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STATE FARM MUTUAL AUTOMOBILE INS. CO. v. UNITED STATES

November 21, 1961

STATE FARM MUTUAL AUTOMOBILE INSURANCE COMPANY, A CORPORATION, PLAINTIFF,
v.
THE UNITED STATES OF AMERICA, DEFENDANT.



The opinion of the court was delivered by: Poos, District Judge.

The plaintiff, State Farm Mutual Automobile Insurance Company, an Illinois corporation, brings this suit against the United States of America to recover an alleged unlawful, illegal and erroneous assessment of income taxes for the years 1955 and 1956. The action is asserted and brought under Title 28 United States Code, § 1346(a)(1). All formal steps preliminary to this suit have been carried out. The plaintiff filed its returns and paid income taxes for the years 1955 and 1956. Thereafter the Commissioner of Internal Revenue examined the returns for the years in question and as a result of the examinations determined that there was an alleged deficiency in income due for the year 1955 in the sum of $109,532.00, and for the year 1956 in the sum of $130,850.00. The Commissioner determined that $10,952,094.00 received by plaintiff as membership fees from new policyholders in 1955 and $13,080,235.00 in 1956, constituted a portion of the net premiums of plaintiff within the purview of Section 823 of the Internal Revenue Code of 1954, 26 U.S.C. § 823, and therefore includable in gross revenue for the purpose of computing the tax imposed by Section 821(a)(2) of the Internal Revenue Code. Pursuant to this determination the defendant assessed and collected for the year 1955 additional income taxes in the sum of $109,532 plus interest in the sum of $18,675.20, and for the year 1956 the sum of $130,850 plus interest of $14,458.91. A claim for refund for each year was filed on January 14, 1959, both of which were rejected on October 5, 1959.

The plaintiff alleges that the aforesaid amounts of $10,952,094.00 and $13,080,235.00 received by the plaintiff for the respective years as membership fees were properly excluded from net premium for each year because said membership fees which were received only from new policyholders do not constitute net premiums within the purview of Sec. 823 of the Internal Revenue Code of 1954, and the determination by the defendant that said membership fees are net premiums and the inclusion of these amounts in gross income for the purpose of the tax computations imposed by Section 821(a)(2) was erroneous and without warrant in law, and that the aggregate sum of $273,516.11 collected was done so illegally and without warrant and authority of law. The plaintiff claims this amount with interest thereon from December 23, 1958 and requests judgment therefor. The defendant denies the allegations.

This case was tried without a jury on a stipulation of facts and the testimony of four witnesses, three of them for the plaintiff and one for the defendant, together with certain exhibits introduced by both parties. All procedural conditions precedent to the bringing of this suit have been met.

From the stipulations and evidence it appears that plaintiff was incorporated as a mutual insurance company in 1922 under the laws of Illinois and writes primarily automobile insurance; that the company from its inception has charged a membership fee which entitles the member to make an application for insurance in the company for the coverage for which the applicant has paid a membership fee; that the membership fee purchases no insurance; that membership fees are not changed at the time of a different rate filing, and have no connection with or relationship to the rate filings; that rate filings are made with the various states as required by state laws; that there have been occasions when persons apply for membership in the company who have not as yet made application for insurance; that all policyholders are members, and there are members who are not policyholders; that there are quite a few million members who are not policyholders who have a right at any time to apply for insurance at some subsequent time, and they will be accepted if they are insurable risks under the standards of the company; that if a membership fee is once exacted, it is never again exacted for that coverage.

Gilbert B. Brown, comptroller for plaintiff, testified that he was experienced with insurance business since 1925, and that his understanding of the word "premium" would be the consideration paid to an insurance company for its acceptance of the risk. This witness, on cross-examination, stated that the privilege given to members who are not policyholders is the right to apply for insurance at any time they are deemed a desirable risk, but they cannot vote unless they are a policyholder, nor are they entitled to share in any dividend distribution unless they are policyholders; that a membership fee once collected gives the member the right to apply for insurance at any future time; that in the past, people who do not own an automobile have come to the Company and applied for membership; that in the years 1955 and 1956, a few applied for membership without applying for a policy. The witness further stated that the expression, "underwriting expenses", is interpreted by two schools of thought, one being those expenses necessarily incurred in determining the qualifications, the eligibility of the insured, and the actual issuance of the policy, and the other school of thought in addition includes acquisition costs and underwriting costs; that acquisition costs are used generally in setting premium rates.

It further appears that under the Illinois law, plaintiff is not required to pay a premium tax because it is a domestic company; that the premium tax is applicable only to foreign insurance companies, those domiciled in other states, but these companies organized on the same plan would not have to pay any premium tax on membership fees because Illinois law does not provide for a premium tax on these fees because membership fees are not enumerated in the Illinois statute.

It further appears that plaintiff was organized on the membership fee plan in 1922 without any thought of income tax evasion, because at that time there was no income tax levied on insurance premiums of mutual companies by the Internal Revenue Code, the tax having been first imposed in 1939 [§ 207(a)(2)] by Section 821(a)(2) of the Code.

It appears that the membership fee plan is not permitted by the laws of Texas and there agent's commissions are paid from premiums as selling expense set aside for the various classes of agents, and that the company pays income tax on the premiums paid in Texas, less return premiums and premium paid for reinsurance.

The Government's Exhibit 1, the plaintiff's report to its members for 1956, at page 18, shows under the column marked "where the money comes from," premium and membership fees rounded to $287,250,000.00, then investment income of $9,000,000.00, a total of $296,000,000.00. The premium and membership fees are not segregated in this report. Page 3 of the same exhibit shows the total premium income to be $287,250,000.00. The annual statement for 1956 shows this figure broken down to premiums of $274,170,000.00, and membership fees of $13,080,000.00, making the above total. Government's Exhibit 2, the similar report for 1955, checked with the annual statement, shows a premium and membership fee total of $241,901,000.00, which breaks down to $230,949,000.00 of premium income, and $10,952,000.00 of membership fees. This witness further stated that Government Exhibits 1 and 2 for 1955 and 1956 are general reports to existing policyholders of the general overall conditions of the Company during the year. These reports are matters of public relations, and the difference between them and the annual reports is that the annual reports taken from the books of the Company reflect the actual breakdown of figures. The annual statement is filed by the Company in each of the States in which the Company does business, including all 48 states and territories in 1955 and 1956, except certain New England states in which the Company does no business.

Lowell S. Rinehart, Assistant Treasurer of Nationwide Mutual Insurance Company of Columbus, Ohio, formerly known as the Farm Bureau Mutual Automobile Insurance Company, testified in behalf of plaintiff that his company operates on the membership fee plan identical to that of plaintiff, and that in 1947 the Treasury Department, Office of Internal Revenue, through Mr. E.I. McLarney, Deputy Commissioner, ruled that "the fees charged the policyholders for membership in the company do not fall within the definition of "net premiums" in section 207(a)(2) of the Code and should not, therefore, be included in its taxable income" (Plaintiff's Exhibit 11). He further testified that in 1960 the Internal Revenue Service revoked the 1947 ruling on the authority of the case of State Farm Mutual Automobile Insurance Company v. Duel, 244 Wis. 429, 12 N.W.2d 696 (1944), aff'd 324 U.S. 154, 65 S.Ct. 573, 89 L.Ed. 812 (1945), but that in the intervening and prior years his company had not included membership fees in its income tax returns as net premiums.

Witness Harold E. Curry stated that he was Vice-President and Actuary of State Farm Mutual Automobile Insurance Company since 1945, and prior to that time from May, 1929, was actuary of the Farm Bureau Mutual Automobile Insurance Company of Columbus, Ohio; that he was familiar with the membership fee plans of plaintiff and the Ohio Company and that both are essentially the same; that the State Farm Mutual plan contemplates that each new applicant for insurance prior to the time he applies for insurance shall become a member of the Company by applying for membership by payment of the membership fees for the various coverages of insurance in which he is interested; that the applicant for membership can subsequently apply for a policy of insurance for the coverages he desires on his automobile; that this plan is not new or unique and has been used by plaintiff since its inception in 1922, and the plan is used by a number of other insurance companies at the present time; that the membership fees that are charged by companies with which the witness was familiar are not considered a part of premium income, but they are separate and apart from premium income because they purchase no insurance and in most instances are fees that are assessed but once at the time that the applicant initially applies to the company; that there is a separate membership fee for each type of coverage, as for example, for a comprehensive coverage, a fee of $2.00; for bodily injury and property damage, a fee of $7.00; and for a $50.00 deductible, a fee of $6.00; and then to activate the insurance you would have to pay a premium on comprehensive coverage, $6.90; for collision coverage on an actual value basis, $27.00 to $29.00; and for bodily injury approximately $40.00; that these total costs for premiums for these three types of coverage would be $73.90 in addition to the membership fees, and for each subsequent year the premium, assuming no rate changes, would be $73.90 without any further membership fee, and there would be no further charges for membership fees even if insurance was not carried in any subsequent year; that the member at any time in the future would be entitled to apply for a policy without payment of another membership fee; that the basic reasoning of this plan was that it is an equitable way of assessing the cost of insurance to an individual; that in the instance of plaintiff, it was of the conviction that it was going to issue policies on a continuous basis, that is, from each six months to each six months, on a continuing basis over a period of years, and that the initial cost of determining whether that applicant was a satisfactory risk for the Company, it would be an extra cost that should be borne by that individual at the time he applied for membership in the Company; that it was a cost assessed to the individual to determine their qualifications and eligibility to become members of the company, a non-recurring cost once having been paid and eligibility having been determined, the membership was irrevocable; that if the information furnished by the agent is complete, the risk will be accepted, but if incomplete, the application will be supplemented by information from a retail credit or other investigating agency, or in some instances state motor vehicle accident records are consulted, and from sources of information that are available and utilized at all times; that if the policy is not issued, the membership fee is returned, and if issued and cancelled in the first 60 days of the initial policy period because it is determined that the risk fails to meet the Company's underwriting standards, the membership fee will be returned to the applicant.

The witness further testified that one of his responsibilities as actuary for the plaintiff was to make and file rates for his company in the various states; that the membership fee is not utilized at all in the determination of rates because it doesn't provide any insurance coverage; that in many states the membership fees aren't filed and are not considered a part of the rate filings; that the membership fee does not purchase any insurance protection and is not given any consideration in the promulgation of the schedule of rates of the company. Referring to plaintiff's exhibit 12 the witness pointed out that the membership fees are not proportionate to the rates, and that on collision coverage there could be a premium ranging from $6.40 to $104.10, yet the membership fee would remain constant at $6.00.

The defendant called, as its sole witness, Robert I. Mehr, Professor of Finance at the University of Illinois, specializing in the insurance field. The witness stated that he has taught insurance on the college level since 1945; that he was familiar with the ordinary receipts and expenses of insurance companies generally, which come in a general way from premium, investment income and from paid in surplus in mutuals and paid in capital and surplus in stock corporations; that the expenses associated with insurance are underwriting, which can include all expenses of acquiring the policyholder, processing him, administering the insurance, all expenses associated with the payment of losses or claims, and the losses themselves; that the non-recurring type of expenses testified to as initial commissions and investigation expenses, are normal underwriting expenses; that in his experience and study he was not familiar with any textbook or article that has taken the position that initial acquisition costs are not normal underwriting expense; that he was familiar generally with the way insurance companies determine what their premiums should be, and how premium rates are established; that the three broad factors are the projected losses, the expense of operating the company, and a contingency in mutual companies and profit in stock companies.

The witness stated he had prepared Government Exhibits 3, 4 and 5. These exhibits show the leading mutual insurance companies in terms of premiums written in the United States, showing those that charge membership fees or policy fees, the amount of net premiums, which is to indicate in terms of premium volume among the largest companies that do have membership fees, and to show that it is not a practice to charge membership fees or even policy fees in taking care of acquisition. Exhibit 4 shows the list of the 387 mutual insurance companies in 1955 with over $200,000.00 of premium income. It also shows that the total net premium was over two billion dollars, and total membership fees were $13,784,000.00 charged by the three companies indicated on Exhibit 3, namely, State Farm Mutual Auto Insurance Company, Nationwide Mutual Insurance Company, and Nationwide Mutual Fire Insurance Company. The total of the membership fees and policy fees of $14,972,000.00, and deducting the policy fees of $13,784,000.00, slightly over a million, represents the policy fees that are charged by the other 381 companies, which the witness said indicates that the practice of charging policy fees in terms of size of insurance operations is not an important factor in the mutual insurance business, and the same comparison is again made for 1956.

The witness stated as he understood the reason for the membership fee at the commencement of their business was because the insurance departments of the states regulate the assets and liabilities of the various companies as to unearned premium reserves; that this is a liability; that the law of Illinois did not require them to include membership fees as premiums; that the unearned premium reserve is a redundant type of thing; that, for example, an insurance company sold a policy and charged a premium of $120.00, on which it could charge off the liability reserve on a monthly basis, which would enable it to charge off $10.00 monthly as earned; that using the figure of $120.00 premium to start with, and a commission of 20 per cent being allowed the agent for procuring the insurance, the agent would get $20.00, and the Company would get $100.00; that in considering other expenses, the Company would get a little less than this, so the effect would be that you'd have a Company with less than $100.00 in cash, or an increase in assets of less than $100.00 to offset a liability increase of $120.00, which would decrease surplus by that difference; that thus, when a Company grows they find that their surplus is going to continue to decrease if they continually grow and charging the full premium, putting everything into the premium, actually would limit the growth of the Company; that taking out of the premium certain parts of the cost, such as membership fee, and then say they collect $20.00 of membership fee and $100.00 premium, and the Company not having to show the $20.00 as part of their unearned premium liability, then it would not make an inroad on the surplus of the Company, and it can grow without weakening the capital structure of the Company.

The witness further stated that an insurance premium is primarily a matter that is defined in a contract of insurance; that you get the policy for the premium stated in the insurance contract; that if they are going to refund the membership fee, keeping in mind the contract, and if the fee is refunded within a period of time then he would consider it to be a part of the premium because the repayment of the fee is an obligation of the company; that it is also an obligation of the company to pay back the membership fee, if the risk is not accepted.

The witness further stated that in his opinion when Congress says net premium under the Act, the term net premium means gross premiums written or received on insurance contracts during the taxable year, less returned premiums and premiums paid or incurred for reinsurance, and that when it speaks of the contract, Congress means the policy of insurance. He said that he thought, though, that it would be impossible to get the contract, without all underwriting costs that are involved in issuing the contract, and he assumed that the membership fee is in lieu of underwriting costs, and that it would be impossible to write a policy without incurring underwriting costs; that it could be taken out of premium. He said that two contracts are made by this Company with their policyholders; that in the first they hold out to the applicant that for a consideration they will sell him a membership fee in the Company, and if the investigation under the membership fee paid finds him eligible for insurance, then the second contract is sold, a policy for a further consideration called premium, which is the policy of insurance. He said that in his opinion he considered the membership fee as a part of the premium, because if this Company were to dispense with membership fees, they would have to add to the premium in order to afford to write insurance.

This government witness further testified that the statute was passed after the insurance company started the practice of operation on a membership fee basis, and that the practice of the company was unrelated to the matter of the tax issue and was in accordance with unearned premium reserve, the reason for writing the six-months policy rather than an annual policy.

He further stated, though, that in his opinion it would not be necessary to write "membership fee" into the statute in order to include the membership fee as a part of the premium because the general method of operation of insurance companies is to charge all these things to premiums; that when a company has no membership fee, the initial costs of commissions, investigation and acquisition, are met out of premiums that they charge in the policy, which is the general practice in the insurance business; that generally speaking, if a company does not have a membership fee to meet initial costs, they would have to be met out of some other charge, presumably the premium, and this is true of mutual companies generally; that the commissions that are paid to selling agents and other acquisition costs are normal underwriting expenses of an insurance company, and are considered in determining the amount of premium; that if the State Farm Mutual had another way of paying for acquisition costs, rather than through premiums, they would need to charge less premiums; that it would reduce the tax liability if the membership fee is not included as a part of the premium, which would put them in a more favorable competitive position insofar as the tax is concerned.

This witness testified that in insurance terminology the word "premium" means simply the amount necessary to be charged in order to procure the coverage under the contract, which would include the initial acquisition costs; that in his opinion one of the reasons why Congress defined net premiums in the statute is that there are two connotations of the term "net premium"; that what the statute says is that all of the premium is taxable, except what they give back in dividends, but they don't take away the expenses of operating the business; that every time we use the term "net premium" in our writings, we have to explain whether we mean gross premiums minus dividends or whether we mean gross premiums minus expenses, and that is the reason Congress tried to spell out what the term "net premium" meant.

The Government witness further stated that in his opinion "premium" would be the cost of losses plus the cost of field and acquisition expenses, plus the allotment for profit, the whole amount the policyholder would have to pay in order to procure the policy; that the membership fee would take care of the acquisition and some of the field expenses, which are normal underwriting expenses; that the membership fees exacted from the members would be premium for the year in which they were paid.

I have set out fully an abstract of the evidence introduced by the plaintiff and the government. The matter to be determined is the meaning of the word "premium" as used in Section 823 of the Internal Revenue Code of 1954, and to determine whether or not the moneys charged by plaintiff under the membership fee provision of its by-laws and policy are to be included as premiums for the purpose of assessing the tax imposed by Section 821(a)(2) of the Internal Revenue Code.

Section 823 of the Code, in so far as applicable here in defining "net premiums", provides,

    "(1) Net premiums. — The term `net premiums' means
  gross premiums (including deposits and assessments)
  written or received on insurance contracts during the
  taxable year less return premiums and premiums paid
  or incurred for reinsurance. * * *"

To reach a conclusion as to whether or not the term "net premium" reaches the membership fee and makes it taxable, the factual situation under which the membership fee is exacted must be examined. This Company was organized under the law of Illinois in 1922 on the membership fee plan. The tax provision of the Internal Revenue Code assessing a tax against net premiums was not enacted until 1939, and from that time until 1954 the membership fee was never considered to be premium by the Internal Revenue Service, and the 1947 letter from the Deputy Commissioner of Internal Revenue stated that it was not taxable as premium income. The government makes no contention that the plan of charging a membership fee is a tax evasion device or tax avoidance scheme.

The provisions of the by-laws of plaintiff providing for membership fees are:

"Article II.

    "Section 1. Every policyholder shall be a member of
  the Corporation. The Board of Directors shall
  determine the eligibility and conditions of
  membership and may make equitable classifications of
  members as respects each kind of insurance. Each kind
  of insurance shall bear its equitable proportion of
  the losses, expenses and liabilities of the
  Corporation computed as required by law. The Board of
  Directors shall determine ...

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