56 T.C. 497">*498 The Commissioner has determined deficiencies in petitioner's income taxes and assessed additions to tax thereon in the amounts and for the taxable years shown below:

Due to certain concessions, the primary issues to be decided are: (1) Whether during any or all of the years in issue, petitioner qualified as a life insurance company under section 801(a); ¹ (2) whether certain expenses incurred in 1958 by officers of petitioner on a trip to Hawaii are deductible as ordinary and necessary business expenses; (3) whether petitioner is entitled in 1959 to an operations loss deduction in the amount of $ 5,478.87 resulting from an operations loss carryback claimed from 1962; and (4) whether petitioner is liable for the additions to tax assessed by respondent under sections 6651(a) and 6653(a).

1971 U.S. Tax Ct. LEXIS 121">*126 FINDINGS OF FACT

The petitioner is an Arizona corporation with its principal office at Phoeniz, Ariz., at the time the petition was filed. The Federal income tax returns for the years in issue were filed with the district director of internal revenue at Phoeniz, Ariz.

Prior to 1957, Arwell L. Pierce and his son Arthur owned substantial property in Mexico, including a corporation engaged in the lumber business, the assets of which they desired to transfer to the United States. H. Lavon Payne, Arwell Pierce's nephew, who was a C.P.A. and an attorney admitted to practice in Arizona, had extensive experience as an attorney consulting with life insurance companies and had been an officer of two life insurance companies. Since 1952, Payne's predominant business experience was in life insurance.

Sometime during 1957, Payne formulated the idea of forming an Arizona life insurance corporation for the purpose of handling the reinsurance business generated by other Arizona life insurance companies. 56 T.C. 497">*499 Payne felt this would be a good business venture because of the good profit potential afforded by reinsurance business and because at that time there was no Arizona insurance company 1971 U.S. Tax Ct. LEXIS 121">*127 which was handling any reinsurance for the Arizona life insurance companies.

Payne advised the Pierces to transfer their property in Mexico to a life insurance company in the United States, which company would be formed to engage primarily in the reinsurance business. Payne sought a ruling from the Internal Revenue Service permitting a tax-free reorganization from the Mexican corporation to a domestic life insurance corporation but was unsuccessful because the primary business of the foreign corporation was lumber rather than life insurance. The Internal Revenue Service indicated it would issue a favorable ruling if the domestic corporation into which the assets were to be transferred were a lumber company or similar thereto. Payne then amended his ruling request by seeking a tax-free reorganization as a lumber company rather than as a life insurance company. The Internal Revenue Service issued a favorable ruling but stipulated that in order for the ruling to retain its effect, the newly formed lumber company would be required to be engaged in the lumber business for 3 years.

Pursuant to the above plan, Interstate Lumber & Development Co. (Interstate Lumber) and Inter-American 1971 U.S. Tax Ct. LEXIS 121">*128 Life Insurance Co. (Inter-American Life) were organized. From 1958 through 1961, Interstate Lumber was wholly owned by Arwell Pierce, his children, and grandchildren. Inter-American Life was incorporated as an Arizona domestic limited-stock life insurer on July 25, 1957, and received its certificate of authority to transact life insurance business in Arizona on December 30, 1957. The Mexican corporation's assets were then transferred to Interstate Lumber. Interstate Lumber in turn transferred to Inter-American Life approximately $ 200,000 of assets as loaned surplus under an agreement providing that the funds could not be returned except from the surplus funds of Inter-American Life. About the same time, Arwell Pierce contributed $ 40,000 in cash to Inter-American Life. The minimum capital required at that time in Arizona to form an insurance company was $ 37,500. The capital in excess of the required minimum capital was transferred to petitioner to fund the reserves petitioner would be required by Arizona law to maintain if it obtained the reinsurance business it sought.

Investment Life Insurance Co. (Investment Life) was incorporated in late 1957 and within a few months thereafter1971 U.S. Tax Ct. LEXIS 121">*129 received its certificate of authority to do business as a life insurance company in Arizona. Payne and Arwell and Arthur Pierce each owned one-half of the outstanding stock originally issued by Investment Life. Additional 56 T.C. 497">*500 stock was issued and sold to the public later. Payne promoted and organized Investment Life in order to have an insurance company selling direct insurance which could feed reinsurance business to petitioner. During the years 1958 through 1961, Payne was employed by Investment Life serving as general manager, vice president, and secretary for which he received an annual salary of approximately $ 10,000. During this same period, he served as director, vice president, and secretary-treasurer for petitioner but neither he nor Pierce received any compensation from petitioner. During those same years, Payne also practiced law and accounting, operating from his office at Investment Life.

At various times during the years 1958, 1959, 1960, and 1961, Payne prepared on petitioner's behalf, filed for, and obtained the approval of the Arizona Insurance Department for various types of policy forms briefly described as follows:

1971 U.S. Tax Ct. LEXIS 121">*130 Petitioner could expand the coverage of the policies by attaching the following riders which petitioner filed for and obtained the approval of the Arizona Insurance Department: (1) Family Income Benefit; and (2) Mortgage Cancellation. These policy and rider forms were used by Investment Life as well as by petitioner. Investment Life maintained petitioner's policy files during the years 1958 through 1961. For the same period, Interstate Lumber's bookkeeper maintained 56 T.C. 497">*501 petitioner's accounting records. Payne and Pierce received no compensation from petitioner for those years.

Petitioner did not maintain an active sales staff soliciting or selling insurance policies during the years 1958 through 1961 and paid sales commissions of only approximately $ 500 during that period.

Petitioner initially secured a small amount of reinsurance business from East-West Insurance Co. and Investment Life. Shortly thereafter, petitioner lost East-West's business to other larger reinsurance companies because petitioner was unable to provide the services that the larger reinsurance companies could provide. Among other things, petitioner's reinsurance competitors would underwrite the prospective1971 U.S. Tax Ct. LEXIS 121">*131 policies to determine whether the applicant was a good insurance risk, provide sales and actuarial assistance, and provide policy forms to be used by the direct writing companies. Petitioner was able only to provide policy forms to the direct writing companies. After petitioner lost East-West's business, Investment Life was the source of nearly all of petitioner's reinsurance business throughout the years in issue.

From 1958 and continuing into 1961, petitioner had an agreement with Businessmen's Assurance Co. (BMA) under which petitioner ceded a portion of its reinsurance business to that company. The agreement was terminated on September 22, 1961, effective December 22, 1961, because petitioner had failed to pay some of the reinsurance premiums owed BMA.

Shortly after the reinsurance agreement was terminated, Arthur Pierce and Payne had a conference with the director of insurance of Arizona during which the director expressed his desire that Inter-American Life and Investment Life merge if they continued in the life insurance business. The director further suggested that Inter-American either aggressively get into the life insurance business or that it withdraw from the life1971 U.S. Tax Ct. LEXIS 121">*132 insurance business and become only an investment company.

After this conference, in a letter dated December 28, 1961, Arthur Pierce and Payne proposed to the director that petitioner temporarily surrender its certificate of authority to transact insurance business and dispose of its policy liabilities, but that for the sake of convenience, petitioner be permitted to continue its corporate existence without modification and with the understanding that petitioner would reapply for a certificate of authority as soon as it was able to concentrate its energies in the sale of insurance. The reason for petitioner's past failure to aggressively engage in writing insurance was that the conditions of an Internal Revenue Service ruling required the Pierces to use most of their time promoting Interstate Lumber and, therefore, they were unable to manage petitioner effectively.

56 T.C. 497">*502 Petitioner did not surrender its certificate of authority but it entered into a reinsurance agreement with Republic National Life Insurance Co. (Republic) under which petitioner reinsured a major portion of its policy liabilities with the understanding that the policies would be ceded back to petitioner at such1971 U.S. Tax Ct. LEXIS 121">*133 time as petitioner was in satisfactory financial position.

Total premiums earned, gross investment income, policies in force issued and reinsured, and total insurance in force by petitioner for the years shown are as follows:

Most of the policies in force, issued and reinsured, listed above were reinsurance as opposed to directly written (issued) policies and Investment Life was the source of nearly all of those reinsurance policies. Almost all of the directly written policies were issued to Payne or to the Pierce family. Petitioner reinsured the bulk of its directly written policies and about 50 percent of its reinsurance policies with BMA and Republic during the year in issue.

For the years 1958 through 1961, petitioner's life insurance reserves as of the beginning and end of each year, the increase to the reserves (after deducting1971 U.S. Tax Ct. LEXIS 121">*134 the investment yield), and the policyholders' share of the investment yield set aside pursuant to section 809 were as follows:

During the years in issue, petitioner's "life insurance reserves" were required by the laws of Arizona and comprised more than 50 percent of petitioner's "total reserves" as those terms are respectively defined in subsections 801(b) and (c). During the same years, petitioner's life insurance reserves were computed or estimated on the basis of recognized mortality or morbidity tables.

During 1960, petitioner paid a $ 413 dividend to its policyholders under section 811 which it deducted under section 809(d)(3).

56 T.C. 497">*503 During the year 1958, petitioner sold two houses described as follows:

If it is determined1971 U.S. Tax Ct. LEXIS 121">*135 that petitioner was a life insurance company under section 801 of the Code during 1958, the gains from those sales are excluded under section 817(d) ² from petitioner's taxable income for that year.

During the years 1959, 1960, and 1961, petitioner sold the assets listed below. These assets were owned by petitioner on December 31, 1958, and were sold for more than their adjusted bases. The fair market value 1971 U.S. Tax Ct. LEXIS 121">*136 as of December 31, 1958, and the year of sale of the assets are as follows:

If petitioner qualifies as a life insurance company under section 801 of the Code for the applicable years, then the gains from the sales of the assets shall be treated as provided under section 817(b) ³ (stepped-up basis treatment).

1971 U.S. Tax Ct. LEXIS 121">*137 As a result of the liquidation of Romney Motor Lodge, Inc., a corporation in which petitioner held a 19 1/4-percent stock interest, petitioner 56 T.C. 497">*504 received in 1961 an undivided proportionate interest in a promissory note payable to Romney Motor Lodge, Inc. The note was executed on February 27, 1961, by Orinn Romney, Jr. (Romney), and his wife Norma. Romney subsequently suffered a nervous breakdown and in 1962 he was in a mental institution and was insolvent. Petitioner's board of directors determined in 1962 that the note was uncollectible and petitioner deducted $ 3,852.13, the amount of their interest in the note, as a bad debt in its income tax return for that year.

In 1958, Arwell and Arthur Pierce traveled to Hawaii. One of them had acquaintances in Hawaii who had expressed an interest in selling insurance in that State for petitioner. On their way to Hawaii, they stopped in Los Angeles and briefly explored the possibility of getting reinsurance business from the Los Angeles area, provided petitioner could qualify to do business in California. At the time of the trip, Inter-American Life was qualified to engage in the life insurance business only in Arizona. Petitioner1971 U.S. Tax Ct. LEXIS 121">*138 reimbursed the Pierces for their travel expenses in the amount of $ 2,857.13, which amount petitioner claimed as a deduction.

Payne timely filed extension requests with enclosed tax payments on petitioner's behalf for the taxable years 1958 through 1962. He prepared the requests while preparing petitioner's annual statements and then gave the annual statements and other information to petitioner's accountants for the preparation of the tax returns. However, no returns were filed and in 1963 when petitioner's records were being audited by a firm of certified public accountants, it was brought to petitioner's attention that no returns had been filed for the years 1958 through 1961.

The filing date, extension request date, extension granted date, the amount of tax paid with the extension, and the tentative amounts of tax due for each of the years 1958 through 1962 were as follows:

1971 U.S. Tax Ct. LEXIS 121">*139 Petitioner timely filed its tax return for the year 1957 and its annual statements with the Arizona Insurance Department for 1958, 1959, 1960, 1961, and 1962, on the forms prescribed by that department 56 T.C. 497">*505 and by the National Association of Insurance Commissioners. All of the above forms were prepared by Payne.

In his notice of deficiency, respondent determined that for the taxable years 1958, 1959, 1960, and 1961, petitioner did not qualify as a life insurance company under section 801 of subtitle A, chapter 1 of subchapter L of the Code. Respondent accordingly recomputed petitioner's taxable income under subchapter B. Respondent determined further that over 80 percent of petitioner's reported gross income for the taxable years 1958, 1960, and 1961 consisted of dividends, interest, rents, and stock transactions and therefore petitioner qualified as a personal holding company as defined by section 542 of the Code and was subject to the personal holding company tax imposed by section 541 of the Code. In addition, respondent determined that part of the underpayment of tax for the taxable years 1958 through 1961 was due to negligence or intentional disregard of rules and regulations1971 U.S. Tax Ct. LEXIS 121">*140 and that petitioner's income tax returns for the same taxable years were not timely filed and that petitioner had not shown that the failure to timely file those returns was due to reasonable cause. Respondent accordingly asserted 5-percent and 25-percent additions to the tax under sections 6653(a) and 6651(a) of the Code, respectively.

Respondent also disallowed deductions of $ 2,857.13 and $ 5,478.87, respectively, for expenses incurred by officers of petitioner on a trip to Hawaii in 1958 and for an operations loss carryback from 1962 to 1959.

OPINION

The first issue for decision is whether petitioner was a life insurance company within the meaning of section 801(a) during the years 1958 through 1961. ⁴

1971 U.S. Tax Ct. LEXIS 121">*141 56 T.C. 497">*506 Section 801, which is applicable to all the years involved, provides in pertinent part:

SEC. 801. DEFINITION OF LIFE INSURANCE COMPANY.

(a) Life Insurance Company Defined. -- For purposes of this subtitle, the term "life insurance company" means an insurance company which is engaged in the business of issuing life insurance and annuity contracts (either separately or combined with health and accident insurance), or noncancellable contracts of health and accident insurance, if --

(1) its life insurance reserves (as defined in subsection (b)), plus

(2) unearned premiums, and unpaid losses (whether or not ascertained), on noncancellable life, health, or accident policies not included in life insurance reserves,