What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax IRS Challenges Property and Casualty Policyholder Dividend Deductions Property and casualty insurance companies are allowed a deduction for dividends and similar distributions paid or declared to policyholders. This article describes a pending case in which the timing of the policyholder dividend is at issue and explains the positions of the insurance company and the IRS. The IRS is challenging the timing of an insurance company s deductions for policyholder dividends. The IRS has challenged LUBA Mutual Holding Company and its predecessor companies (collectively, LUBA ) with regard to policyholder dividend deductions for workers compensation coverage. 1 Monday, October 7, 2013 by Mark Halpin, Financial Services, and Jean Baxley, Washington National Tax Mark Halpin is a senior manager with the Financial Services practice (Chicago). Jean Baxley is a director in the Financial Institutions and Products group of Washington National Tax. In the litigation, the IRS is attempting to impose the all events test for accrual and the attendant section 461(h) economic performance requirement on LUBA s deduction, which is governed by section 832(c)(11). The all events test and economic performance requirement which the IRS interprets to mean that a deduction is available when the dividend is paid and no earlier unless an exception (such as the recurring item exception) applies are applicable generally to non-insurance company accrual method taxpayers and have applied to life insurance company policyholder dividends since Tax Reform Act of changed the standard for life companies. The IRS s current litigating position disregards the fact that non-life insurance companies are subject to special tax accounting rules for specific items of insurance-related income and deductions, including the deduction for policyholder dividends. The IRS has taken the position that nonlife insurance company policyholder dividend deductions must clear the all events and economic performance hurdles, notwithstanding relatively unambiguous precedential authority inconsistent with its position. Put in context, this controversy represents another attempt in a series of attempts by the IRS to overturn settled principles of insurance tax law and 1 2 See the Petition in LUBA Mutual Holding Company v. Commissioner, Tax Ct. Dkt. No (filed Oct. 5, 2012). Pub. L. No , 98 Stat. 494 (July 18, 1984)( 1984 Act ). KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.

2 IRS Challenges Property and Casualty Policyholder Dividend Deductions page 2 to superimpose general accrual accounting tests on an insurance company deduction that is subject to a special tax accounting rule applicable to insurance companies only. Background LUBA Mutual Holding Company is the holding company of a mutual insurance company that writes workers compensation coverage. From its inception in 1991 until January 1, 2006, the LUBA insurance entity operated as a workers compensation self-insurance fund. In 2006, the self-insurance fund converted to a mutual insurance company. In 2007, the LUBA mutual insurance company converted to a mutual holding company structure. The LUBA insurance entity has historically filed its federal income tax returns as a property-casualty company, and has declared and paid dividends to its policyholders. For and in each of the tax years at issue, 2002 through 2005, LUBA s board of trustees passed resolutions declaring policyholder dividends in the amount of LUBA s book income. LUBA s board declared approximately $17 million in policyholder dividends in 2002 through In the year immediately following the year of each dividend declaration, and once LUBA s year-end audited financial statements for the declaration year were available, LUBA s board of trustees passed a second resolution for the declared dividend setting forth the exact amount of the dividend for that declaration year. LUBA paid policyholder dividends in each of the years 2002 through LUBA deducted its policyholder dividends in the year the dividends were declared in accordance with the plain language of section 832(c)(11). The IRS disallowed LUBA s deductions for declared dividends. The IRS, however, did allow LUBA s claimed deductions for the portion of LUBA s policyholder dividends that was actually paid to its policyholders. Unless otherwise indicated, references to section or sections in this article are to the Internal Revenue Code of 1986 (the Code ), as most recently amended, or to the U.S. Department of the Treasury regulations (the regulations ), as most recently adopted or amended. For Property and Casualty Companies, the Policyholder Dividends Deduction Is Allowed For the Year in Which Dividends Are Paid or Declared Nonlife insurance companies are allowed a deduction for dividends and similar distributions paid or declared to policyholders. 3 A dividend is deductible when it is paid or declared in accordance with the method of 3 Section 832(c)(11).

3 IRS Challenges Property and Casualty Policyholder Dividend Deductions page 3 accounting regularly employed in keeping the books of the insurance company. 4 The deduction, or a reasonably accurate estimate thereof, for nonlife dividends and similar distributions declared to policyholders for any tax year equals (1) dividends and similar distributions declared but unpaid at the end of the tax year, plus (2) dividends and similar distributions paid during the tax year, minus (3) dividends and similar distributions declared but unpaid at the beginning of the tax year. Essentially, the deduction is for dividends paid during the year plus the increase in dividends declared during the year. 5 Comparing the paid or declared language in section 832(c)(11) to the life company policyholder dividend deduction language in section 808(c), which allows a deduction for policyholder dividends paid or accrued, one would expect that nonlife companies have a lower threshold for deductibility than life companies i.e., declaration for nonlife companies versus accrual for life companies. Indeed, the 1984 Act changed the policyholder dividend deduction standard applicable for life companies, subjecting their policyholder dividends to the all events test. Of course, this test can and has been satisfied through certain dividend guarantees and by applying the recurring item exception to allow for deductibility in the year the dividends are guaranteed. LUBA s policyholder dividends would appear to meet the declaration standard of accrual for property and casualty companies. 6 Relevant Authority and Current Controversy The IRS has acknowledged in published guidance that declaration is sufficient for deduction. Revenue Ruling addresses whether dividends to policyholders declared during the tax year for book accounting purposes are deductible for tax purposes when the dividends are declared. In the ruling, the taxpayer insurance company s board of directors declared a policyholder dividend in the amount of all the company s profits in excess of a certain dollar amount, to be paid in the year following the year of declaration. At the time of declaration, the amount of the dividend was not yet known. Citing Treasury regulation section as support, the Id. Section Massachusetts Mutual Life Ins. Co. v. United States, 103 Fed. Cl. 111 (2012), confirms that a guarantee of policyholder dividends in the aggregate constitutes an accruable event C.B. 210.

4 IRS Challenges Property and Casualty Policyholder Dividend Deductions page 4 IRS concluded that the dividend was deductible in the tax year at issue. Accordingly, under Revenue Ruling , a nonlife insurance company may deduct policyholder dividends in the year of declaration despite that the dividends (1) are declared in unspecified amounts representing all or a specified portion of net profits of such year and (2) are not paid until the following year. Existing case law also supports the deduction of property and casualty company policyholder dividends when declared. In both Bituminous Casualty Corp. v. Commissioner, 8 and Commercial Fishermen's Inter- Insurance Exchange v. Commissioner, 9 the U.S. Tax Court held in favor of the taxpayer on this issue, allowing the policyholder dividends deduction in conformity with each taxpayer s annual statement treatment. In Commercial Fishermen's, the Commissioner acknowledged that the word declared as used in the statute was the governing word with respect to the taxpayer, and agreed that if a dividend has been declared so as to become an indebtedness or accrued liability of the taxpayer, the statutory requirement for deductibility is met regardless of when or how the liability is paid. In the LUBA controversy, the IRS is nonetheless asserting that the all events test applies. Under Treasury regulation section (c)(1)(ii)(A), a liability of an accrual method taxpayer is incurred and deductible for federal income tax purposes in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Accordingly, the all events test is two-pronged (fact and amount of the liability) and economic performance generally requires payment of the liability as a precursor to deduction. The IRS is asserting that LUBA s declarations are insufficient to establish the fact of LUBA s liability under the all events test, so LUBA s declared policyholder dividends are not deductible as claimed. The IRS argues here that the dividends are contingent and too uncertain to be accrued although this argument appears to contradict the conclusion in Revenue Ruling and the holdings in Bituminous Casualty and Commercial Fishermen's. On the economic performance front, the IRS argues that T.C. 58 (1971). 38 T.C. 915 (1962).

5 IRS Challenges Property and Casualty Policyholder Dividend Deductions page 5 since payment has not occurred by year end LUBA fails this test as well. This position is consistent with the trilogy of letter rulings issued by the IRS in In Private Letter Rulings , , and (Sept. 30, 2009), the IRS Office of Chief Counsel took the position that the all events test applied to nonlife policyholder dividend deductions and concluded that the dividends declared by the taxpayer did not meet the test instead characterizing the declared policyholder dividends as a solvency reserve for increased claims in the future. The discussion in the private letter rulings does not focus on the standard for deduction in section 832(c)(11) but instead discusses general accrual accounting standards applicable to deductions. The conclusion in the private letter rulings that the policyholder dividends are not deductible in the year declared reflects the IRS s reluctance to allow a deduction for an item prior to the time it is actually paid. In LUBA s situation, the exact amount of the policyholder dividend for each policyholder is affected by future profits, which may be decreased by future adverse claims loss development. This fact has led the IRS to assert that LUBA s obligation to pay the declared dividend is conditional because payment is dependent on the company reaching a certain financial result. Yet even if the all events test were to apply, which it does not under the statute, the IRS s own recent guidance in Revenue Ruling regarding the accrual of bonuses for a group of employees allows for some uncertainty regarding the precise amount of each payment and each recipient without negating the fact of the liability for section 461 accrual purposes. Statutory Accounting Treatment of Policyholder Dividends Property and casualty insurance companies account for policyholder dividends in accordance with Statement of Statutory Accounting Principles ( SSAP ) No. 65, paragraphs 45 and 46. Under SSAP 65, a company classifies and records dividends to policyholders as liabilities when they are declared by the company s board of directors. Incurred policyholder dividends are reported in the statement of income. Under statutory accounting rules, the policyholder dividends declared by LUBA in a given year are reflected as a reduction of statutory income. The Code is clear that nonlife company policyholder dividends are deductible when paid or declared, so looking to statutory treatment likely is not necessary to I.R.B. 824.

6 IRS Challenges Property and Casualty Policyholder Dividend Deductions page 6 resolution of this tax issue. However, allowing the deduction for the years in which the dividends at issue were declared would be consistent with statutory principles. Stay Tuned... The IRS s challenge to LUBA s policyholder dividends deduction reflects its discomfort with allowing a deduction for an item before payment has occurred. Particularly because workers compensation is such a long-tailed line of coverage, the IRS may believe there is a substantial and unacceptable delay between the declaration of a policyholder dividend for a particular year and the payment of that dividend. To assuage its discomfort, however, the IRS is stuck arguing that the paid or declared standard in section 832(c)(11) does not replace the basic all events and economic performance requirements applicable to accrual method taxpayers generally, although the plain language of section 832(c)(11) is unambiguous. 11 Briefing has not yet occurred in the LUBA case. Trial was set for September 2013, but in July 2013 the parties filed a joint motion to continue, which was granted. If the case goes to trial, LUBA s arguments likely will focus on the plain language of section 832(c)(11), which allows the deduction of policyholder dividends paid or declared; the IRS likely will attempt to impose the all events test in spite of the plain language of the Code. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. 11 The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP. See P.L.R (Sept. 30, 2009) ( The Service believes that the economic performance provisions of 461(h) (enacted in 1984) literally applies to all accrual basis taxpayers... ; concluding that the declared dividend was not a policyholder dividend, and that the exception to economic performance in section 461(h)(5) did not apply).