Insurance Company Bad Debt
The large investment losses that insurance companies suffered during the credit crisis are adding to the workload of their tax departments and the Internal Revenue Service (IRS). Many companies are involved in tax controversies with the IRS, and others are dealing with tax accounting issues arising from the losses. Because of the natural time lag involved in most tax examinations, the partial worthlessness deductions that companies reported in 2008 and 2009 are just now ripening into proposed adjustments from IRS examiners. Many insurance companies reported large partial worthlessness deductions that are now under scrutiny by IRS examiners. The examinations have created uncertainty and are beginning to result in resource demands on the part of the industry as IRS examiners attempt to verify compliance with bad debt deduction requirements. For this reason, the industry and the IRS have agreed to try to resolve the problem through the IRS’s Industry Issue Resolution (“IIR”) program. We have addressed insurance company bad debts several times in prior Taxing Times articles, but did not have the benefit of the IRS examiners’ positions at the time those articles were written. This article summarizes some of the key issues the IRS and insurance companies are grappling with in the tax compliance and examination process that led to the IIR project.
There are two major tax issues to think about when investments are impaired. The first is whether to continue to accrue interest or discount on the instruments. The second is whether a principal write-down is available, and if so, when. Related to the second issue is whether any write-down will be ordinary or capital in character. The income accrual issue has not drawn significant attention thus far from IRS examiners, but is worth reviewing because of its important tax compliance implications. Treasury Regulation § 1.451-1(a) applies the accrual method of accounting and requires an income inclusion when all events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. For interest, this standard is met when interest is economically earned, payment is due or payment is received. A common law exception to this requirement to accrue income applies when there is a “reasonable doubt as to collectability” at the time the standard otherwise would be satisfied. In the banking context, the IRS has taken the position in a revenue ruling that the doubt as to collectability must be “substantial” in order for the accrual exception to apply.
There are additional issues regarding how the income accrual exception applies in the context of Original Issue Discount (“OID”) and market discount, which are economic substitutes for stated interest. OID is the discount at original issue and is equal to the excess of the stated redemption price at maturity over the issue price. Taxpayers other than life insurance companies are required to follow detailed income recognition rules in I.R.C. § 1272 under which they recognize OID in income on a constant yield basis over the term of the instrument. The income recognition rules are intended to replicate accrual accounting for OID. The IRS has taken the position in a widely criticized Technical Advice Memorandum (“TAM”) that the common law exception to income accrual for doubt as to collectability does not apply at all to OID and that taxpayers must continue to accrue OID even after they know with certainty that they will never collect the discount. The IRS based its conclusion primarily on the fact that the OID rules in I.R.C. § 1272 do not provide an explicit exception for doubtful collectability. This ignores the fact that the exception to income accrual is a common law exception based on the basic principle that a taxpayer “cannot be charged to have realized an income unless there exists reason for believing that the income is likely to be paid.” The IRS made other technical arguments in support of the conclusion, but there is a general consensus in the tax bar that the TAM is erroneous and that the same common law exception that applies to interest accruals also applies to OID.
19 Taxing Times, Vol. 7, Issue 3 (September 2011)