Commissioner of Internal Revenue v. Lincoln Savings and Loan Association/Opinion of the Court

This case presents the question whether the 'additional premium' paid in 1963 by a state-chartered savings and loan association to the Federal Savings and Loan Insurance Corporation under the compulsion of § 404(d) of the National Housing Act, as amended, 12 U.S.C. s 1727(d), is deductible by the association, for income tax purposes, as an ordinary and necessary business expense under § 162(a) of the Internal Revenue Code of 1954, 26 U.S.C. § 162(a).

The Commissioner of Internal Revenue determined a deficiency of $461,454.38 in the 1963 cash basis federal income tax of Lincoln Savings and Loan Association. Nearly all the deficiency was attributable to the disallowance of a deduction claimed for Lincoln's payment of $882,636.86 made pursuant to § 404(d). Lincoln sought redetermination in the Tax Court. Judge Raum, in a decision reviewed by the court without dissent, upheld the deficiency. 51 T.C. 82 (1968). On appeal the Ninth Circuit reversed, one judge dissenting. 422 F.2d 90 (1970). Because of the importance of the issue for the savings and loan industry and for the Government, we granted certiorari. 400 U.S. 901, 91 S.Ct. 139, 27 L.Ed. 137 (1970).

* The pertinent facts are not in dispute. Lincoln is a California savings and loan association organized in 1925 and is licensed under state law. It is subject to Division 2 of the California Financial Code, § 5000 et seq., and is also subject to the regulations of the State's Savings and Loan Commissioner. California Administrative Code, Tit. 10, c. 2.

In 1936 Lincoln applied for membership in the Federal Home Loan Bank of San Francisco (then of Los Angeles). That application was granted and Lincoln has remained a member of the Bank since that time. The San Francisco Bank is one of 12 regional ones established and supervised by the Federal Home Loan Bank Board under the Federal Home Loan Bank Act of 1932, 47 Stat. 725, as amended, 12 U.S.C. §§ 1421-1449. These banks provide liquidity and funds for mortgage lending by making advances to member institutions as needed to meet unusual or heavy withdrawal and credit demands. Each member must purchase capital stock in its bank in an amount equal to 1% of its outstanding 'aggregate unpaid loan principal' and maintain that percentage. 12 U.S.C. § 1426(c).

In June 1938 Lincoln became, and still is, an institution insured by the Federal Savings and Loan Insurance Corporation (FSLIC), a corporation created by § 402 of the National Housing Act, 48 Stat. 1256, 12 U.S.C. § 1725, and under the direction of the Federal Home Loan Bank Board. By statute FSLIC has the duty to insure the accounts of all federal savings and loan associations; it also may insure the accounts of qualified state-chartered associations such as Lincoln. Section 403(a), 12 U.S.C. § 1726(a).

Each institution so insured was originally required, by § 404(a) of the Act, 48 Stat. 1258, to pay FSLIC an annual insurance premium measured by the total amount of its accounts plus creditor obligations. The statute provided that these premiums were to continue annually until FSLIC's reserve for losses amounted to 5% of the insured accounts plus creditor obligations of all its insured institutions, and at such intervals thereafter as were necessary to maintain the reserve at that level.

This pattern was changed, however, effective January 1, 1962, by the Act of September 8, 1961, 75 Stat. 482. That Act, by its § 3, amended § 404(a), 12 U.S.C. § 1727(a), to its present form.

Section 404(a) now requires FSLIC to establish two reserves, namely, a Primary Reserve 'which shall be the general reserve,' and a Secondary Reserve. The requirement for the annual premium of 1/12 of 1% is continued, but the level of the general reserve was lowered from 5% to 2% of the total of accounts plus creditor obligations. Sections 404(b)(1) and 404(b)(2), 12 U.S.C. §§ 1727(b) (1) and 1727(b)(2). The 1961 Act, moreover, added subsection (d) to § 404. 12 U.S.C. § 1727(d). This required that the insured institution pay FSLIC, with respect to any calendar year, an 'additional premium in the nature of a prepayment with respect to future premiums of such institution under subsection (b) * *  * .' This 'additional premium' was, and still is, 2% of the net increase in the total of the institution's insured accounts, less any amount the institution is required, by 12 U.S.C. § 1426(c), as of the end of that year, to expend in purchasing stock in the Federal Home Loan Bank. The additional premium is to be credited to the Secondary Reserve. Section 404(a), 12 U.S.C. § 1727(a).

As noted, FSLIC's statutorily prescribed Primary Reserve is its general reserve. It is credited annually with the Corporation's net income; this net thus represents retained earnings. The § 404(b)(1) premium payments, that is, the 1/12 of 1% required of each insured institution, constitute a major item in FSLIC's gross income. To the extent these premium payments exceed the corporation's expenses and insurance losses for the year, they flow as part of FSLIC's net to the Primary Reserve. The insured institutions have no property interest in the funds constituting the Primary Reserve.

The Secondary Reserve subsists separately and possesses different characteristics. It, of course, receives the 2% 'additional premium,' to the extent such is payable, required by § 404(d) from each insured institution. FSLIC must also credit the Secondary Reserve annually with a 'return' on the Secondary Reserve's 'outstanding balances * *  * at a rate equal to the average annual rate of return to the Corporation during the year *  *  * on the investments held by the Corporation in obligations of, or guaranteed as to principal and interest by, the United States.' Sections 404(a) and 404(e), 12 U.S.C. §§ 1727(a) and 1727(e). In contrast with the Primary Reserve, the Secondary Reserve is 'available * *  * only for losses of the Corporation' and then 'only to such extent as other accounts of the Corporation which are available therefor are insufficient for such losses.' Section 404(e), 12 U.S.C. § 1727(e).

Each insured institution has a pro rata share in the Secondary Reserve. Section 404(e) states that this is not assignable or transferable except as FSLIC, by regulation or otherwise, provides 'in cases of merger or consolidation, transfer of bulk assets * *  * and similar transactions. * *  * ' An insured institution may obtain a cash refund of its pro rata share if its status as an insured is terminated, § 407, 12 U.S.C. § 1730, or if a receiver or other legal custodian is appointed for purposes of liquidation, or if the Corporation determines that the institution has gone into liquidation. Section 404(f), 12 U.S.C. § 1727(f).

Following any December 31 on which the aggregate of the Primary Reserve and the Secondary Reserve equals or exceeds 2% of the total of all insured accounts plus creditor obligations of all the insured institutions (and the Primary Reserve alone does not equal or exceed such 2%), the additional premiums required by § 404(d) are suspended. Section 404(g); 12 U.S.C. § 1727(g). When this takes place, the pro rata share of each insured institution in the Secondary Reserve is used, to the extent available, to discharge the institution's obligation to pay its regular, or basic, premium required for that year under § 404(b)(1). Thereafter, if the aggregate of the two reserves decreases to less than 1 3/4%, the obligation to pay the additional premium under § 404(d) resumes and the pro rata share in the Secondary Reserve is no longer used to pay the § 404(b)(1) regular premium. Whenever, following any December 31, the Primary Reserve alone equals or exceeds such 2%, the Corporation shall pay in cash to each insured institution its pro rata share of the Secondary Reserve and shall not thereafter accept further § 404(d) prepayments.

FSLIC maintains a separate account for each insured institution's share of the Secondary Reserve. It submits to the institution annually a statement disclosing that share and the interest credited to it. Under regulations issued by the California Savings and Loan Commissioner and by the Federal Home Loan Bank Board, Lincoln reports its interest in FSLIC's Secondary Reserve as an asset on its balance sheet and treats the interest earned on its pro rata share of the Secondary Reserve as income.

LIC annually sends Lincoln an 'Insurance Premium Notice' for the basic premium due under § 404(b)(1). It also sends Lincoln annually a 'Notice of Insurance Premium Prepayments' for the amount, if any, due under § 404(d). For 1963 the former was $135,760.52 and the latter was $882,636.86. Each was paid by Lincoln.

On its 1963 federal income tax return Lincoln deducted both its § 404(b)(1) payment and its § 404(d) payment as ordinary and necessary business expenses under § 162(a) of the Code. The Commissioner allowed the former, but disallowed the latter.

The Tax Court held that the § 404(d) payment was a nondeductible capital expenditure and was not an ordinary and necessary business expense, and that the payment was deductible only when used from the Secondary Reserve to pay § 404(b)(1) premiums or to meet actual losses of FSLIC. As noted above, the Ninth Circuit reversed by a divided panel.

To qualify as an allowable deduction under § 162(a) of the 1954 Code, an item must (1) be 'paid or incurred during the taxable year,' (2) be for 'carrying on any trade or business,' (3) be an 'expense,' (4) be a 'necessary' expense, and (5) be an 'ordinary' expense. This Court has considered these several requirements, or one or more of them, in a number of cases. See, for example, Welch v. Helvering, 290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212 (1933); Helvering v. Winmill, 305 U.S. 79, 59 S.Ct. 45, 83 L.Ed. 52 (1938); Deputy v. du Pont, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416 (1940); Interstate Transit Lines v. Commissioner of Internal Revenue, 319 U.S. 590, 63 S.Ct. 1279, 87 L.Ed. 1607 (1943); Commissioner of Internal Revenue v. Heininger, 320 U.S. 467, 64 S.Ct. 249, 88 L.Ed. 171 (1943); Commissioner of Internal Revenue v. Tellier, 383 U.S. 687, 86 S.Ct. 1118, 16 L.Ed.2d 185 (1966); Woodward v. Commissioner of Internal Revenue, 397 U.S. 572, 90 S.Ct. 1302, 25 L.Ed.2d 577 (1970); United States v. Hilton Hotels Corp., 397 U.S. 580, 90 S.Ct. 1307, 25 L.Ed.2d 585 (1970).

In Welch Mr. Justice Cardozo emphasized the difference between the 'ordinary' and the 'necessary' and the need for satisfying both in order to achieve the deduction. It is in that case where his well-known, but elusive, suggestion for the answer appears:

'The standard set up by the statute is not a rule of law; it     is rather a way of life. Life in all its fullness must supply     the answer to the riddle.' 290 U.S., at 115, 54 S.Ct., at 9.

In du Pont Mr. Justice Douglas stressed, 308 U.S., at 493 495 496, 60 S.Ct., at 367, the accepted rule of the 'popular or received import' of a statute's words, and further emphasized that 'ordinary has the connotation of normal, usual, or customary,' and that each case 'turns on its special facts.' In Tellier Mr. Justice Stewart also emphasized the double requirement of 'ordinary' and 'necessary' and said:

'Our decisions have consistently construed the term     'necessary' as imposing only the minimal requirement that the      expense be 'appropriate and helpful' for 'the development of      the (taxpayer's) business'. * *  * The principal function of      the term 'ordinary' in § 162(a) is to clarify the      distinction, often difficult, between those expenses that are      currently deductible and those that are in the nature of      capital expenditures, which, if deductible at all, must be      amortized over the useful life of the asset.' 383 U.S., at      689-690, 86 S.Ct., at 1120.

So much for generalities. Here clearly, as to its § 404(d) 'additional premium' payment in 1963, Lincoln satisfied three of the five listed requirements. The payment was made during the taxable year. It was made in carrying on a trade or business. And it was a 'necessary' payment, for it was compelled by the provisions of the National Housing Act. The Government so concedes. The focus, therefore, and our only concern here, is whether the payment was an expense and an ordinary one within the meaning of § 162(a) of the Code.

Lincoln's argument essentially is that its § 404(d) payment was really no different from its § 404(b)(1) payment for both were premiums for insurance of its depositors' accounts and creditor obligations; that all similarly situated insured savings and loan associations (there were 4,419 on December 31, 1963) paid the § 404(d) premium; and that the possibility of a future benefit from the expenditure does not serve to make it capital in nature as distinguished from an expense.

We feel that the very recital of the facts and of the structure and operation of FSLIC's reserves, in Part I of this opinion, itself provides an answer adverse to Lincoln's argument. It is not enough, in order that an expenditure qualify as an income tax deduction, that it merely be one paid by all similarly insured associations, or that it serves to fortify FSLIC's insurance purpose and operation. Further, the presence of an ensuing benefit that may have some future aspect is not controlling; many expenses concededly deductible have prospective effect beyond the taxable year.

What is important and controlling, we feel, is that the $404(d) payment serves to create or enhance for Lincoln what is essentially a separate and distinct additional asset and that, as an inevitable consequence, the payment is capital in nature and not an expense, let alone an ordinary expense, deductible under § 162(a) in the absence of other factors not established here. We note the following: A. The § 404(d) payment to FSLIC, when made, is subject to positive and rigid continuing controls. The payment must flow into the Secondary Reserve. That reserve is primarily available only for stated and circumscribed purposes, namely, the payment of losses and then only to the extent all other assets of FSLIC are insufficient to cover those losses. The Secondary Reserve thus has complete seniority with respect to demands upon FSLIC. It is the asset last called upon.

B. The insured institution has a distinct and recognized property interest in the Secondary Reserve. This is revealed by: (1) The recognition, in § 404(e), of transferability of the institution's pro rata share therein. This transferability is limited and restricted, to be sure, but it exists for approved situations of merger, consolidation, and the like. (2) The prospective refund, and in cash at that, of the institution's pro rata share upon termination of its insured status, or upon receivership or liquidation, or when the Primary Reserve alone reaches the suspension level. (3) The use of the institution's pro rata share to pay its basic premium under § 404(b)(1) when the suspension level is reached by the aggregate of the Primary and Secondary Reserves. (4) FSLIC's maintenance of a separate account for each insured institution's share in the Secondary Reserve. (5) The statutorily required annual credit from FSLIC's earnings to the institution's share of the Secondary Reserve. The share thus is an income-producing entity and the income inures to the benefit of the insured institution.

C. Although compulsory accounting rules do not control tax consequences, Old Colony R. Co. v. Commissioner of Internal Revenue, 284 U.S. 552, 562, 52 S.Ct. 211, 214, 76 L.Ed. 484 (1932), there is significance in the fact that all concerned here have recognized the presence and the significance of this property interest in the Secondary Reserve. FSLIC submits annual statements to its insured institutions showing payments and credits to their respective shares. Lincoln, albeit by federal and state requirements, shows that interest as an asset on its balance sheet and the credit as income. And Lincoln's parent corporation, First Lincoln Financial Corporation, although not subject to such regulation, has done the same in its financial statements.

D. The nature of the adjustments effected by the 1961 Act is of some import. Due primarily to the rapid growth of insured institutions in the years preceding the passage of that Act, the ratio of FSLIC's reserves to potential liability had declined. S.Rep.No.778, 87th Cong., 1st Sess., 2, 12; Hearing on H.R. 7108 and H.R. 7109 before Subcommittee No. 1 of the House Committee on Banking and Currency, 87th Cong., 1st Sess., 10. By the Act Congress reduced the requirement for Federal Home Loan Bank stock and at the same time channeled new funds to FSLIC's Secondary Reserve. The § 404(d) payment and the reduction in the FHLB stock purchase requirement were effectuated together. Certainly the FHLB stock is an asset and its acquisition is capital in nature. The complementary § 404(d) payment is directed to a fund. Each is a device designed to achieve a particular and common result, namely, the providing of protection to the insured institution and to its depositors by way, in the one case, of liquidity and availability of loan funds and, in the other, by way of segregated amounts available to offset possible losses. Each is more permanent than temporary. Each partakes more of the character of an asset than of an expense. And the two are made complementary by the very provisions of § 404(d).

We do not regard as contrarily persuasive, or as imposing an expense characteristic on the § 404(d) payments, six features emphasized by Lincoln or by the Court of Appeals:

A. The possibility that Lincoln's share of the Secondary Reserve would be consumed by FSLIC's losses and thus would never be refunded to Lincoln. The Tax Court pointed out, 51 T.C., at 97, that this hazard exists with any routine investment in a bank or an insurance company and yet its presence does not make that investment an expense rather than a capital undertaking.

B. The general unlikelihood, as a practical matter, of Lincoln's recovery of its pro rata share of the Secondary Reserve. It is suggested that liquidation will not take place because in this day corporate activity is assumed to be a continuing process and not limited in duration. It is further pointed out that termination of FSLIC insurance is a business impossibility for it would result in mass withdrawal of depositors' accounts and in institutional suicide. It may well be true that liquidation is unlikely and that termination of insurance would be an undesirable business decision. The same may usually be said, however, of a manufacturing corporation's investment in plant and equipment or in patents or in many other assets basic to its business and function.

C. The claimed identity of purpose of the § 404(b)(1) and § 404(d) payments, namely, the providing of insurance for depositors' accounts. The former, however, is only annual in phase and operation. It provides insurance for the year. When the year passes, the insurance ceases. The latter, however, provides a fund available for losses not only in the current year, but in the future. It is a fund capable under certain circumstances of finding its way back to the coffers of the insured institutions. The ultimate purpose of the two payments may have much in common, but the route and the life of each differ from those of the other.

D. The compulsory character of the payment imposed both by the governing statute and the economic facts of life. Lincoln concedes, however, 'Compulsion, whether legal or economic, should have no bearing upon the question whether a payment is an expense or a capital expenditure.'

E. The annual accounting concept of the income tax. This factor is relevant when the year of deduction is in issue. It has less consequence in the determination of whether an item is or is not an ordinary expense. As to this, the mere maturing of liability is not enough.

F. The suggestion that the § 404(d) payment is not included in the list of nondeductible capital expenditures specified by § 263 of the 1954 Code. It is clear from the very language of §§ 162(a) and 263 that the two sections together are not all inclusive, and that § 263 does not provide a complete list of nondeductible expenditures. Iowa Southern Utilities Co. v. Commissioner of Internal Revenue, 333 F.2d 382, 385 (CA8 1964), cert. denied, 379 U.S. 946, 85 S.Ct. 438, 13 L.Ed.2d 543; General Bancshares Corp. v. Commissioner of Internal Revenue, 326 F.2d 712, 716 (CA8 1964), cert. denied, 379 U.S. 832, 85 S.Ct. 62, 13 L.Ed.2d 40. See Helvering v. Winmill, 305 U.S. 79, 59 S.Ct. 45, 83 L.Ed. 52 (1938); Woodward v. Commissioner of Internal Revenue, 397 U.S. 572, 90 S.Ct. 1302, 25 L.Ed.2d 577 (1970); United States v. Hilton Hotels Corp., 397 U.S. 580, 90 S.Ct. 1307, 25 L.Ed.2d 585 (1970).

Lincoln's pro rata share of the Secondary Reserve, of course, is not without its tax aspects. If its share is used to pay losses or if, when the suspension level is reached, it is devoted to the payment of Lincoln's § 404(b)(1) premium, a deduction at that time for the amount so used would appear to be in order. Indeed, the Internal Revenue Service has so ruled. Rev.Rul. 66-49, 1966-1 Cum.Bull. 36, 37. Cf. Treas.Reg. on Income Tax § 1.162-13.

We emphasize that just as compulsory accounting is not controlling tax wise, Old Colony R. Co. v. Commissioner of Internal Revenue, supra, so the statutory labels of 'prepayment' and 'additional premium' contained in § 404(d) are not controlling. Burnett v. Commissioner of Internal Revenue, 356 F.2d 755, 758 (CA5 1966), cert. denied, 385 U.S. 832, 87 S.Ct. 77, 17 L.Ed.2d 68. We also emphasize that the fact that a payment is imposed compulsorily upon a taxpayer does not in and of itself make that payment an ordinary and necessary expense within the meaning of § 162(a) of the 1954 Code.

We therefore conclude that Lincoln's § 404(d) payment made in 1963 is not deductible under § 162(a). See Wichita State Bank & Trust Co. v. Commissioner of Internal Revenue, 69 F.2d 595, 596 (CA5 1934), cert. denied, Wichita State Bank & Trust Co. v. Helvering, 293 U.S. 562, 55 S.Ct. 73, 79 L.Ed. 662.

The judgment of the Court of Appeals is reversed.

It is so ordered.

Judgment reversed.

Mr. Justice DOUGLAS, dissenting.