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Stay up to date with the latest tax updates in the P&C insurance industry. Learn about recent case rulings, deductibility of premiums and expenses, risk distribution requirements, and more.
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DOUG YOUNGRENCPA, JD, Tax Partner Doug is a tax partner in Plante Moran’s insurance practice who oversees all aspects of the firm’s insurance tax practice. He started his accounting career as an auditor; he has a unique hands-on style that incorporates his knowledge and experience as a CPA as well as an attorney. He has written articles on subjects ranging from offshore captive reinsurance to how a P & C company can convert its capital losses into ordinary losses. He has spoken on numerous occasions including at the Federal Bar Associations Insurance Tax Seminar as well as at the Farm Bureau Insurance Accounting conference.
A Brief Agenda • Items Specific to P & C Insurance • SSAP 101: A Refresher • Tax Sharing Agreements • The New Repair Regulations • Foreign Reporting
F.W. Services Inc. v. Commissioner • Fifth circuit finds that premium payments that were held by an insurer as a deposit against future deductibles that were to be refunded to a business at the end of the term of the policy are not deductible as an insurance premium. • The ultimate holding in this case is related to risk shifting since any excess premium would have been refunded and if there had been a need for more, then an additional payment would have been made.
Punitive Damages Treated as Regular Business Expense Deductible When Paid • In State Farm v. Commissioner, the U.S. Court of Appeals for the Seventh Circuit decided to treat a bad-faith damage award which was punitive as not a portion of loss reserves. • The court held that while the portion of the award for compensatory damages should be included in loss reserves, the punitive portion should not. • The court relied heavily on guidance issued by the NAIC. According to that guidance, compensatory damages for bad faith awards are taken into consideration for calculating unpaid loss reserves, not punitive damages.
Foreign Company Qualifies as a Domestic Insurance Company and Reinsurance Premiums Paid to it Are Deductible Business Expenses In PLR 201224018 the IRS ruled that a foreign captive insurance company qualified as a domestic insurance company for income tax purposes, and that reinsurance premiums paid to a reinsurance pool are deductible. • The insurance is offered to 6 related insured corporations and other entities; • To try to achieve risk distribution the Company takes part in a reinsurance pool with 14 other non-related insurers; • The company cedes its risks to the pool and then through another reinsurance agreement assumes a quota share back from the pool; • The IRS determined that none of the companies is paying for a significant portion of their own risk and therefore there is risk distribution.
TAM 201149021 Can You “Insure” Against a Market Decline? • The IRS has ruled that a policy of insurance that insures against a market decline is not insurance. • The logic of the IRS under this TAM was twofold: • The risks under the contract were related to investment risk as opposed to insurance risk. • Secondarily, the IRS concluded that the risk was one of a universal nature (a market decline) as opposed to one in a group of large numbers that might fortuitously happen to one insured rather than to all. Therefore they concluded there was no way to have risk distribution.
Acuity Mutual Insurance Co. v. Commissioner, T.C. Memo 2013-209 Acuity used in-house actuary to compute total loss reserves for 2006 • 900 pages of analysis • 8 separate actuarial methods • $660 million Acuity also used an outside consulting actuary to independently review loss reserves each year • Narrow range of reasonable reserves • $577 million to $661 million • Loss reserves within range, so independent actuary signed a statement of actuarial opinion stating so. Acuity filed Annual Statement showing loss reserves of $660 million
Acuity Mutual Insurance Co. v. Commissioner, T.C. Memo 2013-209 • IRS issued notice of deficiency for 2006 stating Acuity’s loss reserves were overstated by $96 million. • Argued that the annual statement controls only what is includible in the loss reserves, not the amount of reserve itself • Tax court relied on Seventh Circuit case law to the effect that the NAIC-approved annual statement is the starting point for computing unpaid losses • Court disagreed with IRS’s argument, holding that the annual statement should be the source of unpaid losses for federal tax purposes • Acuity produced substantial evidence in support of its position that the loss reserves are fair and reasonable • IRS did not produce persuasive evidence to the contrary
Acuity Mutual Insurance Co. v. Commissioner, T.C. Memo 2013-209 • What does this case mean? • Memorandum decision, precedential value limited • However, it demonstrates what documentation and processes are necessary to prevail when the IRS claims unpaid loss reserves are not fair and reasonable • Makes it more difficult for the IRS to dispute ‘fair and reasonable’ loss reserves just because they exceed the amount that the IRS’s own actuaries would have determined
2013 Tax Rate Changes • Many changes for 2013 • Most at the individual level • Top individual rate: 39.6% (up from 35% in 2012) • Maximum capital gains rate: 20% (up from 15% in 2012) • Medicare contribution tax: .9% on earned income (new for 2013) • Net Investment Income tax: 3.8% on net investment income (new for 2013) • Top rate could be as high as 43.4% • No change to C corporation income tax rates • Graduated scale to maximum 35% corporate rate
2013 Considerations • Compensation structure of key employees • In light of .9% Medicare Contribution tax • Reasonable compensation issues • Depreciation • 50% bonus expires December 31, 2013 • Section 179 expensing • 2013: $2 million qualifying property limit, $500,000 maximum deduction • 2014: $200,000 qualifying property limit, $25,000 maximum deduction
SSAP 101: A Refresher • Admissibility Test, Part 1 • 11.a. • Companies can admit DTAs to the extent that they have paid federal income taxes in prior years that can be recovered during a timeframe corresponding with IRS tax loss carryback provisions, not to exceed 3 years • P & C Federal carryback period for ordinary items is 2 years • Life Federal carryback period for ordinary items is 3 years • Federal carryback period for capital items is 3 years • Year one of the carryback period is the current period
Admissibility Test, Part 2 • Paragraph 11.b. • After the application of paragraph 11.a., companies may admit DTAs expected to be realized within the applicable period, as determined by the Realization Threshold Limitation tables, not to exceed a percentage (as determined by the same Realization Threshold Limitation table) of statutory capital and surplus • RBC levels determine the reversal period as well as the capital and surplus limitation percentage • Non-RBC filers have their own table to determine admissibility • Apply the percentage limitation to current period adjusted capital and surplus, excluding EDP, DTAs, etc.
Admissibility Test, Part 2 • The December 31 RBC ratio is calculated using the end of year ExDTA ACL RBC ratio. • Same calculation as the ratio computed in the annual RBC Report. • TAC (Total Adjusted Capital) does not include any DTAs of the reporting entity.
Admissibility Test, Part 2 • Interim periods (March 31, June 30, September 30) will use the following for the RBC ratio: • Total Adjusted Capital ExDTA for the current quarter as the numerator • Authorized Control Level as filed for the most recent calendar year as the denominator
Tax Loss Contingencies • SSAP 101 replaced “probable” with “more likely than not” (50%) in SSAP 5R in relation to tax loss contingencies • If it is more likely than not that a tax position will not be sustained upon examination, must establish a tax loss contingency • Tax loss contingencies are included in the definition of current income taxes under paragraph 3.a. of SSAP 101 (also includes related penalties and interest)
Tax Loss Contingencies • Assumes an examination with full knowledge of all relevant information • If loss contingency is more than 50% of the benefit, must record contingency at 100% • If the loss contingency relates to a temporary difference, do not record the contingency until an event occurs. Receive a Notice of Proposed Adjustment from the IRS
P & C Example Multiple Year Carryover Gross Deferred Tax Assets
Valuation Allowance Stat and GAAP A valuation allowance is required under GAAP if it is determined that a gross deferred tax asset cannot be realized, in whole or in part. The standard is the more likely than not standard: Based upon all available evidence unless it is more likely than not that a deferred tax asset will be realized a valuation allowance is required. Sources of taxable income that can be used to support a conclusion that a DTA will be realized include: • a. reversals of existing DTLs; • b. carryback capacity under the tax law; • c. projections of future taxable income; • d. income from tax planning strategies.
Valuation Allowance Stat and GAAP I. For statutory purposes the valuation allowance reduces “gross deferred tax assets” resulting in “adjusted gross deferred tax assets” which are then subjected to the admissibility tests; II. In the Q&A to SSAP 101 it is emphasized that the stat valuation allowance is determined on a separate company basis; III. For internal control purposes it is important to note that the four sources of taxable income used to support a conclusion that no valuation allowance is required must be properly documented.
Tax Sharing Agreements • Three Basic Reasons for the agreements: I. Earnings and profits II. Stock Basis III. To determine how to split the actual liability in $$$ - the only limitation here is really the extent of the tax advisor’s imagination
Tax Sharing Agreements • Earnings and profits: • Basic Method 1 - Contribution to consolidated taxable income; a. This method is the default method if the company doesn’t elect; b. This is really the companies share of taxable income; c. no members separate taxable income is treated as being less than zero under this method; d. no credit given for credits or losses or other tax attributes.
Tax Sharing Agreements • Earnings and profits: • Basic Method 2 – Separate return tax liability; a. Ratio of all members separate return tax liabilities; b. Intercompany transactions must be taken into account; c. No dividends received deduction for dividends between the members of the consolidated group; d. No members separate tax return liability is treated as being less than zero. .
Tax Sharing Agreements • Earnings and profits: • 3. Basic Method 3 – Allocation of tax increases from consolidation; • First you allocate the tax liability to each member under basic method 1; • Any tax increases of a member arising from the consolidation are then apportioned to each other member that has a reduction in tax liability. This is determined by comparing the tax liability calculated under Basic Method 1 with what would have been allocated under basic method 2. • 4. Other Basic Methods with the approval of the secretary.
Tax Sharing Agreements • Earnings and profits: • 5. Tax attribute absorption methods; • Wait and see method causes a member who uses the tax attribute of another member to only pay for that usage when the member who originated the tax attribute loses the use of it when it could actually reduce its own liability; • The “percentage method” permits the group to allocate to loss and credit members the consolidated tax benefits attributable to the use of their losses and credits without taking into account (as you would in the wait and see method) the ability of a member to absorb these attributes itself. It is also known as the immediate payment method; • Any other method approved by the secretary.
Tax Sharing Agreements • Stock Basis: • For purposes of calculating stock basis there is only one method. The federal income taxes of the group are allocated among the members by applying 1552 and the percentage method of Treas. Reg. Section 1.1502-33(d)(3) using 100% as the percentage; • There are no other options…
Tax Sharing Agreements • Sharing the liability for state law or payment purposes between the member: • While there may be advantages to having the same methods for E & P, Stock basis and for sharing actually $$ between the entities it is not required. • No reasonable method of sharing the actual dollars paid and shared of taxes as between the entities is off limits.
Repairs and Maintenance • Final regulations issued September, 2013 • Simplify and refine some of the temporary regulations and create new safe harbors • Move away from facts and circumstances and subjective nature of current standards • Taxpayer friendly • Effective for years beginning on or after January 1, 2014 • Option to apply to 2012 or 2013
Basics • Code Section 263 • Capitalization of amounts paid to acquire, produce, or improve tangible property • Code Section 162 • Deduction of all ordinary and necessary business expenses, including certain supplies, repairs, maintenance • New Regulations • General framework for distinguishing capital expenditures vs deductible supply, repair, maintenance costs
Five Main Areas • Materials and Supplies (1.162-3) • Repairs and Maintenance (1.162-4) • Capital Expenditures (1.263(a)-1) • Amounts paid for the acquisition or production of tangible property (1.263(a)-2) • Amounts paid for the improvement of tangible property (1.263(a)-3)
Five Main Changes • Revised/simplified de minimis safe harbor for capitalization of amounts paid to acquire or produce property • Extension of the safe harbor for routine maintenance to buildings • Annual election for buildings that cost $1M or less to deduct up to $10,000 of maintenance costs • New annual election to capitalize repair costs that are capitalized on taxpayers books and records • Refinement of the criteria for refining betterments and restorations
De Minimis Capitalization • Temporary Regs: • Safe harbor to deduct certain tangible property up to aggregate ceiling • This approach is allowed for 2012 and 2013 • Final Regs: • Safe harbor at the invoice or item level • $5,000 per invoice or item, if applicable financial statement • $500 per invoice or item, if no applicable financial statement
De Minimis Capitalization • Applicable Financial Statement • Certified Audited Financial Statement • Not a review or compilation • Financial Statements required to be submitted to a federal or state agency • Includes insurance company Annual Statements • In general, entities included in consolidated audited financial statements are eligible for the larger de minimis option
De Minimis Capitalization • Accounting Policy • To take advantage of the $5,000 de minimis rule, taxpayers must have written book policies in place at the start of the tax year that specify a per-item dollar amount (up to $5,000) that will be expensed for financial accounting purposes. • The policy can set different thresholds for each asset class. • Previous Years • The IRS has declined to grant transitional relief for taxpayers who would otherwise have been able to apply the de minimis rule under the temporary regulations to their 2012 /2013 tax year.
De Minimis Capitalization • Example: Taxpayer N purchases 50 computers for $400 each. • N has applicable financial statements and an accounting policy to expense amounts paid for units of property costing less than $500 • Computers are expensed for financial accounting purposes
Routine Maintenance • Cost of certain routine maintenance need not be capitalized • Recurring activities • More than once during the life of the property • Expect to perform to keep property in ordinarily efficient operation condition • Final regulations now include buildings and structural components • More than once over 10 year period • No need to consider treatment of costs on financial statements
Safe Harbor for Small Buildings • Allows taxpayers to deduct amounts paid for repairs, maintenance, and improvements • Gross receipts must be less than $10 million • Unadjusted basis must be less than $1 million • Deduction can’t exceed the lesser of: • $10,000 or • 2% of the unadjusted basis • De minimis rule and routine maintenance count towards the $10,000
Election to Capitalize Repair and Maintenance Costs • Annual election to opt out of expensing repair and maintenance costs • Must be capitalized on books and records as well • Depreciate expenses
Improvements • Generally: if a unit of property has been improved, the improvement must be capitalized. • The UOP is determined to be improved if after it is placed in service, the activity performed on the property exceeds the BAR standard. • Betterment • Adaptation • Restoration
Unit of Property • Group of functionally interdependent components • Parts of a machine, the machine is the unit of property • Buildings are units of property • Major systems are separate units of property • HVAC • Plumbing • Electrical
