Erroneous Tax Reserve Computations – Year of Correction
A question that frequently arises is whether a life insurance company is permitted, or required, to retroactively correct a tax reserve error that has been made in a previously filed tax return. The answer to this question may depend upon the type of reserve error that has been made. For purposes of analysis, it is useful to classify errors into four general categories:
• Mathematical or posting errors
• I.R.C. § 807(d)1 errors
• Judgmental errors
• Statutory reserve compliance errors.
Before analyzing the consequences of these four types of errors, a review of the basic tax reserve rules that come into play is warranted. Under I.R.C. § 807(d), most life insurance reserves are required to be computed in accordance with the tax reserve method prescribed by the NAIC in effect on the date of issuance of the contract. The tax reserve method for life insurance contracts is CRVM for contracts covered by CRVM, and for annuity contracts it is CARVM for contracts covered by CARVM. For contracts not covered by CRVM or CARVM, the reserve method prescribed by the NAIC as of the date of contract issuance must be used, or, if no method has been prescribed, a reserve method consistent with whichever of the prescribed methods is most appropriate must be used. In applying the tax reserve method, federally prescribed interest rates and prevailing state mortality tables also are required to be used, again, usually determined as of the issue date of the contract. The reserve is then capped by statutory reserves and floored by the net surrender value determined on a contract-by-contract basis. Where particular assumptions, other than interest or mortality, are not prescribed by the NAIC method, the legislative history states that, in general, life insurance reserves are computed by using assumptions made for statutory reserves.
A special rule may apply when a life insurance company changes its basis of computing reserves to correct an error. I.R.C. § 807(f) imposes a “10-year spread” under which the difference between the tax reserves computed under the new method and the reserves computed under the old method as of the end of the year of the change is reflected ratably over 10 years. The 10-year spread rule of I.R.C. § 807(f) is applicable only when there otherwise would have been a change in method of accounting under general tax law principles.
MATHEMATICAL OR POSTING ERRORS
Under the general provisions of the Internal Revenue Code and regulations relating to accounting methods, a mere mathematical or posting error is not a change in method of accounting. Therefore, this type of error is not subject to the 10-year spread rule of I.R.C. § 807(f). The IRS takes the position that most corrections to tax reserves are in the nature of a change in method of accounting and very few situations fall into the category of correction of an error. The IRS has stated that corrections of an error are limited to situations where there are pure mathematical or posting mistakes, such as a defect in the computer program for computing reserves. For example, omitting certain contracts in computing reserves could be considered an error. The Internal Revenue Code does not impose a duty on a taxpayer to file an amended return for a prior year to correct errors when the original return was filed in good faith. Nevertheless, as a practical matter, a failure to file an amended return to correct a material tax reserve error, or to disclose the error at the outset of an audit, could expose the company to accuracy-related penalties. In Rev. Rul. 94-74, the IRS stated that a life insurance company “should” file an amended return to correct mathematical or posting errors.
10 Taxing Times, Vol. 9, Issue 2 (May 2013)