The IRS released a private letter ruling* concluding that changes in related life insurance companies’ reserves were changes in basis subject to Code section 807(f). PLR 201511013 (release date March 13, 2015, and dated November 13, 2014)
PLR 201511013 [PDF 60 KB] represents the first significant, albeit private, guidance on reserve changes since the issuance of Rev. Rul. 94-74, 1994-2 C.B. 157
*Private letter rulings are taxpayer-specific rulings furnished by the IRS National Office in response to requests made by taxpayers and can only be relied upon by the taxpayer to whom issued. It is important to note that, pursuant to section 6110(k)(3), such items cannot be used or cited as precedent. Nonetheless, such rulings can provide useful information about how the IRS may view certain issues.
The letter ruling addresses reserve changes by two related insurance companies.
IC N entered into reinsurance agreements with unrelated third parties in which it assumed risks under whole life insurance contracts and term life insurance contracts.IC N then entered into a reinsurance agreement with IC O under which IC N retroceded the risks on the term life insurance contracts to IC O under a 100% coinsurance arrangement. IC N retained the risks on the whole life insurance contracts.
IC N received policy level data from the cedants with respect to the insurance contracts underlying the reinsurance agreements.
IC N and IC O maintained two information technology systems to account for the data relating to the reinsurance agreement with the unrelated third parties and the intercompany reinsurance of the term life business. A policy administration system tracked data relating to premium, benefit payments, and all relevant items other than life insurance reserves. Life insurance reserves were administered through a valuation system. The two systems maintained the accounting records for the contracts then transferred the data into the general ledger systems that were used to prepare financial statements, including the statutory financial statements that were used to prepare the companies’ federal income tax returns.
In tax year U, it was determined that certain of the whole life insurance contracts were improperly coded in the valuation system as term life insurance contracts. Because of this coding, the valuation system improperly treated the reserves on the contracts as ceded by IC N to IC O even though the contracts were retained by IC N under the terms of the reinsurance contract between IC N and IC O. As a consequence, the life insurance reserves were improperly reported on the statutory annual statement and federal income tax returns of IC O rather than IC N.
All other relevant items of income and deduction, including premiums, claim payments and expenses were reported by the proper legal entity. The reserve deductions associated with the improperly coded contracts were reported by the wrong legal entity for more than one tax years.
Because the deduction for claims paid under life insurance contracts was tracked in the administration system, the claims were reported on the appropriate legal entity when paid. When a claim is paid, the life insurance reserve associated with that insurance contract is released. Thus, the inappropriate reporting of the life insurance reserve is inherently self-correcting over time.
IC N and IC O discovered the incorrect treatment of the reserves and recorded the reserves in the appropriate legal entity for statutory accounting purposes in tax year U.
The letter ruling concludes that the changes in the life insurance reserves of IC N and IC O are changes in basis of computing reserves subject to the 10-year spread rules of section 807(f).
Tax year U is treated as the year of change.The taxpayers’ opening balances of the reserves for tax year V will be adjusted to properly state the reserves and the change for each entity (i.e., a deduction for the increase in reserves for IC N and income for the decrease in reserves for IC O) is spread over 10 years.
There has been scant guidance on section 807(f) since Rev. Rul. 94-74 was issued 20 years ago, so this ruling provides needed insight into the IRS’s position on changes to life insurance reserve computations.
The calculation of life insurance reserves under section 807(d) is highly complex; it is based in complicated actuarial guidance and principles, as well as information technology systems that are constantly evolving. Consequently, life insurance companies frequently make changes to their statutory and tax reserve calculations. Section 807(f) is a provision that allows taxpayers to correct or adjust the basis of their reserve calculations without requiring consent of the IRS to change these calculations.
There has long been uncertainty as to whether certain types of changes are “changes in basis” subject to section 807(f), accounting method changes subject to section 446, or “errors.”
Rev. Rul. 94-74 provided some guidance on identifying changes in basis under section 807(f) and concluded that even changes in computations in a taxpayer’s reserves for items which are mandated by statute, such as interest rates or mortality tables, are changes in basis rather than corrections of errors. Example 4 of the revenue ruling, however, provides that at least some computer coding errors are not changes in basis under section 807(f) and are “errors.”
Reserve calculations are complex and generally made using computer systems. It is often difficult to discern whether a particular issue is caused by a programming error, an input error, or a mistake in categorizing a contract that leads to an incorrect calculation. While Rev. Rul. 94-74 was sufficient to deal with most changes in reserves, it did not adequately address the intersection of section 807(f) with the rules in section 446 and the regulations thereunder, which distinguish between changes in accounting methods and corrections of errors.
PLR 201511013 helpfully clarifies that section 807(f) is a “subset” of accounting method changes governed by section 446. Analytically, one first addresses whether the change in the reserve calculation is a method change or an error under section 446. Under Reg. section 1.446-1(e), items that one might typically think of as errors are treated as changes in method under section 446 if they are recurring and temporary (i.e., they do not result in a permanent reduction or increase in the taxpayer’s taxable income). Therefore, the population of items categorized as errors under section 446 is fairly narrow and generally limited to nonrecurring items. If the change in reserves meets the definition of an accounting method (nonpermanent and recurring), then it is subject to section 807(f).
The private letter ruling appears to take a very broad view of what types of changes in the calculation of a reserve constitute a “change in basis.” In this situation, the reserve was properly computed. There was no change proposed in the calculation of the life insurance reserve for any of the contracts underlying the reinsurance agreements. The only issue was that the reserve was reported in the wrong legal entity. The IRS could have concluded that the change at issue in the ruling was a change in accounting method governed by section 446 because there was no change in the calculation of the amount of the reserve, which one might think necessary for section 807(f) to apply. The letter ruling seems to support the proposition that the concept of a “change in basis” is broad enough to encompass reserve changes that do not involve the calculation of the reserve itself.
The facts at issue in the private letter ruling appear viscerally similar to the facts in Rev. Rul. 94-74 Situation 4, which was the only example of an “error” in the ruling. In Situation 4, the insurance company discovered that due to a computer programming error, certain policies had been omitted from the computation of the company’s closing reserves. Had the omitted policy been included, the company’s closing life insurance reserves under section 807(d) would have been greater than the amounts originally claimed. Rev. Rul. 94-74 concludes that the correction for omission of reserves for certain contracts is not a change in basis under section 807 (f) or a change in method of accounting under sections 446 and 481.
The key distinction between the recent letter ruling and Situation 4 is that the “error” in Situation 4 was nonrecurring—the accounting method change rules in Reg. section 1.446-1(e) require that the mistake occur for more than one tax year. This distinction was made by the IRS in Examination and Appeals Coordinated Issue Papers released subsequent to Rev. Rul. 94-74.
The calculation of the actuarial reserve is only one item that is used to compute the deduction allowed for a reserve under section 807. The other relevant items are the net surrender value of the contract, which serves as a “floor” on the reserve, and the statutory reserve which serves as a “cap” on the reserve deduction. Most practitioners have not viewed changes in the net surrender value or the statutory reserve held with respect to a contract that changes the amount deductible under section 807 as a change in basis. Typically, these items have been viewed as changes in limits around the deduction and as representing neither changes in basis under section 807(f) nor accounting method changes governed by section 446.
The recent letter ruling gives rise to an interesting, unanswered question as to whether, for instance, changes in the calculation of the statutory reserve which indirectly affect the amount of the reserve deduction allowed for a contract is a change in method of accounting even if it does not constitute a change in basis.
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