*2021 Held that when unearned premium reserves of an insurance company are released to the general corporate uses they should be included in income.
*1054 The petitioner seeks the redetermination of a deficiency in income taxes for the year 1922 in the sum of $17,301.48. In its petition and an amendment thereof the petitioner made five assignments of error, three of which have been abandoned. The errors now urged are:
(a) The respondent erred in including in unearned premiums as of December 31, 1921, the amount of $101,393.22, representing the portion of said unearned premiums as of December 31, 1921, transferred to reserve account from paid-in surplus account. (In its brief petitioner reduces the amount in question to $91,670.88.)
(b) The respondent erred in failing to deduct in 1922 a net loss sustained by the petitioner in 1921 in the amount of $60,126.69. (In its brief petitioner reduces the amount of the net loss claimed to $22,511.93.)
FINDINGS OF FACT.
The petitioner is a corporation incorporated in*2022 1916 under the laws of the State of Iowa for the purpose of writing fire, windstorm, tornado and life insurance. Its principal place of business was at Des Moines, Iowa. It commenced business in May, 1917, and the principal business done by it was the writing of fire insurance.
The paid-in capital of the petitioner was $1,000,000, of which $500,000 was credited to capital stock and $500,000 to paid-in surplus. Of the amount credited to paid-in surplus $150,000 was expended in connection with the sale of the petitioner's stock, with the result that the paid-in surplus as of December 31, 1917, amounted to $350,000.
On June 1, 1922, the petitioner entered into a contract with the Connecticut Fire Insurance Company, reinsuring its outstanding risks in the latter company, effective at 12 o'clock noon on June 1, 1922. The petitioner thereupon proceeded to liquidate its affairs. In accordance with the contract entered into by the petitioner with the Connecticut Fire Insurance Company, the latter corporation assumed the following liabilities:
*1055 All the liability of the said Central National for loss or damage under its policies, reinsurance treaties or entries or under*2023 "binder" contracts of insurance awaiting the issuance of policies, in actual force and effect on the first day of June, Nineteen hundred and twenty-two at twelve o'clock noon of that day (standard time wherever any loss may occur).
All liability of said Central National under its policies of insurance or reinsurance which shall be written or renewed by the said Central National or its agents between the first day of June, Nineteen hundred and twenty-two at twelve o'clock noon of that day and the first day of September, Nineteen hundred and twenty-two, at twelve o'clock noon of that day (standard time wherever any loss may occur).
All liability of said Central National under its policies of insurance or reinsurance written or renewed on or before the first day of June, Nineteen hundred and twenty-two, at twelve o'clock noon (standard time wherever any loss may occur), but which policies were written to take effect at a date subsequent to the first day of June, Nineteen hundred and twenty-two.
It being understood, however, that there shall be excluded from this contract any adjusted or unadjusted losses that may have occurred prior to the first day of June, Nineteen hundred*2024 and twenty-two (twelve o'clock noon standard time).
This treaty shall not cover any risks or policies that may, prior to noon of the first day of June, Nineteen hundred and twenty-two, have been entirely reinsured by said Central National in any other company.
The contract of reinsurance also provided as follows:
It is understood that should the Central National hold policies or treaties of reinsurance in other companies covering on any of its own policies or entries embraced under this treaty, it shall be permitted to deduct from the gross unearned premium on its own policies the pro rata unearned premium on such reinsurance policies or entries upon condition, however, that the said Central National shall secure an assignment of such reinsurance in favor and for the benefit of the said Connecticut, the Connecticut reserving to itself the right to reject in whole or any part all such insurance.
The reinsurance commissions hereinafter provided for shall be computed on the net pro rata premiums after deducting said pro rata reinsurance premiums and return premiums up to the first day of September, 1922, the final date for the delivery of the schedule above provided for. The*2025 Connecticut receiving premium and assuming liability only upon the net amount retained by the Central National but representing the said Central National as its substitute in its relations with its reinsurers.
* * *
The Central National hereby covenants and agrees that it will pay the Connecticut the gross pro rata unearned premium for the unexpired terms, respectively, of the policies or contracts reinsured hereby, calculated prior to any deductions of any discount, brokerage or rebate of any kind, after deducting pro rata reinsurances and cancellations, as hereinabove provided for, and a reinsurance commission of sixty per cent.
The unearned premium reserve referred to in the reinsurance contract was the reserve which the petitioner was required to set aside and deposit with the State of Iowa pursuant to the laws of said State in order to protect its policyholders from loss.
*1056 In each of the years 1918, 1919, 1920, 1921, 1922, and 1923 the petitioner filed with the Commissioner of Insurance of the State of Iowa, pursuant to the law of said State, its annual statement showing its condition and affairs for the preceding calendar year. The form on which this statement*2026 was made was the "Convention Edition" for stock fire and marine companies. This annual statement set forth the assets and liabilities of the petitioner as of the last day of the year preceding the date of the statement. Among other things it contained a statement of the earned and unearned premiums as of the last day of the year covered by the annual statement. It also set forth the amount of the petitioner's surplus at the end of the year to which the annual statement related, together with a statement of the amount of the increase or decrease of such surplus during the year.
The unearned premiums at the end of each year from 1917 to 1922, inclusive, were as follows:
| 1917 | $28,722.67 |
| 1918 | 140,592.50 |
| 1919 | 256,663.47 |
| 1920 | $395.564.31 |
| 1921 | 357,949.55 |
| 1922 | None |
At the end of the year 1917 the petitioner's surplus amounted to $350,391.55, an increase of $391.55. At the end of each year from 1918 to 1921, inclusive, the amount of surplus and the amount of decrease thereof were as follows:
| Year | Surplus | Decrease |
| 1918 | $327,228.99 | $23,162.56 |
| 1919 | 305,934.07 | 21,294.92 |
| 1920 | 250,537.33 | 55,396.74 |
| 1921 | 228,025.40 | 22,511.93 |
At*2027 the end of 1922 the surplus set forth in the petitioner's annual statement made to the Commissioner of Insurance of the State of Iowa was $81,500.18, an apparent decrease during the year of $146,545.22. 545.22. In 1922, however, the petitioner had been liquidating its affairs and the record discloses that it made a refund to stockholders amounting to $740,580, of which $500,000 was on account of capital stock, the balance of $240,580 being paid out of surplus.
In its statement of assets contained in its annual reports to the Commissioner of Insurance petitioner deducted the amount of certain assets described as "assets not admitted." These assets "not admitted" included, among other things, agents' balances representing business prior to October 1 of each year and bills receivable past due taken for premium and similar items. In the annual statement for 1921 the amount of such deduction for agents' balances and bills receivable was $20,921.27, an increase over the deduction for the prior year of $15,404.29.
*1057 On June 1, 1922, the unearned premiums on the risks reinsured by petitioner in the Connecticut Fire Insurance Company amounted to $346,119.70. Of this amount*2028 the petitioner paid to the Connecticut Fire Insurance Company, pursuant to the terms of the contract hereinbefore referred to, the sum of $138,448.08, by delivering to the latter company cash and securities amounting in value to that sum. The petitioner retained out of the amount of said unearned premiums the sum of $207,671.62 for its commissions, pursuant to the terms of the contract. The total amount of commissions retained in 1922 by petitioner on the reinsurance of risks in the Connecticut Company and other companies was $210,526.59.
On March 15, 1923, petitioner filed its income tax return for the calendar year 1922, reporting therein no net income. The Commissioner determined a deficiency of $17,301.48.
OPINION.
VAN FOSSAN: There are for our determination only two questions, namely, (1) whether or not respondent erred in including in gross income the sum of $91,670.88, or any other sum, representing a portion of the unearned premium reserve account which petitioner contends was transferred from paid-in surplus; and (2) whether or not respondent erred in failing to deduct from gross income for the year 1922 a net loss sustained by petitioner in 1921.
Petitioner, *2029 by means of an arbitrary allocation, has determined that 25.61 per cent, or $91,670.88 of the total premium reserve of $357,949.55 as of December 31, 1921, represents transfers from paid-in surplus made to restore deficiencies in the premium reserve caused by current operating losses during the years 1918, 1919, and 1920, and contends that this amount should not be taxed as income. Thus arises the first issue.
The unearned premium reserve of petitioner as of December 31, 1921, represented a certain proportion fixed by law of the aggregate gross premiums written in all policies in force, less deductions for reinsurance. In insurance practice and in conformity with legal requirements, this sum is set aside at once on receipt and varies only by reason of fluctuations in the amount of insurance in force. Otherwise it remains intact. At the end of each year if income exceeds expenses the difference is added to surplus; if the expenses exceed income the deficit or loss reduces surplus. Petitioner suffered losses through several years and claims that these losses were charged first against the unearned premium reserve, thereby reducing it below the legal requirement, and that this*2030 deficiency in the premium reserve was then restored by transfer from paid-in surplus. Obviously, such a devious transaction, if indulged in, would be simply a matter *1058 of bookkeeping entries and could not be permitted to obscure the true situation. If permitted, the procedure proposed by petitioner would permit an insurance company to avoid permanently the payment of taxes on that part of its unearned premium reserve so employed.
The practical effect would be to convert part of the premium reserve (on which no taxes have been paid) to the capital account without passing through the income account. That approval can not be given to such a proposal is obvious.
There is a further reason why the decision on this point must be against petitioner. The evidence does not satisfactorily establish that the corporation actually followed the practice for which petitioner contends.
For these reasons we hold that respondent did not err in adding to petitioner's income for 1922 the entire sum of $357,949.55, which was the total amount of petitioner's unearned premium reserve at December 31, 1921. In that year the total reserve was released to general corporate uses and became*2031 taxable. ; ; .
Passing to the second question, petitioner alleges that in 1921 it sustained a net loss of $60,126.99 which it was entitled to carry forward and deduct from gross income for the year 1922. In its brief petitioner reduced this amount to $22,511.93. Respondent has conceded that petitioner sustained a net operating loss in 1921 and that this loss is deductible from gross income for 1922
In its annual statement filed with the Commissioner of Insurance of the State of Iowa for the year ended December 31, 1921, petitioner showed a decrease in net worth amounting to $22,511.93. However, in computing the amount of this decrease the petitioner included the sum of $15,404.29, which is the amount by which certain so-called "non-admitted assets" exceeded the amount of such assets deducted in its annual statement for 1920. These "non-admitted assets" consisted of certain agency balances and past-due bills receivable which were taken for premiums. There is no evidence that these*2032 accounts had been ascertained to be worthless either in whole or in part. On the contrary, so far as the evidence shows, the so-called "non-admitted assets" were good accounts, although the Commissioner of Insurance of the State of Iowa, under the law, could not admit them in the corporate financial statement when determining the profits of the insurance company. It does not follow that though falling under the statutory definition of "non-admitted assets" the value of these assets should be charged off for income tax purposes. Worthlessness is a fact to be proved and is not to be assumed because of an arbitrary classification under a State statute regulating insurance companies. *1059 In determining its operating loss for 1921 petitioner also deducted an item of $744.07 entered in its books as the cost of an improvement to real estate. So far as the proof shows, this cost of improvement to real estate is a capital charge. In our opinion, therefore, in order to determine petitioner's net operating loss in 1921, the total of these two items, namely, $16,148.36, must be deducted from the amount of net operating loss shown in petitioner's annual statement for 1921, namely, *2033 $22,511.93. With this adjustment petitioner's net operating loss for 1921 amounted to $6,363.57. This loss was not deducted from gross income by respondent in computing petitioner's net income. It follows that the petitioner is entitled to a deduction from income in 1922 of its net operating loss sustained in 1921 in the sum of $6,363.57.
Judgment will be entered under Rule 50.