Insurance company planning.

Tax benefit rule

In Allstate Insurnce Co., Fed. Cir., 6/19/91, rev'g Cl. Ct., 1990, the Court of Appeals has held that the "tax benefit rule" entitled Allstate to exclude from taxable income subrogation recoveries in 1971 related to losses incurred in 1969. The tax benefit rule allows taxpayers to exclude from income amounts recovered from a previously deducted loss to the extent that the previous deduction generated no tax benefit.

Allstate, a property and casualty insurance company, had claimed a deduction for losses incurred in its insurance business in 1969. Because of the alternative capital gains tax, a portion of its ordinary deductions in 1969 was not used to reduce tax liability. In 1971, Allstate recovered subrogation from third parties that related to the incurred loss deduction claimed in 1969.

The court explained that the tax benefit rule insures equitable treatment for taxpayers who use estimates of income or loss on their annual tax returns for transactions spanning several annual accounting periods. Subrogation recoveries are often collected and reported after the year of the loss deduction. Because Allstate received no tax benefit for $1.8 million of losses incurred in 1969, it could exclude that amount from its subrogation income in 1971. The court believed Allstate had established sufficient linkage between the 1971 subrogation recoveries and the 1969 loss deductions.

The Allstate decision reinforces the need to challenge other income items that could possibly be excluded from taxable income because of the tax benefit rule.

Estimated taxes 

In certain circumstances, life insurers who have an existing "policyholders' surplus account" under Sec. 815 can minimize their estimated tax payments by making an election to transfer a minimal amount in the policyholders' surplus account to the company's "shareholders' surplus account."

Sec. 6655(d)(1)(B)(ii) allows a corporation that is not a "large corporation" under Sec. 6655(g)(2) to meet an exception to the penalty for underpayment of estimated income tax if, in a tax year, the corporation pays 25% of the tax shown on the return for the previous year, on the prescribed due dates for estimated income taxes. (A large corporation can base only its first estimated income tax payment on 25% of the prior year tax.) This exception does not apply, however, if there is no tax shown on the previous year's return. If, for example, a life insurance company incurred an operations loss and had no tax liability in the preceding year, its estimated tax payments for the current year may not be based on the previous year's tax liability; it must pay 25% of 90% of current year tax at each installment date, or use either the annualized income exception or the adjusted seasonal installment exception of Sec. 6655(e)(2) or (3), respectively.

Life insurance companies with existing policyholders' surplus accounts, however, have the ability to incur an income tax liability even if they have an operations loss. Under Sec. 815(d)(1) (in effect prior to the Tax Reform Act of 1984 and still applicable by virtue of Sec. 815(f)), a life insurance company may elect to transfer amounts out of its policyholders' surplus account and into a shareholders' surplus account. The amount tranferred will generate taxable income that cannot be offset by an operations loss. By electing to transfer a minor amount of policyholder surplus (say $10), the company will incur a tax liability in the year of election and, thus, will be able to avail itself of Sec. 6655(d)(1)(B)(ii) for the next tax year. It should be noted that the tax triggered by the election can be offset by credits; if the credits fully offset the tax, there is no tax liability in the year of election, and Sec. 6655(d)(1)(B)(ii) would not apply. However, in the absence of credits, this strategy may provide significant cash flow savings.