Massachusetts Mutual Life Insurance Company, Appellant, v. the United States, Appellee, 761 F.2d 666 (Fed. Cir. 1985)

Massachusetts Mutual Life Insurance Co. (Mutual) appeals from a decision of the United States Claims Court, Margolis, J., (5 Cl.Ct. 581 (1984)) granting the Government's motion for summary judgment. At issue is the proper treatment of a particular bad debt loss under the special provisions relating to the taxation of life insurance companies in the Internal Revenue Code of 1954, as amended, 26 U.S.C. §§ 801-820 (1982).¹  We affirm.

In 1950, Mutual loaned $2,500,000 to Texas Consolidated Oils (TCO) as part of a $15,100,000 loan package. Of that sum, the Reconstruction Finance Corporation lent $11,100,000 and John Hancock Mutual Life Insurance Co. lent the remaining $1,500,000. TCO signed separate promissory notes with each creditor; each of the notes, however, was secured by a single deed of trust covering almost all of TCO's gas and oil properties. Under the terms of each note, a default as to one creditor was a default as to all.

On April 1, 1960, TCO was unable to meet its obligations. The creditors agreed to sell TCO's property in an effort to recover the amounts due. At this point, TCO owed Mutual $1,976,461.41. From the sale, Mutual received $408,633.18. At that time, Mutual estimated that it might yet recover $25,426.00 and determined the balance, $1,542,405.23, to be worthless debt.

In 1961 and 1963, Mutual recovered a total of $18,245.13. Late in 1963, Mutual concluded that it would never recover the remaining balance, i.e., the $25,426 which it assumed it could recover less the $18,245.13 which it subsequently collected. Mutual therefore charged off $7,180.87 as worthless debt in 1963.

The Internal Revenue Service (IRS) audited Mutual's returns for the tax years 1958-1970. The IRS assessed deficiencies in various amounts for several of the years, including 1961 and 1963. One of the items in contention between Mutual and the IRS was the proper treatment of the TCO bad debt loss written off in those years. Mutual paid the deficiencies and filed claims for refunds, which were, in all respects now relevant, denied.

Mutual then filed a timely petition in the United States Court of Claims seeking to recover the taxes paid (plus interest) relating inter alia to the TCO bad debt loss. Mutual argued alternatively that the bad debt loss was deductible: (1) as an investment expense under Sec. 804(c) (1); (2) as an expense attributable to a "trade or business (other than an insurance business)" under Sec. 804(c) (5); or (3) as an expense incurred by a partnership of which Mutual was a partner, also under Sec. 804(c) (5). The parties filed cross-motions for summary judgment. The Claims Court (which succeeded to the case on the demise of the Court of Claims) granted the Government's motion, and denied Mutual's. Mutual appeals from this decision only to the extent the Claims Court held the bad debt not deductible under the language relating to partnerships in Sec. 804(c) (5).

Section 802(a) (1) imposes a tax on "life insurance taxable income." The complicated formula for determining this amount involves a three-phase computation set forth in Sec. 802(b). Phase I consists of either the insurance company's taxable investment income (computed under rules contained in Sec. 804) or its gain from operations (computed as prescribed in Sec. 809), whichever is smaller. If gain from operations is smaller, the insurance company pays a tax on that amount. If gain from operations is larger, then Phase II consists of one-half of the difference between this amount and taxable investment income. Phase III consists of that portion of the remaining one-half of the excess which the insurance company distributes to its stockholders. Various details of the insurance company taxation scheme have been considered in other cases and authorities. United States v. Atlas Ins. Co., 381 U.S. 233, 85 S. Ct. 1379, 14 L. Ed. 2d 358 (1965); American National Ins. Co. v. United States, 690 F.2d 878 (Ct. Cl. 1982); 8 J. Mertens, The Law of Federal Income Taxation, Sec. 44 A. 01 (1978).

The question in this case is not whether the bad debt loss is deductible, but rather where in the phase I calculation it should be deducted. This is more than an academic problem. Mutual alleges that in the tax years in question, it was taxed only on its taxable investment income; accordingly, a loss deduction from its gain from operations would not lower its tax liability. Moreover, the loss deduction may be crucial if the taxable investment income and gain from operation are sufficiently close that the deduction determines which is greater.

Mutual argues that the deduction should be allowed under Sec. 804 in the calculation of taxable investment income. Taxable investment income is composed of the insurance company's investment yield plus its net capital gains less certain deductions. Sec. 804(a) (2). Investment yield is, in turn, gross investment income less certain deductions. Gross investment income, as defined in Sec. 804(b), includes:

(1) Interest, etc.--The gross amount of income from--

(A) interest, dividends, rents and royalties,

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(2) Short term capital gain....

(3) Trade or business income.--The gross income from any trade or business (other than an insurance business) carried on by the life insurance company, or by a partnership of which the life insurance company is a partner. In computing gross income under this paragraph, there shall be excluded any item described in paragraph (1).

The corresponding deductions listed in Sec. 804(c) which, when subtracted from gross investment income result in investment yield, are:

(1) Investment expenses.--Investment expenses for the taxable year.

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[ (2)-(4) (Real estate expenses, Depreciation and Depletion ]

....

(5) Trade or business deductions.--The deductions allowed by this subtitle [A--Income Taxes] (without regard to this part) which are attributable to any trade or business (other than an insurance business) carried on by the life insurance company, or by a partnership of which the life insurance company is a partner. [This paragraph is subject to certain exceptions not pertinent here.]

Mutual's contention is: it was a partner in a partnership created to arrange the loan to TCO;²  that the partnership itself was not engaged in the insurance business; and the deduction here is therefore allowed under the express language of Sec. 804(c) (5) in Mutual's calculation of investment yield.

The Government argues, on the other hand, that the bad debt loss is not deductible under any provision of Sec. 804(c). Rather, the Government says that the deduction is allowable only in the computation of gain from operations in Sec. 809. Gain (or loss) from operations is the amount by which the company's revenue from all sources (including investments) exceeds (or falls short of) certain deductions listed in Sec. 809(d). The Government's position is that the appropriate place to deduct bad debt losses is under Sec. 809(d) (11):

For purposes of subsections (b) (1) and (2) [gain and loss from operations], there shall be allowed the following deductions:

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(11) Other deductions.--Subject to the modifications provided by subsection (e), all other deductions allowed under this subtitle for purposes of computing taxable income to the extent not allowed as deductions in computing investment yield.

Section 166, which is in the same subtitle as Sec. 809, allows a deduction for bad debts. The last portion of Sec. 809(d) (11) confirms that Sec. 804(c) deductions are not to be included in Sec. 809(d) calculations--for that reason, both the Government and Mutual cannot be right.

Mutual's sole argument to us is that it is entitled to the deduction under Sec. 804(c) (5) because it lent the money to TCO as a partner in a partnership (which we assume for the purposes of this appeal to have been the case), and that this partnership was not itself engaged in the insurance business.

This reasoning seems to have a certain literal appeal, but must fail when considered in the context of Sec. 804 as a whole. The Claims Court definitely ruled that Mutual could not take the deductions as attributable to a "trade or business (other than insurance business)" when viewing Mutual's making of the loan as a solo venture. Mutual has not appealed from this aspect of the decision and we must accept it as given. It would be surprising if Congress had intended to deny the deduction if one insurance company made the loan, but to grant the deduction solely because three companies made the loan in concert. We know of no reason why Congress should make that distinction, and Mutual gives us none. The absence of a ground to make the distinction strongly suggests that none was desired.

In addition, the statutory test, closely read, does not support the distinction. Mutual hinges its argument on the claim that the partnership which entered into the TCO deal is an entity separate from any of the individual partners. Mutual must do so if it is to separate the partnership's business from its own insurance business. This characteristic of partnerships, while necessary to Mutual's case in this aspect, proves to be its achilles heel in another. Under the specific terms of Sec. 804(c) (5), the deduction must be "attributable" to the partnership. Any deductible loss suffered by Mutual "attributable" to the separate partnership, however, is attributable to Mutual's investment in its partnership share. The bad debt is not "attributable" to Mutual's operation of a non-insurance trade or business in partnership form, but rather was incurred by the partnership as a separate entity.³ 

The legislative history of Sec. 804(c) (5) furthers this reading. Congress passed the precursor to Sec. 804(c) (5) as Sec. 803(c) (6) of the code in the Life Insurance Company Tax Act of 1955 (the 1955 Act)⁴  Pub. L. No. 84-429, 70 Stat. 36. The Senate Report states specifically the purpose of the new provisions relating to non-insurance trades or businesses:

The gross income of a life insurance company under present law [i.e., prior to the 1955 Act] is defined as interest, dividends and rents. This definition has been changed by expressly including ... (3) income derived from the operation of a noninsurance business.... Normally a life insurance company will only have income from a non-insurance business where it acquires a going business in foreclosing a mortgage. Income earned in this situation is considered to be similar to mortgage interest. In some cases there is uncertainty as to the status of these items under present law.

S.Rep. No. 1571, 84th Cong., 2d Sess., reprinted in, 1956 U.S.Code Cong. & Ad.News 2253, 2258. The report later explains Sec. 803(c) (6), now Sec. 804(c) (5): "Paragraph (6) of this subsection allows the deductions attributable to any trade or business, the income from which is included in the life insurance company's gross investment income by reason of section 803(b) (2) [now Sec. 804(b) (3) ]." Id., 1956 U.S.Code Cong. & Ad.News at 2264. Section 804(c) (5) is, therefore, directed not at losses incurred by the insurance company in the insurance business, but rather at losses incurred by an operational business run by the insurance company.⁵ 

The legislative history does not indicate a separate rationale for the partnership languages.⁶  However, the reasoning of the rest of the provision applies equally to this provision. As in this case, multiple lenders may find themselves in joint possession of an ongoing enterprise. Section 804(c) (5) makes it clear that, despite their joint ownership and "partnership" status (as defined in Sec. 7701(a) (2) of the tax code), they are entitled to the deductions as if they were the sole holders of the property. Thus, had the partnership of which Mutual was putatively a partner decided to foreclose on its loan and operate TCO's oil and gas properties, it would have been entitled to deduct under Sec. 804(c) (5) its share of all the losses and expenses allowed by subtitle A which were attributable to that business (and which were not deductible under Sec. 804(c) (1)) .

The IRS regulations construing Secs. 804 and 809, which date back to 1960,⁷  support the result that the bad debt loss here is deductible under Sec. 809(d) (11) and not Sec. 804(c) (5). Treas.Reg. Sec. 1.809-6(b) states that "a deduction for specific bad debts shall be allowed [under Sec. 809(d) (11) ] to the extent that such deduction is allowed under section 166 and the regulations thereunder." As noted supra, the loss may not, according to the statute, be deducted under both Secs. 804(c) (5) and 809(d) (11).

The regulations under Sec. 804(c) reach the same result. Treas.Reg. Sec. 1.804-4(b) (6) (i) recognizes that the deductions allowed under Sec. 804(c) correspond to certain items includible in Sec. 804(b)'s calculation of "gross investment income."⁸  By virtue of Sec. 804(b) (3), items included in Sec. 804(b) (1) ("Interest, etc.") are not to be included in Sec. 804(b) (3) ("Trade or business income"). Therefore, the regulation posits that, because interest is included in gross investment income under Sec. 804(b) (1) and not 804(b) (3), then the corresponding deductions must be deductible, if at all, under Sec. 804(c) (1) ("Investment expenses"). Because a bad debt loss is attributable to accrued interest (even in a partnership), the deduction cannot be taken under Sec. 804(c) (5). Accord, "Insurance Industry-Wide Examination, Minutes of April 14-18, 1975, Meeting in Atlanta, Ga.," reprinted in 3 T. Nash, Federal Taxation of Life Insurance Companies at App. 641-42 (1979). Mutual did not appeal that portion of the Claims Court's decision denying the deduction under Sec. 804(c) (1), and we have no reason to reject the Claims Court's ruling on that issue.

For these reasons, the decision of the Claims Court, insofar as it has been appealed from, is affirmed.

AFFIRMED.