An unincorporated concern known as Edward Brown & Sons, of San Francisco, has since 1896 acted as Pacific Coast General Agent for fire insurance companies. In 1923, Arthur M. Brown conducted the concern alone. In 1925 and 1926, he and his son Arthur M. Brown, Jr., conducted it as partners. The general agent receives as compensation from its principals, among other things, a so-called 'overriding commission' on the net premiums derived from business written through the local agents. The question for decision is, how the income of the petitioner, Arthur M. Brown, derived from overriding commissions during the years 1923, 1925, and 1926 should be calculated for purposes of the federal income tax. The Commissioner of Internal Revenue held that, in determining income, the gross overriding commissions on business written during the year should not be subjected to any deduction on account of cancellations expected to occur in later years. The taxpayer contends that either the gross overriding commissions should be subjected to such a deduction of that parts of the gross overriding commissions should be allocated as earnings of future years.
The term 'net premium' as used in providing for overriding commissions means the gross premium on the business written less the return premium and the net cost of any reinsurance. Fire insurance policies are written for periods of one, three, or five years, with the right of cancellation by either party at stipulated rates of premium return. Premiums being payable in advance (subject to the 60-day grace period), a return premium is paid to the policyholder in case of cancellation; and the general agent, who receives the premium, pays the return premium. The company writing a policy frequently reinsures in another company a part of its contingent liability; and the general agent, who makes the payments for reinsurance, receives, in case of cancellation, a return of a proportionate part of the cost of the canceled reinsurance. The general agent makes to each principal remittances on monthly balances, crediting itself, among other things, with the overriding commissions on premiums receivable, with the return premiums paid and with the net amount paid for reinsurance; and charging itself, among other things, with a proportionate part of any overriding commissions previously credited in respect of any business which has been canceled during the month. Thus, whenever there is a cancellation and a return or credit of a portion of the premium and of the cost of any reinsurance, the general agent returns to the company or charges itself with a corresponding portion of the overriding commission.
Prior to 1923, overriding commissions on new business were accounted income of the year in which the business was written; and refunds of overriding commission on account of cancellations were accounted expenses of the year of cancellation. The books of the general agent have at all times been kept on the accrual basis. Although no change was made in the method of accounting between the general agent and its principals, there was set up on the books of the concern at the close of 1923, for the first time, a liability account entitled 'Return Commission.' In it was recorded an estimate of the liability expected to arise out of the general agent's obligations to refund to the companies a proportionate part of the overriding commission received because of cancellations which it was expected would occur in future years. The estimate was based on the experience of the preceding five years. Thus, on the books, the year's income from overriding commissions was reduced by the amount of refunds which, it was estimated, would have to be made in future years. This changed method of accounting has been followed ever since; and the difference in the method of calculating the general agent's income has been reflected in the returns made by Brown of his taxable income.