The Statutory Reserve Cap on Tax Reserves Includes Deficiency Reserves
With the hiring of Interal Revenue Service (IRS) tax actuaries in recent years, IRS examiners are paying closer attention to life insurance reserves in general. In addition to technical issues pertaining to how the reserves are computed, the agents are raising basic legal questions sometimes casting doubt on settled law. One area of particular attention has been deficiency reserves. In a troubling development, examiners are dredging up an old Field Service Advisory (FSA) from 1993, in which a National Office attorney incorrectly concluded that the statutory reserve cap in Internal Revenue Code section 807(d)(1) excludes deficiency reserves. A deficiency reserve is a reserve in addition to the basic life insurance reserve that is equal to the present value of the excess of future net premiums over future gross premiums to be received on a life insurance contract. Historically, deficiency reserves were not deductible because they were held to be an additional reserve that is not held for future claims (i.e., a type of surplus reserve). The prohibition on the deduction of deficiency reserves carried over into the 807(d)(3)(C), in turn, provides that the FPR cannot include deficiency reserves. The issue addressed in the FSA is whether the exclusion of deficiency reserves applies only to the FPR calculated under the assumptions in section 807(d), or also to the aggregate statutory reserve cap.
The most logical place to start the analysis of whether the aggregate statutory reserves cap in section 807(d) includes deficiency reserves is with an explanation of the dual role statutory reserves originally played in the 1984 Act. Under the 1984 Act, aggregate statutory reserves were used not only to cap the tax reserve deduction, but also to measure the increase to a mutual company’s equity base in order to calculate the differential earnings amount for the reduction of the policyholder dividend deduction. The computation of the equity base began with a mutual company’s surplus and capital as reflected on its NAIC annual statement, which was then adjusted for several items. One adjustment was to increase the equity base by the excess of the “aggregate amount [of reserves] set forth in the annual statement” over the amount of tax reserves. Because this adjustment resulted in a larger reduction of the policyholder dividend deduction, the Joint Committee on Taxation’s Staff Report (1984 Bluebook) makes it clear that Congress wanted to make sure that statutory reserves for this purpose included deficiency reserves. The 1984 Bluebook also makes it clear that the statutory reserve cap, like the section 809 differential earnings amount determination, includes deficiency reserves. With regard to the cap, the 1984 Bluebook specifically states:
In no event will the amount of the tax reserves at any time exceed the amount of statutory reserves, which (given the general definition thereof in new sec. 809(b)(4)(B)(i)), include also any deficiency reserves relating to the liabilities.
14 Taxing Times, Vol. 2, Issue 2 (September 2006)