Subchapter L: Can You Believe It? Change in Tax Status of an Insurance Company-IRS Eliminates Catch-22 Situations
An insurance company is taxed as a life insurance company under Part I of Subchapter L of the Internal Revenue Code (the “Code”) only if it satisfies a reserve ratio test found in I.R.C. § 816(a). Under this test, an insurance company is taxed as a life insurance company for its entire taxable year if the company’s life insurance reserves plus unearned premiums and unpaid losses on noncancellable life, accident or health policies exceed 50 percent of its total insurance reserves. This test is performed on the basis of the mean of the opening and closing reserves for the taxable year. Because of this bright-line 50 percent reserve ratio test, insurance companies may sometimes shift tax status from nonlife to life company status and vice versa. This most frequently occurs for companies that issue a significant amount of both group cancellable and individual noncancellable accident and health insurance policies.
There can be material differences in the tax treatment of several items depending on whether the company is taxed as a nonlife company under Part II of Subchapter L or as a life company under Part I. To the extent the varying tax treatments result in timing differences, it is the Internal Revenue Service’s (IRS’) position that a change in tax status will result in changes in methods of accounting for these timing differences. Why does this matter? Before a taxpayer can implement a change in method of accounting, I.R.C. § 446(e) requires the taxpayer to secure the consent of the IRS. The IRS has detailed procedures for taxpay- ers to follow to secure the IRS’ consent for a change in accounting, but until recently these procedures did not permit an insurance company that changed its tax status to secure the necessary IRS consent in time to file a correct tax return. This created a classic Catch-22 situation. The Code requires the taxpayer to change to different accounting methods when it changes insurance company status, yet also precludes compliance until IRS consent is granted, which under former IRS procedures could be difficult to obtain in a timely manner.
Let’s take a typical example. Suppose an insurer issues both group cancellable disability insurance and individual noncancellable disability insurance policies. For many years, the company’s group business was dominant, but the individual market gradually expanded to such an extent that it became likely, but not certain, that the 50 percent reserve ratio test for life company qualification would be satisfied for the first time. If this were to occur, the company would shift its tax status from nonlife to life company treatment for the entire taxable year, even though it could not make an accurate calculation of mean reserves until after the year of the shift.
Among other tax consequences, this situation could result in several timing differences. The most likely would be for experience-rated refunds on the group products, loss adjustment expenses (LAEs) and guaranty fund assessments. For life companies, experience-rated refunds are treated as policyholder dividends and deductible when accrued under the general accrual provisions of I.R.C. § 811(a). I.R.C. § 808(b)(1) specifically includes experience-rated refunds as policyholder dividends which are deductible when paid or accrued during the taxable year under I.R.C. § 808(c). For nonlife companies, experience-rated refunds may be deductible before they accrue as return premiums or policyholder dividends on a reserve basis.
LAEs are costs that are incurred in connection with the adjustment or recording of losses. These expenses include legal expenses, salaries and expenses of the claims department as well as all other claims-related expenses whether or not specifically allocable to particular claims. For a life company, it is the IRS’ position that these expenses are deductible when accrued under I.R.C. § 811(a). Thus, according to the IRS, life companies may not deduct reserves for LAEs that do not meet the “all-events” test under I.R.C. § 461. For nonlife companies, different treatment applies for LAEs. Unpaid LAEs reported on the Annual Statement are included in the calculation of a company’s un-discounted unpaid losses under I.R.C. § 846(f)(2) and, therefore, are deductible on a reserve basis as part of discounted unpaid losses. Similarly, for guaranty fund assessments, life companies generally are required to deduct these amounts on an accrual basis. However, nonlife companies are entitled to deduct the unaccrued liability for guaranty fund assessments on a reserve basis as premium-acquisition expenses.
T3: Taxing Times Tidbits, Taxing Times, Vol . 12, Issue 1 (March 2016)