Commissioner of Internal Revenue v. Lincoln Savings and Loan Association/Dissent Douglas

Mr. Justice DOUGLAS, dissenting.

Respondent is a state-chartered savings and loan institution, whose deposits are insured by the Federal Savings and Loan Insurance Corporation (FSLIC). To obtain this coverage, respondent must pay two premiums. Under § 404(b) of the National Housing Act, it pays an annual premium of 1/12 of one percent of the total amount of its savings accounts and creditor obligations. Pursuant to § 404(d), it must also pay an additional premimum equal to two percent of any net increase in the total amount of its insured accounts. The § 404(b) premium is considered gross income of FSLIC, approximately 95% of which is transferred to its Primary Reserve to cover losses. These premiums must be paid by insured institutions until the Primary Reserve equals two percent of the total insured savings accounts and creditor obligations of all insured institutions. Thereafter, insured institutions need pay no premiums unless and until the Primary Reserve drops below two percent. The § 404(d) premium is not considered gross income of FSLIC but is transferred to a Secondary Reserve, to be used to cover losses only if other accounts prove insufficient, a possibility considered extremely remote. A separate accounting is kept for each insured institution, showing the § 404(d) premiums paid. Under § 404(g), at any time that the aggregate of the Primary and Secondary Reserves reaches 2% of all insured accounts and creditor obligations, no § 404(d) payments need be made, and funds from the Secondary Reserve may be used to make § 404(b) premium payments, until the aggregate falls below 1 3/4%. When the Primary Reserve reaches 2%, FSLIC is to pay each insured institution its pro rata share of the Secondary Reserve in cash. By FSLIC's projections, no § 404(d) premium payments will be required in the years 1971 to 1975 and after 1979. No § 404(b) premiums will be required after 1995, as the Primary Reserve will reach 2%. The respondent argues that there will be no payments of pro rata shares at that time, as the calculations of FSLIC show that the Secondary Fund will be exhausted prior to 1995.

On its federal tax return for 1963 respondent deducted both its § 404(b) and § 404(d) premium payments as ordinary and necessary business expenses. The Commissioner of Internal Revenue allowed the deduction of § 404(b) premiums, but disallowed the latter, characterizing these payments as nondeductible capital investments in FSLIC, to be deducted only when used to pay § 404(b) premiums or when used to meet actual losses of FSLIC. The Tax Court affirmed this ruling. The Court of Appeals for the Ninth Circuit reversed the Tax Court, finding the § 404(d) premiums to be a reasonable and necessary business expense, deductible in the year paid. I agree with the Court of Appeals and dissent from the decision here.

There is no claim that the § 404(d) premiums are not necessary. The position of the United States is that these premiums are not 'ordinary,' but 'in the nature of capital expenditures, which, if deductible at all, must be amortized over the useful life of the asset.' Commissioner of Internal Revenue v. Tellier, 383 U.S. 687, 689-690, 86 S.Ct. 1118, 1120, 16 L.Ed.2d 185 (1966). The Commissioner relies on the principle that a cost which results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year is a capital outlay. From this he argues that the determination of whether respondent's § 404(d) premiums are capital expenditures or deductible business expenses depends on whether the payments will provide a benefit in future years.

Because the respondent will obtain a benefit in the future from these premiums, in the form of lower § 404(b) premiums of by a full refund of its pro rata share on termination or liquidation, he argues, the Secondary Reserve is a capital asset. It is not used for losses, and will never be used except in the event of a national catastrophe. These premiums are not recurring, and will likely be paid only in 13 of the 34 years from 1962 to 1995. Accounting principles, the Commissioner claims, demand that these payments be deducted when they are used, either to pay § 404(b) premiums or to pay losses. 'Only in this manner will the costs of FSLIC insurance be matched against the revenues generated because such insurance is maintained.' The rule professed by the United States is, of course, sound. The error is in applying it to this case. Respondent has not established an asset for future benefit. It has merely paid the premiums necessary to obtain insurance. It is true that premiums paid in 1963 may result in a reduction in premiums in later years. But labeling this the creation of an asset proves too much, for it invalidates the deduction of § 404(b) premiums as well.

The benefit to be obtained from the payment of § 404(d) premiums, whether they be capital expenditures or deductible expenses, is not the reduction of future premiums but insurance coverage. The Government readily admits that the present level of § 404(b) premiums is not needed to cover current foreseeable losses. Indeed, losses have never exceeded investment income. The high premium rate is for the purpose of establishing a Primary Reserve, to cover conceivably serious losses in the future. When the Primary Reserve reaches a level deemed sufficient, no premium payments will be required at all. If 'the cost of FSLIC insurance (are to) be matched against the revenues generated because such insurance is maintained,' a major portion of the § 404(b) premiums should also be capitalized, to be depreciated over some appropriate term.

Nor is it controlling that the Secondary Reserve is a capital account insofar as FSLIC is concerned. As the Court of Appeals stated:

'We think the emphasis upon the treatment of the receipt by     the payee, FSLIC, is mistaken and that in determining whether      an expense is an ordinary and necessary expense of doing      business, the focus should be on the taxpayer and the      taxpayer's business, not on what the payee does with the      money paid. This is not to say that rights retained by the     taxpayer are to be ignored.' 422 F.2d 90, 92.

A decision that § 404(d) premiums are not deductible, while § 404(b) premiums are, must rest on the only distinction between the two, the rights retained by respondent in the Secondary Reserve. These are evidenced by the keeping of separate 'accounts,' the payment of earnings to these accounts, and the possibility of a recovery of a pro rata share of the Reserve. But, as the Court of Appeals noted, respondent is a going concern, and the possibility of a return of its share on liquidation is not a proper consideration. As termination of insurance would surely lead to liquidation, this could not be considered either. The possibility that some part of the Secondary Reserve might be returned to respondent when the Primary Reserve reaches a sufficient level is, at best, remote. This contingent possibility of recovery does not render an otherwise deductible payment nondeductible. Alleghany Corp. v. Commissioner, 28 T.C. 298, 305; Electric Tachometer Corp. v. Commissioner, 37 T.C. 158, 161.

The returns paid on a pro rata share of the Secondary Reserve are paid out of earnings, that is, out of funds which would otherwise be transferred to the Primary Reserve. The payment does not increase the aggregate amount of the reserves. The returns paid are not available to the insured institution, and not taxable to it until paid for its benefit, according to the Internal Revenue Service. At that point, the insured institution would declare the income and deduct the amount as an expense. Therefore, absent the remote possibility that the insured institution might receive a pro rata share, it is immaterial whether returns are paid to the Secondary Reserve or only to the Primary Reserve. Also, the revenue ruling that the insured institution does not have even constructive possession of a pro rata share of the Secondary Reserve, for purposes of taxing returns on that fund, is inconsistent with the position that the same pro rata share is a capital asset of the institution.

On these facts, the Court of Appeals was correct in determining that the § 404(d) premiums, paid for the purpose of obtaining insurance necessary for the success of respondent's business, were deductible as an ordinary business expense.