken by respondent in the instant*192 case.
The DeLoach and Wells families were aware of the generally beneficial tax treatment afforded electing small business corporations when they organized the petitioner. However, the record does not support the respondent's contention that the principal purpose in organizing the petitioner was to allow J. W. Wells to offset his losses against the petitioner's "undistributed taxable income." However, even if this was the case, the enjoyment of this benefit would be consistent with the intent of Congress to allow shareholders of electing small business corporations to "be taxed directly on the corporation's earnings" and to report "corporate income (whether or not distributed) as their own for tax purposes," S. Rept. No. 1983, 85th Cong., 2d Sess., p. 87, and thus cannot be regarded as tax avoidance.
The inapplicability of section 269 in an analogous context supports this conclusion. The respondent has ruled in I.T. 3757, 1945 C.B. 200">1945 C.B. 200, that even though the principal purpose for the formation of a Western Hemisphere trade corporation was to obtain the tax benefits provided for those corporations, such motivation does not constitute tax avoidance within*193 the meaning of the predecessor of section 269. To the same effect, see A. P. Green Export Co. v. United States, 284 F. 2d 383 (Ct. Cl. 1960); Barber-Greene Americas, Inc., 35 T.C. 365">35 T.C. 365 (1960). The Court of Claims has also rejected the notion that section 269 should be applied to deny to a corporation the special tax treatment provided for life insurance companies. Alinco Life Insurance Co. v. United States, 336">373 F. 2d 336, 341 (Ct. Cl. 1967). See also Worthy, "IRS Chief Counsel Outlines What Lies Ahead for Professional Corporations," 32 J. Taxation 90 (1970), where the author indicates that a question exists as to whether there can be a purpose to evade or avoid taxes when a corporation is organized to take advantage of provisions that represent a deliberate granting of tax benefits.
Respondent contends that the principal purpose for the acquisition by Modern Homes Construction Co. of the stock of the petitioner was to secure the benefit of an additional surtax exemption. We disagree. The evidence in this case affirmatively establishes that the principal*194 purpose for the transfer of petitioner from the DeLoach and Wells families to Modern Homes Construction Co. was to place the petitioner within the corporate group controlled by Modern Homes Construction Co. in connection with the public offering that had been made by that company.
Initially mortgage notes resulting from the sale of shell homes were *854 sold by Modern Homes Construction Co., or one of its affiliates, to nonaffiliated finance companies. Later an affiliate raised funds directly and used these funds to finance the sale of shell homes. In both cases title insurance was required on the property that secured the mortgage notes. Rather than allow the profits from the title insurance to go to unrelated parties, the petitioner was formed by the DeLoach and Wells families.
The proposed acquisition of petitioner by Modern Homes Construction Co. was made an item in the prospectus published in connection with the public offering stock. From Modern Homes Construction Co.'s point of view, the acquisition obviously improved the marketability of its stock as it allowed the company to offer the public participation in the profits generated by the title insurance placed on *195 the shell homes. From the DeLoach and Wells families' point of view the acquisition was necessary to foreclose any question of conflict of interest as they remained the principal officers and directors of Modern Homes Construction Co. after the public had purchased approximately 40 percent of the stock of that company. These considerations constituted the principal purpose for the transfer of the stock of petitioner to the construction company.
Respondent argues that "initially Construction or Finance could have been a self-insurer." However, the decision not to self-insure was made before the petitioner was organized. Since the obligations were to be refinanced or hypothecated by the finance company, obviously neither the construction company nor the finance company could meet a requirement that there be insurance with respect to the title or that the debtor be covered by health, accident, or life insurance.
The respondent argues that the petitioner could have written the health and accident insurance so that it was not necessary separately to organize the Modern Home Life Insurance Co. The writing of title insurance and the writing of health and accident insurance involve different*196 types of risk, and are subject to differing regulations. There is ample justification to separate those activities.
The Court finds nothing in this record which would support the respondent's determination that the petitioner was initially formed and subsequently acquired with tax avoidance as the "principal purpose." In fact, the evidence strongly supports the conclusion that the petitioner was organized and its stock subsequently acquired by Modern Homes Construction Co. for valid business reasons. Section 269 is not applicable.
Decision will be entered under Rule 50.
Footnotes
1. This case was consolidated for trial only with that of Modern Home Life Insurance Co., docket No. 1380-68.↩
2. All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.↩
3. In Federal tax law a "casualty" is thought of as an event proceeding from an unknown cause, or as an unusual effect of a known cause, and occasioned by natural or external forces. See 5 Mertens, Law of Federal Income Taxation, sec. 28.57. In insurance law the term is, as a general rule, used to refer to accidental injury to persons and property. See Couch, Insurance, sec. 1.27 (2d ed.).↩
4. SEC. 269. ACQUISITIONS MADE TO EVADE OR AVOID INCOME TAX.
(a) In General. -- If --
(1) any person or persons acquire, or acquired on or after October 8, 1940, directly or indirectly, control of a corporation, * * *
* * * *
and the principal purpose for which such acquisition was made is evasion or avoidance of Federal income tax by securing the benefit of a deduction, credit, or other allowance which such person or corporation would not otherwise enjoy, then the Secretary or his delegate may disallow such deduction, credit, or other allowance. For purposes of paragraphs (1) and (2), control means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock of the corporation.↩