*2083 1. The respondent's determination that a certain payment of money made by the petitioner to his sister in 1923 was a capital expenditure and not deductible in computing the petitioner's net income for that year, sustained.
2. Overriding commissions, representing a percentage of the net premiums written during the month, paid monthly by fire insurance companies to their general agents, as compensation for carrying on the affairs of the insurance companies in the territory in which they represent such companies, are income of the year in which received and may not be allocated to subsequent years through which the policies written during the taxable year are to run.
3. A reserve set aside out of the taxable year's earnings, to cover refunds of overriding commissions which the general agent may be required to make to the insurance companies, in the event of the cancellation or reinsurance in later years of business written during the taxable year, is a contingent liability and may not be deducted from gross income in arriving at taxable net income.
*678 The petitioner seeks a redetermination of deficiencies in income taxes asserted by the respondent for the years, and in the amounts, as follows:
| Docket No. | Year | Deficiency |
| 35305 | 1923 | $17,923.03 |
| 39157 | 1925 | 1,520.19 |
| 43432 | 1926 | 944.30 |
*679 The petitioner alleges: (1) That the respondent erred in disallowing, as a deduction from business income for 1923, a payment of $3,000 made to petitioner's sister under a written agreement; and (2) that the income to petitioner's business for 1923, and to the successor partnership for 1925 and 1926, from commissions on insurance policies written, should be computed upon the basis of a pro rata apportionment of such commissions to the policy years; or, as an alternative, that the income from commissions should be computed by deducting from the gross commissions earned in each year, such an amount as the past experience of the business indicates will probably be refunded to insurance companies on account of cancellation of policies. The proceedings were consolidated for hearing and decision.
FINDINGS OF FACT.
The petitioner, an individual, is a resident of the State of*2085 California.
From 1896 to 1904 the petitioner, his father, Edward Brown, and his brother, Herbert H. Brown, were engaged in business as general insurance agents. The senior Brown died in 1904, and until 1922 the business was carried on by the petitioner and Herbert H. Brown. The latter died in August, 1922, and throughout the remainder of 1922 and all of 1923 the business was conducted by the petitioner alone. On January 1, 1924, the petitioner's son, Arthur M. Brown, Jr., was admitted as a partner, and throughout the taxable years 1925 and 1926 the business has been carried on by the partnership. During its entire existence the business has been carried on under the name of Edward Brown & Sons.
On June 1, 1902, Edward Brown, Herbert H. Brown, and the petitioner entered into a written agreement, as follows:
Edward Brown, Arthur M. Brown and Herbert H. Brown, doing business under the firm name of EDWARD BROWN & SONS, as General Agents of Fire Insurance Companies, at 411-413 California Street, San Francisco, in the State of California, hereby agree and declare their respective interests in such business to be as follows:
After First setting apart and paying the sum of Two*2086 Hundred and Fifty Dollars ($250.00) per month as hereinafter provided for, the remaining profits to be divided as follows:
EDWARD BROWN to have four-tenths;
ARTHUR M. BROWN, to have four-tenths;
HERBERT H. BROWN to have two-tenths.
Bad debts and all other losses connected with the business to be borne by the several parties in like proportions.
Before any division of profits is made the said partners mutually agree to pay monthly to Jesse H. Jones, Edith H. Halton and Ethel Brown, (the three daughters of Edward Brown and Sisters of Arthur M. and Herbert H. Brown), the sum of Two Hundred and Fifty Dollars ($250.00) and Further, that whenever the net income from the business of the said firm shall exceed *680 the sum of Eighteen Thousand Dollars per annum they will pay a one-sixth proportion of such excess to the said Jessie H. Jones, Edith H. Halton, and Ethel Brown.
They further agree that in the case of the Death of one or more members of the said firm his or their heirs or executors shall be paid annually, for a term not exceeding ten years from the date of the death of such member or members, such proportion of the net profits of said firm as hereinafter is*2087 proportion,
To the heirs or executors of EDWARD BROWN one-tenth;
To the heirs or executors of ARTHUR M. BROWN, two-tenths;
To the heirs or executors of HERBERT H. BROWN, one-tenth;
Provided that should Herbert H. Brown die before marrying no payment shall be required to be made to his heirs or executors.
It is further agreed that monthly installments on account of the said proportionate interest or interests shall be made on demand to such heirs or executors.
Witness our hands the date and place above mentioned.
EDWARD BROWN
ARTHUR M. BROWN
HERBERT H. BROWN
Edward Brown died in the year 1904. On May 27, 1905, a written agreement was executed by and between Arthur M. Brown and Herbert H. Brown as surviving members of the firm of Edward Brown & Sons, and as heirs and as executors of the will of Edward Brown, deceased; Henry Michaels as executor of said will of Edward Brown, and Jessie H. Jones, Edith H. Halton and Ethel Crandell as heirs and residuary legatees and devisees under the will of said Edward Brown, deceased, and Irene W. Brown as the widow and heir, and as legatee under the will of Edward Brown, deceased. Said written agreement of May 27, 1905, can*2088 not now be found and there is no evidence as to its contents.
Jessie H. Jones, one of the petitioner's three sisters who were mentioned in the agreement of June 1, 1902, and who were parties to the agreement of May 27, 1905, died subsequent to the latter date and prior to May 28, 1907. On May 28, 1907, Edith H. Halton and Ethel Crandell, the two surviving sisters, executed a written agreement which reads as follows:
We, Edith H. Halton and Ethel Crandell, the undersigned, and each of us, and the survivor of us, do and does hereby consent and agree to accept from the firm of Edward Brown & Sons, General Fire Insurance Agents, San Francisco, California, the sum of Two Hundred and fifty ($250.00) Dollars per month, commencing with the month beginning June 1st, 1907, and ending only by mutual agreement in full satisfaction for all amounts which may be due, or may become due, to us, or either of us, or to the survivor of us, from said firm, under and by reason of the provisions of that certain Agreement dated May 27, 1905, by and between Arthur M. Brown and Herbert H. Brown as surviving members of said firm and as Heirs, and as Executors of the Will of Edward Brown, deceased; *2089 Henry Michaels, as Executor of said Will; and Jessie H. Jones, Edith H. Halton and Ethel Crandell, as Heirs, and as residuary legatees and devisees under the Will, of Edward Brown, deceased; *681 and Irene W. Brown, as Widow and as Heir, and as a legatee under the Will, of Edward Brown, deceased: Provided that any further amounts to which we, or either of us, or the survivor of us, might be entitled from said firm under said agreement shall be retained in the net profits of said firm as the property and to the credit of said Arthur M. Brown and Herbert H. Brown, members of said firm, to be divided between them as they may agree.
This agreement has never been modified in any particular. In 1923, the petitioner made a payment of $3,000 to his sister, Edith H. Halton, in accordance with the foregoing agreements, and claimed the same as a deduction from business income in his return for that year. The deduction has been disallowed by the respondent on the ground that the payment constituted a capital expenditure.
During the taxable years in controversy the firm of Edward Brown & Sons acted as general agents, in eleven Pacific coast and adjacent States, the territories of*2090 Alaska and Hawaii, the Philippine Islands, and the Province of British Columbia, for six fire insurance companies, namely: Hamilton Fire Insurance Company, Globe & Rutgers Fire Insurance Company of New York City, Brand & Lifforsakrings Aktiebolaget Svea, Agricultural Insurance Company of Watertown, New York, Hudson Insurance Company of New York, and United States Merchants & Shippers Insurance Company. The firm's relations with the two first mentioned companies were fixed by conversations with officers of those companies and the acts of the parties. Its relations with the other four companies were fixed by written agreements.
The duties required of and performed by the firm were substantially the same for all six companies. 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 canceled policies; received and receipted for premiums, surveyed all risks offered and accepted or rejected the same; represented its principals on the Pacific Board of Fire Underwriters; computed and paid commissions due local agents; ceded or reinsured certain lines of business*2091 with treaty or other companies; computed and paid return premiums on canceled policies; secured return of premium on canceled 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 endorsement; determined whether its principals should participate in special pools; and generally attended to all of the affairs of its principals in the territory in which it operated.
Under the arrangements with the insurance companies it represented, the firm received, as compensation, a percentage of the net profits on business written in its territory, and so-called "overriding *682 commissions," which are stated percentages of the net premiums written. By net premiums is meant gross premiums written less return premiums and net cost of reinsurance.
All policies written by the firm since 1917 are for periods of one, three, or five years, and contain provisions for cancellation by the insurance company or the assured. If the insurance company*2092 cancels, it is obligated to refund a ratable proportion of the premium for the unexpired term of the policy; if the assured cancels, the company is entitled to retain the customary short-period rate for the time the policy has been in force.
All premiums on policies written by the firm are payable in advance, subject to the usual grace period of 60 days.
The firm makes remittances to the insurance companies on monthly balances, crediting itself with, among other things, the overriding commissions due on the business written during the month, and charging itself, among other things, a proportional part of any overriding commissions previously received in respect of any business which was canceled or reinsured in another company during the month.
The following is a statement by five-year periods, from 1919 to 1926, of gross fire premiums written by the firm, fire premiums canceled, and ratio of premiums canceled to gross premiums written, as shown by the firm's books of account:
| Five-year period | Gross fire premiums written | Fire premiums canceled | Ratio |
| Per cent | |||
| 1919 to 1923 | $14,893,022 | $3,333,104 | 22.38 |
| 1920 to 1924 | 15,647,482 | 3,492,101 | 22.32 |
| 1921 to 1925 | 15,931,443 | 3,432,670 | 21.55 |
| 1922 to 1926 | 17,155,359 | 3,624.071 | 21.13 |
*2093 The firm's books of account have been kept consistently on an accrual basis. Overriding commissions on new business have been accounted income of the year in which the business was written; and refunds of overriding commissions on account of policy cancellations or reinsurance have been accounted expense of the year of cancellation or reinsurance.
At the close of 1923, for the first time, a liability account denominated "Return Commissions" was set up on the firm's books. The purpose of the account was to record the firm's contingent liability to refund to insurance companies a portion of the overriding commissions received during the year on account of future cancellations and reinsurance of business written during the year. At the close of each of the years 1924 to 1926, inclusive, the credit balance in the account was adjusted to reflect the same proportion of the overriding *683 commissions received during the year as the total fire premiums canceled in the next preceding five-year period bear to the gross fire premiums written in the same period.
In computing business income for 1923, the petitioner claimed a deduction of $52,971.96, the amount credited to the*2094 contingent liability account at the close of that year. In computing the partnership net income for 1925 and 1926, deductions of $3,292.98 and $1,947.77, respectively, were claimed, representing the net additions to the contingent liability account in those years. All three deductions have been disallowed by the respondent.
OPINION.
MARQUETTE: The first question presented by the record herein is whether the petitioner, in computing his net income for 1923, is entitled to deduct the amount he paid to his sister, Edith H. Halton, in that year under the circumstances set forth in the findings of fact. The petitioner contends that the sister had an interest in the business of Edward Brown & Sons that antedated the death of Edward Brown, and that the amount paid to her represented her distributive share of the profits. The respondent has determined, and now maintains, that the payment to Edith H. Halton represented a capital expenditure by the petitioner.
On the record we can not disturb the respondent's determination. The petitioner, his father, and his brother entered into an agreement among themselves on June 1, 1902, providing for the payment of a certain part of the profits*2095 of the partnership to the three daughters of Edward Brown (the sisters of the petitioner). Edward Brown died in 1904 and on May 27, 1905, a written contract was executed by the petitioner and his brother as surviving members of the partnership and as heirs and executors of Edward Brown, deceased, and by their three sisters as heirs and legatees under the last will and testament of Edward Brown, that apparently superseded the agreement of June 1, 1902. What the contract of May 27, 1905, provided for or reserved to the daughters of Edward Brown, we do not know, but in any event the surviving daughters agreed in writing on May 28, 1907, to accept $250 per month in satisfaction of all amounts "which may be due, or may become due to us, or either of us, or to the survivor of us" from the firm of Edward Brown & Sons under the agreement of May 27, 1905. Since we are not informed as to the terms of the contract of May 27, 1905, we are unable to determine what interest, if any, the sisters had in the business of Edward Brown & Sons under that agreement. Nor can we say, in the absence of that information, that the amount of $3,000 per year paid *684 by the petitioner to his sister*2096 in 1923 pursuant to the agreement of June 1, 1907, was a capital expenditure. The respondent has determined that it was a capital expenditure and the burden is upon the petitioner to show otherwise, which he has failed to do.
The second issue is as to the proper method of treating the overriding commissions received by Edward Brown & Sons during the taxable years in controversy. The petitioner contends that they should be returned as income upon the basis of a pro rata apportionment of such commissions to the policy years. In other words, the petitioner contends that as to overriding commissions received for writing one-year policies, one-half should be returned as income of the year in which the policy was written and one-half as income of the next year; that as to commissions received for writing three-year policies, one-sixth should be returned as income of the year in which the policy was written, one-third as income of each of the first and second succeeding year, and one-sixth as income of the third succeeding year; and that as to commissions received for writing fiveyear policies, one-tenth should be returned as income of the year in which the policy was written, one-fifth*2097 as income of each of the first, second, third and fourth succeeding years, and one-tenth as income of the fifth succeeding year. The method assumes that all policies written in any one year were issued as of the average date of July 1, and, in that respect, resembles the method generally used by insurance companies for computing the unearned premium reserve.
It is to be observed that the method of computing overriding commissions income now contended for is not the method employed in keeping the firm's books of account. It has been the firm's consistent practice to account for overriding commissions on new business as income of the year in which the business was written; and any departure from that practice now can only be justified on the ground that net income will be more clearly reflected. Section 212(b), Revenue Acts of 1921, 1924, and 1926.
It is argued in petitioner's behalf that the overriding commissions paid by the insurance companies to the firm of Edward Brown & Sons in any one year represent compensation for services rendered in that year and compensation for services to be rendered in later years while the policies, in respect of which the commissions were paid, *2098 continue in force; that such portion of the commissions as represents compensation for services to be rendered in later years can not be considered as earned until the required services have been performed; and that the taxing statutes comtemplate that a taxpayer keeping books on the accrual basis shall account for income only as it is actually earned.
The argument assumes much, for which there is no support in the record. There is no proof that the overriding commissions contain *685 any element of compensation for services to be rendered in future years. On that point the contracts are entirely silent; and there is no positive evidence that the payment of these commissions by the insurance companies created any obligation on the part of the firm to continue to render services while the policies remained in force. The firm made monthly settlements with the insurance companies, withholding the overriding commissions to which it was entitled on the business written during the month. For aught that the written contracts provide, the firm could have ceased to do business following any one of such settlements without any obligation to render further services or to refund*2099 any part of the overriding commissions, except in the event of cancellation of any of the policies prior to the ends of the terms for which they were written or in case of reinsurance of any part of the business covered by those policies.
The argument also assumes that the overriding commissions are paid solely for such services as may be required in connection with the procuring of new business and the adjustment of matters arising out of the policy contracts. This is clearly not the case. The compensation provisions of the contracts, which base the compensation, in part, upon stated percentages of the net premiums written, provide merely the measure of the compensation to be paid the firm for carrying on all of the duties of a general agency. These duties include many which can not be definitely related to any particular line of business, such as the appointment and removal of local agents, representation of the firm's principals on the Pacific Board of fire Underwriters, preparation and submission of reports required of the firm's principals by the authorities of political subdivisions in the territory in which the firm operates, attending to the payment of all fees, licenses*2100 and taxes, furnishing descriptive advertising to local agents, etc.; and for these duties the firm is compensated, in part, out of the overriding commissions.
In our opinion, the overriding commissions withheld by the firm in its settlements with the insurance companies represent compensation for services rendered in the periods covered by those settlements, constitute earnings of those periods, and must be accounted for as income of the same periods. Cf. .
As an alternative, the petitioner seeks to compute its commission income by deducting from the gross commissions earned in each year, such an amount as the past experience of the business indicates will probably have to be refunded to insurance companies on account of cancellation of policies and reinsurance with other companies, the amount to be deducted in each year being the same proportion of the gross commissions earned within the year as the total fire premiums canceled during the preceding five-year period bears to the gross fire *686 premiums written in the same period. This is merely an attempt to compute the income of the years in controversy upon*2101 a basis that will reflect the contingencies of the future. Essentially it is not different from the setting up of a reserve for future contingencies; and however certain it may appear, from the past experience of the business, that such contingencies will arise, such procedure is clearly not countenanced by the taxing statutes. ; ; ; ; ; ; ; ; ; ; ; ; ; ; *2102 ; ; See also, ; and .
Judgment will be entered under Rule 50.