Does the form of malpractice insurance control the deductibility of the premium?

Much liability insurance coverage is purchased on an "occurrence basis." This form of insurance protects against loss events that arise during the policy period and is not contingent on the date on which the claim for reimbursement is filed. Another type of liability insurance coverage, commonly offered as protection against malpractice or other acts of misfeasance, takes the form of "claims-made" insurance. Claims-made coverage indemnifies the policyholder for claims reported during the policy period. Under neither form of insurance is the policyholder purchasing insurance protection against loss events arising beyond the end of the current period. With occurrence-based insurance, the policyholder is paying a premium for protection against losses that arise during the current policy period, no matter when reported. With claims-made insurance, the protection is for losses reported in the current policy period.

The IRS has previously concluded that a premium, paid for insurance indemnification for claims reported in future periods but relating to prior-period loss events, is capitalizable, as the benefits pertain to future periods; see Field Service Advice 9925007 and Letter Ruling (TAM) 9402004. That analysis may be incorrect, and could have been explored by the Tax Court in Steger, 113 TC No. 18 (1999). Unfortunately, in reaching its decision, the Tax Court was able to sidestep the question of whether a payment for insurance that provides future claims protection and indemnification against prior acts is a payment for a long-term benefit that must be capitalized.

Prior to his retirement as a practicing attorney, the taxpayer in Steger maintained malpractice insurance. In the year of retirement, he converted his policy to nonpracticing malpractice insurance coverage for a specified premium amount. For an indefinite period, the nonpracticing insurance covered acts, errors or omissions related to the attorney's professional services rendered prior to his retirement from private practice. This coverage, known as "prior acts" liability insurance, was necessary because (although not explicitly stated in the case), the taxpayer previously maintained claims-made insurance. Without the purchase of this "prior acts" (or "tail") coverage, the taxpayer would not have been insured for acts of malpractice that occurred before his retirement, but which were not reported until after his retirement.

The Service challenged the taxpayer's deduction of the entire cost of the nonpracticing malpractice policy, asserting that the policy possessed an indefinite useful life extending beyond one year, which makes it a capital asset under INDOPCO Inc., 503 US 79 (1992).

It was unnecessary for the Tax Court to decide whether the premium expense was capitalizable or a current expense. The court's analysis indicated that, when a business is terminated, the cost of a business asset, regardless of its categorization as a capital asset or an ordinary and necessary business expense, is fully deductible. The Tax Court cited INDOPCO and Malta Temple Association, 16 BTA 409 (1929), for the principle that a capital expenditure is deductible on the dissolution of a business. On the flip side, if the policy is not a capital asset, its cost would be deductible as an expense incurred by a taxpayer in closing his business. Thus, the taxpayer was granted his deduction.

It is unfortunate the court did not examine the nature of the insurance expenditure to determine whether it qualified as a current expense or truly constituted a payment for a capitalizable benefit extending beyond the year. The concept of insurance shifts the risk of a potential economic loss during a period from an insured to an insurer, with the insurer willing to indemnify the insured against that loss. The period of insurance protection is not the period in which claims may be filed, but the period in which the acts giving rise to potential loss occur and the insurer is liable. The Tax Court decision in USFreightways, 113 TC No. 23 (1999), involving the capitalization of an annual premium payment for protection beyond the end of the tax year, is not inapposite, for it holds that liability insurance premium costs are deducted over the period benefited by the expenditure. The period benefiting from the premium payment is the period for which the risk of loss has been shifted to the insurer.

Prior-acts coverage is insurance coverage for claims incurred before the purchase of the policy but reported after the policy is issued; it provides coverage for events that have already occurred. Although the insured is covered for his prior acts for a lengthy period in the future, this type of insurance coverage should not be treated as a separate and distinct capital asset. The events covered by the insurance policy have already occurred. What remains is merely the reporting of losses and claims to the insurer that would occur in the future. The proper matching of income and expense should not concern when a claim is reported, but when the events that caused the claim occur. Thus, insurance expense relating to such past event should not have to be capitalized and amortized over the period in which the claim may be reported. If an attorney had purchased an occurrence-based malpractice policy for the year before retirement (which provided insurance protection for that year, regardless of when a claim is filed), presumably, no one would suggest the capitalization and amortization of that premium over the period in which claims may be filed. The premium for the prior-acts-based liability policy transfers the financial responsibility for a pre-retirement malpractice loss event to the insurer in the same manner as that of an occurrence-based policy. Thus, the insurance expense should be treated no differently and currently deductible.

(Authors' note: The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.)

FROM ARTHUR C. SCHNEIDER, CPA, AND CHARLES LUBOCHINSKI, J.D., LL.M., WASHINGTON, DC