Commissioner v. First Security Bank of Utah/Opinion of the Court

by Lewis F. Powell, Jr.

MR. JUSTICE POWELL delivered the opinion of the Court.

This case presents for review a determination by the Commissioner of Internal Revenue (Commissioner), pursuant to § 482 of the Internal Revenue Act,^[1] that the income of taxpayers within a controlled group should be reallocated to reflect the true taxable income of each. Deficiencies were assessed against respondents. The Tax Court affirmed the Commissioner's action, and respondents appealed to the Court of Appeals for the Tenth Circuit. That court reversed the decision of the Tax Court, 436 F. 2d 1192 (1971), and we granted the Commissioner's petition for certiorari to resolve a conflict between the decision below and that in Local Finance Corp v. Commissioner, 407 F. 2d 629 (CA7), cert. denied, 396 U.S. 956 (1969). We now affirm the decision of the Court of Appeals.

[p396] Respondents, First Security Bank of Utah, N.A., and First Security Bank of Idaho, N.A. (the Banks), are national banks that, during the tax years, were wholly owned subsidiaries of First Security Corp. (Holding Company). Other, non-bank, subsidiaries of the Holding Company, relevant to this case, were First Security Co. (Management Company), Ed. D. Smith & Sons, an insurance agency (Smith), and—from June 1954—First Security Life Insurance Company of Texas (Security Life). Beginning in 1948, the Banks offered to arrange for borrowers credit life, health, and accident insurance (credit life insurance). The Tax Court found that they did this "for several reasons," including (1) offering a service increasingly supplied by competing financial institutions, (2) obtaining the benefit of the additional collateral that credit insurance provides by repaying loans upon the death, injury, or illness of the borrower, and (3) providing an "additional source of income—part of the premiums from the insurance—to Holding Company or its subsidiaries."

Until 1954, any borrower who elected to purchase this insurance was referred by the Banks to two independent insurance companies. The premium rate charged was $1 per $100 of coverage per year, the rate commonly charged in the industry. The Insurance Commissioners of the State involved—Utah, Idaho, and Texas—accepted this rate. The Banks followed a routine procedure in making this insurance available to customers. The lending officer would explain the function and availability of credit insurance. If the customer desired the coverage, the necessary form was completed, a certificate of insurance was delivered, and the premium was collected or added to the customer's loan. The Banks then forwarded the completed forms and premiums to Management Company, which maintained records of the [p397] insurance purchased and forwarded the premiums to the insurance carrier. Management Company also processed forms filed under the policies. The cost to each of the Banks for the actual time devoted to explaining and processing the insurance was less than $2,000 per year, characterized by the courts below as "negligible." The cost to Management Company of the services rendered by it was also negligible, slightly in excess of $2,000 per year.

It was the custom in the insurance business (although not invariably followed), regardless of the cost of incidental paperwork, to pay a "sales commission"—ranging from 40% to 55% of net premiums collected—to a party who originated or generated the business. But the Banks had been advised by counsel that they could not lawfully conduct the business of an insurance agency or receive income resulting from their customers' purchase of credit life insurance. Neither the Banks nor any of their officers were licensed to sell insurance, and there is no question here of unlawfully acting as unlicensed agents. The Banks received no commissions or other income on or with respect to the credit insurance generated by them. During the period from 1948 to 1954 commissions were paid by the independent companies writing the insurance directly, to Smith, one of the wholly owned subsidiaries of Holding Company. These commissions were reported as taxable income, not by Smith, but by Management Company which had rendered the services above described. During this period (1948-1954), the Commissioner did not attempt to allocate the commissions to the Banks.^[2]

[p398] In 1954, Holding Company organized Security Life, a new wholly owned subsidiary licensed to engage in the insurance business. A new procedure was then adopted with respect to placing credit life insurance. It was referred by the Banks to, and written by an independent company, American National Insurance Company of Galveston, Texas (American National), at the same rate to the customer. American National then reinsured the policies with Security Life pursuant to a "treaty of reinsurance." For assuming the risk under the policies sold to the Banks' customers, Security Life retained 85% of the premiums. American National, which furnished actuarial and accounting services, received the remaining 15%. No sales commissions were paid. Under this new plan,^[3] the Banks continued to offer credit life insurance to their borrowers in the same manner as before.^[4]

Security Life was not a paper corporation. It commenced business in 1954 with an initial capital of $25,000, [p399] which was increased in 1956 to $100,000. Although it did not become a full-line insurance company (contemplated as a possibility when organized), its reinsurance business was substantial. The risks assumed by it had grown to $41,350,000 by the end of 1959, and it had paid substantial claims.^[5]

Security Life reported the entire amount of reinsurance premiums, 85% of the premiums charged, in its income for the years 1955-1959. Because the income of life insurance companies then was subject to a lower effective tax rate than that of ordinary corporations, the total tax liability for Holding Company and its subsidiaries was less than it would have been had Security Life paid a part of the premium to the Banks or Management Company as sales commissions.^[6] Pursuant to his § 482 [p400] power to allocate gross income among controlled corporations in order to reflect the actual incomes of the corporations, the Commissioner determined that 40% of Security Life's premium income was allocable to the Banks as compensation for originating and processing the credit life insurance.^[7] It is the Commissioner's view that the 40% of the premium income so allocated is the equivalent of commissions that the Banks earned and must be included in their "true taxable income."^[8]

The parties agree that § 482 is designed to prevent "artificial shifting, milking, or distorting of the true net incomes of commonly controlled enterprises."^[9] Treasury Regulations provide:

"The purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining according to the standard of an uncontrolled taxpayer, the true taxable income from the property and business of a controlled taxpayer.... The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer."^[10]

The question we must answer is whether there was a shifting or distorting of the Banks' true net income [p401] resulting from the receipt and retention by Security Life of the premiums above described.^[11]

We note at the outset that the Banks could never have received a share of these premiums. National banks are authorized to act as insurance agents when located in places having a population not exceeding 5,000 inhabitants, 12 U.S.C.A. § 92.^[12] Although § 92 does not explicitly prohibit banks in places with a population of over 5,000 from acting as insurance agents, court have held that it does so by implication.^[13] The Comptroller [p402] of the Currency has acquiesced in this holding,^[14] and the Court of Appeals for the Tenth Circuit expressed its agreement in the opinion below.

The penalties for violation of the banking laws include possible forfeiture of a bank's franchise and personal liability of directors. The Tax Court found that the Banks, upon advice of counsel, "held the belief that it would be contrary to Federal banking law... to receive income resulting from their customers' purchase of credit insurance" and, pursuant to this belief, "the two Banks have never received or attempted to receive commissions or reinsurance premiums resulting from their customers' purchase of credit insurance."^[15].

Petitioner does not contest this finding by the Tax Court or the holding in this respect of the Court of Appeals below. Accordingly, we assume for purposes of this decision that the Banks were prohibited from receiving insurance-related income, although this prohibition did not apply to non-bank subsidiaries of Holding Company.^[16]

[p403] We know of no decision of this Court wherein a person has been found to have taxable income that he did not receive and that he was prohibited from receiving. In cases dealing with the concept of income, it has been assumed that the person to whom the income was attributed could have received it. The underlying assumption always has been that in order to be taxed for income, a taxpayer must have complete dominion over it. "The income that is subject to a man's unfettered command and that he is free to enjoy at his own option may be taxed to him as his income, whether he sees fit to enjoy it or not." Corliss v. Bowers, 281 U.S. 376, 378 (1930).

It is, of course, well established that income assigned before it is received is nonetheless taxable to the assignor. But the assignment-of-income doctrine assumes [p404] that the income would have been received by the taxpayer had he not arranged for it to be paid to another. In Harrison v. Schaffner, 312 U.S. 579, 582 (1941), we said:

"[O]ne vested with the right to receive income [does] not escape the tax by any kind of anticipatory arrangement, however skillfully devised, by which he procures payment of it to another, since, by the exercise of his power to command the income, he enjoys the benefit of the income on which the tax is laid."^[17]

One of the Commissioner's regulations for the implementation of § 482 expressly recognizes the concept that income implies dominion or control of the taxpayer. It provides as follows:

"The interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled taxpayer so to conduct its affairs that its transactions and accounting records truly reflect the taxable income from the property and business of each of the controlled taxpayers."^[18]

This regulation is consistent with the control concept heretofore approved by this Court, although in a different context. The regulation, as applied to the facts in this case, contemplates that Holding Company—the controlling interest—must have "complete power" to shift income among its subsidiaries. It is only where this power exists, and has been exercised in such a way that the "true taxable income" of a subsidiary has been [p405] understated, that the Commissioner is authorized to reallocate under § 482. But Holding Company had no such power unless it acted in violation of federal banking laws. The "complete power" referred to in the regulations hardly includes the power to force a subsidiary to violate the law.

Apart from the inequity of attributing to the Banks taxable income that they have not received and may not lawfully receive, neither the statute nor our prior decisions require such a result. We are not faced with a situation such as existed in those cases, urged by the Commissioner, in which we held the proceeds of criminal activities to be taxable.^[19] Those cases concerned situations in which the taxpayer had actually received funds. Moreover, the illegality involved was the act that gave rise to the income. Here the originating and referring of the insurance, a practice widely followed, is acknowledged to be legal. Only the receipt of insurance commissions or premiums thereon by national banks is not. Had the Banks ignored the banking laws, thereby risking the loss of their charters and subjecting their officers to personal liability,^[20] the illegal-income cases would be relevant. But the Banks from the inception of their use of credit life insurance in 1948 were careful never to place themselves in that position. We think that fairness requires the tax to fall on the party that actually receives the premiums rather than on the party that cannot.^[21]

[p406] In L.E. Shunk Latex Products, Inc. v. Commissioner, 18 T.C. 940 (1952), the Tax Court considered a closely analogous situation. The same interest controlled a manufacturer and a distributor of rubber prophylactics. The OPA Price Regulations of World War II became effective on December 1, 1941. Prior thereto the distributor had raised its prices to retailers, but the manufacturer had not increased the prices charged to its affiliated distributor. The Commissioner, acting under § 482, attempted to allocate some of the distributor's income to the manufacturer on the ground that a portion of the distributor's profits was in fact earned by the manufacturer, even though the manufacturer was prohibited by the OPA regulations from increasing its prices. In holding that the Commissioner had acted improperly, the Tax Court said that he had "no authority to attribute to petitioners income which they could not have received." 18 T.C., at 961.^[22]

It is argued, finally, that the "services" rendered by the Banks in making credit insurance available to customers "would have been compensated had the corporations [p407] been dealing with each other at arm's length."^[23] The short answer is that the proscription against acting as insurance agent and receiving compensation therefor applies to all national banks located in places with population in excess of 5,000 inhabitants. It applies equally to such banks whether or not they are controlled by a holding company. If these Banks had been independent of any such control—as most banks are—no commissions or premiums could have been received lawfully and there would have been no taxable income.^[24] As stated in the Treasury Regulations, the "purpose of section 482 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer...."^[25] We think our holding comports with such parity treatment.

We conclude that the premium income received by Security Life could not be attributable to the banks. Holding Company did not utilize its control over the Banks and Security Life to distort their true net incomes. The Commissioner's exercise of his § 482 authority was therefore unwarranted in this case. The judgement below is

Affirmed.

Notes

1. Title 26 U.S.C. § 482 provides:

   "In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary or his delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses."

2. The corporate income tax imposes the same rate of taxation on taxable income up to $25,000 and the same rate for income greater than $25,000. 26 U.S.C. § 11. Therefore, if, excluding the sales commissions in question, we assume, as seems likely, that before 1954 the income of both respondents and of Management Company exceeded $25,000, then the total taxes paid by the Holding Company subsidiaries would not be affected if the commissions were allocated wholly to respondents, or to Management Company, or partially to all three.
3. This plan was proposed to Holding Company by American National, which was making similar recommendations to other financial institutions. The Tax Court found that insurance companies anticipated that lending institutions would soon begin to form their own affiliated life insurance companies to write the credit insurance, which was proving to be a profitable business. Such a move by lending institutions would deprive the independent insurance companies of substantial credit insurance business. The type of plan recommended by American National was intended to salvage a portion of such business by charging a fee for the actuarial, accounting, and other services made available to Security Life, which reinsured the entire risk. T.C. Memo 1967-256.
4. Taxpayers are, of course, generally free to structure their business affairs as they consider to be in their best interests, including lawful structuring (which may include holding companies) to minimize taxes. Perhaps the classic statement of this principle is Judge Learned Hand's comment in his dissenting opinion in Commissioner v. Newman, 159 F. 2d 848, 850-851 (CA2 1947):

   "Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant."

   See Knetsch v. United States, 364 U.S. 361, 365 (1960); Chirelstein, Learned Hand's Contribution to the Law of Tax Avoidance, 77 Yale L.J. 440 (1968).

5. The opinion of the Tax Court, supra, includes tables showing the profitability of Security Life. Its net worth (capital and surplus) increased from $161,370.52 at the end of 1955 to $1,050,220 at the end of 1959, despite the paying out of claims and claims expenses over the five-year period totaling $525,787.91. The Tax Court found that: "Although Security Life's business proved to be successful, there was no way to judge at the outset whether it would succeed. In relation to its capital structure, Security Life reinsured a large amount of risk."
6. Both the Life Insurance Company Tax Act for 1955, 70 Stat. 36, applicable to the years 1955-1957, and the Life Insurance Company Income Tax Act of 1959, 73 Stat. 112, applicable to later years, accorded preferential tax treatment to life insurance companies.
7. The Commissioner made an alternative allocation to Management Company. Because it upheld his allocation to the Banks, the Tax Court rejected this alternative. In reversing the allocation to the Banks, the Court of Appeals found the record insufficient to pass on the alternative allocation. It therefore ordered that the case be remanded to the Tax Court for further consideration. The alternative allocation is therefore not before us.
8. See 26 CFR § 1.482-1 (a)(6) (1971).
9. B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders p. 15-21 (3d ed. 1971).
10. 26 CFR § 1.482-1 (b)(1) (1971). The first regulations interpreting this section of the statute were issued in 1934. They have remained virtually unchanged. Jenks, Treasury Regulations Under Section 482, 23 Tax Lawyer 279 (1970).
11. The court below held that the mere generation of business does not necessarily result in taxable income. As we decide this case on a different ground, we need not consider the circumstances in which the origination or referral of business may or may not result in taxable income to the originating party. We do not agree that origination of business does not necessarily result in such income. In this case if the Banks had been unaffiliated with any other entities (i.e., had been separate, independent banks, unaffiliated with any holding company grouP), they would nevertheless have performed the "services" that the Commissioner asserts resulted in taxable income. These services—namely the negligible paperwork and the referring of the credit insurance to a company licensed to write it—were performed (as the Tax Court noted) for the convenience of bank customers and to assure additional collateral for loans. They also may have been necessary to meet competition. The fact of affiliation, enabling referral of the business to another subsidiary in the holding company group, does not alter the character of what was done. The act which is relevant, in terms of generating insurance premiums and commissions, is the referral of the business. Whether this referral is to an affiliated or an unaffiliated insurance company should make no difference as to whether the bank, which never receives the income, has earned it.
12. Section 92 of the National Bank Act was enacted in 1916. When the statutes were revised in 1918 and re-enacted, § 92 was omitted. The revisers of the United States Code has omitted it from recent editions of the Code. However, the Comptroller of the Currency considers § 92 to be effective and he still incorporates the provision in his Regulations, 12 CFR §§ 2.1-2.5 (1971).
13. Saxon v. Georgia Association of Independent Insurance Agents, Inc., 399 F. 2d 1010 (CA5 1968). See Commissioner v. Morris Trust, 367 F. 2d 794, 795 (CA4 1966).
14. 12 CFR §§ 2.1-2.5 (1971).
15. Findings of fact and opinion in T.C. Memo 1967-256, p. 67-1456, filed Dec. 27, 1967, in this case.
16. MR. JUSTICE MARSHALL's dissenting opinion is based on the "crucial fact... [that] respondents [the Banks] have already violated the federal statute and regulations by soliciting insurance premiums. The statute, 12 U.S.C.A. § 92, prohibits a national bank from acting "as the agent" of an insurance company "by soliciting and selling insurance and collecting premiums on policies." MR. JUSTICE MARSHALL concludes that the banks have violated this statute, and notes that "the penalties... are indeed severe."

    This finding of illegality, with respect to conduct of the Banks extending back to 1948, is without support either in the record or in any authority cited. Indeed, the record is to the contrary. The Tax Court found as a fact that there was no "agency agreement" between the Banks and the insurance companies; it further found that the Banks "made available" the credit insurance to their customers. There is no finding, and nothing in the record to support a finding, that the Banks were agents of the insurance companies or that they engaged in "selling insurance" within the meaning of the statute. The Banks no doubt "solicited" in the sense that they encouraged their customers to take out the insurance. But in the absence of an agency relationship, and in view of the undisputed fact that the Banks received no commissions or premiums, it cannot be said that there was a violation of the statute. Moreover, the Banks were regularly examined by the federal banking authorities "looking for violations in the national banking laws." The making of credit insurance available to customers was and is a common practice in the banking business. There is no suggestion that the federal banking authorities considered this service to customers to be a violation of the law as long as the Banks received no commissions or fees. This administrative interpretation over many years is entitled to great weight.

    The dissenting opinion raises this serious issue for the first time. It was not raised at any stage in the proceedings below. Nor was it briefed or argued in this Court. The Commissioner, the Tax Court, the Court of Appeals, and the Solicitor General all assumed that the Banks' conduct in this respect was perfectly lawful. But quite apart from the consistent administrative acceptance and from the assumptions by the Commissioner and the courts below, we think there is no basis for a finding of this serious statutory violation.

17. See Helvering v. Horst, 311 U.S. 112 (1940) (assignment of interest coupons attached to bonds owed by taxpayer); Lucas v. Earl, 281 U.S. 111 (1930) (taxpayer assigned to wife one-half interest in his earnings). See generally Commissioner v. Sunnen, 333 U.S. 591 (1948), and cases discussed therein at 604-610.
18. 26 CFR § 1.482-1 (b)(1) (1971).
19. James v. United States, 366 U.S. 213 (1961); Rutkin v. United States, 343 U.S. 130 (1952).
20. 12 U.S.C. § 93.
21. Thus, in Commissioner v. Lester, 366 U.S. 299 (1961), in determining that a taxpayer should not be taxed on alimony payments to his divorced wife, the Court determined that it was more consistent with the basic precepts of income tax law that the wife, who received and had power to spend the payments, should be taxed rather than the husband who actually earned the money.
22. As noted at the outset of this opinion, certiorari was granted to resolve the conflict between the decision below and that in Local Finance Corp v. Commissioner, 407 F. 2d 629 (CA7 1969). The Tax Court in this case felt bound to follow Local Finance Corp., which was decided subsequently to L.E. Shunk Latex Products, Inc. v. Commissioner, 18 T.C. 940 (1952). For the reasons stated in the opinion above, we think Local Finance Corp. was erroneously decided and that the earlier views of the Tax Court were correct.

    See Teschner v. Commissioner, 38 T.C. 1003, 1009 (1962):

    "In the case before us, the taxpayer, while he had no power to dispose of income, had a power to appoint or designate its recipient. Does the existence or exercise of such a power alone give rise to taxable income in his hands? We think clearly not. In Nicholas A. Stavroudis, 27 T.C. 583, 590 (1956), we found it to be settled doctrine that a power to direct the distribution of trust income to others is not alone sufficient to justify the taxation of that income to the possessor of such a power."

23. See dissenting opinion of MR. JUSTICE BLACKMUN, post, at 422.
24. If an unaffiliated bank were able to provide the insurance at a cheaper rate because no commissions were paid, this would benefit the customers but would result in no taxable income.
25. 26 CFR § 1.482-1 (b)(1) (1971).