COMMISSIONER v. LINCOLN SAVINGS & LOAN ASSN.
Legal provision: Internal Revenue Code
Argument of Matthew J. Zinn
Chief Justice Warren E. Burger: We’ll hear arguments next in number 544 Commissioner of Internal Revenue against Lincoln Savings and Loan Association.
Mr. Zinn, you may proceed whenever you're ready.
Mr. Matthew J. Zinn: Mr. Chief Justice and may it please the Court.
This federal income tax case is here on a writ of certiorari to the Court of Appeals for the Ninth Circuit.
It raises a question that affects the tax liability of every savings and loan association that insures its depositors’ accounts with the Federal Savings and Loan Insurance Corporation, respondent is such an association.
During 1963, the only taxable year in issue, it paid a regular annual insurance premium for depositors insurance to the Insurance Corporation, amounting to approximately $135,000.00.
This payment was required by Section 404 (b) of the National Housing Act and the Commissioner allowed it as an ordinary and necessary business expense deduction under Section 162 (a) of the Internal Revenue Code.
The treatment of this payment is not in dispute.
Also during 1963, respondent contributed an additional $882,000.00 to the Insurance Corporation.
This contribution was required by Section 404 (d) of the National Housing Act and it is described in the statute as being in the nature of a prepayment with respect to future premiums.
The question presented here is whether the $882,000.00 is an ordinary and necessary business expense of a 1963, on the ground that it is simply an additional cost of current insurance as respondent claims or whether as the Commissioner urges, the $882,000.00 is a capital expenditure, which is deductible in future years, if actually used to pay respondents’ regular annual insurance premiums or to meet insurance losses of the Insurance Corporation.
In other words, the basic question here is not whether a deduction should be allowed, but when a deduction should be allowed.
Justice Potter Stewart: Does is it have to be one or the other?
Mr. Matthew J. Zinn: No, Mr. Justice.
Justice Potter Stewart: Either an ordinary and necessary business expense or a capital expenditure?
Because frankly, I have trouble seeing how it fit into the statutory definition of either.
Mr. Matthew J. Zinn: Mr. Justice, let me deal first with the capital expenditure --
Justice Potter Stewart: Then, we don’t have to decide this case, but I wondered if those are the only two possible facts.
Mr. Matthew J. Zinn: The term cap -- let me start with capital expenditure.
The term capital expenditure appears and is defined in Section 263 of the Code.
Justice Potter Stewart: And it doesn’t fit that definition.
Mr. Matthew J. Zinn: Right, but that issue has been dealt with explicitly by Mr. Justice Blackmun, when he sat on the Eighth Circuit in a case called General Bancshares Corporation, which is not cited in either of the briefs, but was cited below and which is reported at 326 F.2d.
There, Mr. Justice Blackmun speaking for unanimous Eighth Circuit, in the case in which this Court subsequently denied certiorari, said this about Section 263, and I quote, “Section 263, with its denial of deductibility for specified capital expenditures, and Section 162 (a), with its grant of deductibility for ordinary and necessary business expenses, are not of course, mutually exclusive.
Neither are they together all inclusive.”
Section 263 obviously is not in itself an exclusive list of nondeductible capital expenditures.
Apart from Mr. Justice Blackmun’s comments in that case, this Court only last term in two unanimous decisions in the Woodward and Hilton cases held that appraisal expenses incurred in connection with the evaluation of dissenting shareholders’ stock were nondeductible capital expenditures, but they too are not new buildings or permanent improvement or betterments.
And the Court did this of course, without mention of the fact that Section 263 has only a limited definition.
So, I think it's fair to say, Mr. Justice that this Court has innumerable occasions done that in --
Unknown Speaker: At least, did once?
Mr. Matthew J. Zinn: No, on innumerable occasions, as early as 1938 in Helvering and Winmill, it held that brokerage expenses in the acquisition of capital stock are capital expenditures to be added to the cost of the stock.
Unknown Speaker: To be added to its rebate?
Mr. Matthew J. Zinn: Yes sir, and capital itself Mr. Justice is not described in Section 263, but we nevertheless don’t allow a deduction for it.
And so, capital stock, if I go out and buy some --
Unknown Speaker: Make a purchase.
Mr. Matthew J. Zinn: That’s right, for the purchase of capital stock.
It is a capital expenditure, which at least temporarily cannot be deducted.
Unknown Speaker: But a capital expenditure as defined in 263 (a) at least in those definitions and other carries other similar law not be the kind dealt with last term in Woodward nor it be the kind of somewhere under the general category of brokerage should be.
Mr. Matthew J. Zinn: No but --
Unknown Speaker: But that would be expenditures that could be depreciated annually.
Depreciated that’s what 263 (a) says to me.
Mr. Matthew J. Zinn: I am not prepared to say whether Section 263 could also include a non-depreciable asset, but I don’t think it really matters.
The point is that I think it's clear that Section -- that capital expenditures are more broadly defined then in Section 263 that this Court and so far as I know, all courts have consistently subscribed to that.
We don’t think it's any real bar to our position here that the costs that we’re talking about here are not described in Section 263.
Justice Potter Stewart: Well, really the thrust I’m asking you was very consistent with the language that you read to us from Justice Blackmun’s opinion, the Eighth Circuit.
Is it necessary to your argument, when you say in that these expenditures do not come under have 162 (a)?
Is it necessary for you to say that they do come under 263 (a)?
Mr. Matthew J. Zinn: I don’t think it is --
Justice Potter Stewart: You just have to stop with the first one, don’t you think?
Mr. Matthew J. Zinn: Right Mr. Justice, and that’s what the Court did in the Woodward and Hilton cases.
Justice Potter Stewart: And you don’t need to say that they are capital expenditures, do you?
Mr. Matthew J. Zinn: We did not cite Section 263 in our brief.
Justice Potter Stewart: I know (Voice Overlap) but we not need to say that they're capital expenditures.
Mr. Matthew J. Zinn: No, we can call them capital outlays.
I don’t think the verbiage is important.
The question is what they really are and we --
Justice Potter Stewart: We know what they really are depends of course on the verbiage of the Internal Revenue Code.
Mr. Matthew J. Zinn: Well, we say we rely on the verbiage of the Treasury Regulations, Section 1.461, which appears on pages 41 and 42 of our brief.
And reads in pertinent part that “if an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.”
Perhaps, it would be helpful if I point out why it is that we capitalize anything, why do we capitalize buildings now?
Justice Hugo L. Black: Would you mind giving the name of Justice Blackmun’s case.
Mr. Matthew J. Zinn: Yes, sir.
It's General Bancshares Corporation against the Commissioner, 326 F.2d 712, and the material that I quoted was at 716.
The reason why we require the capitalization of anything, as I was saying in our judgment, is that if you didn’t capitalize, you would be charging against the income of a single year, cost of an asset that was going to benefit a number of future years, in the case of a building, for example.
Justice Potter Stewart: And a building, it depreciates over its projected useful life.
Mr. Matthew J. Zinn: As you recover its cost.
Justice Potter Stewart: Land, you don’t depreciate and shares of stock, you don’t depreciate as a manner of your basis.
Mr. Matthew J. Zinn: Right, but the point is that we require capitalization in the first instance, because to charge the whole thing off would distort income.
And I would suggest that to this Court, Mr. Justice that we’d have precisely the same rules, if there were no Section 263 in the Internal Revenue Code, because Section 446 of the Internal Revenue Code requires that income be reported clearly and it seems to us that a clear reflection of income, in the case of a cost that’s going to benefit future years and can properly be described as an asset, within the meaning of the regulation that I have quoted is one that should not be deducted currently.
Justice Potter Stewart: I think perhaps if all of my problems were caused by your characterizing this as a capital expenditure, you don’t need to -- you simply need to argue that it's not deductible under 162 (a).
Mr. Matthew J. Zinn: Right, but we didn’t refer to it capital expenditure in the sense of the statute, but in the sense used by Mr. Justice Blackmun.
At all relevant times, respondent has been a member of Federal Home Loan Bank of San Francisco and has insured its depositors’ accounts with the Insurance Corporation.
Prior to 1962, respondents was required to own stock in itself Federal Home Loan Bank in an amount at least equal to 2% of its mortgage loans and to maintain this percentage of ownership.
Respondent has always capitalized its purchases of such stock.
Also prior to 1962, it was required to pay an annual insurance premium to the Insurance Corporation of 1/12 of 1% of all insured accounts and creditor obligations.
This expense corresponding to the $135,000.00 premium for 1963 has always been allowed as an ordinary and necessary business expense by the Commissioner.
In 1961, Congress changed these requirements, effective January 1, 1962.
This change resulted in the present litigation.
First, Congress reduced the stock ownership requirement in the Federal Home Loan Bank from 2% to 1% of mortgage loans.
Second, it continued the regular annual premium requirement of 1/12 of 1% of savings account and creditor obligations.
And third, it imposed a new requirement in Section 404 (d), that in certain years each insured institution contribute 2% of any increase in its savings accounts and creditor obligations, during the proceeding year to the Insurance Corporation.
Congress thought that the additional contributions required under Section 404 (d) would be about the same as the larger stock purchases that would have been made under the prior Act.
Indeed, if the Savings and Loan Association has to purchase any stock to meet the new lower 1% requirement, its obligation under Section 404 (d) is reduced by that amount.
Regular insurance premiums received by the Insurance Corporation are part of its gross income to the extent that the corporation does not use them to meet its current expenses and losses.
They are transferred to the Insurance Corporation’s primary reserve which the corporation is directed to establish in the National Housing Act.
That reserve contains its cumulative net income and it's available to meet losses if income of any year is insufficient.
Section 404 (d) contributions on the other hand, the ones that are here in dispute are not considered part of the Insurance Company’s gross income and are not added to its primary reserve.
They are transferred directly to the Insurance Corporation’s secondary reserve, which the Insurance Corporation also is directed to establish in the National Housing Act.
Unlike the primary reserve, this secondary reserve is not freely available to meet expenses and losses of the current year.
It may be used only to meet losses and only if all of the corporation’s other accounts are first exhausted.
Once respondent makes a regular annual premium payment, that payment is loss to it.
The premium obligates the corporation only to provide insurance coverage for the current year.
On the other hand, the contributions to the Insurance Corporation’s secondary reserve create a beneficial ownership interest in that reserve.
This interest is evidenced by annual statements which the Insurance Corporation sends to each insured institution each year advising it of its then current share of the secondary reserve.
Respondent’s share of the reserve amounted to nearly $5 million, as of the end of 1967.
This share consists not only of the contributions made by the insured institution, but also includes an annual return on investment at a rate equal to the return earned by the corporation on its investments.
Justice Byron R. White: Now that is credited to the individual member’s account?
Mr. Matthew J. Zinn: That’s right Mr. Justice.
The rate is average to 3 to 4.75% percent annually, roughly.
Justice Byron R. White: Are the 404 (d) payments annual or are they terminated within the reserve distribution?
Mr. Matthew J. Zinn: If you could hold off, I'm just coming to that.
This is a rather complicated background, as you know.
And I'm trying to give a picture in a way I think can make it simplest for the Court.
Although, an insured institution’s interest in the secondary reserve is not generally transferable, an association may transfer its share in a merger, consolidation, or other similar transaction.
Moreover, an association is entitled to a cash refund of its share, if it withdraws from the federal insurance system or if it goes into voluntary or involuntary liquidations.
I come now to consider how an association share in the secondary reserve is built up and how it is used to pay regular annual insurance payments.
Contributions to the secondary reserve, the ones that here in dispute, must be made until the primary and secondary reserves together equal 2% of all savings accounts and creditor obligations of all insured institutions.
When that point is reached, the obligation to make secondary reserve contributions is temporarily suspended, while it remained suspended, an association share in the secondary reserve is used to pay its regular annual insurance premium.
This reduces its share in the secondary reserve.
Now, if a particular savings and loan association has no remaining share in the secondary reserve, while the obligation to make contributions to the secondary reserve is generally suspended, it pays its annual insurance premium in cash.
The use of shares in the secondary reserve to discharge the regular annual insurance premiums continues until the total of the primary and secondary reserves falls below 1.75% of all insured accounts and creditor obligations.
Justice Byron R. White: Mr. Zinn, when the secondary reserve is so used to pay insurance premiums, does the S&L then get a deduction at that point?
Mr. Matthew J. Zinn: Yes, Mr. Justice.
Justice Byron R. White: For the amount so used?
Mr. Matthew J. Zinn: For the amount that is taken out of the secondary reserve and transferred to the primary reserve to pay the regular annual premium for that year.
Justice Byron R. White: Just like the -- they pay the premium in cash?
Mr. Matthew J. Zinn: Exactly, because they don’t have to pay it in cash, when they pay it out of their share of the secondary reserve, that’s why I stressed the point of a particular association doesn’t have any share in the secondary reserve, it's going to they have to come up with the money in cash, instead of valued share.
Justice Byron R. White: Now the determination of the use of the secondary reserve is to pay premiums is the key to -- individual company’s key to the total primary and secondary --
Mr. Matthew J. Zinn: That’s for the general obligation, but each individual company is stuck with its own secondary reserve.
For example, if you had --
Justice Byron R. White: As I understand the -- if the primary and secondary reserve remained above 1.75%, and some company’s share with secondary reserve is zero --
Mr. Matthew J. Zinn: Right.
Justice Byron R. White: -- then it has to pay?
Mr. Matthew J. Zinn: It has to come up with the money.
Justice Byron R. White: Right.
Mr. Matthew J. Zinn: Contributions to the secondary reserve are renewed, as I have said, when the total of the two reserves falls below 1.75%.
At that time and until the total again reaches 2% contributions to the secondary reserve must be made.
Contributions to the secondary reserve are permanently terminated, when the primary reserve alone reaches the 2% level.
Regular insurance premiums must be paid annually either in cash or through use of an association share in the secondary reserve until the primary reserve alone reaches 2% of all insured accounts and creditor obligations of all insured institutions.
When it does, any association who is full share in the secondary reserve has not been used to pay regular premiums is entitled to a cash refund of its remaining share.
Thereafter, regular premiums must be paid whenever the primary reserve falls below the 2% level.
All that this Court needs to understand about this complicated arrangement is that in some years, like 1963, an association will be making regular premium payments in cash, and also, contributing to the secondary reserve in cash.
In other years, for example this year, it will make no cash payments and its regular annual premium will be paid out of its share of the secondary reserve.
I think the matter can be further clarified if we look at what has actually happen since 1962, when this scheme went into effect.
From 1962 through 1969, respondents paid regular premiums and cash, and also made contributions to the secondary reserve.
In its view, it is entitled to two deductions in each of those years.
We say that only the regular annual premium is deductible.
By the end of 1969, the total of the primary and the secondary reserves reach the 2% level.
Consequently, the obligation to make payments to the secondary reserve was suspended and respondent’s regular annual premium was paid of its share of the secondary reserve in 1970.
It will continue to be paid out of the secondary reserve this year, and for the next several years.
Respondent’s position is that no deduction should be allowed during these years.
We say that a deduction should be allowed for the regular annual premium.
In short, under respondent’s method, deductions for insurance coverage would be bunched in the years, in which it makes contributions to the secondary reserve.
Under our method, the cost of the insurance would be spread over the entire period, by allowing a deduction each year for the regular annual premium, irrespective of whether it is paid in cash or out of an association share of the secondary reserve.
The tax court upheld the Government’s position in the unanimous reviewed decision that these payments into the secondary reserve constituted capital outlays, if I may use that word. The Ninth Circuit reversed in a 2 to 1 decision.
As I have said before, our position here is based on the Treasury Regulations that I have quoted.
And these regulations are not challenged by the respondent.
They are not cited by the respondent in their brief.
And they require that the Government show two requirements.
First, that an asset has been created, and second, if that asset has a useful life, extending beyond the close of the taxable year.
Now, we think this is shown by the undisputed facts of this case.
Chief Justice Warren E. Burger: Where do I find that regulation in your brief?
Mr. Matthew J. Zinn: On page 41 of our brief Mr. Justice, roughly halfway down.
Chief Justice Warren E. Burger: Thank you.
Mr. Matthew J. Zinn: We say that respondent acquired an asset, because it had an identifiable interest in the secondary reserve, evidenced by the annual statements furnished by the Insurance Corporation.
It is something that respondent owns.
It is transferable in limited circumstance to another.
It earns interest each year, based on the interest earned by the Insurance Corporation.
And it has real value, which would be recognized for example, if respondent’s parent corporation would sell its stock in respondent to another.
We think it is clear that the buyer would pay more for respondent’s stock than it would for the stock of another savings and loan association that was and all other respects, similarly situated to respondent, except that it had no interest in the secondary reserve.
We also believe that it's clear that respondent’s secondary reserve interest will provide a future benefit to respondent, and thus that it has a useful like extending beyond the close of the taxable year.
If respondent remains in business, that benefit will anew to it in the form of future insurance coverage.
If it merges with another association, its parent will benefit from its share in the secondary reserve are receiving additional shares of stock in the surviving corporation.
If respondent leaves the federal insurance system or goes out of business, it will get a cash rebate of its share in the secondary reserve.
If any amount remains in the secondary reserve, when the primary reserve alone reaches the 2% level, that amount will be refunded to respondent in cash.
In short, respondent will get a benefit from its share in the secondary reserve, in one form or another, in future years.
I should like to reserve my remaining time for rebuttal.
Justice Byron R. White: One more question, there's a bit of a fuzz in your brief about that Weber Paper Company brief, our case.
I don’t find it cited by your opposition here in their brief, and I take it that they’re not relying on it.
Do you have any further comment about that case at all, other than --
Mr. Matthew J. Zinn: No further comment beyond what we’ve said in our footnote.
Justice Byron R. White: Alright.
Chief Justice Warren E. Burger: Mr. Bennion.
Justice Byron R. White: Which I take it is that you don’t think the case is properly decided, at least.
Mr. Matthew J. Zinn: And whether or not so Mr. Justice, not applicable in these circumstances.
Justice Byron R. White: Alright.
Argument of Adam Y. Bennion
Mr. Adam Y. Bennion: Mr. Chief Justice and may it please the Court.
We are certainly in agreement with the Government here that this question not to turn upon what the payments in question really are or were.
It is a taxpayer’s position that in essence the payments were primarily insurance premiums and constituted ordinary and necessary business expenses.
To go back to 1961, when the legislation in question was introduced, each association was required to pay an insurance premium of 1/12 of 1% of its savings accounts and creditor’s obligations.
I will not keep repeating creditor’s obligations, but I refer to them by including them in savings accounts.
Had the savings and loan industry remained static, those insurance premiums of 1/12 of 1% would have produced a 2% reserve in approximately 24 years.
But of course with tremendous growth of the Savings and Loan Association, to continue to collect only 1/12 of 1% did not keep pace with the ultimate insurance risk, which the statute has imposed upon the FSLIC.
And therefore, Congress when it introduced the Act in question, stated in both of the Committee Reports, that there is general agreement that some action should be taken to build up the corporation’s reserves at a faster rate, after pointing out the extent to which they had declined.
And therefore, the legislation took the form of continuing the premium of 1/12 of 1%, but the additional element that was then introduced was that if any association had an increase in its insurance -- in its savings deposits; it would have to pay this additional premium of 2% of the amount of the increase.
And to us it is significant that this is right in line with the element of a premium for insurance, it's an attempt to measure the cost of protection by the increased risk that the insurance is company is put to.
For example, in our particular case, Lincoln’s savings accounts at the beginning of 1962 amounted to approximately $90 million and they increase during 1962 to $135 million, with the result that the potential insurance risk of the FSLIC, which it was obliged by law to insure was increased by $44 million.
And to us, the essence of what Congress required was that because of the additional insurance risk, thus imposed upon the FSLIC, thus should be paid a 2% of that increase as a premium.
Not a premium to take effect 10 years later when there might be a bookkeeping entry transferring an amount from a secondary reserve to a primary reserve, but an insurance risk that it was assumed immediately in 1962 because of the increased savings accounts of Lincoln Savings and Loan Association.
So therefore, it seems to us that basically the nature and the substance of what was paid was a premium measured directly to the increased insurance risk assumed by the FSLIC and therefore, it meets basically the criteria of an ordinary expense.
On the other hand, undoubtedly may have been associations, which experienced no increase in their savings deposits, as such an association, there would have been no increase insurance risk assumed by the FSLIC, there would have been no increase premium paid by such an association which to us gives further illustration of the fact that this really was in essence the payment for an insurance risk.
Justice Byron R. White: Mr. Bennion, are you then making an ad hoc approach to the taxpayers concerned?
You seem to draw a distinction between one whose deposits had increased substantially and one whose deposits had not increased substantially.
Do I understand you to imply, I don’t think you said it bluntly, that for the latter one there would be mo deduction?
Mr. Adam Y. Bennion: That’s true, Your Honor, because there would be no payment due.
In other words, if an association did not increase its deposits, it would pay nothing more than the original 1/12 of 1%.
It would not pay it as 2% and therefore, having paid nothing that of course wouldn’t be entitled to no deduction.
The Government has argued that by this approach --
Mr. Adam Y. Bennion: Let me carry on one more, what then is the statutory purpose in setting out both 404 (b) and 404 (d)?
Why do you think they’re separated?
Mr. Adam Y. Bennion: This will have to be my own personal opinion, because I cannot climb into the minds of Congress, but I think it was primarily a device to bring about fairness.
The plan of the insurance statute from the very beginning has been that there will come a time when the reserves reach a certain point, when all payment of insurance premiums will be suspended.
Under the original Act, it was 5% then it was reduced to 2%.
So, there has been inherent in every payment of every premium, the possibility of a future benefit, when that reserve reached that point.
Now, I personally think the reason they adopted this complicated formula and said, “We’ll charge the growing associations an additional 2%,” was that when the combined primary and secondary reserve should reach 2%.
And therefore, there should be a suspension of payments, under the congressional determination that 2% was enough to cover the risk, that early suspension would be available only to the growing associations which had paid this additional premium.
Whereas, if you had an association which had paid no secondary premiums and therefore, had no secondary account, there would be nothing to transfer on their account, and therefore they would have to continue to pay the 1/12 of 1% premium until the primary premium by itself got to be 2%.
And I believe that that is the only reason for this exceedingly technical and complicated formula was set up, just as a matter of fairness.
And I think it is fair, I think that the associations that had been growing and have been building up this fund and paying the insurance.
When the 2% is arrived at which Congress thought was sufficient.
That’s fine, let's give these associations a little bit of (Inaudible), while the others who have not been contributing will continue until all of the funds are transferred over to the primary reserve.
Justice Potter Stewart: As I understood as you say, and as I understand the law, Section 404 (d) payments are to be made only by institutions, whose deposits are increasing.
Mr. Adam Y. Bennion: That’s correct.
Justice Potter Stewart: If they're not increasing, there are no 404 (d) payments to be made.
Mr. Adam Y. Bennion: That’s correct.
Now, from a practical standpoint, the Government has referred to this transfer of a part of the Lincoln’s account from the secondary reserve to the primary reserve, as an event which should give rise to a deduction at that time and also, which prevents a distortion of income.
I’d like to just call your attention to what seems to me to be a true distortion of income.
Under the Government’s theory, and as the Government said, this transfer started, as far as Lincoln is concerned in 1970.
Under the Government’s theory, the original payment of this $800,000.00 although was completely beyond the control of the taxpayer and in our view, had gone for insurance, is set upon the taxpayer’s book as an asset.
Now in 1970, when the whole industry reserve gets up to 2% and instead of having to pay the original 1/12 of 1%, the taxpayer has the benefit of having transferred, let's say $500,000.00 from the secondary reserve to the primary reserve, this has the effect on the financial statements of the taxpayer of telling the public that is now, its net worth has now decreased to $500,000.00.
And yet, from a practical standpoint, the day before that transfer was made and the day after that was made, we had exactly the same transfer, as far as anybody can tell from the outside, it's worth exactly what it was and yet, under the Government’s treatment, you show a decrease in net worth of a half million dollars.
Unknown Speaker: (Inaudible)
Mr. Adam Y. Bennion: No, Your Honor, because under the Government’s theory, the expense is allowable in that year even though no payment is due.
Unknown Speaker: Well, --
Mr. Adam Y. Bennion: If I understood your Honor’s point, but it did—
Unknown Speaker: But you have actually had to put out money for it?
Mr. Adam Y. Bennion: That is correct.
Unknown Speaker: Well, there -- in another year you wouldn’t have to actually deplete the resources of the company --
Mr. Adam Y. Bennion: It's seems to --
Unknown Speaker: Or you just put the same asset --
Mr. Adam Y. Bennion: No, I think --
Unknown Speaker: (Inaudible)
Mr. Adam Y. Bennion: The way it has worked out as accounts of reaching for us is that if that by deducting, in other words, by writing-off this asset out of the secondary reserve, which appears as an asset on the balance sheet.
Unknown Speaker: That is reducing the $886,000.00 by $500,000.00?
Mr. Adam Y. Bennion: Yes.
Unknown Speaker: This is the way your accounting is handled?
Mr. Adam Y. Bennion: This is the way the Government would handle it.
This is the way we are required to do it by our regulatory agency.
Unknown Speaker: In other words, the asset which had appeared as $886,000.00 would now appear at $386,000.00?
Mr. Adam Y. Bennion: That’s right.
Unknown Speaker: But what about the half million, it’s now a deductible expense by reason of change, what happened to that?
Mr. Adam Y. Bennion: It's just allowed as a deduction, but --
Unknown Speaker: But cash outlay would have been paid out.
Otherwise, are still in your -- it's in your cash register.
Mr. Adam Y. Bennion: Well, that’s true Your Honor.
Unknown Speaker: Well, --
Mr. Adam Y. Bennion: I wish that were better account, but as the way our accounts have explained to me that --
Unknown Speaker: Well, what about now if your cash balance had shown $2.5 million, but you would have to pay out cash (Inaudible) plus $886,000.00?
Mr. Adam Y. Bennion: That’s true, Your Honor.
Unknown Speaker: How will you deal with the $500,000.00 plus fees, exactly the same thing?
Mr. Adam Y. Bennion: I must say that sounds right, Your Honor.
Unknown Speaker: (Inaudible)
Mr. Adam Y. Bennion: [Laughter] Yes, sir.
Now, the government has placed stress upon this question of the fact that the secondary return earns a rate of return which the statute requires the FSLIC to credit to the secondary accounts and it is true that the law does require such a credit.
We have gone through in our brief the presentation in the committee hearings by one of the savings and loan big people who was unhappy that this return was not going to be paid in cash, but nothing happened with that.
And from a standpoint of the taxpayer, it has seemed to us that this so-called “return” is really an illusory thing.
It is credited to the --
Unknown Speaker: Well, what’s suppose, do you mean by that?
Mr. Adam Y. Bennion: The FSLIC your Honor, has invest most of its asset money in the government bonds, and by enlarge its income consist of the return.
Unknown Speaker: So does this mean that if your contribution were half million dollars in the secondary reserve and the secondary reserve have earned enough so that half million now conspired $125,000.00, is that it?
Mr. Adam Y. Bennion: Yes.
Unknown Speaker: Now, do you have to return $25,000.00 as income?
Mr. Adam Y. Bennion: Not in the year crediting, Your Honor.
Actually what happens is the FSLIC does not earmark its bonds as between primary and secondary, it reports all of its investment income as income, and then it deducts from that whatever return is credited to the secondary reserve.
Unknown Speaker: That even the $886,000.00 in you balance sheet include an (Inaudible) in the secondary reserve by use of --
Mr. Adam Y. Bennion: No, the $886,000.00 was just solely the amount we paid in this year, 1963.
The account has subsequently been credited with this increment.
But the -- and so, the amount is credited to the secondary, is then up among the various savings and loan in accordance with their respective accounts.
Now the revenue ruling, which was past upon by the Internal Revenue Service on this whole question, held that the secondary premium payments were not deductible because of all of these limitations and possibilities of refund whatnot.
But then, they ruled on the question whether these credits of income would be taxable as income, and the revenue ruling holds that no -- the income is not subject to a taxpayer’s demand and is so fettered with conditions that is not received either rationally or constructively.
And so, the ruling is that the return is not taxable at the time is credited, but it will be taxable, become taxable when and if there are transfers made from the secondary reserve to the primary reserve.
Unknown Speaker: Well, let’s see.
You have $500,000.00 returns.
Your annual premium is $100,000.00.
(Inaudible) paid out the secondary account and you got $500,000.00 that you invest.
In the 60-year, the increment is huge pay return.
In that year, you get the increment as deduction and also have to return the increment as income.
Mr. Adam Y. Bennion: It's a wash transaction.
Unknown Speaker: What happened?
Mr. Adam Y. Bennion: It was really not the Ninth Circuit, when we finished our argument, there said and asked us if we would next time bring a complicating case.
I tell you the complication arising out of what had just been mentioned here is tremendous.
Actually, the industry is facing this exact situation right now, where in 1970, there were transfers made out of the secondary.
And the associations don’t know what was transferred, whether their contributions, whether the income, and therefore, my recollection is that the only instructions they have so far from the FSLIC is to treat it the way you want it.
But it is true that as far as the income is concerned, it seems to be it would be a wash transaction.
The income would become taxable and then it would be deductible because it applied on this obligation.
But the whole business of credit in this return, forgetting for a moment the possibility of refunds on termination or liquidation, really is of no great moment.
The amount that’s credited from the primary reserve to the secondary reserve simply increases the secondary and decreases the primary.
And yet, any benefit to be derived by any taxpayer, depends upon when the combined primary and secondary reserves reach 2%, so that the mere fact the one is increased, and the other decreased, really is not that significant.
One of the final arguments of the Government and in this respect, the reliance was placed primarily upon an argument, which the Tax Court of the United States developed, and that is the legislative history of the statute proves that the payment is not an insurance premium, but was intended as a capital investment in the FSLIC.
We have searched the legislative history and can find nothing in support of this argument.
The tax court even said that the secondary reserve and the stock of the Federal Home Loan Bank were fungible, which to us indicated a failure to grasp the completely different functions of the two agencies.
The Federal Home Loan Bank Board is a credit organization and an association by stock in that board, and thereby becomes entitled to borrow from it.
On the other hand, the FSLIC is solely an insurance company and is concerned solely with insuring the accounts of the savings depositors of the FSLIC.
The only reference between the two in Congress was that in order to lighten the financial burden upon taxpayers that had to pay the addition of 2% insurance premium.
The amount required to be paid in for the bank stock was reduced from 2 to 1% because as Congress said there was general agreement that the bank was overcapitalized, whereas, the insurance company needed to greatly expand its insurance reserves.
Other -- there is no connection whatsoever in function or purpose of the two payments, and we think the fundamental fallacy of the tax court here was this point that this was in the nature of capital because it was fungible with a bank stock.
We think if there's absolutely no basis for that.
If it please the Court, I think that covers most of our arguments, other than those that we’ve set forth in our brief and this is a complicated thing.
We certainly agree with the Government that really the essence of these payments should govern whether they are deductible expenses.
We think that the Government concedes that they were necessary expenses.
We think the fact show that they are ordinary and it all goes faced in a similar situation to pay them.
And we do not believe that there was any element of the capital expenditure or a capital investment involved here.
I think the Ninth Circuit Court of Appeals should be affirmed.
Chief Justice Warren E. Burger: Thank you Mr. Bennion.
Mr. Zinn you have about 5 minutes.
Rebuttal of Matthew J. Zinn
Mr. Matthew J. Zinn: Yes, thank you Mr. Chief Justice.
A few brief points, I think one of the difficulties in addition to the mathematical difficulties in this case, is the fact that the respondent was required to both pay the regular annual premium in 1963, and also to come up with the additional money that would go into the secondary reserve.
And this aspect of compulsion is one that goes through a lot of tax cases.
And statement from this Court regarding its significance would be most welcome.
I should like to put a hypothetical to the Court, which raises --
Unknown Speaker: And what is the Government’s position as to 1/12 premium?
Mr. Matthew J. Zinn: Oh that’s deductible as an ordinary expense.
Unknown Speaker: Does the Government the same year?
Mr. Matthew J. Zinn: Pay the same year, no that is not, that is a capital outlay.
Unknown Speaker: It’s a -- do you think there is a decree to this prepaid insurance?
Mr. Matthew J. Zinn: Not quite, almost.
The tax court has elaborated in great detail why it could not be considered squarely to be prepaid.
Unknown Speaker: And in here, the secondary reserve is resorted to premium payments, there are no payments in it to the fund?
Mr. Matthew J. Zinn: Well, no cash payment, but they’re still are obligated to pay the regular premium of 1/12.
Unknown Speaker: And no payments under the secondary?
Mr. Matthew J. Zinn: That’s right, they’re suspended.
Unknown Speaker: So that anything except the secondary reserve are never been paid any kind of reserves?
Mr. Matthew J. Zinn: That’s correct.
It used to pay the future premium.
Now, this question of compulsion, as I say, we think is very important.
And I’d like to put a simple hypothetical to the Court to demonstrate what our position is.
Let us suppose that there had been a lot of fires in a particular area.
And a local ordinance is passed requiring each business in that locality to obtain each year, from a local fire department, a certificate of fire safety.
Let's suppose in order to obtain that certificate of fire safety, guards have to be posted on the business premises each night, and also a modern up-to-date sprinkler system has to be installed on the premises.
I would suggest that although the salaries of the guards are ordinary and necessary business expenses, that this Court would hold unanimously that the cost of the sprinkler system is a capital expenditure, this time within the meaning of Section 263, even though, and if I may quote from the respondent’s brief, “the purpose of making both expenditures is the same, the compulsion of making both expenditures is the same, and the consequence of not making both expenditures is the same.”
Justice Potter Stewart: Your point is, I gather, your submission is that whether or not these expenditures are compelled has nothing to do with the issue --
Mr. Matthew J. Zinn: Precisely and an expression from this Court on that issue, I think would do a great deal to resolve for a lot of tax cases that are now pending.
Chief Justice Warren E. Burger: Well, can there be any -- does anyone seriously raise any question that the cost of sprinkler system would be amortized over its useful life?
Mr. Matthew J. Zinn: It seems to us Mr. Chief Justice that respondent’s argument here, principal argument in its brief, which they did not elaborate this afternoon is that it had to pay the Section 404 (d) payments, under the National Housing Act, it had to pay them, that’s what the Ninth Circuit said, that’s why they held adversely to the Government.
And we say the fact that you have to pay them, doesn’t -- isn’t of any more significance in the resolution of this case than the fact that you require to put in a sprinkler system. The question is whether you have an asset within the meaning of those regulations, with the useful life extending substantially beyond the close of the taxable year.
And that question is the same, whether it be a sprinkler system or the contributions to the secondary reserve that are involved here.
Chief Justice Warren E. Burger: Since you put a hypothetical.
Also, let me put one to you if I can Mr. Zinn.
Suppose that in this insurance scheme, there were a formula that fix the amount to be paid.
Mr. Matthew J. Zinn: Each year?
Chief Justice Warren E. Burger: Not each year.
And then based on actual experience, each year there was a refund.
I realized that mathematically it could be a little difficult to do that at the end of the year.
Suppose it could come you would say then the dividend would reduce the total expenditure.
Mr. Matthew J. Zinn: Right, the hypothetical you put is very similar to a ruling relating to the Federal Deposit Insurance Corporation which is cited in both briefs and which we think is not relevant.
And under that ruling, the banks would pay a premium each year, and we’d get back any excess in the following year.
And the question was whether that was an ordinary, necessary business expense and the Internal Revenue Service rule that it was.
The reason that it ruled that it was, was this, the only reason the money wasn’t paid back at the end of the same year was if the FDIC couldn’t go and make all the computations to figure out how much was going to be needed to cover the expenses and losses of that year.
You didn’t have an asset with the useful life extending substantially beyond the close of the year.
The refund was made within a few months of the succeeding year.
As I said, we rely on this regulation, which we think squarely fits this case.
I see that I’m out of time.
Chief Justice Warren E. Burger: Thank you Mr. Zinn.
Thank you Mr. Bennion.
The case is submitted.