Recent Cases on Changes from Erroneous Accounting Methods—Do They Apply to Changes in Basis of Computing Reserves?

A special rule applies when a life insurance company changes its basis of computing reserves. Section 807(f) of the Internal Revenue Code 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. In general, the 10-year spread rule of section 807(f) is applicable only when there otherwise would be a change in method of accounting under general tax law principles. Although the same type of events will trigger the 10-year spread rule and a change in method of accounting, there are four important differences in their consequences.

First, Internal Revenue Service (“IRS”) consent is not a prerequisite for recognizing a change in basis of computing reserves for tax purposes as it is for a change in method of accounting. Second, a change in method of accounting is fully implemented in the year of change, with the opening and closing items for that year computed under the new method. Under the 10-year spread rule, only reserves for contracts issued in the year of change are determined under the new method; contracts issued in prior years remain on the old method until the succeeding year, when the opening and closing balances are computed using the new method. Third, a taxpayer changing its method of accounting from an erroneous method is not permitted to go back and correct the tax return for the first year in which the erroneous method was adopted unless the IRS agrees to the change. Under the 10-year spread rule, a taxpayer changing from an erroneous method of computing reserves is permitted, but apparently not required, to make the correction in the earliest year open under the statute of limitations. Finally, when a change in method of accounting is made, a taxpayer generally must reflect the difference between the old and new method’s opening balances in taxable income all at once as a “481 adjustment,” although the IRS may provide for a spread of a net positive 481 adjustment as a condition of granting its consent to the change. Under the 10-year spread, the difference between opening reserves under the old and new methods for the taxable year succeeding the year of change is spread ratably over 10 years.

The application of section 807(f) to tax reserve changes is discussed at length in an article in the February 2010 Taxing Times. Since that article, two court cases have come out dealing wth change-in-method-of-accounting issues. In both cases, the taxpayers had been on an erroneous method and either the IRS or the taxpayer sought a change to a correct method. We thought it might be interesting to review the courts’ conclusions in these cases to examine whether or how they may apply to changes in basis of computing reserves to correct errors.