Policyholder's Nat'l Life Ins. Co. v. Commissioner , 37 B.T.A. 60 ( 1938 )

POLICYHOLDER'S NATIONAL LIFE INSURANCE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Policyholder's Nat'l Life Ins. Co. v. Commissioner

Docket No. 83875.

United States Board of Tax Appeals

37 B.T.A. 60; 1938 BTA LEXIS 1086;

January 14, 1938, Promulgated

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Interest paid by the petitioner on "founder's certificates", the payment of which was not obligatory, held, not to be interest paid upon indebtedness and, hence, not deductible from gross income.

Holton Davenport for the petitioner.

Gerald W. Brooks, Esq., for the respondent.

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SMITH

This is a proceeding for the redetermination of a deficiency in income tax for 1933 in the amount of $329.55. The question in issue is the right of the petitioner to deduct $2,564.16 from its gross income of 1933 which was paid to the holders of its founder's certificates.

FINDINGS OF FACT.

The petitioner is a mutual life insurance company, organized and existing under the laws of the State of South Dakota and having its principal place of business at Sioux Falls, South Dakota. It was organized in 1919. At the time of organization it was understood that at a later date it would be changed to a stock company. In 1926 the plan was changed to one which has been followed ever since. The company issues four ordinary forms of life insurance policies, namely, ordinary life, twenty-payment life, twenty-year child's policy, and twenty-year endowment. All policies contain a special five-year endowment feature as follows:

POLICYHOLDER'S NATIONAL LIFE INSURANCE COMPANY

Sioux Falls, South Dakota.

The coupon attached to this Policy which becomes due and payable upon the payment of the 6th annual premium on this policy or upon the previous death of the Insured, will be, when due, either paid to the Insured (or to the Beneficiary in event it becomes payable by the death of the Insured) in cash; or if so requested in writing by the Insured at the time of the application for this Policy may be applied to the purchase of a FOUNDER'S CERTIFICATE. In accordance with the agreement contained in the application for this policy, the amount of all FOUNDER'S CERTIFICATES shall be carried as a separate and distinct liability and whenever the amount of such CERTIFICATES outstanding shall equal $100,000 the DIRECTORS shall take the necessary action to change the Company to a STOCK COMPANY and STOCK in the said company will be issued in exchange for all FOUNDER'S CERTIFICATES and of an equivalent Par Value.

Until such time as the change to a STOCK basis shall be made the BOARD OF DIRECTORS may at their discretion pay interest on all outstanding FOUNDER'S CERTIFICATES in an amount not to exceed 6% per annum.

Then follows a "Coupon" stating:

COUPON

POLICYHOLDER'S NATIONAL LIFE INSURANCE COMPANY

agrees to pay

Dollars

to the Insured on provided all premiums to and including the 6th shall have been paid; or, immediately on receipt of due proof of the prior death of the Insured to pay said sum to Beneficiary, provided this coupon has not been assigned to the purchase of a FOUNDER'S CERTIFICATE as provided above. In event the Insured elects to purchase a FOUNDER'S CERTIFICATE with the coupon, the CERTIFICATE so purchased and delivered in lieu of the above cash payment shall be for a par value of and the difference transferred to the Company's surplus for the benefit of the certificate holders.

Secretary.

As executed, these coupons are payable in cash in amounts equivalent to $30 for each $1,000 of insurance, but otherwise redeemable in certificates of $15 par value for each $1,000 of insurance. (Note: On policy contracts sold since 1934 or 1935, on a $30 coupon, the certificate par value has been $10). Practically all of the policyholders have elected to take founder's certificates in lieu of cash. In his application for the policy the insured signs a proxy or consent authorizing the change to a stock company when the par value of the certificates issued reaches $100,000.

In 1926 practically all of the then policyholders converted their policies to the new plan and as the policies were dated back the petitioner commenced issuing founder's certificates at once. A founder's certificate reads as follows:

FOUNDER'S CERTIFICATE

POLICYHOLDER'S NATIONAL LIFE INSURANCE COMPANY

No.

Amount

KNOW ALL MEN BY THIS INDENTURE that is the owner of $ of the Founder's Fund of the Policyholder's National Life Insurance Company of Sioux Falls, South Dakota, and that the amount of said fund represented by this Certificate and all other Certificates of like nature will be carried by the Company as separate and distinct liability and whenever the total amount of such outstanding certificates shall equal $100,000.00, the Company agrees to amend its articles of Incorporation and transform the Company into a Stock Company by legal action of policyholders.

Upon surrender of this Certificate, the owner thereof shall be entitled to stock in said Company, par value of which shall be equal to the face of this certificate. No redemption of this Founder's Certificate, either inwhole or in part shall be made except as above provided. The Board of Directors, however, are authorized to pay interest on said Founder's Fund in an amount not to exceed 6% providing in their judgment the financial condition of the Company shall warrant such payment.

This Founder's Certificate is issued by the Company and is negotiable and transferable. Said transfer should be duly recorded at the Home Office of the Company.

IN WITNESS WHEREOF the duly authorized Officers of the Company have hereunto subscribed their names and caused the corporate seal to be hereto affixed this day of 19

President.

Secretary.

When a coupon matures the company transfers $30 from its surplus account and places $15 to the "Founder's Fund" and $15 to "Founder's Surplus." Upon each $30 coupon the founder's certificate is in the amount of $15. The founder's fund and founder's surplus are always equal in amount. Each increases with the conversion of a coupon.

Founder's certificates outstanding are shown on the petitioner's books under the caption "Founder's Fund." The amount therein was approximately $12,000 in 1929. The amount had increased to $50,332.50 in 1933, and has since risen to more than $80,000. Upon policies issued from 1934 or 1935, the division of a $30 coupon will be $10 transferred to the founder's fund and $20 to the founder's surplus. Under the new arrangement the founder's surplus will increase faster than the founder's fund, but at the end of 1933 the founder's fund and the founder's surplus were equal in amount.

Up to 1929 no interest, so-called, was paid on the founder's certificates. In 1929 the matter was discussed in a board of directors' meeting and, after receiving an opinion from counsel, the board of directors directed that "interest" be paid upon the founder's certificates. In 1933, $2,564.16 was paid as interest on the founder's certificates. Similar distributions have been made in each subsequent year. The amount distributed represented 6 percent on the par value of the outstanding certificates.

No deduction was ever taken or claimed for income tax purposes until an actuary raised the question at the time the respondent was conducting an investigation of petitioner's income tax return for 1933.

The petitioner's income tax return for 1933 has attached to it a copy of the taxpayer's annual convention edition report for the year 1933, made to every state in which it is licensed to do business. In this report the $9,990 of increase in the founder's fund during the year is listed under the heading "Capital Stock." In the same report the amount here in question, namely, $2,564.16, is shown under the heading "Dividends to Policyholders." The annual report of all life insurance companies, convention edition, uses the same form for both stock insurance companies and mutual insurance companies. There is no separate form for mutual insurance companies and about the only difference is that when mutual companies fill in the form the place for "Capital Stock" is left blank.

OPINION.

SMITH: In section 203 of the Revenue Act of 1932 it is provided that in the case of a life insurance company the term "net income" means the gross income less certain items, among which is:

(8) INTEREST. - All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from taxation under this title.

The crucial question in this case is whether the $2,564.16 paid by the petitioner in 1933, representing 6 percent on the founder's certificates, was paid as interest on the petitioner's indebtedness. The petitioner points to the fact that the policy contract provided in each case that "the amount of said fund represented by this Certificate and all other Certificates of like nature will be carried by the Company as separate and distinct liability" and that the founder's certificate provides that:

* * * The Board of Directors, however, are authorized to pay interest on said Founder's Fund in an amount not to exceed 6% providing in their judgment the financial condition of the Company shall warrant such payment. It is argued therefrom that the distribution made by the petitioner in 1933 to holders of its founder's certificates was interest paid upon its indebtedness. If it was paid on its indebtedness it is deductible from gross income; if not, it is not deductible. In ; affd. (C.C.A., 9th Cir.), , this Board stated at page 725:

This question has been presented a number of times to the Board and the courts under slightly varying facts. In some cases the so-called stock was to be retired at a fixed date, ; reversed, , and in others at the option of the corporation or the stockholder, ; affd., . In some cases the interest or dividends were payable regardless of earnings, , and in others payments were to be made only out of surplus or profits, , sustaining ; ; ; affd., . None of the decided cases lay down any comprehensive rule by which the question presented may be decided in all cases, and "the decision in each case turns upon the facts of that case." ; affirming ; ;. In each case it must be determined whether the real transaction was that of an investment in the corporation or a loan to it. On this the designation of the instrument issued by the corporation, while not to be ignored, is not conclusive, . The real intention of the parties is to be sought and in order to establish it evidence aliunde the contract is admissible. If the evidence establishes "that dividends paid are, according to the intent of the parties, in fact interest, and the stock on which the dividends are paid is merely held by the creditor as security, it makes no difference what the reason was for paying in that form."

The question here presented does not turn upon the fact of whether the petitioner considered its founder's fund a liability or whether the distributions made to the holders of founder's certificates were characterized as interest. The question is whether the petitioner borrowed money from its policyholders which it was obligated to pay back and whether the amounts designated as interest represent interest which was paid upon such borrowings. In ; affd., , the Board said:

* * * A corporate creditor is one who has loaned to the corporation money or its equivalent, usually for compensation or interest, at a fixed rate, to be repaid at a designated time or in a designated manner. The stockholder risks his money in the enterprise. The creditor assumes no such risk. * * *

The facts in this case clearly show that as a means of inducing persons to take out life insurance policies the petitioner afforded them an opportunity of eventually becoming a stockholder in the company. Each policyholder understood that by means of the coupon attached to his policy and made a part thereof, he could, upon the maturity of the coupon, receive a founder's certificate in the amount of $15 for each $1,000 of insurance contracted for. The petitioner did not obligate itself to redeem the certificate for $15 or for any other amount. It did, however, obligate itself to issue to the holder of the certificate $15 of the capital stock of the company as soon as the founder's fund should reach the amount of $100,000. The founder's fund was always at the risk of the business. It was just as much at the risk of the business as the founder's surplus or the free surplus of the company.

It is plain from the provisions of the policy coupon and the founder's certificate that the petitioner was not obligated to pay interest upon the amount of the founder's certificate. The board of directors were, however, authorized in their discretion to pay interest on those certificates in an amount not to exceed 6 percent "providing in their judgment the financial condition of the Company shall warrant such payment." The evidence shows that no interest was paid upon these founder's certificates until 1929. In that year the board of directors, considering the financial condition of the company and believing that it was morally obligated to pay the interest, did pay it. But this did not constitute interest paid upon an obligation of the company. The holders of the founder's certificates had a proprietary interest in the company. To all intents and purposes the distribution made constituted a division among the holders of the founder's certificates of a part of the profits or assets of the business. We are of the opinion that the respondent correctly held that the amount of $2,564.16 paid in 1933 did not represent a payment by the petitioner of interest upon its indebtedness, but a voluntary distribution to the holders of the founder's certificates of a part of the profits or assets of the petitioner. The amount was not a legal deduction from gross income.

Judgment will be entered for the respondent.