Subchapter L: Can You Believe It? The Internal Revenue Code Requires Companies to Use Statutory Reserve Assumptions for Tax Reserves (Except Where It Doesn’t)
Insurance tax professionals sometimes downplay the role of statutory reserves in the computation of tax reserves, asserting that Federally Prescribed Reserves are required to be computed in accordance with I.R.C. § 807(d). This is an incomplete and often misleading way to describe the tax reserve provisions. In fact, the proper starting place for computing tax reserves is not I.R.C. § 807(d), which provides certain rules for computing life insurance reserves, but I.R.C. § 811, the Internal Revenue Code (the Code) section that sets forth the accounting requirements for determining life insurance company taxable income. This hierarchy of relevant Code provisions has important ramifications in determining deductible tax reserves.
I.R.C. § 811(a) provides a general rule that taxable income for life insurance companies shall be determined using the accrual method of accounting. But, this Code provision goes on to add the following qualification to the general accrual accounting rule:
To the extent not inconsistent with the preceding sentence or any other provision of this part, all such computations shall be made in a manner consistent with the manner required for purposes of the annual statement approved by the National Association of Insurance Commissioners.
In the 1977 Standard Life & Accident case, the Supreme Court interpreted similar language in the predecessor of I.R.C. § 811 to mean that NAIC accounting principles must be used for tax reserves because accrual accounting concepts are not applicable. In that case, the Supreme Court further concluded that accrual accounting should not apply to exclude unaccrued net deferred and uncollected premiums from gross income because doing so would be inconsistent with NAIC accounting. This Supreme Court holding was overturned by Congress in the 1984 Act. Congress amended the accounting provisions in what is now I.R.C. § 811(a) to legislatively reverse the holding of Standard Life & Accident as it related to the timing for recognition of premium income. As a result, premium income is now determined on an accrual basis and unaccrued deferred and uncollected premiums are no longer included in gross income. To make sure that premium income and reserve deductions remained matched, a special provision was added in I.R.C. § 811(c)(1) to exclude deferred and uncollected premiums from tax reserves. Importantly, however, the 1984 Act did not change the Supreme Court’s holding as it related to tax reserves generally; I.R.C. § 811(a) carried over the basic rule that NAIC accounting rules apply to tax reserves, i.e., because tax concepts of accrual accounting do not apply to insurance reserves, which Subchapter L specifically allows as deductions.
It is true that the 1984 Act added new I.R.C. § 807(d) that sets forth specific rules for computing some tax reserves. That Code section provides that life insurance reserves in most, but not all, cases should be computed using the NAIC-prescribed tax reserve method, specified prevailing mortality and morbidity tables and assumed rates of interest. The I.R.C. § 807(d)-mandated tax reserve method and assumptions do not operate in a vacuum, however; they are adjustments made to statutory reserves. The legislative history makes this clear:
Thus, in computing the Federally prescribed reserve, a company should begin with its statutory or annual statement reserve, and modify that reserve to take into account the prescribed method, the prevailing interest rate, the prevailing mortality or morbidity table, as well as the elimination of any net deferred and uncollected premiums (see new sec. 811(c)) and the elimination of any reserve in respect of “excess interest” guaranteed beyond the end of the taxable year (see new sec. 811(d)). Except for the Federally prescribed items, the methods and assumptions employed in computing the Federally prescribed reserve. . . should be consistent with those employed in computing a company’s statutory reserve.
A conclusion that the computation of tax reserves begins with statutory reserves has important consequences when a company makes a change to a statutory reserve assumption by adjusting a factor not prescribed by I.R.C. § 807(d). Is it necessary to make a change to tax reserves to conform with the changed statutory reserve assumptions? The answer is usually yes; I.R.C. § 811(a) requires this result.
Taxing Times, Vol. 12, Issue 3 (October 2016)