18 T.C. 570">*570 The respondent determined1952 U.S. Tax Ct. LEXIS 162">*164 deficiencies in petitioners' income tax for the calendar years 1944, 1945, and 1946, as follows:

The petitioners, who as partners were engaged in the life insurance business as general agents, retired in April 1944. The deficiencies result primarily from the inclusion in the income of each petitioner terminal commissions, the receipt of which was deferred until subsequent taxable years under an amendment to their former contract which was executed prior to their retirement. The issue is whether these commissions were income to petitioners during the taxable years, though they did not actually receive them. There are some minor adjustments which are not contested. The adjustments which are in 18 T.C. 570">*571 issue are illustrated in Docket No. 27396 by adjustment (a) to the net income as disclosed in the income tax return of James F. Oates for the year 1944. This adjustment is explained in the deficiency notice, as follows:

(a) It is held that 50% of the renewal commissions credited to the Fund of Hobart and Oates on the books of The Northwestern1952 U.S. Tax Ct. LEXIS 162">*165 Mutual Life Insurance Company of Milwaukee, Wisconsin during the year 1944, as the result of payment by the insured of renewal premiums on policies written on applications previously procured by its general agents, Ralph H. Hobart and James F. Oates, are taxable to you in 1944. This is in accordance with the provisions of sections 22 (a) and 42 of the Internal Revenue Code. It is further held that the so-called Amendment of April 27, 1944 to your general agent's contract, which is an authorization to the insurance company to remit to you after retirement such renewal commissions as you may be entitled to under that contract, in a certain manner, has no effect on the taxability of such income.

Accordingly your gross renewal commissions from The Northwestern Mutual Life Insurance Company have been increased $ 16,587.49 which is 50% of $ 33,174.98 balance in the Fund of Hobart and Oates as of December 31, 1944, exclusive of interest.

A similar adjustment for the year 1944 is in issue in Docket No. 27397, estate of Ralph H. Hobart, deceased. Also similar adjustments are in issue in both docket numbers for the taxable years 1945 and 1946.

Petitioners by appropriate assignments of 1952 U.S. Tax Ct. LEXIS 162">*166 error contest the correctness of these adjustments. Inasmuch as both proceedings involve a common issue, they have been consolidated.

FINDINGS OF FACT.

James F. Oates and Ralph H. Hobart prepared their Federal income tax returns for the calendar years 1944, 1945, and 1946 on a cash receipts and disbursements basis. These returns were filed with the collector of the first district of Illinois.

Petitioner James F. Oates is an individual residing in Evanston, Illinois. Ralph H. Hobart died on December 29, 1949, and the other petitioner in this proceeding is the estate of Ralph H. Hobart, deceased. The duly qualified and acting executor of decedent's estate is John H. Hobart of Winnetka, Illinois. For the sake of convenience Oates and the decedent are referred to herein as the petitioners.

On January 1, 1911, petitioners formed a partnership which operated as a general insurance agency in Chicago under the name of Hobart & Oates. The petitioners shared equally in partnership profits. The partnership, as a general agent of Northwestern Mutual Life Insurance Company of Milwaukee, Wisconsin, ¹ was engaged in the business of soliciting applications for life insurance and servicing 1952 U.S. Tax Ct. LEXIS 162">*167 of life insurance policies.

18 T.C. 570">*572 In 1928, petitioners and Northwestern executed a general agency contract which continued in effect without amendment until a short time prior to petitioners' retirement. This contract was more or less a standard one, being used by Northwestern and most of its general agents. The contract provided that petitioners were independent contractors and that they were not employees of Northwestern. The general agents of Northwestern are the field representatives of the insurance company. The general agent establishes and maintains his own office at his own expense, hires his own employees, and supervises the work of the subagents. He is a combination of salesman, sales manager, businessman, and general manager of the area covered by his agency.

The general agent's income is received primarily from three sources. First, to the extent that he personally sells insurance, the commissions on those sales1952 U.S. Tax Ct. LEXIS 162">*168 constitute income to him. Second, fees are received for collecting premiums on and servicing policies written by other general agents. His third and main source of income is from a so-called "margin" or "overriding commission." Usually a general agent has subagents working for him writing insurance policies. A subagent receives the major portion of the commission computed on the premium paid on that policy while the remainder of such commission goes to the general agent as his "overriding commission."

The general agency contract sets forth the fees and commissions that the general agent was entitled to, and the amount of those commissions depended not only upon the amount paid as the initial premium on the policy but also upon renewal premiums on the policies paid during the next succeeding 9 years. The schedule of commissions as contained in the general agency contract provided various rates of commissions for the different policies written by the general agent. An example of the operation of the commission is the ordinary life insurance policy, where the general agent is entitled to 55 per cent of the first year's premium and 7 1/2 per cent of the renewal premiums for each 1952 U.S. Tax Ct. LEXIS 162">*169 year, second to tenth, both inclusive. Of the first year's premium the general agent would retain 55 per cent, with the balance of that premium being remitted to Northwestern. In many instances, 5 per cent of the first year's premium would be retained by the general agent and the balance of the commission, or 50 per cent of the first year's premium, would be paid to a subagent. Then, in the ensuing 9 years if the renewal premiums were paid, the general agent was entitled to a commission of 7 1/2 per cent of the premium. Of this commission on renewal premiums the general agent might retain 2 1/2 per cent as his margin and pay 5 per cent to the subagent who made the sale. On all but single premium and 5-year premium policies Hobart & Oates was entitled to a percentage of the renewal premiums 18 T.C. 570">*573 during the period from the second through the tenth year of the policy.

The premiums on life insurance are collected from the policyholder by a going general agent. From the premiums collected on policies written by him, the general agent deducts the commission due him under the contract and remits the net balance to the Company. From the premiums collected on policies not written1952 U.S. Tax Ct. LEXIS 162">*170 by him, the general agent deducts a collection fee or service charge as provided under the agency contract and he remits the balance to the Company. When the general agent has retired, the premiums on business written by him are received from the policyholder by his successor general agent.

After retirement, the general agent receives his commissions on renewal premiums from the Company and not from the successor general agent.

The agency contract provided that upon retirement the general agents were to receive commissions on renewal premiums as they were earned during the 9-year period following the date of retirement, with provision for reduced payments under certain retirement conditions not applicable to the petitioners herein. Under the contract the general agent would receive a comparatively large amount of commissions on renewal premiums during the first year of his retirement, with a decrease in each year thereafter, until at the end of the ninth year of retirement he would no longer be entitled to any payments. The decline in commissions earned in each successive year after retirement is rapid for two reasons. First, the general agent during his first year of retirement1952 U.S. Tax Ct. LEXIS 162">*171 receives commissions from policies written during the 9 years previous to retirement, and during the second year of retirement commissions are received only on the policies written during the 8 years previous to retirement and so on until the ninth year of retirement when the retired general agent receives commissions from only the policies written during a single year, the year previous to his retirement. A second factor causing the yearly income from commissions to decline is called the persistency of renewals. Not all life insurance policies are renewed each year. Policies may lapse because of the death of the insured or because the insured is financially unable to pay the premiums to keep the policy in force.

The provisions of this standard contract form (providing for the payment of terminal commissions over a period of 9 years) had, prior to July 1939, caused considerable discontent and dissatisfaction among general agents. There were 86 general agencies, some of which were partnerships and some of which were sole proprietorships. Over a period of years of operation the experience of the general agents whose contracts had terminated under the standard form had proved that1952 U.S. Tax Ct. LEXIS 162">*172 18 T.C. 570">*574 the operation of that contract, in respect of terminal commissions, had some serious defects; at least the general agents thought so. Experience had shown that in many cases the retirement of a general agent came at a late period in his life and that as his income from renewal commissions under the standard contract rapidly decreased, and as he grew older, his capital and his income progressively decreased.

In many cases the potential receipt of commissions during the years following their retirement constitutes the bulk of the estates and resources of such retired general agents and they look to that for their living after their retirement. This situation caused distress to some retired general agents and brought general conviction to general agents that the period of terminal commission payments under the existing contract was too short, that the portion of total payments received during the first 5 years after retirement was so large as to pose an investment problem which the general agents were not trained or qualified to solve and that the situation should be remedied in such a manner as to afford security for a period more nearly coincident with the life expectancy1952 U.S. Tax Ct. LEXIS 162">*173 of a general agent after retirement.

The general agents of Northwestern have an association known as "General Agents' Association of the Northwestern Mutual Life Insurance Company." It has had a long existence. It was organized to promote the best interests and welfare of the general agents and to treat with company officials upon matters of mutual interest to both general agents and the Company. It holds regular annual conventions and, upon occasions, officials of Northwestern are invited to attend for discussion and advice on matters of common interest.

The dissatisfaction and discontent of the general agents as to the methods of payment under the old contract had been growing prior to the association's annual convention in July 1939, and at that meeting the matter of the payment of these terminal commissions came up for discussion on the floor of the convention and, as a result thereof, the president of the association appointed a committee designated as the "Special Committee for the Conservation of General Agents' Estates." The purposes and functions of this special committee were to investigate the problems which were causing the dissatisfaction among the general agents and1952 U.S. Tax Ct. LEXIS 162">*174 to negotiate with and make recommendations to the Company looking to a solution and adjustment of those problems.

The special committee began its work in July 1939, and conducted an investigation into this problem as it concerned all the general agents of the Company and sought to find a solution which would give greater protection and security in old age in all the varying circumstances under which these general agents were situated. The problem was to seek a solution which would fit all these diverse situations. 18 T.C. 570">*575 The general agents were located in all parts of the United States and the special committee sought to investigate each case. During the period of over four years while it was conducting its investigations, the special committee was in informal and unofficial touch with officials of Northwestern (particularly the chief counsel and the director of agencies) and acquainted those officials with the result of the work of the special committee. Those Company officials assisted the committee in its work by furnishing it with information of like nature which had come to the attention of Northwestern and requested the special committee to find, and offer for the Company's1952 U.S. Tax Ct. LEXIS 162">*175 consideration, a possible solution to the problem.

In October 1943, the special committee had completed its investigations and thereupon met officially with the officers of the Company and submitted its report and findings. The committee reviewed the entire subject matter and pointed out the objections to the prevailing contract and requested the Company's officials to give consideration to an amendment to the contract with the general agents which would be more elastic and more adaptable to the circumstances and needs of the individual general agents. The committee urged upon the Company's officials that an amendment should be devised which would give the greatest possible stability in security of income by leveling the potential payments of terminal commissions over a period more nearly in accord with the life expectancy of the retired general agent.

During the conferences between the committee and the Company's officials, or later when the proposed amendment came on for discussion at the convention of the association, it was agreed that the amendment should provide that interest should be added to the amount ultimately to be paid under the amendment, computed at the rate currently1952 U.S. Tax Ct. LEXIS 162">*176 used by the Company (2 per cent) in computing the purchase price of immediate life annuities. This rate would be about 60 per cent of the amount the Company would currently earn on the same amount. The interest provided for in the amended contract was not included in the adjustments to net income by the Commissioner and is not involved in the instant proceeding.

Various plans for such an amendment were discussed between the committee and the Company's officials. A 20-year period and a 15-year period were both discussed. In order to give the desired flexibility which would make a contract amendment adaptable under such widely varying circumstances, it was agreed between the committee and the officials of the Company that an amendment providing that general agents might have an election to amend their contracts or to continue the standard contract without amendment, and providing (in the event of contract amendment) for the exercise of various options and elections by the general agents and for payment of stipulated 18 T.C. 570">*576 monthly installments over a period not to exceed 180 months, the amount of such monthly installment to be agreed upon between Northwestern and the general1952 U.S. Tax Ct. LEXIS 162">*177 agent. The committee requested Northwestern to formulate and offer a proposal along those lines and the Company's officials acceded to that request. Thereafter the officials of the Company made a study based upon a set of tables compiled by the actuary of the Company known as the "Evans' Valuation Tables." The first category, Table A, estimated that of the total number of policies written in a given year 70 per cent of such policies would persist and continue to be in force at the end of 10 years. The second category, Table B, estimated that 65 per cent of such policies would so persist and remain in force. The third category, Table C, estimated that 50 per cent of such policies would so persist and remain in force. The fourth category, Table D, estimated that 35 per cent of such policies would persist and remain in force.

Since the amount which the general agent might receive after his retirement was conditioned upon persistency of future renewals and upon the future premiums paid by policyholders subsequent to the date of such retirement on policies written nine years or less prior to the general agent's retirement, there was no way for either the Company or the general agent1952 U.S. Tax Ct. LEXIS 162">*178 to know how much a general agent might receive subsequent to his retirement other than by estimation and approximation. The Evans' Tables were developed to provide an actuarial method by which the general agents could calculate the value at date of retirement of all terminal commissions based on premiums payable after date of retirement. The Evans' Tables were predicated upon four different assumptions of persistency of renewal as stated in the letter quoted hereafter. The actuarial value at retirement date of a general agent's possible terminal commissions varied according to the percentage of renewal persistency (Tables A, B, C, or D) estimated or assumed by the general agent himself. Having arrived, by the use of the Evans' Tables, at the value at date of retirement of the possible terminal commissions, the general agent could more intelligently decide the amount and frequency of payments to provide for in the amendment to his contract than he could have without the help of the Evans' Tables. The Evans' Tables were neither an assurance, a guaranty, nor a promise on the part of the Company of the payment of any amount as or in lieu of terminal commissions.

Pursuant to their1952 U.S. Tax Ct. LEXIS 162">*179 agreement with the special committee, the officials of Northwestern worked upon the problem and became convinced that in order to solve the problem it would be necessary to find a formula which would be adaptable generally to the situations of all retiring general agents under the varying circumstances presented 18 T.C. 570">*577 by such cases and that to give such formula the flexibility necessary to meet the conditions arising in such a variety of cases certain basic predicates would have to be observed: (1) that the new contract should contain optional provisions from which a general agent might select the provisions best adapted to his case; (2) that a general agent should be allowed to continue under the then existing standard contract or be allowed to enter into an amended contract containing the option of his choice; (3) that the election to continue under the existing contract or under a new contract should be exercised and executed prior to the retirement date of the retiring general agent; and (4) that the election once so executed prior to the date of retirement should be irrevocable and binding upon him and upon the Company from and after the date of his retirement. Accordingly, 1952 U.S. Tax Ct. LEXIS 162">*180 they formulated a proposed amendment as follows:

AMENDMENT TO GENERAL AGENT'S CONTRACT

Commissions After Termination

Upon the termination of this contract, the approximate amount of all commissions accrued or to accrue hereunder, which the General Agent shall be entitled to receive, except such portion of any first and/or renewal commission as is payable to an agent or agents under contract with General Agent, pursuant to the terms of such contracts, shall be determined by application of the Evans' Commission Valuation Table     without interest, and the Company shall retain such renewal commissions in a Fund to which shall be credited interest annually on the balance in hand, at the rate currently used by the Company in computing the purchase price of immediate life annuities as certified by the Actuary of the Company. Subject to the "Offset of Commissions" provision of this contract, and subject to the rights of any assignee, payments from such Fund to General Agent or to the personal representative of his estate shall be made in monthly instalments initially elected by General Agent until either, the Fund is exhausted, or until 180 instalments have been paid, first instalment1952 U.S. Tax Ct. LEXIS 162">*181 payable within 60 days after date of termination of this contract and monthly thereafter, but no such payment shall be less than 1/180th of the Fund, or more than the amount in the Fund at any time any instalment is payable. In the event of the death of General Agent while receiving such payments, the remaining instalment payments or the amount in the Fund if less than such instalment, shall be paid in like instalments to the personal representative of his estate or to the person or persons entitled to receive the same. At the expiration of 180 months any proceeds remaining in the Fund shall be paid in one sum.

The officials of the Company submitted the proposed amendment to the special committee who approved it and agreed to recommend it to the General Agents' Association. They then submitted it to the Insurance and Agency Committee of the Company, which committee spent considerable time in discussion and consideration of it and at length approved it. Thereupon it was submitted for approval to the Executive Committee of the Company which is the highest Company authority. The Executive Committee approved it on December 17, 1943, and directed that it be offered as a proposed amendment1952 U.S. Tax Ct. LEXIS 162">*182 at the 18 T.C. 570">*578 next convention of the General Agents' Association. Accordingly, on March 6, 1944, a letter was sent to each general agent by the Company as follows:

THE NORTHWESTERN MUTUAL LIFE INSURANCE COMPANY

Milwaukee 2, Wis., March 6, 1944.

To the General Agents: Realizing that present provisions of General Agents' Contracts relating to the payment of commissions after termination of the contract are not entirely satisfactory to many General Agents, the Company has been studying the subject with the object of developing an amendment to the contract relating to the mode of settlement which may be substituted for the present provisions at the option of any General Agent. We have finally agreed upon a plan which is now offered for your consideration. A copy of the amendment is enclosed.

In order to approximate the amount that will be paid to a General Agent during the ten years following termination of the contract, allowance must be made for the termination of insurance by death, surrender and lapse. Tables with various termination rates have been constructed by Mr. Evans, Vice President and Actuary. These tables are known as the Evans' Commission Valuation Tables. 1952 U.S. Tax Ct. LEXIS 162">*183 They are designated as A, B, C and D. Considering the gross amount of premiums as 100%, the approximate proportion of the insurance that will renew in the tenth year is shown in the following tables:

Instead of receiving commissions after termination of the contract as they accrue, the General Agent upon the adoption of the amendment will receive his entire commissions in monthly instalments in amounts to be designated by him, over a period of not more than 180 months. To illustrate: If the present value under Table D is $ 90,000, the General Agent could elect to receive $ 500 a month for 180 months. If he elects income for 120 months, the monthly instalments would be $ 750; or he may elect $ 600 a month for as long a period as there are sufficient funds in the possession of the Company, not exceeding 180 months. Any balance at the end of 180 months would be paid in one sum.

If this method of settlement is desired, the General Agent, prior to the termination of his contract, must request the Company to modify his contract accordingly. 1952 U.S. Tax Ct. LEXIS 162">*184 He must also determine the amount of monthly income desired, the period during which it shall be paid and the Commission Valuation Table to be used to approximate the net amount of commissions payable. If his commissions are assigned as collateral for loans or he is indebted to the Company, such indebtedness must be liquidated first.

If commissions payable are not subject to indebtedness, they will be retained by the Company in a fund to which interest will be added annually at the rate currently used by the Company in computing the purchase price of immediate life annuities (current rate 2%). If at any time the amount of the monthly instalment elected is greater than the amount in the fund, only the amount in the fund will be paid.

If the General Agent dies during the settlement period, similar payments, or the amount then in the fund, if less, will be paid to the personal representative of his estate or to the person or persons entitled to receive them under the terms of his will, until the expiration of the period selected by the General 18 T.C. 570">*579 Agent. Such period shall not exceed 180 months, and if there is any balance in the fund when the last monthly payment is due1952 U.S. Tax Ct. LEXIS 162">*185 it will be then paid in one sum.

Because this plan can and should be carefully integrated into the General Agent's insurance program and the distribution of his personal estate, it is vitally important that you consider it carefully and discuss it thoroughly with your personal attorney before requesting the Company to amend your contract so as to substitute it for the present provision. * * *

* * * *

Yours cordially,

(Signed) Grant L. Hill,

Director of Agencies.

The General Agents' Association met in convention in Chicago on March 14, 1944. Practically all of the general agents of Northwestern were in attendance. The proposed amendment was discussed on the floor of the convention and questions were propounded to the Company's officials who answered them. Thereafter the convention unanimously approved the amendment offered by the Company. Following the convention of the General Agents' Association about 75 per cent of the general agents executed the amendment proposed by the Company. Among these were Hobart and Oates, the petitioners herein, each of whom executed amended contracts on April 27, 1944. They had made their preparations to retire as of midnight on April 30, 1944, 1952 U.S. Tax Ct. LEXIS 162">*186 but due to a delay in printing the Company had been unable to get the printed copies of the amended contracts until April 26, 1944. The amended contracts were executed between them and the Company prior to their retirement as general agents. The contract amendment executed by each of the petitioners was in the following terms:

AMENDMENT TO GENERAL AGENT'S CONTRACT

The Northwestern Mutual Life Insurance Company.

Milwaukee, Wisconsin.

Effective as of the date hereof, I hereby request that the provisions of my General Agent's Contract with the Company dated July 9/1928, effective date July 2/1928 relating to the payment of all Commissions payable after termination of the contract be amended as follows:

"Upon the termination of this contract, the approximate amount of all commissions accrued or to accrue hereunder, which the General Agent shall be entitled to receive, except such portion of any first and/or renewal commission as is payable to an agent or agents under contract with General Agent, pursuant to the terms of such contracts, shall be determined by application of the Evans' Commission Valuation Table C without interest, and the Company shall retain such commissions1952 U.S. Tax Ct. LEXIS 162">*187 in a Fund to which shall be credited interest annually on the balance in hand, at the rate currently used by the Company in computing the purchase price of immediate life annuities as certified by the Actuary of the Company. Subject to the 'Offset of Commissions' provision of this contract, and subject to the rights 18 T.C. 570">*580 of any assignee, payments from such Fund to General Agent or to the personal representative of his estate shall be made in monthly instalments initially elected by General Agent prior to the termination of the contract but not thereafter, until either, the Fund is exhausted, or until 180 instalments have been paid, first instalment payable within 60 days after date of termination of this contract and monthly thereafter, but no such payment shall be less than 1/180th of the Fund, or more than the amount in the Fund at any time any instalment is payable. In the event of the death of General Agent while receiving such payments, the remaining instalment payments or the amount in the Fund if less than such instalment, shall be paid in like instalments to the personal representative of his estate or to the person or persons entitled to receive the same. At the expiration1952 U.S. Tax Ct. LEXIS 162">*188 of 180 months any proceeds remaining in the Fund shall be paid in one sum."