Change in Basis of Computing Reserves — Is It or Isn’t It?

(co-authored with Peter H. Winslow)

High on the list of the most frequently asked questions by tax professionals working for life insurance companies is whether a change in reserving methodology or assumptions will be subject to the “10-year spread” requirements of section 807(f) of the Internal Revenue Code. Section 807(f) applies where there is a change in basis of computing certain reserves of a life insurance company. When applicable, it requires that the difference between the deductible insurance reserves listed in section 807(c) computed under the new method and the reserves computed under the old method as of the end of the year of the change be reflected ratably over 10 years. Usually the question is posed as, “Is the reserve change reflected all at once or is it spread over 10 years?” Understanding when the 10-year spread rule applies is important because it is a favorite topic for Internal Revenue Service (IRS) agents and is included as a disclosure item in the standard tax reserve questionnaire presented by the IRS to life insurance companies at the beginning of audits. And, it is a coordinated issue at IRS Appeals, which means that an individual Appeals Officer cannot settle a section 807(f) issue that has been raised in an IRS audit without first coordinating the proposed settlement with the Appeals Insurance Industry Specialist.

OVERVIEW OF GENERAL ACCOUNTING METHOD RULES VERSUS SECTION 807(f)

The starting place for any analysis of the tax consequences of a reserving change is to determine whether there would be a change in method of accounting for tax purposes in the absence of section 807(f). It is well-settled that section 807(f) is merely a special change-in-method-of-accounting rule for tax reserves and is intended to apply only when an accounting method change otherwise has occurred. Although the application of section 807(f) is triggered by the same factors that give rise to a change in method of accounting, there are four differences in tax treatment. First and perhaps most important—unlike a change in method of accounting—IRS con- sent is not a prerequisite for recognizing a change in basis of computing reserves for tax purposes. A second difference is that an accounting method change is implemented in full in the year of change with both opening and closing items for the taxable year computed on the new method. Under section 807(f), by contrast, only reserves for contracts issued in the year of change are determined under the new method and reserves for contracts issued prior to the year of change stay on the old method until the change for these contracts is implemented in the succeeding year when the opening and closing balances are computed using the new method. The third difference is the year of change in situations where the method from which the change is being made was erroneous. A taxpayer changing its method of accounting from an erroneous method cannot go back and correct the tax return for the first year in which the erroneous method was adopted unless the IRS agrees to the change on audit. Under section 807(f) and, specifically under Rev. Rul. 94-74, the taxpayer is permitted, but apparently not required, to correct an erroneous basis of computing reserves in the earliest year open under the statute of limitations. The fourth way accounting method changes differ from section 807(f) reserve changes is the treatment of the transition adjustment for the amount by which the opening balance of the reserve computed on the old basis is greater or less than the opening balance computed on the new basis. In the case of a change in method of accounting, the Code generally requires that the difference between the old and new method’s opening balances be reflected in taxable income all at once as a “481 adjustment,” although the IRS may provide for a spread of a net positive 481 adjustment as a condition of granting its consent to the change. In the case of section 807(f), the difference in opening reserves on the old and new methods for the taxable year succeeding the year of change is spread ratably over 10 years.