Recent Developments on Policyholder Dividend Accruals

As part of the Deficit Reduction Act of 1984 (the “1984 Act”), life insurance companies are required to use the accrual method of accounting for tax purposes (except with respect to insurance reserves). Previously, life insurance companies were able to claim a deduction for re- serves for policyholder dividends that were to be paid in the following tax year. Following the changes made by the 1984 Act, however, life insurance companies are now required to satisfy the same conditions as other accrual method taxpayers before they can claim deductions for policyholder dividends. For unpaid policyholder dividends on a single contract attributable to the current policy year, the Internal Revenue Service’s (“IRS’s”) position is that the accrual standard is not met as of year-end because, under the terms of the policy, the company is not required to pay a dividend if the policy is surrendered prior to the anniversary date.

In general, an accrual method taxpayer may not claim a deduction for a liability it owes until the “all-events test” is met and “economic performance” occurs with respect to the item. The all-events test requires that all events have occurred that determine the fact of the liability and the amount of the liability can be determined with reasonable accuracy. When economic performance occurs depends on the nature of the liability. If the liability of the taxpayer is to pay a rebate or refund, for example, economic performance generally is treated as occurring when the rebate or refund is paid to the person to whom it is owed. Similarly, when the regulations do not specify the time that economic performance occurs for a particular item, the default rule is that the deduction is deferred until the time that payment is made to the person to whom the liability is owed. Under the recurring item exception, however, an item is treated as incurred, and thus deductible, in a taxable year if: (1) the all-events test is met; (2) economic performance with respect to the liability occurs within the first 8 1⁄2 months following the close of that taxable year (or, if earlier, before the taxpayer files a timely (including extensions) return for that taxable year); (3) the liability is recurring in nature; (4) the amount of the liability is not material or the accrual of the liability for that taxable year results in a better matching of the liability with the income to which it relates than if the liability were accrued in the taxable year in which economic performance occurs; and (5) the liability is a type eligible for the recurring item exception. A rebate or refund is a type of liability eligible for the recurring item exception.

In response to the change in law in the 1984 Act, many companies that issue participating policies changed their business practices so that they could argue that policyholder dividends satisfy the accrual standards as of year-end. A typical way to accomplish this objective is for the board of directors, shortly before the end of the year, to adopt a resolution in which it declares unpaid policyholder dividends, specifies formulae on which policyholder dividends will be paid in the following year, and provides that the company is making an irrevocable commitment to pay dividends in all events of no less than a stated aggregate amount with respect to the entire block of post-1983 policies in force on their next anniversary date (“aggregate policyholder dividends”). The board’s actions, in combination with the terms of the policies, establish the fact of the company’s liability and the amount of that liability. To the extent the aggregate policyholder dividends are paid within the first 81⁄2 months following the close of the taxable year in which they are declared, they meet the requirements of the recurring item exception as a rebate or refund of a portion of the premiums paid with respect to the policies. Thus, the company might claim a deduction for an accrued liability for the aggregate amount of policyholder dividends paid within the 81⁄2-month period.