Adjustments to life insurance reserves | KPMG | GLOBAL

Adjustments to life insurance reserves determined as change in basis

Adjustments to life insurance reserves

An IRS field attorney advice memorandum* concludes that an increase in a life insurance company’s tax reserves for an annuity rider due to a change in the statutory reserve, which eliminated the effect of the statutory cap, is a change in basis in computing reserves subject to section 807(f).

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Related content

Read FAA 20165101F [PDF 9.91 MB] released on December 16, 2016, and dated June 7, 2016

 

*Field legal advice memos are documents prepared by IRS field attorneys in the Office of Chief Counsel that are reviewed by an Associate Office, and subsequently issued to field or service center campus employees of the IRS. They are not to be used or cited as precedent.

Background

The redacted field advice memo reveals that:

  • Taxpayer is the parent of a life-nonlife consolidated group that includes two life insurance companies. 
  • The life insurance company subsidiary of the parent started marketing a rider to specified annuities.
  • In performing statutory reserve valuations for the first three years, the company understated its statutory reserve liability. During these years, the understated statutory reserve served as a cap on the amount of the tax reserves.  
  • The understated statutory reserves were subsequently corrected in Year 4, with the company reporting an increase in statutory reserves at the beginning of that year due to a change in computing the understated reserve at the end of Year 3. 
  • The corrected (and higher) statutory reserves no longer capped the tax reserves.  
  • Taxpayer argued that the increase to the tax reserves as a result of the elimination of the statutory cap was not subject to section 807(f) because there was no change in Year 4 to the computation of the Federally Prescribed Reserve (FPR) under section 807(d).  

Issue and positions

At issue was whether there was a change in basis subject to section 807(f) in Year 4 when the parent company computed its tax reserves taking into account the corrected statutory reserve methodology.

  • IRS position: Under section 807(d), the required tax reserve is generally the FPR, unless the statutory reserve is lower. The IRS asserted that when the statutory reserve "limitation" applies, the amount of the reserve is identical—whether characterized as the tax reserve subject to the statutory reserve limitation, or the statutory reserve. The IRS further concluded that, when the statutory reserve limitation applies, there is no distinction between a statutory reserves "limitation" and a statutory reserves "method." When the limitation applies, statutory reserves determine the amount of the tax reserve, and thus a change in the statutory reserve method is a change in basis.
  • Taxpayer’s position: Taxpayer claimed that the only method of accounting involved in the computation of the tax reserve is the method of computing the FPR without regard to the statutory reserve limitation (or, presumably also, the net surrender value floor). Taxpayer argued that there is no change in basis when there is a change in the method of computing statutory reserves, if, in the year of change, the computation of the FPR has not changed.

Legal advice

An adjustment to the consistent treatment of an item that affects the timing for recognition of the item and does not permanently change lifetime income is a change in method of accounting. Huffman v. Commissioner, 518 F.3d at 363 (6th Cir. 2008).  The computation of life insurance reserves does not have a permanent effect on the taxpayer's lifetime taxable income, as any deduction for the increase in reserves will ultimately be offset by the release of the reserve and the recognition of this amount in income. American Mutual Life Ins. Co. v. United States, 267 F.3d 1344, 1350 (Fed. Cir. 2001). Based on this logic, the IRS concluded that the computation of life insurance reserves is a method of accounting.  

Taxpayer made two arguments that section 807(f) does not apply.  

  • The first argument, using analogous language from the 1984 Act Blue Book, was that the statutory cap, like the cash surrender value floor, is not subject to the 10-year spread of section 807(f). The IRS disagreed, noting that a change in the reserve method under section 807(d) would be subject to section 807(f) whether arising from a change to the FPR or a change in the application of the statutory cap. 
  • The second argument was that the statutory reserves should not be included in section 807(f) because these amounts are not “computed” under section 807.  Again, the IRS disagreed, noting that prior to 1984, the applicable method for determining life insurance tax reserves was the statutory reserve; statutory reserves qualified as an accounting method; and changes in statutory reserves "transcribed" onto the tax return were changes in basis. 

The IRS legal advice concludes that the difference between the statutory reserves computed on the correct method as of the end of Year 4, and reserves computed as of the end of Year 4 on the prior incorrect method is attributable to a change in basis that must be recognized under section 807(f), beginning in Year 5. 

The IRS addressed and rejected Taxpayer’s arguments in support of its position that the statutory reserve is not a component of the tax reserve method of accounting.

KPMG observation

In this field advice memo, the IRS concludes that a change in the statutory cap (due to understated statutory reserves) is subject to 807(f).  The IRS field advice rejects the position that the amount of the statutory cap is merely lifted from the annual statement and not computed for tax purposes. 

Tax professionals have expressed concerns that a field attorney advice memorandum is not the proper vehicle for the IRS to announce such a position, and believe that the IRS needs to propose guidance and allow potentially affected taxpayers to comment on such proposals, and that any rule developed would need to be applied on a prospective basis.

 

For more information, contact a tax professional with KPMG’s Washington National Tax practice:

Sheryl Flum | +1 (202) 533-3394 | sflum@kpmg.com

Fred Campbell-Mohn | +1 (212) 954-8316 | fcampbellmohn@kpmg.com

Liz Petrie | +1 (202) 533-3125 | epetrie@kpmg.com

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